How Capital Projects Impact Stock Market Value

by Herb Kirchhoff

Big capital projects, such as building a new factory, store or business center, remodeling existing facilities or replacing aging equipment fleets, may move a company’s stock price up or down. The direction and amount of the stock price change depends on how investors view the capital project’s impact on short- and long-term cash flow, dividends and the company’s business risk. Since the stock market is generally efficient, investors’ views are reflected quickly in the company’s stock price.

Evaluating Projects

Companies undertake capital projects because they expect a positive return on their capital investment once a project is completed. Management will select projects that they believe will add value to the company and thereby raise the price of its stock. If investors agree with management’s view that the project will increase earnings, the company’s stock price will stay stable or rise. However, if investors doubt the accuracy of the company’s projected return or believe the capital project will increase the company’s exposure to business risks, they will drive down the stock price. It’s all about investor perceptions and beliefs.

Cash Impacts

Capital projects usually require a lot of money. To fund a project, company management usually looks first to internal sources of money such as current cash flow and accumulated retained earnings. However, capital spending absorbs money that otherwise could be available to shareholders, such when dividends are paid on company stock. A capital project not only diverts cash, it also diverts managerial and personnel resources that could be applied to increasing current earnings. Investors may view capital projects as curtailing earnings growth in the short term, and push down the stock price. If a company reduces or suspends current dividends to finance a capital project, the price of its stock may go down.

Going Outside

If a capital project is too big to finance entirely with internal resources, company management must seek money from outside the company. Companies have two ways to obtain outside capital. They can raise equity capital by releasing a new stock issue, or borrow money for the project by issuing new corporate bonds. Current investors won’t like new stock issues because it dilutes their ownership and reduces earnings per share. However, if the company borrows the money for its capital project, the added debt may be seen by investors as increasing overall financial risk.

Confidence Level

Investors’ view of capital projects will be influenced by their overall level of confidence in the economy. If investors believe the general business climate is good and likely to get better, they are more likely to take a positive view of capital investment projects and drive up the stock price. However, if investors are uncertain or pessimistic about future levels of demand and profits, they will also tend to be pessimistic about capital projects and are likely to drive down the stock price. Interest rates have an effect on investor perceptions of general business conditions.

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