Capital budgets

Learning outcome statements

The learning outcome statements relevant for this section are:

1. Prepare a capital expenditure budget
2. Demonstrate an understanding of the relationship between the capital expenditure budget, the cash budget, and the pro forma financial statements

Components of a capital expenditure budget

The capital expenditure budget plans resources for major long-term investments, such as equipment, property, and infrastructure. These expenditures are generally substantial and impact the company’s operations over several years. Unlike the annual, recurring operating budget, the capital expenditure budget spans multiple years and covers large, one-time asset outlays that typically require separate strategic approval.

The capital expenditure budget consists of planned expenditures on long-term assets that support the company’s operational and strategic goals. The main components of a capital expenditure budget include:

1. Asset description: Each planned capital item is described to provide context and clarify the type and purpose of the expenditure. For instance, a new production line, expansion of office space, or major machinery upgrades might be included.
2. Project cost estimate: This component captures the estimated total cost for each capital project. Cost estimates may involve various cost elements such as purchase price, installation fees, initial training, or infrastructure improvements.
3. Time frame: Since capital expenditures typically span multiple budget periods, the capital expenditure budget specifies the timeline for each investment, such as expected completion dates and timing of payments.
4. Expected benefits: Many capital expenditure budgets include a brief justification or forecasted benefits, like increased production capacity, cost savings, or entry into new markets, to help prioritize and support the budget approval process.
5. Funding source: This section identifies how each capital project will be funded, whether through internal funds, debt financing, or other means, to integrate with the cash budget and financing plans.

Example: capital expenditure budget

Bright Co. plans two projects for the year:

• A $500,000 production line, installed by Q2 and paid in two installments: $250,000 in Q1 and $250,000 in Q2. Funding: 60% bank loan ($300,000) and 40% cash ($200,000).
• A $300,000 warehouse expansion, completed and paid in full in Q4 from internal funds.

Project	Description	Cost	Q1	Q2	Q3	Q4	Funding
Production line	New production line	$500,000	$250,000	$250,000	-	-	60% bank loan, 40% cash
Warehouse	Warehouse expansion	$300,000	-	-	-	$300,000	100% internal funds

These quarterly figures feed straight into the cash budget: $250,000 disbursements in Q1 and Q2 for the production line, plus a $300,000 loan-proceeds inflow in the financing section when the loan is drawn, and a $300,000 disbursement in Q4 for the warehouse.

Answer: The capital expenditure budget lists each project’s description, cost estimate, time frame, and funding source - exactly as shown above.

Relationship between the capital expenditure budget and other budgets

The capital expenditure budget is interconnected with other budgets, particularly the cash budget and pro forma financial statements:

Cash budget

The cash budget reflects cash inflows and outflows over the short term, making it essential to integrate capital expenditures. As major asset purchases can lead to substantial cash outflows, the capital expenditure budget provides inputs to the cash budget, helping management to plan financing needs and avoid liquidity shortages when the capital expenditures are incurred. The capital expenditure budget feeds the cash budget with the timing of each payment. The full $500,000 for the production line appears under cash disbursements in the quarters it’s paid - $250,000 in Q1 and $250,000 in Q2. The $300,000 bank loan appears separately as a borrowing in the financing section when the funds are received, so the net drain on cash is $200,000 (the 40% cash portion). Interest and principal repayments on the loan then appear in later periods’ financing sections as the loan is paid down.

Pro forma financial statements

Capital expenditures impact pro forma and budgeted financial statements, including the balance sheet, income statement, and statement of cash flows:

• Balance sheet: As new assets are acquired, the balance sheet reflects increases in asset accounts and, if financed by debt, changes in liabilities.
• Income statement: The purchase itself is capitalized, not expensed, so it doesn’t reduce net income directly; only depreciation, recognized gradually over the asset’s useful life, later reduces net income. Depreciation is a non-cash expense: it reduces net income but not cash, so it is added back in the operating section of the cash flow statement (indirect method); its only cash effect is the lower income tax it produces.
• Statement of cash flows: the asset purchase appears as an investing outflow, and any related borrowing appears as a financing inflow.

Effective capital expenditure budgeting thus involves assessing how large investments affect cash flow and financial statements - including when capex needs exceed available cash and require outside financing such as loans - and aligning expenditures with strategic objectives.

Summary

The capital expenditure budget lists planned long-term asset investments and their funding sources. It feeds the cash budget with the timing of the related cash outlays and any related borrowing, and it drives future balance sheet, income statement, and cash flow statement changes as assets are added, financed, and then depreciated.