Types of capital investments
Capital investments are long-lived assets, tangible or intangible, recorded on the balance sheet and expensed over time through depreciation or amortization. They fall into four groups: keeping the business running, meeting regulations, expanding the existing business, and moving into new lines of business, with risk generally rising in that order.
Before this: Time Value of Money in Finance
On the exam
- Describe types of capital investments
Describe the types of capital investments. Expect a classification item (which type is this project?), a question on compliance projects with a negative net present value (NPV), and a maintenance versus growth capital expenditure estimate from capex and depreciation.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What counts as a capital investment?
Capital investments (also called capital projects) are investments with a life of a year or longer. They usually appear on the balance sheet as long-term assets, and they can be tangible (a plant, a fleet) or intangible (software, a patent). The same cash-flow logic applies to all of them.
An asset is first recorded at cost. The spending does not hit the income statement all at once. Instead, a slice is expensed each year as a non-cash depreciation charge (for tangible assets) or amortization charge (for intangible ones) over the asset’s useful life. On the cash flow statement, the full cash outlay shows up when it is paid.
Take a bakery oven bought for 90,000 with a five-year life. The income statement carries 18,000 of depreciation each year, and the oven sits on the balance sheet at 72,000 after year one, 54,000 after year two, and so on. The cash left the business on day one.
What are the four types of capital project?
Projects differ in why they exist and in how much they can go wrong. Some keep the business as it is; others change it.
- Maintain the business keep what exists
- Going concern (maintenance) Memorize replace, repair, improve efficiency
- Risk: lowcopies existing operations
- Regulatory / compliance Memorize required by a law or a supervisor
- Risk: low business riskoften negative NPV but required
-
- Grow the business add size or scope
- Expansion of existing business Memorize bigger, wider, R&D and deals in the core
- Risk: moderateknown customers and skills
- New lines of business and other Memorize outside the current business
- Risk: highestnew markets, new skills
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| Type | Purpose | Risk | Example |
|---|---|---|---|
| Going concern (maintenance) | keep current operations running, replace worn assets, improve efficiency | low | a brewery replaces aging fermentation tanks |
| Regulatory / compliance | meet safety, environmental or supervisory rules | low business risk; often negative NPV but required | a mine installs gas detection that a new safety law requires |
| Expansion of existing business | grow size or scope, including research and development (R&D) and acquisitions in the core business | moderate | a bakery chain opens 20 stores in a new region |
| New lines of business and other | enter unrelated areas, start-up-like bets, acquisitions outside the core | highest | a shipping firm launches a battery-recycling unit |
Going concern projects
Going concern projects continue current operations at their current size: replacing assets near the end of their life, keeping IT systems current, improving efficiency. They copy what the business already does, so they are the easiest to forecast and the least risky. The spending is often called maintenance capital expenditures .
Regulatory compliance projects
Regulatory compliance projects are imposed by a third party (a law, a regulator) and are needed to avoid fines or to keep operating. They usually add cost and no revenue, so their NPV is often negative, yet they go ahead. There is a strategic side too. Rules can raise barriers to entry and protect incumbents, and companies with financial flexibility that adopt a rule early can gain an edge. Sometimes the extra cost can be passed on in prices. If it cannot, and the business no longer earns its minimum return, the company may decide to wind the affected operation down.
Expansion and new lines of business
Expansion projects grow the size or scope of the business the firm already knows: more stores, a bigger plant, research and development, or acquisitions inside the core business. The firm has customers, skills and data to forecast from, so risk is moderate.
New lines of business (with other investments outside the current business) are the riskiest. The company enters a market where it has no track record, and its forecasts are the least reliable. A cinema chain building a video-game studio is a typical case.
Exam tip Ask one question: is the spending inside the current business or outside it? Inside and required is compliance, inside and replacing is maintenance, inside and growing is expansion, outside is a new line.
How do you split capex into maintenance and growth?
Companies are not required to disclose how much of their capital spending is maintenance. Analysts therefore assume maintenance equals depreciation and amortization, since D&A spreads out the cost of assets that are wearing out. Whatever remains of total capex is treated as growth spending.
A company reports capital expenditures of 520.00 and depreciation and amortization of 380.00. Its growth capital expenditure is most likely about:
520.00 − 380.00 = 140.00
Growth capex140.00
- 520−380=140
- 520ENTER380−140
ENTER enter (on the HP, puts the number on the stack)
Go deeper When D&A is a poor proxy for maintenance
The shortcut rests on two assumptions: that the accounting life of an asset matches its real life, and that the historical cost of an asset is close to what it would cost to replace. Both are likelier to hold for short-lived assets such as vehicles and computers. For a long-lived asset bought decades ago (a rail line, a dam), inflation means replacement costs far exceed historical cost, so D&A understates true maintenance. Treat the result as an estimate, never a disclosed fact.
Intangible and digital capital investments follow the same rules. Software built in-house or a purchased patent is a long-lived asset, amortized over its life, and evaluated by its cash flows just like a factory.
How should long-lived assets be funded?
Managers, and the lenders who finance them, tend to follow match funding : the term of the financing is matched to the life of the asset. A toll-road operator that builds a tunnel lasting 40 years issues a 40-year bond. This avoids rollover risk, the risk that during the life of the asset the company must refinance at an uncertain cost, or cannot refinance at all. Borrowing for longer than needed has a cost too: a higher long-term rate, or the expense of buying the debt back once the money is no longer needed.
Go deeper Who funds expansion?
