The capital budgeting process is the process of identifying and evaluating capital projects, that is, projects where the cash flow to the firm will be received over a period longer than a year. Any corporate decisions with an impact on future earnings can be examined using this framework. Decisions about whether to buy a new machine, expand business in another geographic area, move the corporate headquarters to Cleveland, or replace a delivery truck, to name a few, can be examined using a capital
budgeting analysis.
For a number of good reasons, capital budgeting may be the most important responsibility that a financial manager has. First, since a capital budgeting decision often involves the purchase of costly long-term assets with lives of many years, the decisions made may determine the future success of the firm. Second, the principles underlying the capital budgeting process also apply to other corporate decisions, such
as working capital management and making strategic mergers and acquisitions. Finally, making good capital budgeting decisions is consistent with management's primary goal of maximizing shareholder value.
The capital budgeting process has four administrative steps: * Step 1: Idea generation. The most important step in the capital budgeting process is generating good project ideas. Ideas can come from a number of sources including senior management, functional divisions, employees, or outside the company. * Step 2: Analyzing project proposals. Since the decision to accept or reject a capital project is based on the project's expected future cash flows, a cash flow forecast must be made for each project to determine its expected profitability. * Step 3: Create the firm-wide capital budget. Firms must prioritize profitable projects
according to the timing of the project's cash flows, available company resources, and the company's