Every company wants to expand its operations and be more competitive. This requires a certain outlay of capital expenditure with careful planning.
The planning for capital expenditure requires meticulous thinking and is prepared in the capital expenditure budget.
A budget is a great tool for spending money as capital expenditures and spending it more efficiently.
Capital expenditure plays a focal role for companies trying to overhaul their capital assets or make major changes to their operations.
Capital expenditures include purchasing new equipment, machinery, land, plant, furniture, fixtures, vehicles, software, or intangible assets such as a patent or license.
Capital expenditures identify the amount of cash the company invests in projects and long-term assets.
The process for approving funds for specific capital expenditure items differs by company rules and regulations. The process, however, is the same.
This includes a financial evaluation of whether the required return on investment targets would be met.
Once targets are met, the review would be done for quality purposes by the top management.
Various significant decisions, such as whether to hire, purchase, lease or construct the company’s capital assets, shall be made in tandem with the company’s financial requirements.
Types of capital expenditure
There are two types of capital expenses: CAPEX required for maintenance of current operations and production levels within the company and expenditure to be undertaken for the company’s future growth.
Capital expenditure can be both tangible and intangible.
Tangible capital expenditure contains assets such as machines, vehicles, or plants, whereas intangible expenditure is related to developing or purchasing a patent or trademark.
Purpose of the capital expenditure budget
The capital expenditure budget is prepared to 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.
A good project can turn bad if expenses are done in an uncontrolled fashion and not accounted for at all.
3) Helps in Investment Decisions
Capital expenditure decisions require time and critical thinking to make correct investment decisions. The risk in capital expenditure is very high.
Hence, management shall be flexible in making the right investment decision for the company’s long-term benefit.
4) Long-Term Effect on Profitability
A long-term vision is necessary for making capital expenditure decisions. This is required for the company’s survival and impacts capital budgeting in the long run.
If the capital budgeting expenditure occurs after preparing the budget reasonably, the chances of enhancement of profitability increase for the enterprise.
Preparation of capital expenditure budget:
The process for the preparation of capital expenditure can be explained below :
Separation of expenditure budgets
The first step in preparing the capital budget is the separation of capital expenditures and operating expenditures.
These have their nature, and 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 at the current time.
Implementation of budget limit.
It is important to put a cap on any expenditure to be made. The senior management shall thoroughly assess required capital needs 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 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.