When talking about capital expenditures, it helps to view them as investments. With that in mind, all investments should be considered carefully, and have a return. It’s typically something that you own, depreciates over a useful life, and is recorded as an asset on your balance sheet.
As consumers, capital expenditures are like when you buy a car. Usually you make that investment because your previous car has become too expensive to maintain, or you simply want to upgrade to something that will meet your needs better- that’s a capital expenditure. It’s no different for companies. A company’s capital expenditures, however, can range from building more facilities, investing in new equipment, new technology, real estate, and a variety of other tangible assets, depending on the company.
Similar to your own personal finances, for companies, cash is a limited resource and you can deploy it in one of several ways. One method is to reinvest in the business to grow and expand operations. Capital expenditures are used to do that. Capital expenditures are also used to invest in new equipment or technology or to replace equipment or technology that has reached the end of its useful life, and are too expensive maintain. Doing this lowers the ongoing operating cost for the company.
What’s important to remember is that all capital expenditures should have some type of return. Finance uses metrics like Net Present Values (NPV’s), Internal Rate of Returns (IRR’s) and payback periods to quantify returns.
In order to optimize the effectiveness of capital expenditures, the first step is to create a budget. You only have so much capital that you can access, and you have to know this constraint when you plan. Remember, a company has other options to deploy their cash, including returning it to shareholders (with stock buybacks or dividends), paying down debt, acquiring another business or conserving cash for future needs. It’s usually good know what you have to work with by setting a target, and creating a capital budget.
After you have your budget, the next order of business is to create a listing of all your alternatives. Often times there are more capital expenditure options and alternatives than there is a budget. So you may set aside a certain amount, but have a wish list that far exceeds that amount. The important aspect in that case is to prioritize those alternatives, which is typically done through standard financial metrics. As mentioned earlier, metrics like return on investment, net present value, payback period, and many more methods are utilized to sort through the alternatives. It many times it also comes down to qualitative factors that influence where you choose to invest.