What is capital investment?
Capital investment is when a company spends money on assets. Assets are things that help a company make products or provide services. Examples of assets are:
- Buildings
- Machines
- Equipment
- Patents (special rights to make something)
- Copyrights
The company hopes that by buying these assets, it can earn more money in the future. This is because the assets let the company create and sell more products or services.
Why companies make capital investments
Companies make capital investments for different reasons:
- To replace old assets that don’t work well anymore
- To get more assets so they can make more products
- To follow laws or rules that say they need certain assets
- To start selling their products in new places
How companies decide on capital investments
Looking at how much money an investment will make
When a company thinks about making a capital investment, it needs to figure out if it’s a good idea. The company wants to know if the money it spends on the assets will be less than the extra money it will earn because of the assets.
To figure this out, the company does some math. One way is called the “net present value” calculation. This calculation looks at:
- How much the asset costs to buy
- How much extra money the company thinks it will earn each year because of the asset
- How many years the company thinks the asset will last
- The “time value of money” – the idea that money now is worth more than the same amount in the future
If the calculation shows the asset will earn more money than it costs, it’s probably a good investment.
The capital budgeting process
Many companies decide on capital investments during “capital budgeting”. This is when the company makes a plan for what big assets to invest in over the next year.
During capital budgeting, the company looks at:
- What assets it needs
- How much those assets will cost
- How much money the company has to spend
The company has to choose carefully because it usually can’t afford to buy everything it wants. It picks the investments that will help the company the most.
The kinds of capital investments
Replacement investments
Over time, assets get old and don’t work as well. Companies need to replace them so they can keep making products.
Replacing an old machine with a new one is an example of a replacement investment.
Expansion investments
Sometimes, a company wants to make more products than it does now. To do this, it needs more assets.
Building a new factory so the company can make more products is an example of an expansion investment.
Mandatory investments
There are laws and rules companies have to follow. Sometimes, these laws say a company needs certain assets.
Buying a special filter for a factory so it doesn’t pollute the air could be a mandatory investment.
New market investments
Companies can decide to start selling their products in new places. These new places are called “new markets.” The company might need new assets to make this happen.
If a company starts selling its products in a new country, building a store there would be a new market investment.
Risks of capital investments
Capital investments can help a company make more money. But they can also be risky. Here are some of the risks:
The investment might not earn as much as the company thinks
The company makes a guess about how much extra money an asset will help it earn. But this guess could be wrong. Maybe customers don’t want the extra products. Or maybe something happens that hurts the company’s business, like a recession.
If the asset doesn’t earn as much as the company thought, the investment might not have been a good idea.
The asset might cost more than expected
When a company plans a capital investment, it tries to figure out how much the asset will cost. But sometimes, things end up costing more than planned. This could be because:
- The price of the asset goes up
- Building or installing the asset takes longer than planned
- The company needs to buy other things it didn’t think about to make the asset work
If the asset costs too much, the investment might not earn enough to be worth it.
Technology can change
A company might buy an asset thinking it’s the best thing available. But technology can change fast. A new, better asset might come out soon after the company makes its investment.
Then, the company is stuck with an asset that isn’t the best anymore. Rivals that buy the newer asset can make better products or sell them for less. This can hurt the company’s business.
