Capital budgeting is a multi-step process that is used to determine if a particular business project or plan is worth the investing. It is a long-term planning for financing of a proposed project such as purchase of a new machinery or equipment, investing in new products or projects, etc. Capital budgeting projects are categorized as follows:
1) Considering Potential Project Opportunities
The first step of capital budgeting includes considering various project opportunities available. There can be either one or multiple project opportunities. You will have to identify which project would work the best for your business.
2) Estimating the Investment Costs
Once you have shortlisted some projects, the next step is to estimate the investment cost required to implement them. This stage will require you to conduct some intensive research. If you plan to choose multiple business projects, you can prioritize them based on the investment required. You need to consider the actual investment required and also the cost of financing the investment in the form of interest rates to determine the actual investment cost.
3) Estimating Cash Flow and the Payback Period
Now, it is time to see the bigger picture and consider the profits or benefits the project will provide for your organization in the future. This stage deals with estimating the total cash flow that you will receive once you purchase the machinery or the project is complete. The cash flow that a company receives can last for quite a few years. It is important that the cash flow amount exceeds the actual investment cost and generates a substantial amount of profit for the organization.
Apart from looking at the amount of revenue generated from the project or the purchase of machinery, it is important to know after how many years, you will recover your initial investment. Some projects may generate profits for many years but the time required to cover the initial investment may take too many years. On the other hand, some projects may recover the investment in a shorter period but may not yield sufficient revenue. It depends on the management to decide which project is most suitable to invest based on the profits generated and the amount of time taken to recover the initial investments.
4) Assessing the Risk
This step involves estimating the risk associated with the project that can affect the desired motive and the profitability. Some projects may end before they are completed or further costs may arise all of a sudden. Therefore, it is important for businesses to assess the risks associated with the projects and decide whether it is worth moving forward or not.
5) Implementing the Project
In this stage, you proceed with the particular or multiple business projects. A project plan is created and the project begins. The plan includes means of paying for the project, method of tracking the cost of investment, the timeline of the project, and a process for recording cash flows.
Capital budgeting is a process of selecting the best long term investment decisions. If you need any assistance in capital budgeting for your business plans and investment or don’t know how to get started with capital budgeting, you can contact the small business accountants Edmonton to help you out.