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Capital budgeting process and categories of projects

Capital budgeting is the process through which companies decide about their long-term (>1 year) investments. Understanding of capital budgeting is important because (a) they can decide the future of companies due to their size and (effectively) irreversible nature, (b) principles of capital budgeting is also used for many other corporate decisions, such as leasing, (c) valuation principles in capital budgeting are also used in security analysis and portfolio management, and many innovations in security analysis are also adapted for capital budgeting, and (d) analysis can use any information deduced about capital budgeting techniques used by a company to see whether it has accounting focus or economic focus.

Capital budgeting process

While the actual capital budgeting process depends on the level of decision making, size of project and company, following are the steps involved in a typical capital budgeting process:

  • Generating ideas: ideas may come from any level, from top or bottom, or even outside;
  • Analyzing individual proposals: gathering information to determine profitability;
  • Planning the capital budget: gathering all profitable investment opportunities in an overall plan while considering the timing of the project and corporate strategy;
  • Monitoring and post-auditing: comparing actual results with initial forecasts to (a) determine the soundness of initial forecasts, and (b) improve operational/financial efficiency, and (c) generate ideas for future investments.

Planning for capital investments may require input from a number of people/departments and the authority needed to undertake investments depends on the complexity and size of the project.

Classification of capital budgeting projects

Capital budgeting projects are often classified into:

  • Replacement decision: Often quite easy if some equipment is to be replaced with a piece of similar equipment but might require a detailed analysis if the existing equipment is to be replaced with improved equipment. In any case, the level of confidence in any conclusion reached is high.
  • Expansion projects: Relatively more uncertain than replacement decisions because they increase the size of business.
  • New products and services: Evermore uncertain and complex than expansion projects.
  • Regulatory, safety and environmental projects: Required by regulation, may generate zero revenue; a company might incur the expenditure unless they are too high in which case a company might find it better to just exit the line of business instead of incurring the expenditure.
  • Others: Many projects can be subjected to NPV analysis.

by Obaidullah Jan, ACA, CFA on Wed Feb 26 2020

This article can help you prepare for Reading 32 LOSa.

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