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Capital Expenditure (CAPEX) Definition
Capital Expenditure (CAPEX) refers to a cash flow component of investment activities which is usually monitored by shareholders. It is the amount of financial resources that a company uses to purchase capital goods with the aim of expanding the operational scope of the company. Examples of CAPEX include building a new plant or buying vehicle fleets to improve production.
A Little More on What is CAPEX
In the business world, CAPEX refers to the expenses incurred by a company to purchase capital goods in order to improve the status of the company through the purchase of new assets or by valuation of existing fixed assets. Buying new computers, office suppliers, or delivery vans are examples of CAPEX.
Another meaning of CAPEX is the amount of cash that a company spends in keeping its assets stable and operational thereby influencing the overall output of the organization.
In accounting, expenses are only regarded to as capital expenses once the existing assets start depreciating or accruing amortization costs. This is so because in accounting, every company should discount its fixed costs with depreciation and amortization against the life of an asset.
It is also noted in accounting that precise expenses that cover investments are capitalized if they increase an asset value. The capitalized expense should be distributed throughout the life cycle of the asset.
The Importance of CAPEX
Companies use CAPEX as an indicator of the life cycle stage that an organization is at a particular time. When a company begins, the CAPEX is usually high since the company would need series of equipment goods for production.
In case the company develops quickly, the CAPEX will be greater than the depreciations of the fixed assets, which is an indication of the rapid rising of capital goods. However, in the case that the CAPEX is lower than or similar to the depreciations, then the company is decapitalizing and would eventually decline.
Where to find CAPEX statement
Companies can obtain their CAPEX statements from the cash flow statement generated from investing activities. There are several ways that companies can name CAPEX line in their cash flow statements including:
- Capital expenditures
- Expenses of acquisitions
- Acquisitions of plant, property, and equipment
The amount of investment that a company requires is always dependent on the industry it is located. Companies in industries such as telecommunication, oil, public utilities industries, and manufacturing are always highly demanding for capital.
It is important to note that capital expenditure (CAPEX) is NOT the same as operating expenses (OPEX). The later refers to the short-term costs needed to meet the current operating expenses for running a business. OPEX, unlike CAPEX, can be fully deducted from tax the same year that expenses occurred.
Capital Expenditure and Relative Value
Capital expenditure refers to the ratio of cash flow to capital expenditure. It shows a company’s ability to purchase long-term assets using cash flow.
When the ratio of cash flow to capital expenditure is less than 1, there is an insufficient cash flow to fund the acquisition of assets, and vice versa. Below is the formula for free cash flow:
Free Cash Flow = Earnings Per Share – (CapEx – Depreciation) (1 – Debt Ratio) – (Change in Net Working Capital) (1 – Debt Ratio)
Free Cash Flow = Net Income – Net CapEx – Change in Net Working Capital + New Debt – Debt Repayment
References for Capital Expenditure
Academic Research for Capital Expenditure (CAPEX)
- Corporate capital expenditure decisions and the market value of the firm, McConnell, J. J., & Muscarella, C. J. (1985). Journal of financial economics, 14(3), 399-422. This study investigates the corporate capital expenditure and its impact on a firm’s market value using a sample of 658 companies across different sectors. The study was conducted around the dates when the corporations were publicly announcing their future capital expenditure plans. Based on the findings, announcements of increases (decreases) in planned capital expenditures are associated with significant positive (negative) excess stock returns in industrial firms. However, in the case of public utility firms, neither increase nor decrease of planned capital expenditure can influence excess stock returns.
- Investment opportunities and market reaction to capital expenditure decisions, Chung, K. H., Wright, P., & Charoenwong, C. (1998). Journal of Banking & Finance, 22(1), 41-60. This article argues that the share price reaction to the capital expenditure decisions of a firm depends on the assessment of market’s quality in regard to investment opportunities. The authors, thus, postulate that announcements of increases (decreases) in capital expenditures positively (negatively) affect the stock prices of firms with valuable investment opportunities. However, they predict that announcements of increases (decreases) in capital expenditures negatively (positively) affect the stock prices of firms that lack such opportunities. The authors deduce that it is the quality of a firm’s investment opportunities that determine the reaction of share price to its capital expenditure instead of industry affiliation.