Expansion into new, unproven businesses is usually funded with equity, because cash flows are too uncertain to service debt. Established firms with steady cash flows can borrow for expansion in their core business. The riskier the project type, the more the funding leans on equity investors who share in the outcome, which links this lesson to the capital structure module.
Memorize this
MemorizeFour types of capital project
| Type | Purpose | Risk |
|---|---|---|
| Going concern (maintenance) | keep operations running, replace old assets, improve efficiency | low |
| Regulatory / compliance | meet safety, environmental or supervisory rules | low; NPV often negative but required |
| Expansion of existing business | grow size or scope; R&D and acquisitions in the core | moderate |
| New lines of business | enter areas outside the current business | highest |
Memory hook Two keep the lights on (maintain, comply), two grow the firm (expand, new lines). Risk climbs as the project moves away from what the firm already does.
Know it cold Compliance projects are done even when NPV < 0. R&D inside the core is expansion; outside the core it is a new line.
MemorizeCapex split
| Quantity | Estimate |
|---|---|
| Maintenance capex | ≈ depreciation and amortization |
| Growth capex | ≈ total capex − D&A |
| Financing rule | match funding: long-lived asset, long-dated funding |
Memory hook Depreciation is the yearly "wearing out", so replacing what wore out is about D&A. Whatever is left of capex is new capacity.
Know it cold The proxy works best for short-lived assets whose replacement cost is close to historical cost.
- Maintain the business keep what exists
- Going concern (maintenance) Memorize replace, repair, improve efficiency
- Risk: lowcopies existing operations
- Regulatory / compliance Memorize required by a law or a supervisor
- Risk: low business riskoften negative NPV but required
-
- Grow the business add size or scope
- Expansion of existing business Memorize bigger, wider, R&D and deals in the core
- Risk: moderateknown customers and skills
- New lines of business and other Memorize outside the current business
- Risk: highestnew markets, new skills
-
Quick example
A company reports depreciation and amortization of USD 410 million. Its maintenance capex is estimated at about USD 410 million.
Quick example
Total capex is USD 780 million and D&A is USD 410 million. Growth capex ≈ 780 − 410 = USD 370 million.
- 780−410= 370
- 780ENTER410− 370
ENTER enter (on the HP, puts the number on the stack)
How it is asked
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Name the project type
A dairy co-operative sets up a company that makes wind-turbine blades. Which type?
Outside the current business: new line of business. Trap: expansion of existing business.
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Compliance with a negative NPV
A hospital group must upgrade its fire-alarm systems by a regulatory deadline. The upgrade adds no revenue and its NPV is negative. Does management still do it?
Yes: it is a compliance project, required to avoid penalties or loss of the operating license.
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Growth capex from two numbers
Capex USD 780 million, D&A USD 410 million. Growth capex?
780 − 410 = 370. Traps: 410 (the maintenance estimate) and 1,190 (adds them).
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Matching the financing
A water utility finances a reservoir that will last 40 years. Which funding fits?
A 40-year bond. Short funding for a long asset adds rollover risk.
Exam traps
- Rejecting a compliance project because its NPV is negative. It is usually mandatory.
- Calling R&D or an acquisition inside the core business a new line of business. That is expansion.
- Treating depreciation and amortization as an exact measure of maintenance capex. It is only a proxy.
- Funding a long-lived asset with short-dated debt. Rolling it over leaves the cost and availability of funding uncertain.
Checkpoint
5 exam-style questions. About 90 seconds each.
1A new law requires a chemicals plant to fit emissions filters, and the estimated NPV of the spending is negative. The company will most likely:
2A furniture maker invests in a plant to produce electric-bike batteries. The project is best classified as:
3A company reports capital expenditures of USD 900 million and depreciation and amortization of USD 650 million. Its growth capital expenditure is most likely about:
4A port operator will build a container terminal expected to last 25 years. Which financing is most consistent with match funding?
5An analyst uses depreciation and amortization as the estimate of a company's maintenance capital expenditures. The estimate is most likely to be accurate when the company's assets:
Key takeaways
- Four types: going concern (maintenance), regulatory or compliance, expansion, new lines of business.
- Risk generally rises from maintenance to new lines of business.
- Maintenance capex is estimated by depreciation and amortization; growth capex by total capex minus that.
- Match funding pairs long-lived assets with long-dated financing.
Quick example
A company reports depreciation and amortization of USD 410 million. Its maintenance capex is estimated at about USD 410 million.
Quick example
Total capex is USD 780 million and D&A is USD 410 million. Growth capex ≈ 780 − 410 = USD 370 million.
- 780−410= 370
- 780ENTER410− 370
ENTER enter (on the HP, puts the number on the stack)
All Corporate Finance formulas, every lesson
Practice exam-style questions on Capital Investments and Capital Allocation
Questions about this lesson?
Where this comes back
- The capital allocation process, NPV and IRR Capital Investments and Capital Allocation
Questions candidates ask
What are the types of capital investment projects?
There are four: going concern (maintenance) projects that keep operations running, regulatory or compliance projects that meet rules, expansion projects that grow the existing business, and new lines of business outside the current one. Risk generally rises in that order.
How do you estimate maintenance capital expenditure?
Companies rarely disclose it, so analysts use depreciation and amortization as the estimate. Growth capex is then total capital expenditures minus that figure. The shortcut is most reliable for short-lived assets whose replacement cost is close to their original cost.
Why would a company accept a negative-NPV project?
Regulatory compliance projects are required by a law or a supervisor. They often add cost without adding revenue, but skipping them risks fines or the loss of the right to operate, so they go ahead. A firm may also protect its position, since rules can raise barriers to entry.
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