capital-expenditure

Capital Expenditure: CAPEX Vs. OPEX And How They Work

Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed assets, with a longer-term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

CAPEX vs. OPEX

They are the acronyms for Operating Expenditure and Capital Expenditure. For example, imagine you own a real estate firm.

The firm bought an apartment complex with few units. In order for you to rent the apartments, you have to clean and furnish them.

The former activity implies that you call the maid, and pay him/her $100 to have the apartment cleaned.

The latter activity instead implies buying things, such as couches, kitchen stoves, beds, and so on. They will cost you thousands of dollars but will last for a few years.

The Operating Expense is money spent on the day-to-day operations of the business. Capital Expenditure, instead, is money invested in the business from a long-term perspective.

Stop for a second and think. Is the cleaning service OPEX or CAPEX? 

The $100 paid to the maid is OPEX.

The money spent on furnishing the apartment, instead, will be defined as CAPEX.

What helps to discriminate between the two are actually three factors:

  • Useful Life (More than one accounting cycle).
  • Amount Spent (Over $2,500).
  • Future Benefits (Will generate revenue).

Indeed, in the first scenario, the maid cleaning expense will have a useful life of a few weeks. Furthermore, it is worth less than $2,500 and it won’t produce any future benefits.

On the other hand, couches and kitchen stoves will have a useful life of few years.

Further, whey will be worth over $2,500 and it will produce future benefits. Of course, there are a few exceptions. 

Case study

Imagine, the apartment complex your company bought needs to be repainted. Therefore, the painting work is comprised of material (Paint) for $500 and labor (Painter) for $5,000.

The painter’s work meets all the criteria above; thereby it is a Capital Expenditure. What about the material (paint)? Even though the paint does not meet all the three CAPEX requirements.

Although, it can have a useful life of more than one accounting cycle, in our specific case it is not worth more than $2,500. Indeed, there is no way the painter would be able to finalize the work without pain.

Therefore, we will consider the paint as part of the overall work. Thereby, the paint and the labor will be both considered CAPEX. Why is this difference between operating and capital expenditure crucial? 

In reporting terms the operating expense will be stated on the Income Statement (Expense Section), the Capital Expenditure instead will be stated on the Balance Sheet (Non-Current Assets Section). 

Why is Capital expenditure stated on the Balance Sheet?

Because it will be capitalized. What does it mean? Let me give you a further example. Imagine you bought $20,000 worth of furnishing.

Assuming that the useful life of the items is ten years.

If you were to report the $20K furniture as an expense in the first year your profits would be completely eroded due to the fact that you should report a $20K expense under your income statement.

Instead, since this is a capital expenditure it needs to be spread along with its useful life. In the specific example: ten years.

Thereby, you will report a depreciation expense of $2,000 on your income statement and concurrently decrease the asset value by $2,000 on your balance sheet.

See the example below:

Difference between Tangible and Intangible Assets

The former are things with a physical entity, while the latter does not have a physical entity. Imagine you own an IT corporation.

What do you need to operate the business? Of course, you need the office, computers and office supplies.

Assuming the corporation produces accounting software. How is your organization generating revenue? Through licensing the software. Therefore, it is crucial to make sure no one will clone it. 

How can you avoid cloning?

Through patenting the software. In this example, the patent is an Intangible Asset. The remaining assets: Office building, computers, and supplies are Tangible Assets. 

Why is this difference important? 

Depreciation & Amortization (D&A).                                    

In the previous example, the IT Corporation needs computers to operate. Assuming 10 computers were bought for $2,000 each, the total Capital Expenditure was $20K.

Furthermore, they won’t last forever. Assuming a useful life of five years we have to figure out: What is the depreciation and How to record the transaction.

First, depreciation is the decreasing value of the asset on a yearly basis. Second, the formula to compute the depreciation rate is (Asset Cost – Residual Value) / Useful Life.

Let’s solve the previous example: the asset cost = $20,000 minus the residual value = $2,000. Divide the result by 5. 

This is the formula: ($20K Cost – $2k Residual Value) / 5 years Useful Life) =  $18K / 5 = $3,600 per year. In conclusion, your schedule will look like the following:

Assuming the computers were bought at the beginning of Year 1, at the end of the year their value would decrease by $3,600 to $16,400. Up to Year 5, when the residual value will be $2,000. 

This method is called straight-line depreciation. Although there are several depreciation methodologies, the straight-line is the most commonly used.

Why do we need to depreciate?

