What is capital investment (capex)?
– Capital investment—often called capital expenditure or “capex”—is the money a business spends to acquire, improve, or extend the life of long-lived physical assets used in its operations. Examples include land, buildings, machinery, vehicles, and major IT systems. These are assets intended to deliver benefits over multiple accounting periods.
Key ideas (short)
– Purpose: increase production capacity, lower long‑run costs, modernize operations, expand market reach, or gain a strategic advantage.
– Funding: internal cash, bank loans, bonds, sale of equity, venture capital, or leasing.
– Accounting: capitalized on the balance sheet and expensed over time through depreciation (except land, which is not depreciated); impairment tests may apply if value falls.
– Trade-offs: upfront cash outlay and financing costs versus long‑term benefits; can reduce near‑term profitability and liquidity.
How capital investments work (step-by-step)
1. Identify need and options: e.g., buy or lease equipment; upgrade plant; acquire a competitor.
2. Estimate costs: purchase price, installation, commissioning, taxes, and any working capital tied up.
3. Forecast incremental cash flows: additional revenues, cost savings, routine operating costs, maintenance, and eventual salvage (resale) value.
4. Choose evaluation metrics: payback period, net present value (NPV), internal rate of return (IRR), and scenario/sensitivity analysis.
5. Decide financing: use internal cash or raise funds (equity, debt, leases). Include financing costs in project analysis where appropriate.
6. Approve and implement: procure asset, record capital expenditure on books.
7. Account and monitor: depreciate annually (or amortize), review actual performance vs. forecast, test for impairment if performance deteriorates.
Common types of capital investment
– Land and buildings (real estate)
– Production machinery and plant equipment
– Vehicles and transport fleets
– Information technology systems and major software implementations
– Office fit‑outs and infrastructure upgrades
– Acquisitions of other businesses or significant equity stakes
(Note: accounting treatment for intangibles and R&D can differ by accounting standards.)
Advantages
– Higher capacity and productivity (e.g., faster machines, automated lines)
– Lower unit costs over time if the investment is more efficient
– Improved product or service quality
– Potential long‑term competitive barriers (higher entry costs for rivals)
– Possible tax benefits through depreciation allowances
Potential drawbacks
– Large upfront cost; may require external financing
– Short-term reduction in reported profits because of high initial outlay and financing costs
– Reduced liquidity and higher leverage risk if financed with debt
– Difficulty selling specialized assets (low resale value)
– Shareholder dilution if financed by issuing stock
Accounting basics (what gets recorded)
– Capitalize the cost: debit an asset account for the purchase price plus directly attributable costs (installation, transport).
– If financed with debt: recognize the corresponding liability.
– Depreciate the asset over its useful life (straight‑line, declining balance, or other methods), except for land, which is not depreciated.
– Record depreciation expense on the income statement and accumulated depreciation on the balance sheet.
– If future cash flows fall below carrying value, perform an impairment test and write down the asset if needed.
Short checklist before approving a capital investment
– Objective: What business problem or opportunity does this solve?
– Alternatives: Buy vs lease vs outsource; different suppliers or configurations.
– Cost estimate: Purchase, installation, taxes, and working capital impact.
– Cash‑flow forecast: Incremental revenues, cost savings, recurring costs, and salvage value.
– Evaluation metrics: NPV (use a realistic discount rate), IRR, and payback (discounted and undiscounted).
– Financing plan: Source(s) of funds and implications (interest, covenants, dilution).
– Accounting and tax impact: Depreciation schedule, tax benefits, and disclosure.
– Exit and liquidity: Resale prospects and marketability of the asset.
– Risk assessment: Sensitivity scenarios and contingency plans.
Worked numeric example (simple)
Assumptions
– Equipment cost: $500,000 (cash outflow at t = 0)
– Annual incremental operating cash inflows: $120,000 at year‑end for 6 years
– Salvage value at end of year 6: $50,000
– Discount rate (company’s required return): 10%
1) Net Present Value (NPV)
– PV of annual cash inflows = 120,000 × [1 − (1 + 0.10)^(−6)] / 0.10 ≈ $