Capital Improvement

Updated on January 2, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Capital Improvement?

A capital improvement is a kind of capital (big) expenditure mainly on the assets of the company like repairing the building or changing a part of a production machine or something similar which can increase the life of that asset as well as will result in future economic benefits to the company incurring the capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more by way of the increased life of the asset or better performance of the asset.

Types

Types of Capital Improvement

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  • #1 – Recurring – This refers to expenditures that need to be done within a fixed period due to the usage of that asset or the particular asset requirement.
  • #2 – Non-Recurring – This refers to those capital expenditures that a company incurs when they view that such spending is required and will increase the asset’s life.

Examples of Capital Improvement

Example #1

Suppose a US-based company B Inc. owns many auditoriums in different parts of the US. This company has been in this business since 1985. In 2015, the company management believed that the assets used in the auditorium like push-back chairs, sofa sets, air conditioners, lighting arrangements, and flooring needed to be completely changed because it had been 30 years. Since then, no renovation has been done. Also, to compete in a challenging environment, it needs to be updated with many new technologies and better comfort. So, the company incurred $750,000 on all the assets to renovate all its auditoriums.

This expenditure may increase the life of auditoriums and result in future economic benefits, i.e., more and more people may come and enjoy their entertainment time comfortably. So, this is a kind of capital expenditure in which the company will capitalize on respective assets and not expense it off in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more.

Capital-Improvement

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Example #2

An Ltd. dealing in the manufacturing of passenger cars has a lot of big machines in its production plant. These, if stopped or do not work correctly, may result in substantial revenue losses for the company. So, considering this, the company’s management decides to examine the conditions of the machines regularly. In 2018, they found that two machines were about to stop working properly due to their continuous usage. Still, if they could replace some machine parts, they would be back in their original condition and work for another 5 years without any downtime. For this, the company incurred $ 10,000,000 on both machines.

Consequently, both machines started working properly, thus increasing the life of those machines and resulting in future economic benefits to the company. So this is an example of capital improvement.

Advantages

  1. Capital improvement increases the life of assets and results in the company’s future economic benefits.
  2. It helps the company retain its image in the market by providing updated facilities.
  3. Companies can retain the asset for a more extended period.
  4. It helps in more depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more claims for the company due to the increased cost of the asset and life.
  5. Capital improvement helps the company save the downtime on assets due to its update.
  6. It helps the company maintain its revenue year over year and sometimes increases.
  7. It helps the company retain its employees for a longer period due to the better working of the assets and a better work environment.

Disadvantages

  1. Capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more leads to a huge outflow of the company’s funds.
  2. In capital improvement, assets are not replaced with a new one. Instead, it results in old assets or not using the latest technologies.
  3. It can lead to the company’s misappropriation of funds, resulting in fraud.
  4. Sometimes there is unnecessarily investing in assets even when not required to divert the funds.
  5. With huge investment comes the risk associated with it, i.e., the risk of failure of assets even after invoking new parts.

Limitations

  1. Every company may not be able to invoke such huge funds due to its poor financial condition.
  2. Whenever an asset cannot be just updated, it sometimes needs to be fully charged with the new and latest technology.
  3. Investing a large amount needs a lot of planning and professional judgment regarding the benefits and risks associated with capital expenditure.
  4. Arranging funds from outside is also not an easy task for companies having lower credibility.
  5. All stakeholders need consent for a huge amount to be invested, which sometimes becomes tough for the companies as many may not agree.

Important Points

The different important points related to the capital improvement are as follows:

  • Before going for capital improvement, the company must determine whether there is a requirement for such expenditure at that time or not. It requires considering the benefits and risks associated with the cost.
  • The company should consider the relevant laws and regulations for that particular industry or any changes coming in future years.
  • Determine the interest cost on the funds to be borrowed for capital expenditure.

Conclusion

A capital improvement is always dependent on factors. e.g., nature of assets, type of industry you are dealing in, investment amount, related benefits, risks, etc. Just for the benefits part, a company should never incur a huge amount in capital improvements; because if there is no proper planning in advance, the benefit can turn out into a major loss.

It is always better to take financial advice from some experts considering all the factors related to capital improvement, accept all the stakeholders, study the relevant laws and regulations, and determine the interest cost payable. Most essentially determine whether the requirement is of progress or a complete change then. Also, ensure that it is always capitalized and should never be expensed off in its income statement.

This article has been a guide to capital improvement and its definition. Here, we discuss types and practical examples of capital improvement and its advantages and disadvantages. You may learn more about finance from our below articles: –

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