http://valuationacademy.com An Introduction to Corporate Finance: Capital Investment — Valuation Academy

An Introduction to Corporate Finance: Capital Investment

Making capital investment decision requires the combination of various factors.  A firm realizes that its main goal in investing in a project is to maximize its shareholders value.  Before making the ultimate decision to invest a firm needs to analyze the potential long-term growth and evaluate whether it is a project worth pursuing.  Most of the times, prospective project’s lifetime cash inflows and outflows are assessed in determining whether the returns generated reach a sufficient target.  Ideally, businesses should have the ability to pursue all project opportunities, which will allow them to enhance shareholder value.  However the amount of capital for a new project is limited, therefore businesses face the decision in separating the projects that they can not only afford, but will also generate the most value.

Another aspect of investing in a project would also have to include a businesses capital structure.  Capital structure refers to the mix of a company’s long-term debt, specific short-term debt, common equity, and proffered equity.  In other words, how does a business finance its operations by using different sources of funds.  When referring to capital structure, it is simpler to compare its debt-to-equity ratio.  This provides an insight into how risky a company is.  Debt usually comes in the form bonds issued or long-term notes payable, whereas equity is usually in the form of common stock or retained earnings.

Working capital plays another crucial role in the investment process.  Working capital analyzes a company’s efficiency and its short-term financial health.  The following formula represents this relationship:

Working Capital = Current Assets – Current Liabilities

A positive working capital means that a company has the ability to pay off its short-term liabilities.  If it is negative then a company does not have the ability to pay off its short-term liabilities, and is considered to be very risky.  Overall, working capital gives investors the idea of the company’s underlying operational efficiency.