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Capital Expenditures
by WealthEffect Staff

 

Capital expenditures (Cap ex) fall into two categories
  There is a difference between necessary and discretionary cap ex
  This is not an exact science
 
1.

Cap ex encompasses all expenditures for factories and equipment that have a useful life of more than one year. These expenditures are not treated as an expense on the income statement when they are incurred. Rather, they are capitalized, meaning that they are expensed over time. For example, a new factory which cost $20m and has an estimated useful life of twenty years would created a depreciation expense of $1m/year on the income statement.

Cap ex falls into two categories: (1) expenditures which are necessary to maintain the existing plant & equipment in premium condition, and (2) discretionary expenditures for growth.

 
2.

Since necessary capital expenditures are required to maintain the business, it is a true expense. In determining free cash flow — the cash that the company has generated for its owners — necessary cap ex should be deducted from gross cash flow.

Discretionary expenditures, on the other hand, are a voluntary reinvestment in the growth of the business. The cash spent here could instead have gone to dividends, acquisitions, or share repurchases without harm to the existing business. These discretionary expenditures should not be deducted from gross cash flow in determining free cash flow.

 
3.

Although this distinction is crucial, it is often academic. Only a handful of companies distinguish between necessary and discretionary cap ex in their financial statements, and most can't even give you a confident estimate. Almost all will give you an estimate, but it's like asking for directions — people feel obligated to give an answer, whether or not they know.

As a practical matter, ask the question and, based on the reasoning behind the answer, judge for yourself its accuracy. The cap ex question will also give you some insight on how well managers, whether in operations or investor relations, know their business. At a minimum, assume that necessary capital expenditures are no less than depreciation. You can't be exact, but you should try to make a reasonable estimate. John Maynard Keynes argued, "I'd rather be vaguely right than precisely wrong."

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