November 23, 2020

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Introduction to Capital Expenditure

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Introduction to Capital Expenditure

Definition

Capital expenditure can be defined as any expenditure incurred in creating, acquiring, expanding, or improving an asset for use by a company. The important point is that the benefit from such capital expenditures will be spread over a number of accounting periods. For example, a brand new research center for Company B would be correctly classified as a capital expenditure. On the other hand, the cost of operating the equipment in it would be an ongoing (operating) expense.

Depending on the type and price of the equipment in question, the purchase price of these machines can be attributed to either operating costs or capital costs. Those that are quite expensive and which are supposed to be used for a long period of time will correctly be attributed to capital costs; everything else can be considered operating.

Examples

Examples of capital expenditure (CapEx) are:

  • purchase of fixed assets (plant, property, and equipment)
  • significant improvement of existing fixed assets
  • long-term lease acquisition.

Take the example of a trader who needs, among other things, a space for his operations. In addition, he will bear the costs of lighting and heating, as well as the payment of wages and salaries to his staff. The purchase of the premises is classified as capital expenditure. On the other hand, the costs incurred by him for the purchase of goods are classified as operating costs and represent the cost of doing business. At the end of the accounting period, capital expenditure costs will be shown on the Balance sheet statement under the heading of the respective main asset.

Throughout the life of the company, most capital expenditures gradually become expenses as part of the profit-making process. For example, if an asset was originally valued at $3,000 and had an estimated useful life of three years at zero residual value, then it would lose a portion of its original $3,000 value in the process of generating profit for the company through the output it provides every year. 

Introduction to Capital Expenditure

What does the CapEx size mean for an investor?

CapEx is used in the financial analysis of an enterprise when calculating free cash flow, as well as in some financial ratios. However, the expected amount of capital investment in future periods in itself can also provide some information to investors.

A company generally has two main options for distributing earned profits: paying out profits to shareholders in the form of dividends or investments in fixed assets (CapEx). Thus, the growth of capital expenditure reduces the expected amount of dividends.

At the same time, capital expenditures contribute to the development of the company and the growth of its profits in the future, therefore, in itself, they are not a bad thing. In essence, the choice between dividends and CapEx is a choice between making a profit here and now, and making a profit in the future, but on a larger scale.

It should be noted, however, that capital-intensive enterprises need such resources not only to expand but also to maintain the current level of production. Otherwise, at some point, production and profits will begin to decline due to the depletion of fixed assets, which will lead to a lower return on equity. Therefore, from the shareholder’s point of view, the company must maintain a reasonable balance between dividends and capital expenses.

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Author: Charles Lutwidge

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