Theory of capital expenditure
Capital expenditure and the fluctuations have a significant impact on the bottom line of a company and the entire economy. Studies carried out on capital expenditure show that there is a high positive correlation between capital expenditure and profit. A high amount of capital expenditure results in higher profit while a low amount of capital expenditure results in lower profit level. This relationship is based on acceleration principle.
Further, the positive association between these two variables is expected to last for a prolonged period of time. This implies that the amount of capital expenditure that a company incurs depends on the expected profitability (Cho, Freedman & Patten, 2012). Therefore, if a company intends to increase profitability in the future, then it will increase the amount of capital expenditure now.
Comparison of capital expenditure
In this section, a comparison will be carried out on the capital expenditure of Gap and American Eagle Outfitters companies. The two companies are based in the United States and they operate in the apparel store industry. A review of financial statements of the two companies shows that they have made a significant amount of capital expenditure in the past years. The table presented below shows a summary of the amount spent by the two companies on capital expenditure during the last three years.
In the table above, it can be noted that during the last three years, the total amount spent on capital expenditure by Gap ($1,877 million) is more than the amount spent by American Eagle Outfitters ($514 million). In the case of Gap, there was a 1.62% decline in the amount of capital expenditure at the beginning of the period of analysis. In 2012, the amount of capital expenditure for the company rose from $548 million in 2011 to $659 million in 2012, an increase of 20.26% from the previous year. The balance of capital expenditure increased further to $670 million in 2013, which is an equivalent of 1.67% increase.
Thus, it can be noted that there was a general rise over the three-year period. A further review of financial statement shows that the whole amount of capital expenditure was used in the purchase of property and equipment. On the other hand, American Eagle Outfitters started with an increase of 59.52% from the year 2010. The company had a decline from $134 million in 2011 to $95 million in 2012, an equivalent of 29.10% decrease.
Further, the capital expenditure rose from $95 million in 2012 to $285 million in 2013. The increase is equivalent to 200%. The financial statement indicates that the whole amount of capital expenditure was used in the purchase of property and equipment and a number of intangible assets. However, the proportion spent on property and equipment was higher than proportion spent on intangible assets.
A comparison between the two companies shows that Gap had a continuous increase in the amount of capital expenditure during the three year period. The total percentage increase during the period was 22.26%. On the other hand, American Eagle Outfitters’ amount of capital expenditure fluctuated in the same period. The company had a decline in 2012 and an increase in 2013. The total change in capital expenditure during the three-year period is 112.6% increase. The graph presented below shows a comparison of trend of capital expenditure for the two companies.
In the graph above, it can be noted that the level of capital expenditure for Gap is higher than that for American Eagle Outfitters. The positive relationship between capital expenditure and expected profit holds for the two companies. For instance, in the case of Gap, there was a continuous increase in net profit and sales. This increase is consistent with the increase in capital expenditure. In the case of American Eagle Outfitters, the net profit and sales declined in periods when capital expenditure declined. Also an increase in capital expenditure led to increase in sales in the subsequent years. This shows that the theory discussed above holds.
Capital structures
Theories of capital structure
There are various studies that have been conducted to show the optimal debt – equity mix. The most popular theory is the Miller and Modigliani model. The model asserts that in the absence of transaction cost, the capital structure of a company has no effect on the value of the firm. Therefore, the capital mix that a firm uses is of no importance. The theory further asserts that the capital structure of a company is irrelevant. However, various scholars have criticized this theory. They argue that the Miller- Modigliani model is based on unrealistic assumptions of absence of taxes, efficient market, absence of agency cost, and perfect information.
In the contemporary business world, these assumptions are quite unrealistic and do not exist. For instance, Aswath Damodaran argues that capital structure has an impact on the value of the firm. Damodaran argues that the amount of debt in the capital structure of a company affects cash flow. Thus, altering the amount of debt changes cash flows and equity because cash flow is attained from assets, after repayment of debt and making reinvestment for future growth. Further, as the amount of debt increases, equity becomes more risky and the cost of equity increases (Huang & Ritter, 2009).
Analyzing the capital structure of a company is of utmost importance because it determines the rate at which the company grows. The capital structure shows the composition of funding for such company. A company should maintain an optimum mix of various sources of funds. The table presented below shows the capital structure of the two companies.
Comparison of capital structure
Gap Company
American Eagle Outfitters
Analysis of the capital structures shows that Gap is more aggressive in financing than American Eagle Outfitters. Apparently, Gap had 31.28% debt and 68.72% equity in the capital structure while American Eagle Outfitters had 100% equity. In the analysis above, it was evident that the level of capital expenditure for Gap was higher than its counterpart. From this comparison, it can be concluded that a company with an aggressive capital structure is likely to have a high amount of capital expenditure than a company with low capital. This can be attributed to the fact that it is easier and quicker to raise additional capital through debt than equity (Jack, 2008). Therefore, there is a relationship between capital expenditure and capital structure.
References
Cho, C., Freedman, M., & Patten, D. (2012). Corporate disclosure of environmental capital expenditures: A test of alternative theories. Accounting, Auditing & Accountability Journal, 25(3), 486–507.
Huang, R., & Ritter, J. (2009). Testing theories of capital structure and estimating the speed of adjustment. Journal of Financial and Quantitative Analysis, 44(2), 237-271.
Jack, A. (2008). The capital expenditure function. The Manchester School Journal, 34(2), 133-158.