There is a common misunderstanding about capital investment: Many consider it to be the cash used to acquire plant, property, and equipment.
While this is true, it understates the scope of capital investment, which also covers R&D expenditure and even software purchases and upgrades.
Capital investment is a broad term. DealRoom plays a host to capital investments of all sizes and in this article, we explore it further.
Understanding Capital Investments
As such an all-encompassing category, capital investments are relevant to almost literally any company at any stage of their development. There may be exceptions, but they are truly rare.
Who Makes Capital Investments
Whether it’s a startup looking to buy more computers (as was famously the case with Facebook when they received funding from Peter Thiel) or a mature company looking to replace outdated machinery, a capital investment is required.
What is the Minimum/Maximum level of Capital Investment?
There is no minimum or maximum level of capital investment. If the company is seeking outside funding for the capital investment, the lender will inevitably look at the company’s balance sheet and their ability to repay before extending a loan.
Mostly, however, a capital investment is made on the basis of the Net Present Value (NPV) decision. If a capital investment passes this metric, most companies will tend to look on the capital investment favorably.
What are the Motives for Capital Investment?
The motives for capital investment will differ among companies at various stages of their development. Below, we look at some of the motives for a range of different scenarios in :
Startup capital investment
Typically with low cash resources, startup firms look for startup financing, which usually involves some form of capital investment (technology investments, hardware, software, and/or equipment). Later on, as these companies grow and see Series A-D investments, capital investments may be required for improving technology (moving away from Beta versions of software, for example) and even acquiring furniture for newer, more modern office spaces.
Mergers and Acquisitions
Mergers and acquisitions are a form of capital investment, where the acquirer takes on the assets of the target company – thus benefitting from them over several periods – for an agreed fee. Note that the most common method of valuing a capital investment in M&A is the DCF method, as outlined above.
Capital Intensive Businesses
Capital intensive businesses (the most extreme example of which are utilities companies), are the textbook example of companies which make capital investments. Utilities companies typically have a level of debt 2-3 times their equity, as they’ve taken on outside funding to fund their large capital investment requirements.
Advantages and Disadvantages of Capital Investment
Advantages:
- Valued additive: Well-planned capital investments add value for the company. A new piece of equipment, be it a computer or ball bearing machine, should create efficiencies in the company’s value chain.
- Efficient use of company funds: Well-planned capital investments tend to be efficient use of company funds, directing them to DCF-positive projects that ensure a positive long-term return.
- Maintain relevance: A company has to make capital investments to maintain relevance with competition. A Silicin Valley tech firm is unlikely to have computers from 20 years ago. Rather, they continue to update and add to their tech stack.
Disadvantages:
- Capital investment can be risky: Capital investments bring risks. Primarily, risks that the returns generated by the investments won’t be as good as projected, and the investment ends up destroying value.
- Misvaluations: Any time that an asset has to be valued, it opens up the possibility of misvaluation, or more specifically, overvaluation. An asset which is required which is overvalued will ultimately destroy value for the company.
- Unpredictability: Closely related to the previous two disadvantages, unpredictability means that a high quality asset which is well valued can become obsolete overnight. Think of the value of a DVD plant straight after streaming comes on the market.
Capital Investment Example
In April 2022, e-commerce giant Amazon announced that it would make $1 billion of capital investments in warehouse technologies for its fulfillment centers.
Remember that Amazon’s fulfillment centers are already among the most technologically advanced in the world, so this $1 billion investment amounts to an effort to update the technology and maintain Amazon’s competitive positioning.
Amazon said that the technologies would focus on speeding up deliveries to customers and improving the safety of workers in its fulfillment centers.
Conclusion
Capital investments are an unavoidable part of conducting business. Therefore, as with any investments, it’s important to make the right ones, at the right price, at the right time.
DealRoom works with companies that make several capital investments every year, providing them with the tools to make the right decisions when confronted with a range of options. Talk to us today about the difference we can make to your capital investments.
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