The level of a firm's profits depends upon the success with which it is able to employ all its assets-human and non-human. The firm's future profitability depends on two factors, firstly, maintaining and enlarging its asset structure, and secondly, devising a successful strategy for that asset structure. The previous webpage drew attention to the fact that preparing the capital expenditure plan is part of the long-range planning process. The activity of investing in new assets, often termed capital budgeting, involves planning capital expenditure and arranging the financing of this expenditure. It is an area of management decision making which has attracted a great deal of interest among accountants and economists in recent years, and much research has been devoted towards evolving methods for improving the quality of these decisions.
We can only hope to touch upon the main issues. We shall deal mainly with capital expenditure decisions, and we shall examine the relevant factors and the methods which are currently employed for making capital investment decisions. Financing capital expenditure, which is the other aspect of capital budgeting, belongs to a sophisticated area of study known as the Theory of Finance. We shall make only brief reference to this aspect of capital budgeting, and must refer the reader to the literature of the Theory of Finance for a proper treatment of this subject.
Capital investment decisions
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Probably the most significant factors affecting the level of profitability in a business is the quality of managerial decisions affecting the commitment of the firm's resources to new investments within the firm. The reasons which render such strategic decisions so important may be listed as follows:
(a) they involve the commitment of substantial sums of money;
(b) this commitment is made for a long period of time, and the element of uncertainty is therefore much greater than in the case of decisions whose effects are limited to a short period of time;
(c) once made, capital investment decisions are almost impossible to reverse should they appear subsequently to have been wrongly made;
(d) occasionally, the success or the failure of a firm may depend upon a single decision. In all cases, the future profitability of the firm will be affected by the decision;
(e) not only is capital expenditure policy of major importance to a firm, but it is of great significance to an industry as well as to the national economy.
The purpose of this webpage has been to emphasize the necessity of setting long-run objectives and of relating short-term decisions to these objectives. Long-range planning has received increasing attention in recent years due to rapidly changing business conditions, which have persuaded management to take a longer view of the firm's activities than has hitherto been thought necessary. It is becoming widely recognized that effective long-range planning should result in a firm being always in the best position with products, resources and processes deployed in such a way as to take advantage of all... see: Planning Summary