- The Impact of Firms’ Capital Expenditure on Working Capital Management: An Empirical Study across Industries in Thailand., Appuhami, B. (2008). International Management Review, 4(1). This study investigates the impact of capital expenditure of a firm on its working capital management. It uses data gathered from firms listed in the Thailand Stock Exchange. The authors developed multiple regression models which they used as a proxy for working capital measurement. Based on the study, it was found that a capital expenditure has a great impact on the working capital management. In addition, it was found that the operating cash flow of a firm has a significant correlation with the working capital management.
- The capital expenditure decision-making process of large corporations, William Petty, J., Scott Jr, D. F., & Bird, M. M. (1975). The engineering economist, 20(3), 159-172. This paper discusses the process through which large corporations in the manufacturing sector make decisions in regard to capital expenditure.
- Market response to product-strategy and capital-expenditure announcements in Singapore: Investment opportunities and free cash flow, Chen, S. S., & Ho, K. W. (1997). Financial Management, 82-88. This study examines the significance of investment opportunities and free cash flow in explaining the market response to firms’ announcements of capital expenditures and product strategies. Using data from Singapore, the study supports the hypothesis that investments by high-q firms are worthwhile compared to those with low-q firms.
- Hurdle rates for screening capital expenditure proposals, Brigham, E. F. (1975). Financial Management, 17-26. This paper outlines the findings of a survey designed to investigate how industrial firms set hurdle rates for use in capital budgeting. According to the authors, large firms use different discount rates in different divisions for different projects. However, the products for measuring risks are never accurate enough to warrant risk-adjusted discount rates of each project.
- Cash flow and capital spending: Evidence from capital expenditure announcements, Vogt, S. C. (1997). Financial management, 44-57. In this paper, the author analyses the role of cash flow in explaining both the capital-spending decisions and price response to announcements of such decisions. The author asserts that the level of announced capital spending is positively correlated with the level of cash flow which in turn influences capital spending. Based on the overview, positive returns around capital-spending announcements are associated with low cash-flow coverage, marginal firms, and small asset size.
- … AND FORMAL CAPITAL EXPENDITURE CONTROLS IN DIVISIONALISED COMPANIES: PERFORMANCE MEASUREMENT AND FORMAL CAPITAL EXPENDITURE …, Scapens, R. W., & Sale, J. T. (1981). PERFORMANCE Journal of Business Finance & Accounting, 8(3), 389-416. This article describes the role of ‘residual income’ as a measure of performance in divisionalised firms as well as the controversy surrounding the concept. The authors highlight whether residual income could be appropriate in determining the performance of divisions and their managers.
- The stock market reaction to investment announcements: the case of individual capital expenditure projects, Burton, B. M., Lonie, A. A., & Power, D. M. (1999). Journal of Business Finance & Accounting, 26(5‐6), 681-708. This paper illustrates how markets react to capital expenditure announcements using examples from the UK. Utilizing over 500 disclosures for analysis, the study explores hoe the market reaction to joint venture announcements is significantly positive. However, it was also discovered that some of the announcements do not elicit similar response. The authors also report that the market variability in regard to announcements due to large cash inflow can be significantly lower than the variability in investors’ reactions to announcements.
- Capital expenditure decision/making: Some tools and trends, Rosenblatt, M. J., & Jucker, J. V. (1979). Interfaces, 9(2-part-1), 63-69. This paper provides an overview of previously conducted surveys discussing the art and science of capital budgeting in businesses and industries. Some of the topics discussed include the implementation of discounting methods, determining cut-off rates and discounts, using mathematical programming and capital rationing, and risk and uncertainty in the capital budgeting process.
- Agency problems and capital expenditure announcements, Brailsford, T. J., & Yeoh, D. (2004). The Journal of Business, 77(2), 223-256. This journal examines the market valuation of business announcements in regard to new capital expenditure. According to the authors, previous studies had suggested that growth opportunities and cash flow position influence the market response. As such, they attempt to examine the role of cash flow and growth and interaction between the two variables.
- Capital expenditure decision making in small firms, Runyon, L. R. (1983). Journal of Business research, 11(3), 389-397. This paper explains to what extent large firms utilize sophisticated techniques in capital expenditure decision making. The authors focus their study on financial decision making procedures implemented by small firms. Some of the key topics explored include investment opportunities evaluation, risk adjustment methods, expenditure purpose, and profitability concern.