As we saw in step 1, it would be unfair to report the whole asset cost under the Income Statement since it would completely erode Net Income.

It is correct instead to spread the value of the asset over the useful life. 

Amortization follows the same process as Depreciation. Keep in mind: that the tangible assets are depreciated; the intangible assets are amortized.

If we go back to the example made a while ago, the IT corporation has at its disposal: tangible assets, such as computers, and intangible assets, such as patents.

Therefore, the former will be subject to depreciation, the latter to amortization. 

Amortization and Depreciation are linked to ordinary events in the asset’s life. When, instead, an asset loses value unexpectedly, it will be subject to impairment.

Imagine your real estate company bought a building at $10 million, with a useful life of 5 years.

At the end of year two due to earth quick, the building is badly damaged. Suddenly the fair market value drops to $5 million. The company decides to sell the building. 

How do we estimate the impairment?

First, we have to estimate the carrying value of the Building. This is the Cost of the asset minus its accumulated depreciation = $6 million, or $10 million minus $4 million (10 million/5 years = 2 million x 2 years). 

The book value of the building at year two is $6 million and the recoverable amount is $5 million, therefore the impairment amount is $1 million.

The following journal entry will be recorded on our balance sheet and income statement:

The impairment loss will be reported under the income statement as an expense and the accumulated impairment on the balance sheet will decrease the value of the building. 

Imagine the opposite scenario. The building increased in fair value instead. At the end of year one, the building is worth $9 million.

Given the carrying value of the building of $8 million, it revaluated by $1 million. We have to record the revaluation on our books:                               

The revaluation will increase the value of the building on the balance sheet and determine a surplus/gain on our income statement.

Capital expenditure examples

Below we will list some examples of where a business may spend money to purchase, upgrade, or extend the life of an asset. 

Property, plant, and equipment

Property, plant, and equipment (PP&E) assets are tangible, identifiable, fixed, long-term assets that are predicted to result in an economic return for at least one year, operating cycle, or reporting period.

PP&E is a broad classification with many different asset types.

But in general, purchases of these assets are made with secured debt with repayments made over a number of years.

Here are some of the asset types and some examples for each.

Machinery/equipment

Consider a cement manufacturing company that wants to upgrade the assets at its factory.

In this example, capital expenditure applies to items such as a cement roller press, cement rotary kiln, shaft kiln, and cement vertical mill.

The costs acquired to transport the machinery/equipment to its intended location can also be considered capital expenditure.

Land

The purchase of land is also a capital expenditure in some cases.

When an airport management company wants to expand its operations, it may purchase a tract of land to build a new airport or expand an existing one.

CAPEX also applies when the land is upgraded.

For example, the company that owns a sports stadium may install a new irrigation system or build a new parking lot for fans.

Vehicles

Broadly, vehicles are considered a capital expense when they pick up clients, transport goods, or are otherwise used for business-related purposes.

In the case of a rental company that leases vehicles to individuals and other businesses, the vehicles are considered a capital expense irrespective of whether their purchase was funded by debt or cash.

However, it should be noted that if another business leases vehicles from such a company, it is an operational expense.

Software 

Software purchases are complex in that some are CAPEX and others are OPEX.

Owned enterprise software licenses and upgrades are generally considered capital expenditures and can be depreciated provided they meet certain criteria. 

If the company is creating software from scratch, some internal research and development or technical design expenses can also be capitalized and depreciated.

Hardware

Hardware such as computers, servers, and uninterrupted power supply (UPS) systems can be listed as a capital expense provided the company owns them and has total control over their location, disposition, and use.

If a company wants to enable its staff to work remotely, for example, a capital expense may be the laptops it must purchase.

Intellectual property, patents, and licenses

Intangible or non-physical assets such as intellectual property, patents, licenses, and trademarks can also be considered capital expenditures.

One example is a taxi company that needs to purchase a taxi license to operate lawfully.

Another example is the pharmaceutical giant GlaxoSmithKline (GSK).

The company has significant capital expenses related to research, development, and patenting of medicines, vaccines, and other consumer healthcare products.

Key takeaways

  • CAPEX or capital expenditure represents the money spent by the organization, in what are defined as fixed assets, on the balance sheet.
  • The capital expenditure will sit on the balance sheet, and be amortized over the years as amortization expenses under the income statement.

Connected Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

profitability
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.

Triple Bottom Line

triple-bottom-line
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

behavioral-finance
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

Connected Video Lectures

Resources:

About The Author

Scroll to Top
FourWeekMBA