What is Fixed Capital?

Fixed capital refers to the investment made by the business for acquiring long-term assets. These long-term assets do not directly produce anything but help the company with long-term benefits.A fixed capital example can be if a firm invests in a building where the production process will occur. It would be referred to as fixed capital. Because: –

  • Firstly, the production process will not directly consume the building. But if the company does not have the building, it would not run the production process.Secondly, investing in the building is a fixed capital because this building will serve the business for a long period, and the building can be referred to as a long-term asset.Thirdly, if the company decides to sell out the building in the future, it will get a residual valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed.read more even if its economic usefulness is exhausted.

Fixed Capital Examples

The following is an excerpt from Colgate SEC filings. Here, we can find many fixed capital examples: –

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  • LandBuildingManufacturing machinery and equipmentOther equipment.

Also, please note that intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can’t touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more like patents and copyrights are 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 us take a simple example to illustrate this.

Let us say that Peter wants to start a bookselling business. He has lots of old books lying around in his house. Peter knows that they are valuable, and most are out of print. So, he can charge a premium to sell those books.

The challenge is, where does he start his business? He does not have any place to open a shop. So, he talks to his old friend Sam and tells him he wants to buy a shop in the town. But now the issue is that he needs furniture to stack up books and arrange them so that the shop looks nice.

He asks a local carpenter to build a structure to adorn his books. Within 15 days, everything is completed, and Peter starts his business. But, if Peter had not invested in a shop or furniture, could he start his business?

The answer is “No.” Here the “shop” and the “furniture” are Peter’s fixed capital, without which he could not start his business.

Sources of Fixed Capital

There are many sources of fixed capital. Let us have a look at them one by one: –

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?

One should do it by comparing the value of a particular long-term asset with how much cash flow it would generate in the long term. So, for example, let us say that a business has purchased a machine. And it has been found that the device would serve the industry for the next ten years. And using this particular machine would improve the production process and enhance the workers’ productivity. So, as a result, the business knows investing in a device is a good idea.

The businesses use three techniques to determine whether the potential cash inflows would outweigh the cash outflows.

  • Net Present Value (NPV): This technique helps a business see its present value of future cash inflow and easily compare whether it is a good idea to invest in the asset.Internal Rate of Return (IRR): IRR IRRInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.read more helps determine the right rate of return with a lot of trial and effort. If the IRR seems good, investing in a long-term asset is wiser.Payback Period (PP): If you invest in an asset, it will return the cash outflow within how much time. 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 article is a guide to Fixed Capital and its meaning. We discuss fixed capital sources, examples, and the 3 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: –

  • Fixed Income FundsKey Differences – Fixed Cost vs Variable CostBank CapitalCapital Accumulation