Capital budget
The process by which a company selects alternative mid-range or long-range capital asset investments. In making decisions as to which capital investments to make, companies usually use a combination of formal financial criteria, including net present value (NPV), internal rate of return (IRR), and payback period. Potential investments are also evaluated with respect to as strategic consistency and risk. And, because capital budgeting is designed to maximize value, investments should be undertaken whose returns are equal to or greater than the average cost of capital.
As the above suggests, an entity’s capital budget and
budgeting process are usually quite distinct from its operating budget and budgeting process.
The two kinds of budgets represent different expenditures, are planned through different
processes, use different criteria, and may involve different managers. In order for a
specific expenditure to be funded from a capital budget, its sponsors may have to justify
it with a formal business case analysis, including estimates of NPV, IRR, payback period
and other financial criteria. If the company has limited funds for capital spending,
moreover, the potential capital expenditure may have to enter a competitive capital
review process, where all requested expenditures are compared on the same financial
criteria and only the most favorable receive funding.
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