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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 develo ping 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 inclu ded 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 prov iding 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 utilizati on over time and

the products process among other things. After th e 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.

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The selected project(s) is (are) then implemented in terms of arranging of finance,

purchasing of land, plant and machinery, etc., co nstruction 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, particularlywithin 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 indus trial 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- -vis its 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 econom ies only. Since there is a good overlap in economics

and finance, the use of finance concepts and techniques have to be used as well.