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Capital budgeting is a process where companies evaluate major projects that may be worthy, long-term investments. Steps in capital budgeting follow a particular process in order for a company to ensure each possible project receives due attention. The most common steps in capital budgeting include the identification and evaluation of opportunities, review of cash flows from each project, and the selection of a capital mix to pay for selected projects. A business often pursues any project that enhances revenue, profit, and shareholder value. Therefore, capital budgeting is a reduction process that lets a business select only the projects that increase the company’s wealth.
Identifying and evaluating opportunities is the starting point for all steps in capital budgeting processes. Here, owners, executives, and managers find new opportunities in which a company may increase shareholder wealth. Once a group of new opportunities is identified, each one must be evaluated. This process determines if each project is realistic, doable, has long-term viability, and will be a reliable source of income for some time. The final projects selected in this step then move forward through the capital budgeting process; all others are shelved for the time being.
The next steps in capital budgeting processes are to review cash flows from each project in the final selection group. Accountants or financial analysts look at current economic conditions and make cash flow estimates for each project over a stated time period. These individuals may then create an upper limit and lower limit for expectations, with the assumption that economic conditions may improve or deteriorate over time. In some cases, the number of years for planned cash flows may be three, five, or seven, which are common measurements in which a company prefers to receive repayment for money spent on a project. All cash flows must be in annual time periods.
The final steps in capital budgeting include finding a capital mix that allows the company to pay for a project with other people’s money. The different attributes of a capital mix include various loans, bonds, and equity financing that pays for all start-up costs associated with a project. The cost of capital for this mix is the average of all interest rates for the different methods used to pay for the project. Accountants and financial analysts then compare cash flows against the start-up costs. The project whose net present value of future cash flows is greater than start-up costs is typically the best one.