Business Investment: Definition, Purpose, Types, How to Evaluate

By | Januari 10, 2022

What it is: Business investing is about investing to make more money. You can identify it with an increase in the company’s assets or productive capacity.

We relate it to capital expenditures. We might also categorize inventory investment as business investment, as when we measure gross domestic product.

Capital investment is for long term projects. The example is:

  • Building a factory
  • Setting up a sales office in a new market
  • Adding production vehicles
  • Taking over another company
  • Building research and development facilities

Business investment goals

Investment is important to make more money in the future. For example, when building a new factory, the company expects to sell more volume. The company earns more revenue.

Apart from profit, other objectives of business investment are:

  • Maintain current production capacity. The company spends the amount of depreciation of existing capital assets. Thus, the production capacity does not change.
  • Achieve higher economies of scale. Expansion into new markets or building new production facilities makes the size of the company bigger.
  • Reduce costs. Higher economies of scale reduce average costs. In addition, the company may acquire its current distributors or suppliers, enabling it to derive savings from its existing value chain.
  • Improve market position. For example, the company acquires a competitor. Thus, the market share and customer base becomes larger.

Types of business investment

Business investment takes a variety of forms, including:

  • Buying capital goods
  • Acquire another company
  • Residential investment
  • Marketing expansion

Capital goods investment

The Company purchased a number of fixed assets such as:

  • Production machine
  • Operational vehicle
  • Computer

Investments in capital goods do not earn interest or increase sales. But, it helps companies maintain or increase production capacity, lower costs, and increase business profits.

Acquisition

Acquiring other companies is a quick way to grow a business. The target company may be their competitor – we call this a horizontal acquisition. Or, it is the company’s current distributor or supplier (vertical acquisition). Finally, the target may be companies in other businesses, which are not related to the current business (conglomerate acquisitions).

Acquisition motives varied, including:

  • Develop synergies with existing capabilities and resources
  • Securing the supply chain
  • Ensure efficient and effective distribution
  • Improve market position

Residential investment

Companies invest by, for example, building office buildings, retail stores, warehouses, or marketing representative offices. It may be cheaper in the long run to own, than to rent.  

Marketing expansion

This investment goes beyond just running a promotion or buying advertising. Building internal capacity for research and development is an example. It may require facilities such as laboratories.

Another example is building distribution channels. That may be through establishing stores in multiple territories or setting up marketing representative offices overseas.

Sources of funding

Business investments require significant money. Usually, companies rely on external financing. Internal cash is often insufficient to finance investments.

Sources of investment financing can come from:

  • What internal
  • Bank loan
  • Issuance of shares
  • Issuance of debt securities
  • Financial leasing

Internal cash can come from retained earnings ( retained earnings ). Or, the company might sell some of its existing assets, raise cash, use it to finance investments.

Companies can also raise equity capital by selling shares to the public through a stock exchange. If we do it for the first time, we call it an initial public offering (IPO).

Issuing shares allows companies to earn a lot of money quickly. In addition, the company does not have to pay interest.

That is different from raising debt capital such as by borrowing from a bank or issuing debt securities. Although funds accumulate quickly, companies are required to pay interest regularly, even when their income is zero.

Then, financial leasing is the next alternative financing method. In this case, the company does not buy the asset directly. Instead, the leasing company (lessor) buys the asset and leases it to the company. As compensation, the company must make a series of payments, including interest, in accordance with the agreed contract.

Evaluating investment feasibility

Investments involve significant capital. The success of these investments has an important influence on the company’s future prospects.

 

Therefore, companies make a capital budget before investing. It aims to measure the feasibility of the investment. Ideally, the money generated from the investment should be more than the money invested.

Management considers the estimated cash outflows and inflows to assess the feasibility of the investment. Then, they can select several alternatives to measure investment viability, including:

  • Net Present Value (NPV)
  • Internal Rate of Return (IRR)
  • Payback Period
  • Profitability Index

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