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Often referred to as an investment appraisal, the capital budget is a tool that helps individuals and companies to plan for the acquisition of long term investments in capital assets, such as new machinery for use in a business or the replacement of existing machinery with upgraded equipment. There are several elements that go into the process of making plans for long-term outlays that help to shape the structure of the capital budget, and make it a valuable means of making smart decisions about the operation of the business.
One of the first components of planning an effective capital budget is to consider the net present value of the capital assets currently in use. This is especially important if there is an expectation of financial outlays in order to replace capital assets that have been depreciated or are now outmoded and are inhibiting profitability. Understanding which assets are currently stable, and how these stable assets should be valued, will aid in determining where replacements will be required over both the short term and the long term, and what that replacement will mean to the overall value of the capital assets.
Another important factor within the capital budget is the profitability index. Essentially, this is a component that determines the reasonable incidence of return on the fixed assets included in the capital budget. Each fixed asset is considered in turn, and helps to formulate the internal rate of return. In terms of formulating budget allotments for replacement and repair of existing assets, or in deciding to secure new assets, the profitability index serves to help set limits so that the anticipated generation of resources will in fact cover the investment.
All the components of the capital budget rely on correct evaluation of the use of resources and the cash flow that results from each investment that appears as a line item in the budget. General accounting practices govern the creation of a capital budget, making the process easy to formulate and also relatively easy to follow, assuming the owner of the assets is willing to commit to the indicators that are identified in the final draft of the capital budget.