Capital Expenditures – Definition

Cite this article as:"Capital Expenditures – Definition," in The Business Professor, updated September 23, 2019, last accessed June 3, 2020, https://thebusinessprofessor.com/lesson/capital-expenditures-definition/.

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Capital Expenditures (CapEx) Definition

Capital exchange refers to the funds that a company utilizes to buy and sustain its long term assets to increase the overall productivity of the company. The long-term assets include; physical assets such as equipment, real estate, or infrastructure that have a useful life of more than a financial year.

Capital expenditures also include; purchases of new machinery, land, warehouses or buildings, vehicles, plants, furniture, patents, or copyrights. The money is a capital expenditure only when the company uses it to purchase new assets or maintain the already existing assets.

A Little More on What is CapEx

Capital expenditures are not similar to operating expenses, which are the everyday expenses that the company incurs to ensure an asset is operational. Operational expenses include things like electricity bills or cleaning services.

Differentiating capital expenditure and operational expenses may be difficult, as some expenses do not directly affect the operations of the asset. A company considers an asset as a capital expenditure if its financial benefits go for more than the current financial year.

Types of Capital Expenditures

Capital expenditures exist in two forms; expenses the company incurs to ensure operations are smooth, and expenses that will be profitable in the future. The expenses can either be intangible, like copyrights, patents or licenses, or tangible, like vehicles or machinery. Both tangible and intangible capital expenditures are assets since the company can sell them when the need arises.

Calculating Capital Expenditure

The formula for calculating capital expenditure is:

Capital Expenditure = Current depreciation + change in property, plant, and equipment

One may collect all the information from the company’s balance sheet and the income statement. The income statement provides the expenses on the depreciation of assets for the current financial year. The company can get data on the current balance of property, plant, and equipment on its balance sheet.

Find the company’s previous PP&E balance, and then subtract it from the current balance to find the change in PP&E. Add the depreciation expenses to the change in PP&E to find the current capital expenditure.

However, all these calculations will be unnecessary if you have access to the cash flow statements of a particular company. The investment sector of the cash flow statement shows all the capital expenditures of the company.

Examples of how to use Capital Expenditures

Other than analyzing the investments of a company, the company can use the expenditure metric to analyze various financial ratios. For example, a company can use the cash flow to capital expenditure ratio to purchase long-term assets. A ratio larger than one means, the daily activities of the company are fetching the cash that the company can use to purchase assets.

However, ratios lower than one indicates that there are issues with the cash flows in the company. Purchasing any asset may force the company to borrow funds. The formula for calculating cash flow to capital expenditure ratio is:

CF/Capital Exchange = (operations’ cash flows) / (capital expenditure)

The Effects of Capital Expenditures

Investing in capital expenditures can be an important decision for an organization because of the following factors:

  • Long-term effects

The decision to invest in capital expenditures extends into future years. The current operational and manufacturing activities in a company is often an outcome of previous capital expenditures. Equally, current investments in capital expenditures will influence the company’s future operations. The financial status of the organization needs to be in place bore the company decides to invest in capital expenditures.

  • Irreversibility

The company may incur major losses whenever they want to undo the capital expenditures. Most companies’ custom-make their equipment so that they can suit the operations of the company. However, once the equipment is in use, it begins to depreciate. Investing in low capital expenditures requires critical analysis because the markets for used equipment is often poor.

  • High Initial Costs

Capital expenditures for companies that deal with production and manufacturing are generally pricey. Assets like warehouses or buildings, property, or equipment may be beneficial to the company, but purchasing them for the first time is expensive. The more technology advances, the higher the capital costs of assets.

Limitations of capital expenditures

The measurement, identification, and estimation procedure for the costs of capital expenditures can be difficult to determine. The company cannot, however, measure factors like the morale of employees after the addition of a new facility or equipment

Most companies that invest in capital expenditures predict the outcomes, but it is not a guarantee that the investment will generate profits. Companies need to factor in the risks of incurring financial losses when planning to invest in capital expenditures.

Conclusion

Companies investing in capital expenditures may end up using a fortune if they do not handle the finances properly. However, if the company makes use of the right tools, plans and manage the project effectively, there wouldn’t be any overspending.

The company should adequately prepare the budgets for the purchases to ensure there is no mishandling of cash. Budgeting software is available to help managers in the companies succeed in the budgeting process.

Reference for “Capital Expenditure (CAPEX)”

https://www.investopedia.com › Investing › Financial Analysis

https://corporatefinanceinstitute.com › Resources › Knowledge › Accounting

https://en.wikipedia.org/wiki/Capital_expenditure

https://www.accountingcoach.com/blog/what-are-capital-expenditures

https://www.accountingcoach.com/terms/C/capital-expenditures

Academics research on “Capital Expenditure (CAPEX)”

Corporate capital expenditure decisions and the market value of the firm, McConnell, J. J., & Muscarella, C. J. (1985). Corporate capital expenditure decisions and the market value of the firm. Journal of financial economics14(3), 399-422. This paper is an ‘event-time’ study of the common stock prices of a sample of 658 corporations around the dates on which they publicly announced their future capital expenditure plans. For industrial firms, announcements of increases (decreases) in planned capital expenditures are associated with significant positive (negative) excess stock returns. For public utility firm, neither increases nor decreases in planned capital expenditures are associated with significant excess stock returns. We interpret the evidence as being consistent with the hypothesis that managers seek to maximize the market value of the firm in making their corporate capital expenditure decisions.

Public capital expenditure in OECD countries, Sturm, J. E. (1998). Public capital expenditure in OECD countries. Books. This important book investigates the causes of the decline in public capital spending which has occurred in most OECD countries over the past 25 years, and estimates the macroeconomic consequences of this decline

Investment opportunities and market reaction to capital expenditure decisions, Chung, K. H., Wright, P., & Charoenwong, C. (1998). Investment opportunities and market reaction to capital expenditure decisions. Journal of Banking & Finance22(1), 41-60. In this study, we argue that share price reaction to a firm’s capital expenditure decisions depends critically on the market’s assessment of the quality of its investment opportunities. We postulate that announcements of increases (decreases) in capital expenditures positively (negatively) affect the stock prices of firms with valuable investment opportunities. Contrarily, we predict that announcements of increases (decreases) in capital spending negatively (positively) affect the share prices of firms without such opportunities. Our empirical results are generally consistent with these predictions. Overall, empirical evidence supports our conjecture that it is the quality of the firm’s investment opportunities rather than its industry affiliation which determines the share price reaction to its capital expenditure decisions.

The Impact of Firms’ Capital Expenditure on Working Capital Management: An Empirical Study across Industries in Thailand., Appuhami, B. (2008). The Impact of Firms’ Capital Expenditure on Working Capital Management: An Empirical Study across Industries in Thailand. International Management Review4(1). The purpose of this research is to investigate the impact of firms’ capital expenditure on their working capital management. The author used the data collected from listed companies in the Thailand Stock Exchange. The study used Shulman and Cox’s (1985) Net Liquidity Balance and Working Capital Requirement as a proxy for working capital measurement and developed multiple regression models. The empirical research found that firms’ capital expenditure has a significant impact on working capital management. The study also found that the firms’ operating cash flow, which was recognized as a control variable, has a significant relationship with working capital management, which is consistent with findings of previous similar researches. The findings enhance the knowledge base of working capital management and will help companies manage working capital efficiently in growing situations associated with capital expenditure.

The capital expenditure decision-making process of large corporations, Brigham, E. F. (1975). Hurdle rates for screening capital expenditure proposals. Financial Management, 17-26.

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