Capital Expenditure (CAPEX)
A capital expenditure (CAPEX) is defined as an expenditure contributing value to the property and equipment of a business. It is an expenditure toward capital assets, as contrasted with spending that covers operating expenses (OPEX) or purchase of investments unrelated to the company's primary business.
Capital expenditures generally takes two forms: maintenance expenditures, whereby the company purchases assets that extend the useful life of existing assets, and expansion expenditures, whereby the company purchases new assets in an effort to grow the business. It is important to understand that money spent to repair or conduct ongoing, normal upkeep on assets is not considered CAPEX and should be expensed on the income statement when it is incurred.
A capital expenditure is recorded as an asset, rather than charging it immediately to expense. The fixed asset is then charged to expense over the useful life of the asset, using depreciation. For example, if you acquire a $25,000 asset and expect it to have a useful life of five years, charge $5,000 to depreciation expense in each of the next five years.
Capex is an important component in the determination of free cash flows in a business. It has become common place to use EBITDA as a proxy for free cash flows and as the default metric when calculating the enterprise value of a company. EBITDA does not consider capex, and in a capital intensive business, EBITDA could be considerably different from free cash flows due to the cash investment required for capital equipment. Using EBIT as a valuation metric partially alleviates some of these issues by deducting depreciation. EBIT may take into account the capital expenditure needs of the business but only if annual depreciation and capex are similar. A hybrid calculation being "EBITDA less future capex" is often used by sophisticated buyers. When selling a business it is also important to distinguish between:
- sustaining capex - capital expeditures required to maintain the existing asset base at their current capacity and condition in order to achieve similar revenue levels; and
- growth capex - capital expenditures required to achieve any additional revenue growth and expansion over and above what was reached historically.
The differentiation of sustaining and growth capex is relevant in the preparation of a company's financial forecasts. If future projections show 'hockey stick" growth, then potential buyers will expect to additional growth capex in the forecasts that will reduce future cash flows.