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What are Capital Costs?
In business terms the word capital refers to money. Capital costs are the fees associated with the initial setup of a plant or project. These costs will usually only occur at the beginning of a project, as the operational costs cover reoccurring business expenses. It may take a wide array of resources to begin a business, so capital costs may finance a number of expenses.
The cost of capital will vary depending on the type and size of the business being established. In order to build an entire plant, capital costs may need to cover the expense of materials and labor to create the new structure. Capital costs tend to mostly cover costs incurred as the result of buying land and building a plant or structure for business use.
In order to account for these expenses, they are capitalized and added to the cost of the asset. If the expenses were deducted in one large sum, it could be potentially devastating to a new business. These costs are instead capitalized and deducted over time from depreciation or depletion.
Most capitalized costs are considered to be fixed assets. Since fixed assets are not included in current net income, they tend to affect net income slowly, over several financial periods. Capitalized costs may be considered fixed assets since they include any facility the company constructs for its own use, such as a wind or power plant. Other costs that may be considered fixed assets are real estate developments that may be leased or sold, large office buildings and ships.
Being categorized as a fixed asset makes the company’s funds both an equity and a debt. Eventually, for a business to remain intact, the return on the capital must reach a higher point than the cost of capital. The company typically needs to make enough money so investors receive at least their original return on the initial investment of capital costs.
The Weighted Average Cost of Capital (WACC) is a calculation formula that is used to measure a company’s capital costs. This calculation is done prior to financing to estimate if a business venture will be worth the risk. This weighted average includes the cost of debt, the market value of equity equivalents and the total capital amount projected for business start-up. This is a fairly useful tool for determining whether the capital costs are a good investment, but the formula does become more complex if there are multiple funding sources to account for or if there is currency exchange involved in the calculation.
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Discussion Comments
@bythewell - I wonder if that also has to do with the fact that internet companies probably don't have the kind of fixed assets that, say, a plastics company is going to have. When a plastics company puts a lot of money into their capital assets, those assets are real things, that can then be resold if necessary (things like land and factory space).
But, internet companies are mostly going to be hiring people and renting office space. I don't know if that makes a difference, but it might.
Generally, I think the best advice is to plan really well and not get overly optimistic about anything.
@Ana1234 - You see that kind of thing with internet start-ups all the time as well. They think they are going to be the next Facebook and they manage to attract all kinds of investors with ludicrous amounts to invest, and then the product never takes off.
It does OK, and an ordinary company would be happy with it, but because they hyped it up so much and had such a huge capital cost allowance, they end up going under in the first few years.
It's really important to get this kind of calculation right. I think when you start a new business it feels like you have all the time in the world to pay back the initial loans you might have got for the capital costs, but in reality you have to meet your goals.
I was reading about a video game company recently that went under, even though it was really promising and the first game they released was fairly well received. Unfortunately, they had borrowed a huge amount in order to set up the business and their first product wasn't enough to recoup those costs, so they went bankrupt.
I guess you really have to factor in how long it's going to take before you see a profit and what safety net you have if that first release isn't a run away hit (which is what I think this company was banking on).
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