The steps involved in the capital budgeting process are:
(i) Project Generation
(ii) Project Evaluation
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(iii) Project Selection
(iv) Project Execution.
(i) Project Generation:
Investment proposals of various types may originate at different levels within a firm. The investment proposals may fall into one of the following categories:
1. (a) Proposals to add new product to the product line.
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(b) Proposals to expand capacity in existing product lines.
2. Proposals designed to reduce costs in the output of existing products without altering the scale of operation.
The investment proposals of any type can originate at any level from top management level to the worker’s level. The proposal may originate systematically or haphazardly. In view of the fact that enough investment proposals should be generated to employ the firm’s funds fully well and efficiently, a systematic procedure for generating proposals must be evolved. The healthy firm one in which there is a continuous flow of profitable investment proposals.
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(ii) Project Evaluation:
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Project evaluation involves two steps:
(a) Estimation of benefits and costs. The benefits and costs must be measured in terms of cash flows, and
(b) Selection of an appropriate criterion to judge the desirability of the projects.
The evaluation of products should be performed by a group of experts. All care must be taken in selecting a criterion to judge the desirability of the projects. The various desirability criteria include the (1) traditional methods (a) pay back method and (b) accounting rate of return method; (2) discount cash flow criteria (r) net present value method (b) internal rate of return method and (c) probability index method. As far as possible the criterion selected must be consistent with the firm’s objective of maximising its market value.
(iii) Project Selection:
No standard administrative procedures can be laid down for approving the investment proposal. The screening and selection procedures would differ from firm to firm. However, projects are screened at multiple levels.
(iv) Project Execution:
The funds are appropriated for capital expenditure after the final selection of investment proposal. The formal plan for the appropriation of funds is called the capital budget.
Systematic procedures should be developed to review the performance of projects during their life and after completion. The follow up comparison of actual performance with original estimates not only ensures better forecasting but also helps to sharpen the techniques for improving future forecasts.