CFO v CFI and effects of capitalizing

I feel like I am losing my mind and this is probably a layup, but why does CFI increase when an item is expensed rather than capitalized?

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Don’t believe it does. You may be confusing CFI with CFF. CFF will increase when an item is expensed rather than capitalized because under capitalization a portion of the lease payment is categorized as financing cashflows (outflow) rather than an operating cashflow

Sorry, i have leases on the brain! A capitalized expenditure appears as a CFI outflow (i.e. lowers CFI) whereas expensed expenditures appear as CFO outflow (i.e. no impact to CFI, and therefore higher CFI relative to capitalization). Hope that helps, sorry for the confusion!

When you purchase a machine and capitalize it, it is an investment in your firm that sucks out cash.

Net Income = 1000

CapEx = 100

Let’s assume no WC adjustments and CFO is 1000 while CFI is -100 because you just invested 100 in your business and capitalized it to be depreciated over x period of time.

If you instead decided to expense the purchase of your machine of 100 then your net income is 900 and your CFI would be 0 because you chose not to classify any spending as investments in your business. (Depreciation in the ongoing quarters will then be lower). Total cashflow is not adjusted in any way, but CFI is higher while CFO is lower, and the book value of your company drops by 100 immediately, rather than taking the 100 and depreciating it over a period of time.

CFI does not increase when you an expense an item. (If you look at CFI, of a firm which expenses rather than capitalized, in isolation)

But CFI will be higher for the firm which expenses its purchases if you COMPARE it with a firm which CAPITALIZES its purchases.

That’s because when you EXPENSE an item, you recognize ALL OF THE EXPENDITURE in the INCOME STATEMENT which will cause your net income to be lower. It will also cause your CFO to be lower because you start with Net Income for cfo calculation (using the indirect method). Since the expense gets recognized in CFO, we do not deduct it from CFI otherwise it will be double counted.

Now, a firm which CAPITALIZES its expenses do not recognize ALL OF THE EXPENDITURE at once. They depreciate it over years (allocate the expense over years rather than recognizing the expense at once). However, all of the expense is recognized in CFI which causes the CFI of the capitalization firm to be lower.

Hence, if one firm expenses its purchases and the other firm capitalizes it purchases. The CFO of the expensing firm will be lower than the CFO of the capitalization firm.

Similarly, CFI of the expensing firm will be higher than the CFI of the capitalization firm.