Businesses often purchase fixed assets, including land, machinery and buildings. The money used to purchase such assets is capital investment. Businesses make this type of investment, keeping company growth in mind. Let’s read about the meaning of capital investment in detail and understand how it decides the fate of a business!
Capital Investment Meaning:
So, what is a capital investment? Capital investment is one that is made in acquiring fixed assets for a business. It could be for plant & machinery, land, office business furniture, etc.
Key Takeaways
- Capital investment refers to the investment made by a business in its long-term physical assets.
- This type of investment can be financed in two ways – equity financing and debt financing.
- Nowadays, startups’ most popular mode of capital investment financing is sourcing it as venture capital investment from angel investors.
Did You Know?
When an organization/business makes a capital investment, it implies that they are confident of the growth in future.
Importance of Capital Investment:
A business is required to carefully plan and make the capital investment to ensure the following –
- A newly established or established business needs this investment to begin the operational processes and deliver its goods and services. It needs to make a capital investment in its land, plant & machinery, and other necessary physical assets for the timely execution of the plans.
- An established business needs a flow of capital investment to plan and execute its growth initiatives and scale the business up. This helps the business enjoy more profits due to an increased scale.
How Capital Investment Works?
Now that you know what is capital investment, you must know how it works. This investment provides businesses with the funds they need to achieve their goals. There are 3 key reasons to make capital investments.
- To acquire capital assets for the company’s growth, which allows the business to increase production and create new products.
- To benefit from novel technology or advancement in machinery.
- To replace existing assets with new ones.
How to Finance Capital Investment?
There are two ways to finance this investment. Let’s discuss them in detail below –
- Debt Financing – Under this method of financing, a business seeks a loan from a bank or a financial institution. In most cases, if the business has high-value collateral to submit to the lender, it can avail this type of financing.
- Equity Financing – Under this mode of financing, the capital investment is known as venture capital investment. It is provided to a business by angel investors or venture capitalists, who do so to earn profitable returns in the long term.
Techniques Used For Capital Investment Decisions
Businesses make use of the following techniques to select different alternatives available for financing their capital investment requirements –
Payback Period Method:
As the name suggests, businesses try to assess how many years they will require to repay the acquired funds under this method.
| Payback Period (in years) = Original Capital Investment/ Annual Expected Return |
This assessment method isn’t accepted as it may not give accurate results. This is because the annual expected return of a business is usually low in the initial years but can rise later. However, the annual expected return is treated as a constant in this method.
Present Worth Method:
This is a better method to weigh the capital investment financing alternatives, as it helps company owners know the present-day value of the physical asset they can acquire. For this, the present worth is calculated for all future values by using the following formula –
| Future Value of Money = Present Value of Money (1 + Interest Rate) ^ Number of Years |
Rate of Return Method:
In this method, the expected return from the planned capital investment is calculated by assessing the average annual net income generated by the investment money.
| Rate of Return Percentage = (Net Return on Capital/Cost of Investment) * 100 |
An alternative way is to calculate the internal rate of return by assessing the difference between the expected future value of the capital investment and the current value, divided by the current value and multiplied by 100.
Also Read: Best Investment Plan for 1 Year
Which is Better – Venture Debt or Venture Capital Investment?
To understand which style of capital investment financing suits you better, let’s dig deep into the differences between venture debt and venture capital investments –
| Basis of Comparison | Debt Venture Investment | Venture Capital Investment |
| Equity | When a business finances its capital investment by way of debt financing, it does not need to give any portion of its equity to the lender. | In order to acquire venture capital investment from investors, businesses need to generally do away with a large portion of their equity in return. |
| Cost of Financing | In the case of debt financing, the cost of acquiring the funds for capital investment remains fixed according to the amount borrowed and the rate of interest agreed upon in the beginning. | Since, to get venture capital investment, a business needs to give its equity, the cost of financing keeps varying with time. This is because the value of equity changes in accordance with the company’s performance. |
| Repayment | A business pays back venture debt investment just like a traditional loan which includes the principal amount and the accumulated interest payment. | In the case of venture capital investment, the business need not repay anything as it has already given its shares to the investors. |
| Ownership | There is no ownership dilution in this case. | The business owners need to dilute their ownership and give shares to investors under this method. |
| Company Valuation | There is no need to get the valuation of the business assessed under this mode of capital investment financing. | Businesses need to get them valued for acquiring venture capital investment from investors as they take an equity percentage basis the ascertained valuation. |
Advantages and Disadvantages of Capital Investment
Take a look at the benefits of capital investment.
- Capital investment boosts the financial status of the business.
- It helps generate wealth that helps the company grow
- It boosts market competition, which pressurizes organisations to build quality products.
- Building quality products helps attracts more customers.
Now that you know the benefits, let’s know the disadvantages too.
- This investment only acquires fixed assets.
- It requires a huge amount of money that increases the overall cost of business.
Factors to Consider Before Making Capital Investment
The following things must be taken into consideration before making a capital investment decision –
- P/L of the Business – The profit and loss statement of the business must be carefully examined before making a capital investment decision to see how the company is performing and if more funds should be poured into it.
- Equity Structure – If the business plans to enhance its capital investment, it must check how much equity it has to offer to the investors.
- Future Business Prospects – Another important factor to be considered is the prospects of the business. If the organisation has good prospects, it can consider pooling more money; otherwise, building viable business prospects is the priority.
Did You Know?
Bessemer Venture Partners (BVP) is currently the world’s biggest venture capital firm, valued at $5 billion, and has helped fund 117 IPOs, including LinkedIn and Shopify.
Also Read: Types of Investment
Word to Remember:
Annualised Rate of Return
It refers to the average annual rate of return calculated by dividing the returns generated over the years divided by the number of years.
Conclusion
Capital investment serves as the foundation of any business. And a business can only thrive well if they have enough funds available to them at the right time and in the right quantity to meet its financial requirements.
Thus, it is very important to evaluate a business’ capital requirements accurately and fund them from the optimal sources. As stated above, there are two ways to arrange this type of investment, either venture debt or venture capital financing. Please choose the one that aligns more with your business requirements and plan its usage accordingly. We hope you’ve understood capital investment meaning and why it’s important for a business.
FAQs:
The purchase of land and buildings for your business is an example of capital investment.
The three types of capital investment are –
– Diversification
– Replacement and Modernization
– Expansion
A capital gain refers to an appreciation in the value of a capital asset. A capital investment gain is realised at the time of sale of the asset.
A business can make a capital investment and either add an element of diversification to the business or replace depreciated assets, or if it wishes to expand its operations.
The working capital of a business refers to the funds it uses for meeting its day-to-day financial obligations and operational expenses.
Yes, capital refers to the amount of money invested in the business. In contrast, equity refers to the sum of money that a business can expect to receive if it liquidates its assets.
For a business, both working capital and capital investment are highly important. While working capital is the blood of a business, capital investment is the foundation on which it has been built.
Investment means a purchase made with the hope of generating income. Capital investment means the acquisition of fixed assets by a business with the aim of growth.
Also, read about How PPF Interest is Calculated on Investment Simplified.
