Lesson 1 of 8 · All lessons in this module
- Types of capital investments
- The capital allocation process and NPVVideo lesson
- IRR, and choosing between IRR and NPVVideo lesson
- Return on invested capital (ROIC)Video lesson
- Integrated case: three projects against a ROIC target
- Principles of capital allocation
- Capital allocation pitfalls
- Real optionsVideo lesson
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Lesson 1 of 8 · 12 min
Types of capital investments
Capital investments are long-lived assets bought to keep the business running or to grow it, and their risk rises as the project moves further from what the company already does.
In short
- A capital investment (capital project) lasts a year or more and is recorded as a long-term asset at cost, then expensed gradually through depreciation or amortisation.
- Four types: going concern (maintenance), regulatory/compliance, expansion of existing business and new lines of business and other.
- Maintenance and compliance projects maintain the business and are lower risk; expansion and new lines grow it and carry more risk, with new lines the riskiest.
- Analysts often proxy maintenance capex by depreciation and amortisation; total capex minus that estimate approximates growth (expansion) capex.
- Match funding finances an asset with debt of a similar life, avoiding rollover risk.
How a capital investment shows up in the accounts
A capital investment (or capital project) is spending on an asset that will produce benefits for at least a year: a factory, a delivery fleet, a software platform. It can be tangible or intangible; more and more capital spending today goes into digital capabilities.
The purchase is not expensed when paid. It is recorded on the balance sheet as a long-term asset at cost. Each year a slice of the cost moves to the income statement as non-cash depreciation (tangible assets) or amortisation (intangibles). Spending is thereby smoothed over the years in which the asset produces benefits.
The balance sheet shows the asset net: cost less accumulated depreciation. That net figure falls each year until it reaches zero or a salvage value. The cash flow statement, by contrast, shows the full cash outlay in the period it is paid.
Analysts care because capital spending reveals strategy. Where a company puts its capital, and what it earns on it, says more about management quality and future prospects than almost any other decision.
Projects that maintain the business
Going concern projects, usually called maintenance capital expenditure, keep current operations running at their present size. Examples: replacing worn-out machines, upgrading IT hardware, swapping old lighting for more efficient units. They mostly repeat what the firm already knows, so they are relatively easy to evaluate and low in risk. Efficiency upgrades are judged by comparing the upfront cost with the expected savings.
Companies like to fund long-lived assets with financing of a similar life, called match funding. Financing a 25-year turbine with five-year loans creates rollover risk: the firm may have to refinance at a worse rate, or not at all, before the asset is worn out. Borrowing for much longer than the asset lasts has the opposite cost: a higher long-term rate or the expense of buying back debt that is no longer needed.
Regulatory/compliance projects are required by a third party, such as a government or regulator: pollution controls, safety upgrades, transaction-monitoring systems at a bank. They often add cost without adding revenue, but skipping them means fines or being forced to stop operating. So they may go ahead even with a negative NPV.
Compliance spending can still have strategic upside. New rules can act as a barrier to entry that protects incumbents. Firms with strong finances may adopt standards early to reduce uncertainty and win customers. And if the added cost pushes a business line below its required return, the right answer may be to pass costs on in prices, or to wind that line down.
Projects that grow the business
Expansion of existing business increases size (more capacity, more stores) or scope (adjacent products, new regions). Risks include sourcing inputs, production or distribution bottlenecks, the cost of winning new customers, and, for scope expansion, the complexity of running more business lines against new competitors. Young firms fund expansion mainly with equity; established firms with a good track record can often use debt.
New lines of business and other projects move into activities outside, or barely related to, what the firm does today: a startup-style venture into new technology, or the acquisition of a company in another industry. These are the riskiest capital investments, because management is on unfamiliar ground and may overpay.
Issuers rarely disclose how capital spending splits between maintenance and growth. A common shortcut is to treat depreciation and amortisation as maintenance capex, so growth capex ≈ total capex − D&A. The proxy works best for short-lived assets, where historical cost is close to replacement cost and expected useful lives match actual ones.
| Type | Purpose | Typical risk |
|---|---|---|
| Going concern (maintenance) | Keep current operations running, improve efficiency | Low |
| Regulatory/compliance | Meet rules set by a third party | Low; may proceed with negative NPV |
| Expansion of existing business | Grow size or scope of current activities | Low to moderate |
| New lines of business and other | Enter unrelated activities, often by acquisition | Highest |
Analysts should follow the level and trend of growth capex, by segment where disclosed, and ask what return it is earning compared with the alternatives.
Formula
- Estimated growth (expansion) capex
Uses D&A as a proxy for maintenance capex; most reliable for short-lived assets whose historical cost is close to replacement cost.
Worked examples
Example 1 Classifying capital projects
Classify each project: (1) a Swiss chocolate maker replaces ageing conveyor belts; (2) a Spanish bank installs software required by a new anti-fraud rule; (3) a Korean car maker opens a second plant for an existing model; (4) a Brazilian food group buys a drone-delivery start-up.
Example 2 Estimating growth capex
Halvorsen Marine reports total capital expenditure of NOK 820 million and depreciation and amortisation of NOK 510 million. Estimate its maintenance and growth capex.
Example 3 Match funding
A Danish utility is installing a wind turbine with a 25-year useful life. Its CFO is choosing between 5-year bank loans and a 25-year bond. Which is consistent with match funding, and what risk does the other choice create?
On the exam
Expect classification items (which project type fits a description, which is riskiest, which proceeds even with a negative NPV) and a quick growth-capex estimate using D&A.
- Thinking the purchase price of a capital asset is expensed immediately. It is capitalised and depreciated; only the cash flow statement shows the full outlay at once.
- Assuming a compliance project must have a positive NPV. It is required, so it may go ahead anyway; the real question is whether the whole business still earns its required return.
- Treating D&A as an exact measure of maintenance capex. It is a proxy, weaker for long-lived assets whose replacement cost differs from historical cost.
Check yourself
Q1A company reports total capital expenditure of GBP 640 million and depreciation and amortisation of GBP 410 million. Its estimated growth capex is closest to:
Q2Which type of capital project is most likely to be undertaken even if its estimated NPV is negative?
Q3Which category of capital project typically carries the highest risk?
Q4A water utility funds a pipeline with a 40-year life using five-year bank loans. This choice most likely exposes the utility to:
Q5When a company buys a new production machine for cash, the outlay is most likely recorded:
Answer the 5 questions: +10 XP for each one you get right first time.
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