Capital expenses are large investments that companies hope will add value in the future. Capital budgeting ensures a company can pay for the investment without cutting off funding for other activities. It involves identifying costs, creating a budget, and finding external funding with low costs of capital.
In business, a capital expense is a large use of cash for an item or project that a company hopes will add value to the business in the future. In most cases, capital spending corresponds to the company’s capital budgeting process. The importance of capital budgeting is to ensure that a business has the ability to pay for the new item or project without cutting off funding for other current business activities. A corporate finance department or management accountants are the sources a company can use to estimate potential costs and revenues under capital budgeting procedures. Three activities fall under the importance of capital budgeting: identifying the cost of new opportunities, creating a capital budget, and finding sources from outside sources, if necessary.
The cost of new items, projects, or opportunities is typically the focus of corporate finance departments and management accountants, among other things. The importance of capital budgeting in identifying the costs of new opportunities is to ensure that a company does not sacrifice successful business operations for potentially unprofitable operations. Costs can vary widely from project to project and include items such as direct materials, labor, and new fixed assets to complete activities associated with a new opportunity. Once a company has all the costs associated with a project, it can review the potential income that may arise from the new business opportunity. A review of costs versus revenue is the next phase in the capital budget paper.
Creating a capital budget for each new project or opportunity is the crux of capital budgeting. The importance of capital budgeting here is to look at the bottom line for each project rather than the intangibles for each. The budget usually includes a line for each cost to start the project, with a total of all costs at the bottom. The company can then list the current funds the company has available to dedicate to starting the new projects. In some cases, a company may not finance the project entirely through internal funds, leaving some necessary funds from external sources.
External funds are almost always required in the capital budget. The difference between the expected start-up costs and the internal funds allocated for the project represents the amount of debt or equity funds needed. The importance of capital budgeting here is to find the sources of external funds that have the lowest cost of capital. Low interest rates on debt and equity make capital spending more profitable. This is important for companies starting new projects.
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