Capital Budgeting

Overview

Firms generally have two large categories of expensens:

• Operational Expenses (OPEX) - these are the expenses required to run current operations, with possibly maintenance expenses.
• Capital Expenditures (CAPEX) - expenses that are typically large and of an investment nature.

Capital expenditures are closely aligned with a company's strategy, and chosen to further that strategy. The returns to capex generally play out over time.

Accounting Treatment

Even though capital expenditures spend large amounts of company resources, they do not initially show up as expenses on the financials of the firm. Rather, they are usually interpreted as purchases of assets and capitalized on the balance sheet as an asset.

This treatment recognizes the fact that the benefits of capex are realized over time, and therefore tries to match the expense to the revenue through depreciation.

Capital Budgeting Process

Many companies of sufficient size develop a budgeting process by which projects (or programs) are evaluated and given the green light. The process is usually integrated with the processes of the project management office and/or the program management office.

The key decision in a capital budgeting process is the decision to proceed with a project or not. There are typically two factors that materially influence the decision.

• Financial Estimates - typical financial estimates include a pro-forma projection of the costs and revenues associated with the project. If the project is deemed to have a return sufficiently greater than the firms cost of capital, then the project is deemed worthwhile.
  
  Alternatively, the committee can use Real Option Analysis to evaluate the effectiveness of a project.
• Alignment to Strategy