The capital budgeting process is an activity that helps a company create a budget for acquiring assets. Asset acquisitions often are an expensive process, leading to the need for a budget. Several components are necessary to complete this process, and, in some cases, a capital budget does not follow a traditional budget process.
Cash inflows represent all receipts a company will receive from the asset acquisition. In most cases, the inflows represent extra money earned through increased operating activity. Cash flows usually are specified for each year in a specific time period. For example, a company may have a five-year plan for repaying the costs associated with the asset acquisition. The cash inflows for these five years are part of the capital budget.
In the capital budget, cash outflows are any cost a company must pay for the asset acquisition. For example, the purchase price, freight and handling and similar costs are part of the cash outflows. Training and costs for changing current facilities also fall under this category. Another term for cash outflows may be cash payments, which clarifies what falls under this category.
Businesses can choose from among several capital budget models. These include the payback period, rate of return and net present value. Companies often select one model for this process. The payback period determines the number of months or years it takes to recoup cash outflows. The rate of return presents the average return for the asset's entire life. Net present value discounts future dollars earned into today's dollar value for comparison.
Each capital budget model usually presents a different figure. A company can prepare a capital budget using each model, although this is not necessary. The best method for this process is to review multiple alternatives using the same method, such as payback period. This allows for a comparison process that provides similar numbers for all assets involved in the budget process. Companies can select whichever method they believe provides the best representation for the given scenario.