Capital budgeting is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds, within the framework of company goals and objectives. A capital project is any available alternative to purchase, build, lease, or renovate buildings, equipment, or other long-range major items of property. The alternative selected usually involves large sums of money and brings about a large increase in fixed costs for a number of years in the future. Once a company builds a plant or undertakes some other capital expenditure, its future plans are less flexible.

In order to successfully analyze these long-term investments, they need to be broken into discrete projects with definite beginning and ending dates. For instance, a college campus master plan may include new dorms, new academic buildings, a parking structure, and even buying up neighboring homes and vacant lots as they come available in order to create a broader footprint for expansion. However, each piece of the master plan has to be broken into smaller, manageable parts and outlined along a time horizon. Often, this is in the form of a Gantt chart which might indicate that in order to build the parking structure, the college must first buy adjacent property, perform a feasibility study, commission an architect, obtain a bond underwriter (for financing), get permits, select a construction company, and so on. Projects have to be prioritized as well, but for this section, we are focusing on the discrete time constraints around any one particular project.

As you will see, whether you are using a payback period, net present value (NPV) analysis, internal rate of return (IRR), or accounting rate of return (ARR), you need to establish a definite number of time periods. Even a long time period such as a building that will provide revenue and cash flow for 40 years has a beginning and ending date. Of course, these time constraints are estimated. For instance, in our example where Cynthia Becker buys a van, she used a 4-year time constraint. In reality, the van may break down after three years, or it may still be providing reliable service after five years.

Most importantly, as we analyze investment options, we will be adjusting cash flows to reflect the time value of money.

Before we move on to present and future values though, check your understanding of the need for time constraints on capital investment decisions.