When to Make Capital Budgeting Decisions

Learning Outcomes

  • Identify situations that require capital budgeting decision making

Mary walks into your office and announces, “Our machinery is 20 years old, and has become inefficient. We should think about replacing it with one of the new, faster pieces of equipment.” She has several pieces of paper in her hand showing beautiful and shiny machines with really high price tags!

Your company has a capital expenditure budget of $100,000 available this year and each of these machines has a price that approaches that amount. They also have payment and lease options. But you are thinking “will these new machines create enough in higher efficiency and costs savings to recoup this large investment, or will the ones we have continue to work just fine? Or which of the three would make the most financial sense for us right now?”

Watch It

Capital budgeting can help you to make these decisions.

Capital budgeting decisions are for the big stuff. When might we need to make such a decision?

  1. Cost reduction: Should we buy new equipment to reduce manufacturing costs? Might a newer machine save us money even considering the initial capital outlay?
  2. Expansion: Would a new plant, warehouse or other building help to increase sales and capacity? Are we not making the income we could, by not expanding?
  3. Picking the equipment: There may be three or more options for equipment at various prices with different options. Which one will make the most sense? We know we need new stuff, but with all of the various options out there, evaluation of all of the options is important.
  4. Leasing or buying: Should we purchase a new piece of equipment or lease it? Sometimes leasing may be a better option!
  5. Replacement: Should we replace a machine now, or wait? The machine we are currently using to make widgets still works, but it is slow and frequently breaking down. A new one is a huge investment, but how long will it take to pay for itself?

All of these situations require analysis to figure out which is going to be the best decision in the long run. We make these kinds of decisions personally when we evaluate buying a new car, dishwasher or house. Businesses go through a similar process to determine what will work best, and ultimately create the best financial outcome.

Practice Question