Capital expenditure (CAPEX or capex) occurs when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life that extends beyond the taxable year. Capex is used by a company to acquire or upgrade physical assets such as equipment, property, or industrial buildings.
For tax purposes, capital expenditures are costs that cannot be deducted in the year in which they are paid or incurred, and must be capitalized. The general rule is that if the property acquired has a useful life longer than the taxable year, the cost must be capitalized. The capital expenditure costs are then amortized or depreciated over the life of the asset in question.
So basically, capex means buying fixed assets. These fixed assets are used to generate future profits; the assets are a means to an end. It is the future profits that add value to the company rather than the capex. Let me illustrate this through the telecoms industry. Operators invested billions in networks and yet these operators are now being acquired for mere millions. Why – because the income from the assets in which they invested has plummeted with the fall in bandwidth prices. The assets have a value in the accounts but the value that counts to an investor is based on the income that they can generate.
It is the market that determines the real value of capex.
Opex or operating expenses are those expenses that relate to keeping the business running in the current period – in other words COGS, SG&A (Selling, General and Administrative) and R&D. So Opex is what you deduct from Revenues to get EBITDA.
You often hear of firms restricting capex and may have got the impression that capex is bad. Capex ties up money. It is risky because technology, customer preferences or economic conditions may change. So avoid capex. Rather than invest in plant and equipment, outsource. Let others manufacture whilst you safeguard your capital and minimize risk. Or so the logic goes.
It isn’t quite that simple. As we shall see when we look at shareholder value, the key factors that we need to consider in evaluating our future strategy from a financial perspective are:
Here are two reasons why investing in capex can be the better option:
Capex, of course, doesn’t only relate to manufacturing. A professional services firm may invest in a management information system or buy their own offices. There is currently a debate raging relating to the merits of using cloud computing or one’s own servers. Like most arguments around capex v opex, there are other factors to consider and whichever option is chosen, there are trade-offs to be made: scalability, loss of control, data security, support staff and so on.
The key point is: neither capex nor opex is inherently right or wrong. A business case should be developed which considers all factors.