Capital Expenditure

Capital Expenditure - CAPEX

Capital expenditure or CAPEX is referred to the investment of financial capital in plant, equipment, buildings and related items that are used to produce and/or deliver the company’s products and services. Capital expenditure decisions are usually performed by operations managers and business analysts who analyse the different investment options available to the company in order to invest capital. Capital investment is also a part of the strategic plan for a business.

Plant and equipment bought as capital expenditure is not classified as an expense on the company’s financial statements, and is added to the company’s balance sheet and then depreciated every year by a certain amount for a certain period of time depending on its useful life and depreciation schedule.

Analysis of Capital expenditure investment

The different options or projects are usually analysed and ranked by different measures of financial KPI’S or a combination of these, some of these are

Return on Capital; the return on capital for the capital expenditure investment must usually be above the cost of capital for the company as a minimum. Each company will usually have its own hurdle rate for return on capital so that a capital expenditure can go ahead, this may be based on a real return on investment they may wish to achieve in their particular industry or market conditions

Payback period; the payback period is the time it takes to recoup its investment capital. This is a common investment KPI used to gauge the benefits of purchasing plant and equipment. Some companies use the discounted payback period as a more accurate measure.

Discounted Cash flow valuations; this measure is used to analyse the additional cash flows that a capital expenditure may generate for a business and then discount these cash flows to present day values to see if the sum of these cash flows is positive or negative. This will greatly depend on the discount rate used and cash flows generated in the years ahead. Other market/industry factors; other factors may still influence a company to commit capital into purchasing plant and equipment such as regular wear and replacement, sustaining industry position and market share or to establish production capacity well ahead of demand to deter new entrants.

Executing Capital Expenditure

Capital Expenditure requests are a formal set of documents completed by the executing department in the company which will be presented to senior management for consideration. A typical Capital expenditure request will consist of a brief explanation on the location, use and nature of the items or plant/equipment to be purchased, followed by its financial justification using one or several of the measures mentioned above. For plant and equipment purchases most company policies require several competing quotations from different suppliers or providers.

It is quite usual for most capital expenditure request put forward to senior management to have provisions for unforseen costs and allowance for purchase price variations which are likely to happen with larger and more complex capital expenditure projects. These potential costs overruns should be included into the analysis or investment valuation model to understand the potential impacts on rates of return if they were to eventuate.