Capital budgeting decision is an important criterion, which affects the profitability of a company. A capital budgeting decision is defined as the investing of a firmâ€™s current funds efficiently in long-term assets in anticipating of an expected flow of benefits over a period of time. So, capital budgeting involvesâ€”
* Exchange of current funds for long-term assets.
* Benefits from long-term assets spread over a period of time.
The capital budgeting decision involves commitment of large amount of funds in the long term assets. These decisions are irreversible and the commitment of funds to long-term assets changes the risk complexion of the firm.
Capital budgeting process involves
* Identification of potential investment opportunities
* Preliminary screening.
* Feasibility study.
* Performance review.
Identification of Potential Investment Opportunities:
Identification of appropriate investment opportunities is a complicated exercise primarily because of the innumerable opportunities available to a promoter. To identify such investment opportunities that are prima facie feasible and promising, the promoter has to
* Scan the various investing opportunities that can throw-up promising investment opportunities.
* Understand the governmental regulatory framework and policies that have a bearing on the different investments.
* Appraise the potential investment in relation to his organizationâ€™s strengths and weakness.
* The list of the promising investment opportunities identified from various sources is first subjected to an analysis within the governmental regulatory framework to obtain a set of feasible investment opportunities that merit further considerations. Since it will be a tedious task to undertake a detailed appraisal of each of these opportunities the list has to be further narrowed down by evaluating the investments against certain specific criteria and selecting only those investments that are prima facie desirable. The criteria that are typically applied for the preliminary evaluation are
* Compatibility with the promoterâ€™s strengths.
* Compatibility with governmental priorities
* Availability of raw materials and utilities
* Size of the potential markets.
* Reasonableness of cost.
* Risk inherent in the project.
Feasibility study :
Once a project opportunity is conceived and it is considered acceptable after preliminary screening, a detailed feasibility study has to be undertaken covering all marketing, technical financial, and economic aspects of the project.
Marketing: Estimating market size and demand
Technical: Product and manufacturing process:
Finance: Risk and return.
Economic: Evaluating from the view point of society
The study in the form of detailed project report (DPR) will contain fairly specific estimates of project costs, means of financial schedules of implementation, estimates of profitability based on projected sales and production costs, estimates of cost and benefit streams in terms of cash flows, debt servicing capability of the project and social profitability. The ultimate decision whether to go in for the project or not and how to finance it is undertaken after this study which discloses whether the project is technically feasible, economically viable and financially sound.
The implementation of a project that is translating the investment proposal into a concrete project is a highly complicated, time consuming, tension fraught and risky affair. The various stages of implementation are:
* Preparation of blue prints and designs for project and plant engineering, selection of machines and equipment.
* Negotiating for project finance with various financial institutions, entering into technical know how agreements and if necessary, entering into contracts for construction of buildings, supply of machinery, marketing of the companyâ€™s products etc.
* Actual construction of buildings and other civil works, erection and installation of machinery and equipment.
* Training of engineers, technicians, workers
* Commissioning of plant and trial run.
* Commercial production.
Once the project has been implemented, the trial run is successful, and commercial production started, a review of the actual performance with the performance projected in the feasibility study is required. This is an integral and vital part of project management because, it throws light on how realistic were the assumptions underlying the project and it is a valuable tool for decision-making in future.