The first step in determining the costing of capital is defining what is capital expenditure. Capital cost is the amount of money that an entity or business spends on fixed assets during a period of time to purchase, improve, or maintain its fixed assets, including buildings, furniture, equipment, and land. Fixed assets are items that an entity or business owns outright such as real estate, personal property, and patents. These assets cannot be replaced, but they can be altered or modified to increase their value. Examples of fixed assets include machinery, buildings, and vehicles.
When determining what is capital expenditure, one must determine which category of fixed assets of the entity or business will use. For most businesses, this category is fixed equipment. Fixed assets do not depreciate over time, although changes in tax laws and the economy can have a significant impact on the effective value of a fixed asset. In most cases, a business’s total cost of ownership is equal to the sum of its total cost of operation divided by the total number of years it has been in business. This includes all expenses necessary to operate the business, such as overhead costs, rent, and utilities.
A company’s operating cash flow, also known as recurring sales revenue, represents the amount of money it receives minus the amount it pays out to investors, contractors, and subcontractors. The two components of a company’s capital consist of assets and liabilities. One must consider what is capital expenditure when determining the operating cash flow. The value of an asset or liability is determined by comparing it to the price that someone would pay to purchase or sell the item with similar characteristics to the ones being purchased or sold. Therefore, allocating assets and liabilities between net working cash and long-term financing results in an accurate picture of a company’s capital structure.
There are several factors that determine what is capital expenditure. Factors that directly affect capital expenditures include the age and condition of the fixed assets. If they are still operable and if they are not being replaced, there is no need to calculate capital expenditures. Fixed assets that are still owned by the business can be depreciated over time. If, however, the fixed asset has a fair market value, the company can allocate part of its capital budget to capitalizing an asset.
The other major factor that determines what is capital expenditure is a company’s capex. Capital expenditures are equal to the cost of doing business divided by the net book value of the fixed assets or equity. The portion allocated to fixed assets can be considered the fixed capitalization limit. Any part of the capitalization limit that is not used can be allocated to long-term financing.
Fixed capital expenditures are a direct result of the rate of interest, period of time, and the interest rate spread, and other factors such as credit risk and capital gains. Fixed capital assets include machinery, property, and fixed assets that have high productivity. Long term capital expenditures include plant and equipment, and fixed assets such as construction and real estate. The combination of these types of capital assets and long term capital expenditure results in what is termed a ‘fixed income.’
A company may choose to allocate a small portion of its total capex for fixed asset and long term financing and another small portion of its case for short-term financing needs. When determining what is capital expenditure, the ratio of long-term versus short-term financing borrowings is considered. A company’s capital expenditures can be split into two categories: one category that represents fixed assets that are used primarily for equipment and production and another category that represents fixed assets that are used for plant, property, and production but that are not actually used for production. A company’s primary activity will determine the second category more than the first.
The total of a company’s capital assets can only be determined at the annual or quarterly shareholders’ meeting, at which point the CPA provides a breakdown of the company’s assets for the previous year. The process of capitalization begins at this point in the year. As the company progresses through the year, a CPA may provide a breakdown of the company’s operating expenses and determine what is capital expenditure. This is also where the company’s operating cash flow is calculated. At the end of the year, the CPA may provide a breakdown of the company’s cash flow performance, determining what is operating, increasing cash flows, and what is capital expenditure.