Lesson 3 of 9
A company, from time to time, will have to make investments in a variety of capital projects. Whether it is the need to purchase new machinery, expanding the production facility, or even buying new transport, all these projects require firms to make high investment now. In all these projects, the cash flow or the benefit is expected to be received for several years.
A company at any time may have many capital projects in foresight. It is the responsibility of the finance manager to evaluate these projects through the capital budgeting process which involves evaluating each project for its profitability, eliminating the ones that are not profitable, and prioritizing the profitable ones based on the company’s available resources and requirements. The finance manager needs to follow a consistent process and exercise caution while making capital budgeting decisions, as they involves huge cost, and can significantly impact the shareholder value.
The capital budgeting process involves four steps:
Step 1: Capital Project Ideas
The first step is to get or generate project ideas. These ideas can be put forth by the management, employees, or even outsiders.
Step 2: Evaluate Each Project proposal for Profitability
The finance manager needs to accept or reject each capital project proposal based on its profitability. To do so, a cash flow forecast will be created and the project will be evaluated using NPV/IRR.
Step 3: Prioritize Profitable Projects Based on the Firm-wide Project
Once the profitable projects have been identified, the finance manager needs to prioritize these projects based on the firm-wide capital budget, requirements and strategy. Sometime a project may be profitable but can wait for some time compared to another project which is critical for the firm’s strategy. For example, while choosing between buying new machinery vs. replacing an existing technology with a new one, the finance manager needs to evaluate the pros and cons of both, timings of future cash flows, etc., before prioritizing them.
Step 4: Feedback and Evaluation
Once the capital budgeting decisions have been made, they need to be constantly monitored and evaluated for their performance. The finance department needs to check whether the actual cash flow matches the forecasted cash flow or not, and if not, they need to identify the reasons for the mismatch. They also need to look for any systematic errors committed in the forecasting process and provide feedback so that the forecasting processes can be improved.
Capital budgeting projects can fall under the following categories: