Capital Budgeting Process | CFA Level 1 - AnalystPrep (2024)

Capital budgeting describes the process which companies use to make decisions on capital projects, i.e., projects whose lifespans can either be one year or more than one year. It is a cost-benefit exercise that seeks to produce results and benefits which are greater than the costs of the capital budgeting efforts.

There are several steps involved in the capital budgeting process. The choice of the procedures adopted by a manager is, however, dependent on factors such as the manager’s position in the company, the size, and complexity of the particular project being evaluated, and the size of the company.

Capital Budgeting Process

Below are the steps involved in the capital budgeting process.

Step 1: Generation of ideas – Generation of good ideas is the most important step.

Step 2: Analysis of individual proposals – This entails gathering of information which helps to forecast cash flows for each project. Equally critical is the analysis of the profitability of the project.

Step 3: Planning the capital budget – This step involves consideration of project execution timelines, scheduling, prioritization, and coordination.

Step 4: Monitoring and post-auditing – How the project is performing is assessed and actual results (revenues, expenses, cash flows, etc.) are compared with planned or projected results.

Categories of Capital Projects

Capital budgeting projects may be classified in several ways. The following are some of the common classifications:

• replacement projects: sometimes capital budgeting decision involves replacement of broken down, worn out or old equipment with new, and more efficient ones;
• expansion projects: these increase the size of the business activities of a company and ultimately, the size of the company;
• new products and services: capital budgeting projects which aim to increase the products of a company and service offerings carry more uncertainty than expansion projects;
• regulatory, safety, and environmental projects: these are usually undertaken due to a requirement by a governmental agency, insurance company, or some other external party. Oftentimes they do not generate any revenue for the company. Indeed, in the end, it is normally prudent to shut down that part of the business that is related to the project;
• other: these projects tend not to be subject to the usual capital budgeting analysis, and include, for example, pet projects of the CEO of the company.

Question

Which of the following is least likely a classification for a capital project?

A. Expansion project.

B. Modernization project.

C. New products and services project.

Solution

The correct answer is B.

A modernization project is not a classification used to describe capital projects. However, expansion projects and new products and services projects are classifications that are used.

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