Capital Budgeting Decision

Capital budgeting describes decisions where expenditures and receipts for a particular undertaking will continue over a period of time. These decisions usually involve outflows of funds (expenditures) in the early periods (sometimes just one expenditure will be made at the beginning of a project, as for the purchase of a new machine), and the inflows (revenues) start somewhat later and (it is hoped) continue for a significant number of periods.

The following figures is a simple illustration of the components to be considered in making capital budgeting decisions. The figure shows one outflow at the beginning of the project and five inflows in subsequent periods. This model could represent the purchase of a new machine that will last five years and provide new revenues (or savings, if it decreases the cost of production) during that time. We could have shown an example with outflows occurring during say, the first three years. Such outflows could represent a company's decision to build a new plant and equip it with new machines. Such a large investment could easily occur over a period of three years, and revenues would not start until the fourth year or even later.

Types of Capital Budgeting decisions: 

• Expansion of facilities: Growing demand for a company's products leads to consideration of a new or additional plant. Planning for other new facilities, such as sales offices or warehouses, would also be included here. 
• New or improved products: Additional investment may be necessary to bring a  new or changed product to the market.
• Replacement: Replacement decisions can be of at least two types: (1) replacement of worn-out plant and equipment or (2) replacement with more efficient machines of equipment that is still operating but is obsolete.
• Lease or buy: A company may need to decide whether to make a sizable investment in buying a piece of equipment or to pay rental for a considerable time period.
• Make or buy: A company may be faced with deciding whether to make a significant investment to produce components for its products or whether to forgo such investment and contract for the components with a vendor.
• Other: The preceding list is certainly not complete, since a capital budgeting problem exists whenever initial cash flows and subsequent cash flows are involved. 
• Safety or environment protection equipment:Such investments may be mandated by law and therefore are not necessarily governed by economic decision making. However, if there are alternate solutions, capital budgeting analysis may be helpful in identifying the most cost-efficient alternative.