Capital In Finance
Understanding what capital is and how it can be used is vital to growing an individual's net worth or a business's value.
What Is Capital?
Capital is money that is used to make additional money by being invested. Capital is used to produce either a product or a service, and to generate revenue and income. Businesses use capital to create the goods and services they sell and to invest in future growth. They invest capital in the hope of earning a higher return than the cost of the capital. The "Father of Economics" Adam Smith defined capital as "that part of man's stock which he expects to afford him revenue."
4 Ways Business Capital is Raised
Business capital is anything that can be used to produce something that creates value, and the greater that value, the higher the return for the business. Because it is used to make money, business capital is considered an asset on company balance sheets.
Businesses raise capital in a variety of ways and this is called a company's capital structure.
Equity is the money an investor pays for shares of stock in a company. Equity capital is comprised of private and public equity.
- Private equity is shares of stock that are sold to a closed group of investors.
- Public equity is shares of stock that a company lists on a public stock market.
Debt is issued by borrowing from either government or private sources.
For big companies, those private sources include:
- Other financial institutions
- The issuing of bonds
For small businesses, debt capital can be acquired from:
- Credit cards
- Federal loans
- Small business loans
- Angel investors
- Venture capital
- Borrowing from family and friends
On a balance sheet, debt shows up as a liability because it must be paid back, and the borrower will also have to pay interest on the loan.
3. Working Capital
Working capital is comprised of liquid assets and non-liquid assets. Liquid assets include cash, cash equivalents, bank balances, and accounts receivable which is money owed by clients to the company. Companies use their liquid assets to pay employee salaries and to pay rent and bills. Non-liquid working capital is profit-generating assets such as machinery, real estate, and raw materials.
Working capital is comprised of the following subsets:
- Human capital: It is comprised of the employees and contractors that a business uses to produce its goods or services.
- Intellectual capital: Includes patents, proprietary software, and copyrights which are things the business can use to generate more profit.
- Physical capital: Includes manufacturing equipment, raw materials, machinery, inventory, and production and storage facilities which are all things that allow the company to produce goods or services.
- Real estate capital: Any offices, factories, warehouses, or stores that a business owns.
- Securities Capital: Is created when one company buys the stocks or bonds of another company, and the purchaser uses the profits from those investments to invest back into itself.
The formula for calculating working capital is:
Working capital = Current assets – Current liabilities
There can be negative working capital which occurs when a company's liabilities exceed its assets. For a business, negative working capital can cause problems obtaining credit and it can inhibit growth.
4. Trading Capital
Trading capital is money that businesses in the financial sector, such as brokerages, have reserved in order to invest and to trade securities such as stocks and bonds.
Capital Gains and Losses
A capital gain occurs when an investment becomes worth more than its initial purchase price. For example, a business that purchases a raw material for $1,000, then produces a final product that it sells for $2,000 incurs a capital gain of $1,000.
A capital loss occurs when an investment is worth less than its initial purchase price. For example, if a company bought a used machine for $2,000, and spent $1,500 on spare parts and $1,000 on labor, it would have to sell the machine for greater than $4,500 in order to avoid a capital loss.
How To Determine the Cost of Capital
The cost of capital is the minimum rate of return a business or an individual can receive on an investment to make that investment worthwhile. Because businesses can be financed by either debt or equity, and most companies use a mix of both, the cost of capital is the weighted average cost of all the sources of capital. These include preferred stock, common stock, bonds, and long-term debt.
This weighted average is known as the weighted average cost of capital, or WACC, and the formula to calculate it is:
WACC = E / (E + D) x Cost of Equity + D / (E + D) x Cost of Debt x (1 - Tax Rate)
- E = the market value of a company's equity, also known as the market cap
- D = the market value of a company's debt
Let's look at a real-world example, that of Microsoft Corp. (MSFT). As of June 16, 2022, Microsoft's weighted average cost of capital is calculated as:
0.9645 x 8.773% + 0.0355 x 3.3811% x (1 - 15.17%) = 8.56%
Microsoft's weighted average cost of capital is 8.56% while its return on invested capital, or ROIC, percentage is 32.27%. Therefore, the company generates a return on its capital. What this means for investors is that companies that generate positive excess returns on new investments can expect their value to increase and can anticipate future growth.
Cost of Debt
There are several ways of calculating the cost of debt, depending on whether you’re calculating pre-tax or post-tax debt. To calculate pre-tax debt, the formula is:
Cost of Debt = Total Interest / Total Debt
For example, if a company pays a total of $4,500 in interest on all its loans, and its total debt is $60,000, then its cost of debt is:
$4,500 / $60,000 = 7.5%
Post-tax debt is the cost of debt after taxes, and it is calculated using this formula:
Cost of Debt After Taxes = Effective Interest Rate x (1 – tax rate)
Using the 7.5% we calculated above as the average interest rate for all loans, and if the company has a 10% corporate tax rate, its after-tax cost of debt would be:
0.075 x (1 - .10) = 6.75%
Cost Of Preferred Stock
The cost of preferred stock is determined by the formula:
Cost or Preferred Stocks = D / P
- D = annual dividend
- P = current share price
For a company that pays its preferred shareholders an annual dividend of $4 per share, and whose current share price is $50, its cost of preferred stock is 8%.
$4 / $50 = 8%
Cost Of Equity
The cost of equity can be calculated by using either the CAPM (Capital Asset Pricing Model) or the Dividend Capitalization Model, depending on whether a company pays a dividend or not. The formula for calculating CAPM is:
Cost of Equity = Risk-Free Rate of Return + Beta x (Market Rate of Return - Risk-Free Rate of Return)
- Risk-free rate of return = the rate of return from investments such as Treasuries
- Beta = a measure of risk where companies having higher volatility also have a higher beta and greater risk compared to the market as a whole
- Market rate of return = the average market rate.
The formula for calculating the cost of equity using the Dividend Capitalization Model is:
Cost of Equity = D / C + G
- D = the dividend per share over the coming year
- C = current market value of the stock
- G = growth rate of dividends
Capital is necessary for the functioning of an individual, a family, a small business, a large corporation, or an entire economy. What's most important is how efficiently that capital is being used.
Financial capital is the number of assets measured in money value that a company needs to provide its goods or services. Economic capital is the amount of money that a company, typically one in the financial sector, needs to cover any possible losses due to unexpected risk, that is, the amount of money it needs to stay solvent.
Capital investment is money a business uses to purchase fixed assets, including buildings, machinery, or land. The term can also be used to refer to money invested in a business to purchase fixed assets rather than being used to cover the business's operating expenses. Companies access capital investment through either debt, such as a loan from a bank, or equity financing from venture capitalists or angel investors.
This article was written by
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