Capital Expenditure (CapEx)

What is Capital expenditure (CapEx)?

Capital expenditure, or CapEx, refers to the funds a business uses to acquire, upgrade, or improve long-term tangible assets such as property, plant, and equipment (PP&E). Unlike operating expenses that are expensed immediately through the income statement, CapEx is capitalized and held on the balance sheet as it is considered an investment in the company’s future operations. Capital expenditure is crucial for companies aiming to grow and maintain their businesses, however CapEx has a significant impact on cash flow even though there may not be an immediate impact on the income statement.

Examples of CapEx are shown below:

• Office buildings
• Land
• Equipment and machinery
• Computers
• Furniture
• Vehicles

CapEx Formula

CapEx can be determined using two primary methods:

1. Finding CapEx on the Cash Flow Statement
2. Calculating CapEx through BASE analysis

1. Finding CapEx on the Cash Flow Statement

CapEx can be found in a company’s cash flow statement, it is reported in the cash flow from investing activities. If the proceeds from the sale of PP&E and other assets are also listed, that amount should be subtracted to arrive at the net CapEx.

Example of CapEx calculation:

Snapshot of Microsoft’s 10-K filing

Source: Felix

According to Microsoft’s 10-K filing, its capital expenditure for the year ending June 30, 2024, was $44.5bn, compared to $28.1bn in 2023 and $23.9bn in 2022.

2. Calculating CapEx through BASE analysis

BASE analysis involves comparing the beginning and ending amounts of net PP&E on the balance sheet, adjusting for depreciation and any asset disposals. The net PP&E BASE is as follows:

The formula can be rearranged to calculate CapEx as follows:

Where to find these line items:

• Depreciation is usually found under operating activities in the Cash Flow Statement, often grouped with amortization. To find the exact depreciation amount, it’s advisable to check the PP&E notes. Alternatively, depreciation may also be listed in the Income Statement, though it may not always appear as a separate line item there.
• Current and prior period PP&E values can be located on the Balance Sheet.

Example of CapEx calculation:

Snapshot of Microsoft’s 10-K filing

Source: Felix

Based on the above information, the capital expenditures made by Microsoft during the year ending June 30, 2024 is as below:

Insight:

The CapEx calculated from the two methods above is significantly different. CapEx on the cash flow statement is $44.5bn whereas the BASE analysis gives a figure of $55.2bn, a difference of $10.7bn. The cashflow figure of $44.5bn is likely to be the more correct figure as the BASE analysis will be distorted by a number of factors such as the effect of business acquisitions and disposals on the net PP&E amounts. In practice therefore CapEx for the current and previous years is typically sourced directly from cash flow from investing activities, while BASE analysis is used to forecast future periods in financial models.

Importance of CapEx

Driving Sales Growth

• Capacity Expansion: Investing in new facilities or equipment increases production capacity, enabling higher sales volumes.
• Product Development: Some product and process development costs can be capitalized which can lead to new products or processes that boost sales.

2. Enhancing Operational Efficiency

• Technology Upgrades: Implementing advanced systems can streamline operations and reduce costs.
• Equipment Modernization: New machinery often operates more efficiently than older models.

3. Strategic Advantages

• Market Positioning: Continuous investment signals to the market that the company is committed to growth and innovation.
• Attracting Investors: Robust CapEx plans can make a company more attractive to investors seeking growth opportunities.

Types of CapEx: Expansion and maintenance

CapEx which is mentioned above is the sum total of both expansion CapEx and maintenance CapEx:

1) Expansion CapEx refers to the CapEx that expands the company’s operations, increases production capacity, or enables entry into new markets. These investments are intended to generate additional revenues and drive the company’s growth beyond its existing capabilities.

For example: Tesla building gigafactories to scale up the production of electric vehicles and batteries.

2) Maintenance CapEx refers to the CapEx necessary to maintain the company’s current operational capacity and efficiency. This includes replacing worn-out or obsolete assets to ensure that the company can continue its existing level of production or service delivery. Unlike growth CapEx, maintenance CapEx does not contribute to growth; instead, it preserves the company’s ability to generate current revenues. An important aspect of maintenance CapEx is that its benefits should extend over multiple years; otherwise, if the benefits are limited to just one year, it would be considered an operating expense instead.

For example: Ferrari conducted a major repair in the paint shop, extending the usability of paint equipment by another 5 years.

CapEx vs. Operating Expenses (OpEx)

Aspect	CapEx	OpEx
Nature	Long-term investment	Short-term expenses for daily operations
Accounting Treatment	Capitalized and depreciated over the asset’s useful life	Expensed fully in the period incurred
Impact	Affects the balance sheet (assets increase) and income statement (depreciation expense over time)	Directly reduces net income on the income statement, since it is treated as an operational expense
Example	Purchasing land, buildings, and machinery	Rent, utilities, wages and salaries

Forecasting CapEx

Accurate CapEx forecasting is essential for budgeting and valuation models. Here are methods to forecast CapEx:

1. Company guidance

• Approach: Review statements from company management found in earnings transcripts, annual reports, or investor presentations.
• Benefit: Offers direct insight into planned investments and short-term CapEx needs.
• When to use: Company guidance is most useful for near-term forecasts, typically covering the next 1 to 3 years. It reflects the company’s immediate investment plans based on their strategic objectives.

