A capital budget consists of three components, explains Iowa State University. The first is an opening section for the purchase of capital assets such as equipment and facilities as a part of a new project. The second contains the estimated cash flows from that project's ongoing operations, and the third contains the salvage cash flows and costs stemming from the winding down of that project.Continue Reading
A project's operating cash flows generally consist of its revenues and expenses as well as tax payments, notes Iowa State University. Because capital budgets are prepared on a cash basis, these amounts do not reflect accounting expenses such as depreciation. Cash flows generally vary somewhat with each year's anticipated productivity, with sales and variable costs increasing with higher levels of output. At the end of a project's final year, businesses recover working capital, which includes funds that are tied up in the business provide liquidity. These funds, in addition to the residual value of any capital assets, make up the project's final financial inflows.
Once a business has projected its cash flows for each year, it can apply a discount rate to determine the project's present values, says Iowa State University. By comparing this amount to any initial capital outlays, a business can determine a project's net present value, or NPV. Capital budgets often include sensitivity analyses, which indicate projects' NPVs under different cash flow and discount rate assumptions.
Businesses may also use methods such as the internal rate of return, or IRR, to determine a project's profitability as a part of its capital budgeting, explains The Free Dictionary by Farlex. The IRR is the discount rate at which a project's net present value is zero, according to Investopedia. Businesses can use this to compare projects of different sizes.Learn more about Accounting