7 Procedures for Capital Budgeting | Financial Analysis (2024)

The following points highlight the seven procedures for capital budgeting.

Capital Budgeting Procedure # 1. Identification of Investment Proposals:

The capital budgeting process begins with the identification of investment proposals. The proposal or the idea about potential investment opportunities may originate from the top management or may come from the rank and file worker of any department or from any officer of the organisation.

The departmental head analyses the various proposals in the light of the corporate strategies and submits the suitable proposals to the Capital Expenditure Planning Committee in case of large organisations or to the officers concerned with the process of long-term investment decisions.

Capital Budgeting Procedure # 2. Screening the Proposals:

The Expenditure Planning Committee screens the various proposals received from different departments. The committee views these proposals from various angles to ensure that these are in accordance with the corporate strategies or selection criterion of the firm and also do not lead to departmental imbalances.

Capital Budgeting Procedure # 3. Evaluation of Various Proposals:

The next step in the capital budgeting process is to evaluate the profitability of various proposals. There are many methods which may be used for this purpose such as payback period method, rate of return method, net present value method, internal rate of return method etc. All these methods of evaluating profitability of capital investment proposals have been discussed in detail separately in the following pages of this chapter.

It should, however, be noted that the various proposals to the evaluated may be classified as:

(i) Independent proposals

(ii) Contingent or dependent proposals and

(iii) Mutually exclusive proposals.

Independent proposals are those which do not compete with one another and the same may be either accepted or rejected on the basis of a minimum return on investment required.

The contingent proposals are those whose acceptance depends upon the acceptance of one or more other proposals, e.g., further investment in building or machineries may have to be undertaken as a result of expansion programme. Mutually exclusive proposals are those which compete with each other and one of those may have to be selected at the cost of the other.

Capital Budgeting Procedure # 4. Fixing Priorities:

After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight away. But it may not be possible for the firm to invest immediately in all the acceptable proposals due to limitation of funds. Hence, it is very essential to rank the various proposals and to establish priorities after considering urgency, risk and profitability involved therein.

Capital Budgeting Procedure # 5. Final Approval and Preparation of Capital Expenditure Budget:

Proposals meeting the evaluation and other criteria are finally approved to be included in the Capital Expenditure Budget. However, proposals involving smaller investment may be decided at the lower levels for expeditious action. The capital expenditure budget lays down the amount of estimated expenditure to be incurred on fixed assets during the budget period.

Capital Budgeting Procedure # 6. Implementing Proposal:

Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the budget does not itself authorize to go ahead with the implementation of the project. A request for authority to spend the amount should further be made to the Capital Expenditure Committee which may like to review the profitability of the project in the changed circ*mstances.

Further, while implementing the project, it is better to assign responsibilities for completing the project within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs. Network techniques used in the project management such as PERT and CPM can also be applied to control and monitor the implementation of the projects.

Capital Budgeting Procedure # 7. Performance Review:

The last stage in the process of capital budgeting is the evaluation of the performance of the project. The evaluation is made through post completion audit by way of comparison of actual expenditure on the project with the budgeted one, and also by comparing the actual return from the investment with the anticipated return.

The unfavourable variances, if any should be looked into and the causes of the same be identified so that corrective action may be taken in future.