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Student
Weekly Handout 3
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Contents
3.1 Capital Investment & Sources of Finance Overview ……………………………………………………………………….. 3
Capital Investment Overview ………………………………………………………………………………………………………… 3
Sources of Finance Overview ………………………………………………………………………………………………………… 4
3.2 Capital Investment …………………………………………………………………………………………………………………………………….. 5
Purpose and various investment types ………………………………………………………………………………………. 5
Management role ………………………………………………………………………………………………………………………………. 5
Investor behaviour and risk tolerance ……………………………………………………………………………………….. 6
Components of an intended capital investment ………………………………………………………………………. 8
Initial Investment …………………………………………………………………………………………………………………….. 8
Cost of capital and expected cash outflows ………………………………………………………………………. 9
Expected cash inflows ……………………………………………………………………………………………………………10
Expected return ……………………………………………………………………………………………………………………….11
3.3 Sources of Finance ……………………………………………………………………………………………………………………………………12
Debt financing and various financing instruments ………………………………………………………………..12
Cost involved and interest rates ………………………………………………………………………………………………….14
Collateral asset …………………………………………………………………………………………………………………………14
Financing: market view …………………………………………………………………………………………………………15
Floating charge…………………………………………………………………………………………………………………………15
References ………………………………………………………………………………………………………………………………………………………………16
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3.1 Capital Investment & Sources of Finance Overview
This week we shall examine in brief but quite enough detail is
given so as to be aware about these two aspects; capital
investment and the sources needed to finance it.
Below a summarized report is given to help you plan your study
approach.
Capital Investment Overview
• Investment purpose and types
• Management role in capital budgeting
• Investor behavior and risk tolerance
• Capital investment components
o Initial investment
o Cost of capital and expected cash outflows
o Expected cash inflows
o Expected return
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Sources of Finance Overview
• Debt and various financing instruments
• Cost involved and interest rates
o Collateral asset
o Financing; market view
o Floating charge option
 LIBOR
 EURIBOR
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3.2 Capital Investment
Purpose and various investment types
Funds that are invested within any business to achieve or
enhance business objectives, are held for a long term period
and are not bought for the intention to be sold are
considered to be a capital nature investment.
These can be either securities, or property with useful life
more than a year like property, plant or equipment. The
source of funds can be found from equity investors,
commercial or investment bank loans, and venture capital
or angel investors.
Management role
Capital investment budgeting is a process performed by senior management.
This tool is used to transform long term business strategic goals into business
budgeting plans. Then the long term business budgeting plans are expressed into
short term and eventually into annual budget plans.
The most essential part of the budgeting process is to identify the investment
viability, the cash inflows, and cash outflows and non-cash expenditure.
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The management decision during capital
budgeting process that needs to be made is the
proper evaluation and determination whether
the potential project or investment is worth to
be made. For this purpose, several
methodologies have been developed to
determine such feasibility study.
Investor behaviour and risk tolerance
Senior management which is the board of directors wants to see detailed plans,
various analyses and supportive information. Sometimes, due to the strategic plans,
investment projects determine the business future.
The most important issue to always keep in mind is that money earned today worth
more than the money to be earned in the future; concept called as time value of
money.
Normally, senior management is reluctant to step into such long term plans since
they can really deviate from reality.
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And surely a reason to avoid such projects is that a biased decision can be made
based only upon probabilities and optimistic confidence.
A normal approach would be to be to favour projects that produce early cash inflows
and sacrifice projects with positive net present value (NPV).
And sometimes projects with negative NPV are undertaken for various reasons other
than the projected cash inflows but for the reasons that provide value to the business
in the long run.
To enter into such management decisions every business has different substantial
risks to address and the decision to be made depends upon the business risk
appetite.
Each capital investment is affected by many variables, known and certain for their
occurrence but also for quite few unknown.
The longest the project duration is, then higher future cash inflows are expected to
be earned.
Where any unknown inherent variables exist at a substantial portion in such capital
investment type, then the risk is higher for the project to produce in the end a
negative NPV that adds no value to the business.
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Components of an intended capital investment
The business wants to maximize shareholders’ value and through capital investment
this can be achieved.
Capital budgeting techniques determines that the proper decision process is followed
so that investment is made upon for those appropriate projects that satisfy
management’s criteria set; either produces the required return or the satisfactory
cash inflows with the use of minimum expenditure, the cash outflows.
Therefore, several components exist during a capital investment process.
Initial Investment
As previously was mentioned, senior management gets involved in exploring any
available options so as to maximize returns and add value to the business.
To proceed to any decision, financial situation needs to be thoroughly examined.
Business needs to determine whether is feasible to take such capital investment
decisions; or whether business affords to invest without taking unnecessary risk for
its solvency and look for the possibility to obtain affordable sources to finance such
decisions.
Furthermore, based upon the current business financial stability and upon the
strategic goals set in the mission statement the maximum tier available amount to
invest is set. And if the same amount is invested upon different projects, this fact
does not guarantee that these projects shall produce the very same cash inflows or
returns.
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But in the end, what matters most is the valuation methodologies used during this
process to decide upon the worthwhile projects to invest. And where prospects exist
to recover any initial money invested with any substantial return.
Cost of capital and expected cash outflows
The average cost of capital, usually called as weighted average cost of capital, the
WACC, is the business cost to acquire new loan, debt based upon its capital structure.
The various sources used by any business to finance its operations determine the
leverage and risk it holds; debt to equity ratio is the measure used by analysts as
indication upon business financial condition.
When a business is heavily financed by debt, loans, has high leverage ratio then it has
an aggressive capital structure; this business cost of capital is high caused by the
lenders or investors greater risk they hold. A business needs to find that optimal
capital structure so that any cost of capital for any future project funding has an
acceptable cost and therefore an acceptable minimum required rate of return.
