Capital review process / Capital budget
The capital budget typically results from a capital review process by which a company selects alternative mid-range or long-range capital asset investments.
When deciding 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 strategic consistency and risk. And, because capital budgeting is designed to maximize value, investments should be undertaken only when expected returns are equal to or greater than the average cost of capital.
Capital budget planning is usually accomplished through an organization's Budget Office or through a Capital Review Committee, which establish their own criteria for prioritizing proposals and for setting the capital budget ceiling. 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.
Those who propose or request funding for capital expenditure will want to be sure they understand
- The organization's criteria for prioritizing capital expenditure proposals.
- The timing of the current and next capital budget cycles.
- The current or expected capital budget ceiling.
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