Capital Investment: How it Works

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.

Learn more about how to secure funding for your startups in our startup financing guide.

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Understanding Capital Investments

As such an all-encompassing category, capital investments are relevant to almost literally any company at any stage of its development. There may be exceptions, but they are truly rare.

Who Makes Capital Investments

Whether it’s a startup looking to buy more computers or a mature company looking to replace outdated machinery, capital investments are necessary.

Learn more about what is startup capital in our detailed guide.

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 capital investment, the lender will inevitably look at the company’s balance sheet and their ability to repay before extending a loan.

Most capital investments are made on the basis of the Net Present Value (NPV) decision. If a capital investment passes this metric, most companies will tend to favorably look at capital investment.

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 motive examples:

Read more about startup capital in our detailed blog post.

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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 seek Series A-D investments, capital investments may be required for improving technology (for example, moving away from Beta versions of software) or growing 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.

Capital Intensive Businesses

Capital-intensive businesses (the most extreme example of which are utility companies) are textbook examples of companies that make capital investments. Utility companies typically have a level of debt of 2-3x 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 to a company. A new piece of equipment, such as 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 an 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 the competition. A Silicon Valley tech firm is unlikely to have computers from twenty years ago. Rather, they continue to update and add to their tech stack.

Disadvantages:

• Capital investment can be risky: Capital investments bring risks. Primarily, there is always a risk that the returns generated by the investment won’t be as good as projected, and the investment ends up destroying value.
• Misvaluations: Any time that an asset has to be valued, there is the possibility of misvaluation, or more specifically, overvaluation. A required asset that is overvalued will ultimately destroy value for the company.
• Unpredictability: Closely related to the previous two disadvantages, unpredictability means that a high-quality asset that is well-valued can become obsolete overnight. Think of the value of a DVD factory after streaming came 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.

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 business growth. Therefore, as with any investment, it’s important to make the right ones, at the right price, and 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.