Nevertheless, management to evaluate properly any potential project must initially
identify its outcome upon the overall business.
Any capital investment involves capital expenditures and these can add up to quite
huge sums if no proper monitoring process is in place. During the budgeting process,
expenditure is projected and the relevant spending is set. Careful capital expenditure
analysis needs to be prepared especially for large scale projects where any deviation
from the initial budget can minimize the projected returns.
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Many researchers identified this flaw over the capital budgeting process and this is
the reason that corporations with global activities handle their capital expenditure
with exceptional care.
Expected cash inflows
Senior management aims to invest and get a substantial financial return and cash
inflows. These cash inflows are projected to inflow at different times and in
accordance to each project’s budget plan.
First on this list are the outflows, initial investment and relevant project expenditure
and it is assumed that during the implementation period of the project cash inflows
are to produced so as to compensate for the money invested therein.
Every project’s expected cash inflows are calculated in future values. And their
timing matters; for practical reasons any cash inflow received during the year is
assumed as received at the year end.
Furthermore, so as to be able to evaluate project efficiently those future values have
to be viewed in terms of present value. This can be achieved through discounting
methods so as those expected future values are evaluated at their projected value
but adjusted in today’s terms; their present values.
Overall what really matters is the actual outcome of any potential project that brings
to the business.
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Through incremental analysis we compare the two fundamental parameters;
business cash flows inclusive the potential project and deduct the existing business
cash flows without this potential project.
The outcome is the actual cash inflows produced by the potential project if decided
to invest thereon.
= –
Expected return
Capital investment needs to provide some
additional value to the business; this term is
something to always remember. To proceed in any
capital investment it is assumed that any money
invested is recovered with an additional premium.
This premium is actually the expected return
needed to add the required business value needed.
As indicated earlier, any business depending upon its capital structure has its own
cost of capital. This average cost is a crucial parameter upon whether to invest or not
to invest upon any project.
Any capital investment to be made must exceed or at least meet this average cost of
capital. Unless the potential project to invest provides any other form of
compensation or value to the business.
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3.3 Sources of Finance
For business funding
Debt financing and various financing instruments
Debt financing involves borrowing money with the
intention to be repaid. The debt is provided against a
relevant cost; the interest. The prearranged repayments
involve two elements; the capital, also called as
principal, and the interest.
Capital or principal, concerns the actual money borrowed and the repayment is
spread over a determined period with an additional amount, the interest which is the
lender’s compensation fee to receive for giving away the money.
It is considered that equity finance is more expensive than debt finance. Equity
finance involves higher risk and never guarantees a stable return.
On the other hand, debt finance involves certain costs, like arrangement fees and
interest fee that has to be paid based upon the contractual agreement made.
Shareholders, or equity holders, are paid only if available funds exist to distribute as
dividend. For this reason debt holders have higher ranking during a liquidation
process.
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Debt as a contractual agreement between business
and lender, usually bank, contains affirmative
covenants and requirements to present financial
statements and the relevant fees involved for
providing the funding. Basic covenants usually
restrict borrower’s rights until full loan repayment.
Main sources of business financing are classified as indicated below
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Cost involved and interest rates
Any debt finance constitutes a contractual agreement made between the two
parties, the business and the lender, which ensures that lender receives back the
money given against an additional benefit, the interest, so as to compensate lender
for the temporary money loss.
Furthermore, there are cases where further risk is involved due to the amount to be
provided to the business. In such cases lender wants more assurances so as to
minimize the risks involved.
Therefore, as backup it is often required a collateral, a business asset so as to secure
the loan in the possibility of business default.
Collateral asset
In case, where business is unable to repay the loan then lender has the legal
entitlement to proceed to the sale of the asset given as collateral.
And it must be mentioned that interest rate upon such cases is quite higher than
other loans given without collateral, so as to incorporate the higher risk taken by the
lender.
Therefore, business has to think carefully before granting fixed charge on its assets to
the bank, the lender. In fact, business abandons the flexibility to handle that specific
asset upon its discretion; not able to use, rent or sell without having the lender’s
consent.
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Financing: market view
The lender’s role has been dominated by banks due to their flexibility; the
competition which exists between these financial institutions helps businesses to get
more approachable loans.
This fact acts in favour of the businesses since they can directly negotiate with the
lender. Imagine the case where business wants to issue a bond so as to get funding
and all those expenses involved; underwriting, regulatory and marketing
arrangements.
Specifically, any bank loan involves an arrangement fee upon initial agreement made,
possibly a percentage upon loan amount. The involved interest rate depends upon
the agreement made. Interest can be either fixed, floating percentage or
combination of both over the loan duration.
Floating charge
• LIBOR
The floating charge is a certain percentage either above the base rate of the bank or
the London Inter-Bank Offered Rate, the LIBOR, which is the rate that very safe
banks, can lend at financial markets.
The Bank of England makes changes at irregular intervals to respond to financial
market conditions in an attempt to stabilize the economy.
• EURIBOR
Within European Union, the Euribor is introduced, the Euro Interbank Offered Rate.
This is a daily rate issued by the European Money Markets Institute and is based upon
the average interest rate that Eurozone banks lend in the Euro money market.
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References
Arnold, G. (2005). The Handbook of Corporate Finance, A business Companion to
Financial Markets, Decisions and Techniques. Great Britain: Pearson Education
Limited.
Richard A.Brealey, S. C. (2011). Principles of corporate finance (10th ed.). McGraw-
Hill/Irwin
Richard Pike, B. N. (2009). Corporate and Investment Decisions and Strategies (6th
ed.). Pearson Education.

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