Steps in Capital Budgeting

A proper investment analysis must proceed through the following consecutive steps:

1. Project Identification
2. Project Formulation
3. Project Appraisal and selection
4. Project Implementation and Monitoring
5. Project Evaluation or Post-completion audit.

Projects are identified through a search of investment opportunities. The prospective investor could carry on this step either through collecting this information from development organizations who are engaged in developing full projects, through borrowing ideas from well to do investors in the country and abroad, or/and through inventing new project ideas. In the context, is should be noted that there is no dearth of projects, particularly in relation to the quantum of investment one desires to undertake. Further, it costs both time and money to analyze an investment. Thus one must try to generate a limited number of project ideas. However, one has to be careful in limiting such ideas, for if a good project is not included in the list of projects identified for scrutiny that project can never be selected. In view of this step is quite crucial and so it is often entrusted to the professionals.

Once a list of projects is ready each project in it must have a blue print providing detail of the requirements of various assets such as land, buildings, plant and machinery, raw materials, labor, etc. and their price tags together with the expected capacity utilization over time and the products’ process among other things. After the alternative investment opportunities are well formulated each must be examined in terms of the feasibility of their implementation. Here one would examine the technical feasibility in terms of the availability of land, plant and machinery, raw materials, technical know-how etc financial feasibility in terms of the availability of finance in required times; economic feasibility, in terms of the employment generation and development of backward areas and communities; and the management feasibility, in terms of the availability of the managerial personnel for the smooth implementation and running of the project. At this stage some of the projects identified in the first stage may be dropped if they do not meet the test of feasibility.

The feasible projects are then appraised in terms of their economic viability. This step is carried out through first projecting cash flows from each project and the comparing them through the use of measures of investment worth discussed the pervious section. The projects which lead the list of the viable projects and which are within the capital constraint of the investor if any are then selected.

The selected project(s) is (are) then implemented in terms of arranging of finance, purchasing of land, plant and machinery, etc., construction of buildings, hiring of labor and other staff etc. While implementing the project and after it is commissioned for commercial production, the investor must monitor the project on a regular basis. Under this activity, the investor would see to it that the project is commissioned as soon as possible, particularly within the stipulated time unless unwarranted by unforeseen and unavoidable circumstances. During the running period of the project there is ample need for close monitoring. This is with regard to the quality and quantity of production, development of the market for the product, repayments of loans, payments of reasonable dividends, maintenance of good industrial relations and customers’ goodwill, etc.

The last step in capital budgeting called project evaluation is concerned with the post-completion audit of the project. In this step the investor examines the validity of his decision. This he does by re-computing the measures of investment worth, this time on the basis of actual cash flows rather than expected cash flows of the project appraisal stage. He then examines the actual worth of his chosen project vis-à-vis it’s expected worth and to the extent possible in relation to the projects he had rejected. This he does not because he can undo the project but simply to know what errors, if any, he committed in that investment decision. The fact finding exercise helps him to learn so that he does not commit such blunders in future.

It would now be obvious that a proper investment analysis requires the knowledge of various disciplines; technical (engineering), economics, finance, business forecasting, etc. The text is basically an economies one and thus we could deal with that part of analysis which can be handled through the tools of economies only. Since there is a good overlap in economics and finance, the use of finance concepts and techniques have to be used as well.