# Basics Steps in Capital Budgeting

Conceptually, the capital budgeting process involves six logical steps. Â First, the cost of the project must be determined. Â This is similar to finding the price that must be paid for a stock or bond. Â Next, management must estimate the expected cash flows from the project, including the value of the asset at a specified terminal date. Â This is similar to estimating the future dividend or interest payment stream on a stock orÂ bond.Â Â Third, the riskiness of projected cash flows must be estimated.Â Â To do this, management needs information about the probability distributions of the cash flows. Fourth, Â given Â the Â riskiness Â of projected Â cashÂ flows Â andÂ the cost Â of funds Â under prevailing economic conditions as reflected by the riskless rate, *R**F*, the firm must determine the appropriate discount rate, or cost of capital, at which the project=s cash flows are to be discounted.Â Â This is equivalent to finding the required rate of return on a stock or a bond investment. Â Fifth, expected cash flows are converted to a present value basis to obtain a clear estimate of the investment project=s value to the firm. Â This is equivalent to finding the present value of expected future dividends or interest Â plusÂ principal Â payment.Â Â Â Finally, Â the present Â value of the expected Â cash inflows is compared with the required outlay, or cost, of the project. Â If the present value of cash flows derived from a project exceed the cost of the investment, the project should be accepted. Â Otherwise, the project should be rejected.