Capital Expenditure Budget: Definition, and Purpose

Definition

Every company wants to expand their operations and be more competitive. This requires certain outlay of capital expenditure with careful planning. The planning for capital expenditure requires meticulous thinking and is prepared in capital expenditure budget.

The budget acts as great tool on how to spend the money as capital expenditures and how to spend it more efficiently. The capital expenditure plays focal role for companies that is trying to overhaul its capital assets or make major changes to its operations.

Capital expenditures include the purchase of new equipment, machinery, land, plant, furniture, and fixtures, vehicles, software, or intangible assets such as a patent or license.

The capital expenditures identify amount of cash that company invests in project and long term assets. The process for approving funds for specific capital expenditure items differ by company rules and regulations. The process however is the same.

This includes financial evaluation of whether the required return on investment targets would be met and once targets are met, the review would be made for quality purpose by the top management.

Various significant decisions such as whether to hire purchase, lease, or construct the capital assets by the company shall be made in tandem within the financial requirements of the company.

Types of capital expenditure

Basically there are two types of capital expenses as CAPEX required for maintenance of current levels of operations and production within the company and another one is expenditure to be undertaken for the future growth of the company. The capital expenditure can be both tangible or intangible in nature.

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Tangible capital expenditure contains assets such as machines, vehicles, or plants whereas intangible expenditure is related to development or purchase of patent or trademark.

Purpose of the capital expenditure budget

The capital expenditure budget is prepared to basically track the expenditure made on capital assets and adjust for the items on an ongoing basis. The purpose of the budget can be explained in the following points:

1) Tracking huge investments

The capital expenditure is of huge outlay of money. Therefore, constant monitoring of the movement of funds is required. Any small wrong decision can escalate the problems and sustainability of capital expenditure. Hence, it needs close monitoring by the senior level management of the company.

2) Expenditure control

Capital budgeting requires special attention for the outlay. Research and development for the expenditure may even be required. The good project can turn bad if expenses are done in an uncontrolled fashion and not accounted for at all.

3) Helps in Investment Decision

The decisions of capital expenditure require time and plenty of critical thinking goes in order to make correct investment decisions. The risk in capital expenditure is very high.

Hence, management shall be flexible in order to make the right investment decision for the long term benefit of the company.

4) Long Term Effect on Profitability

The long-term vision is necessary for making capital expenditure decisions. This is required for the survival of the company and it does impact capital budgeting in the long run.

If the capital budgeting expenditure occurs after preparing the budget reasonably, the chances of enhancement of profitability increases for the enterprise.

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Preparation of capital expenditure budget:

The process for preparation of capital expenditure can be explained below :

Separation of expenditure budgets

The first step in the preparation of the capital budget is the separation of capital expenditures and operating expenditures.

These both have their own nature and also separate tax treatments are available for these expenditures. So, they need to be treated carefully.

Inputs from various department

The department heads provide important input for the required capital expenditure as they run day to day operations in the business.

Their critical input helps to determine if capital expenditures are beneficial for long term growth and economically feasible in the current time.

Implementation of budget limit.

It is important to put a cap on any expenditure to be made. The senior management shall make thorough assessment of required capital needs, either for maintenance, acquisitions or growth. This also helps in determining how much to budget for capital expenditure.

Measure capital expenditure returns.

Any capital expenditure item needs to be measured in terms of returns. The internal rate of return must be computed for each capital expenditure.

The IRR must be greater than the cost of capital in order for the capital expenditure to be undertaken. Further, various tools are available to compute returns on capital expenditure like return on investment ratios and payback periods.

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