Introduction
In a typical investment setup companies are often faced with a number of investment options. In these situations, the companies usually have limited capital to invest in all the investments. The natural approach often is to invest in any project that promises a positive return at the end of the day. However, in cases where these investment projects are diverse and numerous, the company ought to settle for the best investment that would address their short and long term interests. Capital budgeting refers to the promise through which the companies select the investment option and undertake the implementation of the projects. The process has a number of steps which shall be the subject of this paper. In overall capital budgeting is both a managerial and an accounting function which needs to be pursued inclusively so as to address the diverse functional organizational objectives. For purposes of this paper, capital budgeting process will be divided into four broad stages or steps. These are identification of projects or opportunities, evaluation and computation, selection and finally implementation of selected projects.
Identification of projects
In this step, the management and the organization set to explore available investment opportunities. As long as the investment is legal and within the scope and mandate of the firm, the opportunity needs to be considered. All the necessary information in terms of costs and returns, equipment, legal procedures and regulatory requirements are gathered. The process enables the organization to examine different options available to their disposal.
Evaluation, Computation and Analysis
Once all the opportunities are identified and relevant data and information gathered, the technical aspect is commenced under the evaluation. In this stage the likely returns against the needed costs are considered. In this stage, depending on the policy of the organization, a number of accounting techniques are used in the computation and analysis. Some of the techniques often recommended and preferred include the payback period, the Net Present Value, the Economic Value Added, and the Internal Rate of Return. This is the most essential stage of the project. It is instructive to appreciate that businesses often suffice for the pursuit of profits. In addition, it is at this stage that the overall capital available for investment is essential. For analytical purposes, the technical expertise at this stage identifies projects that would fall within the margin of capital available for investment.
Nonetheless, the management at large has to be cautious of time and mutuality. The amount of time available for the organization to implement a project is compared against the expected time of the projects available. In some cases, it could be the case that the organization is enjoying a tax holiday for say five years. The projects identified can, therefore, be of no concerned to taxation for at least five years. In other cases, it may be the position that the company would need to pay back a loan after say three years. In that breadth, the project must start reaping positive cash flows within three years so as to cover the aspects of the loan payments. It is consequently essential to consider time at this stage. In addition, it is at this stage that mutuality is examined and entertained. Mutuality of projects refers to the possibility or impossibility of undertaking two or more projects simultaneously. Mutually exclusive projects cannot be undertaken simultaneously and the organization has to settle for one to the exclusion of the other. On the other hand, mutually inclusive projects can be pursued simultaneously. It is, therefore, significant for the organization to factor in such cases in the analysis and consequential computations. This stage equally simulates the possible scenarios and postulates likely results. The products of this stage are essential for the next stage which is the decision making stage.
Selection
Selection is considered the most significant step. This is because it sets the final impact of the organization. This is stage is the decision making stage of the capital budgeting. In this step, all the results gathered from the analysis and computation is digested at the managerial level. The possible scenarios are examined with possible risks, omissions, eras and technicalities considered. At this stage, a set of projects are selected for the capital available. The rejected projects are discarded. The selected projects are then built upon and possible amends and changes to the projects made. For example, it is at this stage that the management may opt for additional funding through loans. Once a set of projects have been selected, the next stage now departs from theory to practise.
Implementation
This is the last step of capital budgeting and the most practical. In this stage, the capital is allocated as agreed and decided at the managerial level. Implementation has an inclusive element in that the entire organization is involved and practically impacted. In the implementation process feedback is gathered and analysed with changes and amends made as and when the need arises.
References
Banks, E. (2010). Finance: The Basics. New York: Routledge.
Dlabay, L. R., & Burrow, J. L. (2007). Business Finance. New York: Cengage Learning.
Mortal, S., & Reisel, N. (2013). Capital Allocation by Private and Public Firms. Journal of Financial and Quantitative Analysis, 3(2), 23-35.
