What is Fixed Capital?
Fixed capital refers to the investment made by the business for acquiring long term assets. These long term assets don’t directly produce anything, but help the company with long-term benefits.
A fixed capital example would be that if a firm invests in a building where the production process will take place, it would be referred to as fixed capital. Because –
- Firstly, the building will not get directly consumed by the production process. But if the company doesn’t have the building, it wouldn’t be able to run the production process.
- Secondly, investing in the building is a fixed capital because this building will serve the business for a long period of time and the building can be referred to as long term assets.
- Thirdly, if the business thinks to sell out the building in the future, it will get a residual value even if its economic usefulness is exhausted.
Fixed Capital Examples
Below is an excerpt from Colgate SEC Filings. Here we can find may fixed capital examples
- Manufacturing machinery and equipment
- Other equipment.
Also, please note that Intangible assets like Patents and Copyrights are also classified as examples of fixed capital investments.
Why is fixed capital important to any business?
There are multiple reasons for which fixed capital in a business. Let’s take a simple example to illustrate this.
Let’s say that Peter wants to start a bookselling business. He has lots of old books lying around in his house. He knows that they are valuable and most of them are out of print. So he can charge a premium to sell those books.
The challenge is where does he start his business? He doesn’t have any place to open a shop. So, he talks to his old friend Sam and tells him that he wants to buy a shop in the town. But now the issue is he needs furniture to stack up books and arrange them in order so that the shop looks nice.
He asks a local carpenter to build a structure within which he can adorn his books. Within 15 days, everything is done and Peter starts his business. Now the question is if Peter would’ve not invested in a shop or in the furniture, could he start his business?
The answer is “no”. Here the “shop” and the “furniture” are Peter’s fixed capital without which he couldn’t start his business.
Sources of Fixed Capital
There are many sources of fixed capital. Let’s have a look at them one by one –
- Owner’s own resources: This is the first and foremost source of fixed capital. Since at the start of business, fixed capital is must-have, the owner sources it from his own resources.
- Term loans from bank/financial institution: If the owner doesn’t have enough money to invest in fixed capital; s/he would take help from the bank or any financial institution and take a loan either against the mortgage or against no mortgage. If the loan amount is bigger, the owner has to arrange a mortgage to take the loan; if the loan amount is smaller, the owner doesn’t need to arrange any mortgage to avail the loan.
- The issue of shares: If a company feels that it has to issue shares to finance the dire need of buying/acquiring long assets, we will call it the fixed capital. A private company can become public by conducting IPO or a public company can issue new shares to finance the need for fixed capital into the business.
- Retained earnings: When a company needs to invest in fixed capital, it can use internal finance also. Retained earnings are a portion of the profit that is retained and reinvested into the company. Usually, retained earnings are invested in acquiring new fixed capital.
- The issue of debentures: By issuing of debentures, companies source funding for acquiring long-term assets. Companies issue bonds. People who are interested in investing in a company buy those bonds and pay the money for those. And the companies then use that money to invest in acquiring long-term / non-current assets.
How does a business know which long-term assets to invest into?
As you can see, fixed capital is important for running a business. But how does a business know which long-term assets to invest into?
It should be done by comparing the value of a particular long-term asset with how much cash flow it would be able to generate in the long term. For example, let’s say that a business has purchased a machine. And it has been found out that the machine would serve the business for the next 10 years. And using this particular machine would improve the production process and also improve the productivity of the workers; as a result, the business knows investing in a machine is a good idea.
There are three techniques that are being used by the businesses to find out whether the potential cash inflows would outweigh the cash outflows.
- Net Present Value (NPV): Using this technique helps a business see its present value of future cash inflow and can easily compare whether it is a good idea to invest in the asset.
- Internal Rate of Return (IRR): IRR helps find out the right rate of return with a lot of trial and effort. If the IRR seems good, it’s wiser to invest in a long-term asset.
- Payback Period (PP): If you invest in an asset, within how much time it would return the cash outflow. For example, if a business has to decide between investing in “building A” and “building B” and if the payback period of A and B are 5 and 10 respectively, the business should choose to invest in A (depending on the amount invested is similar).
This is a guide to what is Fixed Capital and why it is important for any business. Here we also discuss various sources of fixed capital along with the three techniques (NPV, IRR, and Payback) to evaluate fixed capital investments. You may also have a look at the following articles to learn more about Corporate Finance –