2. Sector analysis using ratios

• Approach:
  • Identify at least three comparable companies in the industry, with similar revenue and growth profile (Peer 1, Peer 2, Peer 3)
  • Calculate key ratios such as CapEx to Sales ratio for peers
  • Compute sector averages
  • Multiply the sector average ratio by the company’s relevant line item to estimate CapEx
• Benefit: Helps establish benchmarks and anticipate industry-wide investment patterns.

a) CapEx to Sales Ratio

CapEx to Sales Ratio Formula: This ratio is the most common when benchmarking a target firm to its peers.

• Insight: Indicates how much the company is investing in capital assets relative to its revenue. Forecasting based on this ensures that CapEx scales with company growth, aligning investment with expected revenue. Higher ratio suggests aggressive investment for growth or modernization, whereas, lower ratio may indicate underinvestment, potentially affecting future growth.
• When to use: Useful for both medium and long-term forecasts to project CapEx based on expected sales growth.
• Other CapEx related ratios that give and insight into the CapEx and Non-current asset position of a firm include

b) Reinvestment Ratio

• Reinvestment Ratio Formula:  
• Insight: This ratio indicates whether a company is expanding, maintaining, or reducing its asset base. A ratio above 1 suggests asset base expansion, a ratio around 1 indicates maintenance of current assets, and a ratio below 1 points to underinvestment or asset divestment.
• When to use: Helps in assessing the sustainability of operations over the medium to long term.

c) Average Age of Assets

• Average Age of Assets Formula:
• Insight: By assessing accumulated depreciation as a percentage of the asset’s gross value, we can gauge the asset’s age in relation to its total lifespan. A high ratio indicates that a significant portion of the asset’s life has been utilized, suggesting an ‘aging asset base’ that will soon require investment.
• When to use: Important for long-term forecasting to anticipate significant asset replacements.

CapEx in Free Cash Flow Analysis

CapEx is a critical component when calculating Free Cash Flow to Firm (FCFF), which measures the cash available to the company after accounting for capital expenditure.

• Discounted Cash Flow (DCF) Analysis: FCFF is used as an input to estimate the present value of a company by projecting future cash flows and discounting them back to their present value.
• Debt Capacity Assessment: Lenders assess FCFF to determine a company’s ability to service and repay debt.
• Note that while CapEx reduces FCFF in the short term, prudent capital investments can lead to higher cash flows in the future.

Relationship Between CapEx and Depreciation

When a company incurs CapEx, the expenditure is initially capitalized, i.e. added to the asset base on the balance sheet. However, this cost is then expensed to the income statement over its useful life through depreciation (for tangible assets) or amortization (for intangible assets).

To illustrate the impact on financial statements, consider this example: A machine purchased for $100,000 in cash at the start of the financial year, with a 10-year useful life, is depreciated using the straight-line method. The financial statement impact in the first year would be as follows:

• Income Statement: A depreciation expense of $10,000 ($100,000 ÷ 10) will be recorded as an expense.
• Balance Sheet: Gross PP&E initially increases by $100,000. At the end of the first year the depreciation is deducted from the PPE balance leaving a net balance of $90,000.
• Cash Flow Statement: The only impact on cash is the initial spend of $100,000 which is shown as CapEx appears under cash flow from investing activities. Under the cashflow from operating activities the depreciation of $10,000 is added back to the net income as it is a non-cash expense.

Insight: In financial modeling, towards the end of the projection period, depreciation is often set as a percentage of CapEx, typically around 90-95%. This reflects that most CapEx is allocated toward replacing depreciated assets, also referred to as maintenance CapEx. Since revenue growth rates are normalized to a steady state of around 2-3% by this stage, only a small portion, usually 5-10% of CapEx, is allocated to growth CapEx. This approach aligns with the assumption that, as the company matures, the focus shifts from expansion to sustaining existing operations, with incremental CapEx primarily supporting replacement rather than expansion.

Challenges with Capital Expenditure

1. High Initial Costs

• Financial Strain: Significant upfront investment can strain cash flow and liquidity.
• Financing Needs: May require external financing, leading to increased debt and interest obligations.

2. Risk of Obsolescence

• Technological Changes: Rapid advancements can render new assets obsolete quickly.
• Market Shifts: Changes in consumer preferences may affect the viability of invested assets.

3. Capital Allocation Decisions

• Resource Allocation: Determining where to invest limited resources for maximum return is complex.
• Opportunity Cost: Investing in one area means potentially neglecting others.

4. Implementation Risks

• Project Delays: Construction or installation may take longer than planned, delaying benefits.
• Cost Overruns: Projects may exceed budgeted costs, affecting profitability.

Conclusion

CapEx is a crucial investment that enables companies to expand, innovate, and maintain their competitive edge. While it requires significant upfront costs and carries risks, strategic CapEx decisions can lead to increased operational efficiency, higher sales growth, and long-term value creation. Understanding CapEx’s role in financial statements, cash flow analysis, and forecasting is essential for investors, managers, and stakeholders aiming to assess a company’s financial health and growth prospects.

Additional Resources

Investment Banking Courses

M&A Explained

Fixed Asset Ratios

Free Cash Flow to Firm

Accumulated Depreciation

Depreciation

Straight Line Depreciation