INITIAL INVESTMENT IN A COMPANY: STRUCTURE AND EXAMPLE - DUDAS - 2024

The initial investment in a business or startup capital is the money that the owner of that business needs to start the business. This money is used to cover initial costs, such as the purchase of the building, purchase of equipment and supplies, and the hiring of employees.

These funds, or equity, can come from the business owner's personal savings, a bank loan, a government grant, money borrowed from various sources, including family and friends, or money raised from outside investors.

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The initial investment for a business is simply money. It is the financing for the company or the money that is used for its operation and for the purchase of assets. The cost of capital is the cost of obtaining that money or financing for the business.

Even small companies need cash to operate, and that money is going to come at a cost. Companies want this cost to be paid as low as possible.

Capital budget

Capital budgeting decisions involve careful estimation of the initial investment outlay and future cash flows of a project. The correct estimation of these inputs helps to make decisions that increase the wealth of the shareholders.

Projects often require a large initial investment by a company at the beginning of a project, which will generate positive cash flow over time.

This initial investment is included in the profitability of a project during the discounted cash flow analysis that is used to assess whether the project is profitable or not.

Structure

The initial investment structure is the way a company plans to finance its initial operation and growth using different sources of funds.

The combination of debt and equity financing for a company is known as the company's capital structure.

Debt is in the form of long-term loans or promissory notes, while equity is classified as common or preferred shares.

Short-term debt, like working capital requirements, is also considered part of the initial investment structure.

Initial investment cost

The cost of a company's initial investment is simply the cost of the money the company intends to use to finance itself.

If a business only uses current liabilities and long-term debt to finance its initial operations, then it only uses debt, and the cost of equity is usually the interest rates to be paid on those debts.

When a company is public and has investors, then the cost of capital becomes more complicated. If the company only uses funds provided by investors, then the cost of equity is the cost of equity.

Usually this type of company has debts, but it is also financed with capital funds or money that investors provide. In this case, the cost of equity is the cost of debt plus the cost of equity.

Supporters of startups typically invest in the hope that these businesses will develop into lucrative operations that can cover startup capital and also pay higher returns through an exit.

Debt-equity ratio

When analysts refer to the capital structure, they are most likely referring to the relationship: Debt / Equity of a company, which provides information about the risk of the company.

Investors can check the capital structure of a company by monitoring the Debt / Equity ratio and comparing it with its peers.

Generally, a company that is heavily financed by debt has a more aggressive capital structure and, therefore, presents a higher risk to investors. However, this risk can be the main source of the company's growth.

Debt is one of the two main ways that companies can obtain an initial investment in the capital markets.

Debt allows a business to retain ownership, as opposed to equity. Also, in times of low interest rates, debt is abundant and easily accessible.

Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not have to be repaid if earnings decline.

Debt and equity on the balance sheet

Both debt and equity can be found on the balance sheet. Assets on the balance sheet are purchased with this debt and equity.

Companies that use more debt than equity to finance assets have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure.

A high leverage ratio and / or an aggressive capital structure can also lead to higher growth rates. On the other hand, a conservative capital structure can lead to lower growth rates.

The goal of company management is to find the optimal combination of debt and equity. This is also known as the optimal capital structure.

Importance of capital

Capital is the cash that companies use to finance their operations. The cost of equity is simply the interest rate it costs the business to obtain financing.

Capital for very small businesses can be based only on supplier credit. For larger companies, the equity can be the supplier's credit and long-term debts or liabilities. These are the liabilities of the company.

To build new plants, buy new equipment, develop new products, and upgrade information technology, companies must have money or capital.

For every decision like this, the business owner must decide whether the return on investment is greater than the cost of capital, or the cost of money it takes to invest in the project.

How to calculate it?

Business owners rarely invest in new projects, unless the return on capital they invest in these projects is greater than or at least equal to the cost of the capital they must use to finance these projects. The cost of capital is the key to all business decisions.

The initial investment is equal to the money needed for capital expenses, such as machinery, tools, shipping and installation, etc.

Additionally, any existing increase in working capital, and subtracting any after-tax cash flow, obtained from the sale of old assets. Hidden costs are ignored because they are irrelevant. The formula is as follows:

Initial investment = Fixed capital investment + Working capital investment - Income from sale of assets (Salvage value).

Fixed capital investment

It refers to the investment to be made to buy the new equipment required for the project. This cost will also include installation and shipping costs associated with purchasing the equipment. This is often viewed as a long-term investment.

Investment of working capital

It corresponds to the investment made at the beginning of the project to cover its operating expenses (for example, inventory of raw materials). This is often viewed as a short-term investment.

Rescue value

Refers to cash proceeds collected from the sale of old equipment or assets. Such gains are only realized if a company decides to sell the oldest assets.

For example, if the project was a manufacturing plant overhaul, this could involve the sale of old equipment. However, if the project is focused on expanding into a new production facility, it may not be necessary to sell old equipment.

Therefore, the term only applies in cases where the company is selling older fixed assets. The salvage value is often quite close to the prevailing market value for the particular asset.

Example

Saindak Company started a copper and gold exploration and extraction project in Baluchistan in 2015. Between 2016 and 2017, it incurred expenses of $ 200 million in seismic studies of the area and $ 500 million in equipment.

In 2018, the company abandoned the project due to a disagreement with the government. Recently, a new, more business-friendly government was sworn in.

Saindak's managing director believes the project needs to be reconsidered. The company's financial analyst and chief engineer estimate that $ 1.5 billion in new equipment is needed to restart the project. Shipping and installation costs would amount to $ 200 million.

Current assets should increase by $ 200 million and current liabilities by $ 90 million. Equipment purchased in 2016-2017 is no longer useful and must be sold for an after-tax profit of $ 120 million. To find the initial investment outlay required, we have:

Calculation of the initial investment

Initial investment = purchase price of equipment + shipping and installation + increase in working capital - income from asset sales.

Initial investment = $ 1.5 billion + $ 200 million + ($ 200 million - $ 90 million) - $ 120 million = $ 1.69 billion.

Saindak needs $ 1.69 billion to restart the project. You need to estimate the future cash flows of the project, and calculate the net present value and / or internal rate of return to decide whether or not to go ahead with the restart.

Spending $ 200 million on seismic studies is not part of the initial investment, because it is a sunk cost.

References

1. Rosemary Peavler (2018). What Is Startup Capital? The Balance Small Business. Taken from: thebalancesmb.com.
2. Business Dictionary (2018). Initial capital. Taken from: businessdictionary.com.
3. Xplaind (2018). Initial Investment. Taken from: xplaind.com.
4. CFI (2018). Initial Outlay Calculation. Taken from: corporatefinanceinstitute.com.
5. Investopedia (2018). Startup Capital. Taken from: investopedia.com.
6. Investopedia (2018). Capital Structure. Taken from: investopedia.com.