What is Capital Budgeting?
Capital budgeting is the process of evaluating and selecting long-term investments consistent with the company’s objective to maximize the wealth of the owners. It is the design analysis process and decision-making in its various phases, the capital budgeting reflects the overview of a company and its steps to achieve the goals.
Reasons to prepare a Capital Budget
1. Expansion: expand the level of operations through acquisition of fixed assets; additional infrastructure such as real estate and facilities.
2. Replacement: replace or renew obsolete or depreciated assets; update of software, preventive maintenance with consumable parts.
3. Modernization: reconstruction, reconditioning or adaptation of new machine existing installations; electrical installations, air conditioning, reconstruction.
4. Other purposes: advertising, research and development, consulting services and new products.
Steps involved in Capital Budgeting Process
There are various steps involved in capital budgeting process. A few steps are presented here.
1. Generation of investment proposals: Proposals for investments are made by people at all levels of the organization.
2. Evaluation and analysis of cash flows: The proposed costs and benefits are estimated and then converted into a number of relevant cash flows, to which several capital budgeting techniques are applied to measure the return on investment.
3. Decision making: The values of the projects determine at which level of the organization, the decision making process will be carried out. This decision will be based on the overall strategies of the organization or the cost / benefit.
4. Implementation of the project: Once the proposal has been approved and the necessary resources are available, it goes to the implementation phase.
5. Monitoring or audit of the project: Involves monitoring of results during the project’s operational phase comparing the actual results, in terms of costs and benefits, with the estimated values to provide a better project management.
Lifespan of Capital budgeting:
In the accounting sense, lifespan is the estimated time of the asset or rights, in terms of its physical capacity or circumstantial use or economic exploitation.
For its changing nature and limitations of life, property and rights that are part of the project or the company must be depreciated, amortized or depleted to the extent of use or time, becoming expenses or production costs.
In Capital budgeting, it is assumed that the life of the asset or right will be exhausted at the end of the project; otherwise, there should be a residual value that will be part of the project’s cash flow.