Capital Expenditure

What is Capital Expenditure?

Capital expenses signify a company's investment in existing or new fixed assets to develop or enhance its business. Alternatively, capital expenditure is a type of cost that an entity capitalizes, i.e., it appears in the balance sheet as an asset instead of an expenditure in the income statement. From a reporting standpoint, an entity must divide the capital expenditure over its useful life.

Capital expenditure is an important financial metric and allows analysts to understand the company's investment pattern and future outlook. It has a significant effect on the financial health of an organization. The management must be mindful of capital expenditure's short-term and long-term consequences for efficient decision-making.

The amount of capital expenditure varies for each industry. Industries such as telecommunications, automobile production, oil exploration, and production are capital intensive, whereas the services or eCommerce industry has minimum capital expenditure.

The cash flow statement of a company captures capital expenditure under investment activities. There are different ways to depict CAPEX - it may be a capital or acquisition expense. Alternatively, an entity includes capital expenditure in its income statement and balance sheet. In the balance sheet, the expense appears as an asset; likewise, depreciation is an expense recorded for the current period.

Types of Capital Expenditure

Based on the objective, one can classify capital expenditure as follows:

a.    Expenses that enable future growth and
b.    Expenses that maintain the current level of operations for the company.

Capital expenditure involves the acquisition cost for tangible assets such as land, building, equipment, machinery, furniture, fixtures, etc. It also includes expenses for creating or purchasing intangible assets such as patents, trademarks, or licenses.

Capital expenditure may reduce costs, increase revenue, or achieve non-economic purposes. Also, CAPEX includes strategic expenditure to expand production capacity, product innovation, and the creation of barriers against capital fluctuations.   

One may classify a tangible and intangible capital expenditure as an asset only if the company can sell it in the future. Any repair or maintenance is not a capital expenditure since it does not enhance the asset's value. Therefore, expenses incurred for upkeeps must be a cost in the income statement.
 

Example of Capital Expenditure

The following capital expenditure examples will help you understand the CAPEX meaning.

Example 1

Consider XYZ Ltd, currently engaged in cement production with an existing capacity of 500 MT. There is a major increase in demand for cement. Thus, XYZ Ltd. decides to set up a new production unit with an additional production capacity of 300 MT.

In this case, the latest unit is an example of capital expenditure. The production capacity will increase considerably due to the unit, and the company will reap its benefits for more than one financial year.

The increase in the production capacity is one of many reasons for classifying the amount spent to set up the unit as capital expenditure. Even if the production capacity remained constant but increased the overall efficiency, it would be a capital expenditure.

Example 2

Amazon classifies purchases of property and equipment, including internal-use software and website development, as an item of capital expenditure in its cash flow statement. The investment amount is a negative number and indicates cash outflow.
 

Significance of Capital Expenditure

Capital expenditure is crucial for decision-making. It is important for the following reasons:

1.    Long-term Investment
Typically, capital expenditure decisions have a long-term effect on a company's financial health. For most companies, its existing production is mainly a function of prior period capital expenditures. Similarly, the recent decisions on capital expenditure majorly affect the company's future activities.

Also, capital investment decisions direct the future roadmap of an organization. The long-term strategic goals and budgets must align with the extent of capital expenses.
 
2.    Irreversibility
The resale market for capital equipment is weak and tends to yield a little scrap value. Also, companies experience losses to reverse any capital expenditure. Typically, companies customize most types of capital equipment to meet specific requirements. 
 
3.    Initial Costs
While capital investments in tangible assets such as plant, property, or equipment offer potential returns in the long term, it requires a massive initial investment. Advanced technology also tends to increase capital costs. Such capital expense is much greater than regular operating outlays. 

4.    Depreciation
Initially, capital expenditures increase the asset and net worth of an organization. Over time, the value of the capital asset decreases due to wear and tear. Capital expenditure is subject to regular repair, maintenance, and depreciation. These periodic expenses impact the overall profitability of the firm. 
 
5.    Free Cash Flow
Capital expenditure helps calculate the free cash flow for equity shareholders of a firm. Analysts prefer comparing the free cash flows of companies in the same industry. 
 

Challenges of Capital Expenditure

Although capital expenditure decisions are crucial, a fair amount of complexity is involved. It includes the following:

1.    CAPEX Valuation
One of the major challenges for capital expenditure is its valuation. The process of identifying, measuring, or estimating costs for capital expenditure is complex. The measurement of CAPEX involves various assumptions.
 
2.    Unpredictability
It is difficult to gauge the future benefits that the company may derive from the current capital expenditure. Companies incur massive expenses in capital assets to produce predictable outcomes. However, there is no guarantee for such outcomes, and the company may suffer losses.

There is a lot of uncertainty about the costs and benefits of capital expenditure decisions. Even the most experienced analysts are prone to mistakes. Financial planning requires companies to evaluate the risk of potential losses and eliminate it. If elimination is impossible, the company must strive to develop mitigants.
 
3.    Temporal Spread
For most industries, the costs and advantages of capital expenditure are usually over a relatively long period. Such a temporal spread impacts the discount rate estimation and entails challenges for comparison. 

Difference between Capital Expenditure and Revenue Expenditure

The table below summarizes the key difference between capital and revenue expenditure –

Capital expenditure is a critical factor for consideration. It can either make or break a company. Thus, an entity must dedicate substantial efforts to CAPEX management. For instance, the leadership may adopt professional budgeting, finance, and review practices. The company may generate periodic reports and use effective software and other practices to manage and regulate capital expenditure more effectively.