Capital

Definition

In finance, capital refers to financial resources or assets that are used by a business or individual to fund operations, investments, or value creation. It typically represents the wealth (in the form of money or other assets) available for producing more wealth.

There are multiple forms of capital, including:

• Equity Capital

• Debt Capital

• Working Capital

• Human Capital

• Natural Capital

Origins

The concept of capital dates back to early economic theory, particularly in classical economics, where it was one of the factors of production (land, labor, capital, and entrepreneurship). Adam Smith, David Ricardo, and later Karl Marx discussed capital as the driver of production and investment. In modern finance, capital evolved into a key element in valuation, risk, and investment decision-making.

Usage

Industry Applications:

• Corporate Finance – Raising and deploying funds via equity or debt.

• Banking – Capital adequacy for risk absorption (Basel III).

• Valuation – Calculating cost of capital in DCF models.

• Private Equity – Deploying capital to acquire and grow companies.

• Macro Policy – Governments track capital formation to gauge economic growth.

How Capital Works

At the firm level, capital can be raised through:

• Equity: Selling ownership (common or preferred stock).

• Debt: Borrowing funds via loans, bonds, or credit facilities.

• Internal Generation: Retained earnings and asset sales.

At the macro level, capital formation refers to investments in physical assets (machinery, infrastructure) that increase a country’s productive capacity.

In valuation and finance, capital is often viewed in terms of sources and uses:

• Sources of Capital: Equity, debt, hybrid instruments

• Uses of Capital: CapEx, acquisitions, R&D, working capital, dividends

Key Takeaways

• • Capital is essential for growth, expansion, and value creation.

  • Firms manage their capital structure to optimize risk and return.

  • Capital is not static—it's deployed, invested, and reallocated.

  • The cost of capital directly affects business valuation and investment decisions.

     

Types & Variations of Capital

Context in Financial Modeling

Capital impacts multiple layers of modeling:

1. Capital Structure Modeling

• Determines mix of debt and equity (target ratios).

• Affects WACC, interest expense, EPS, and valuation.

2. DCF Valuation

• Cost of capital used to discount free cash flows.

• Capital expenditures reduce free cash flow.

3. LBO Models

• Capital deployment is primarily debt-driven.

• Modeling capital repayment schedules, IRR, and equity returns is critical.

4. Scenario Planning

• Analyze capital needs under different revenue/cost projections.

• Stress test liquidity and capital availability.

Nuances & Complexities

• Cost of Capital: Varies by capital type; equity is more expensive than debt.

• Capital Constraints: Access to capital depends on creditworthiness, market conditions, and investor appetite.

• Regulatory Requirements: Banks must maintain capital adequacy ratios.

• Tax Considerations: Interest on debt is tax-deductible, dividends are not.

Mathematical Formulas

1. Capital Structure Ratio:

$$\text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Equity}}$$

2. Cost of Capital (WACC):

$$WACC = \left(\frac{E}{E + D} \times R_e\right) + \left(\frac{D}{E + D} \times R_d \times (1 - T)\right)$$Where:

• $E$ = Equity

• $D$ = Debt

• $R_e$ = Cost of Equity

• $R_d$ = Cost of Debt

• $T$ = Tax rate

3. Working Capital:

$$\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}$$

Related Terms

• Capital Structure

• WACC

• Equity

• Debt

• Cost of Capital

• Return on Capital Employed (ROCE)

• CapEx

• Leverage

Real-World Applications

1. Capital Budgeting

A manufacturing firm evaluates whether to invest $50M in new machinery using NPV and IRR, funded by a mix of equity and debt.

2. Bank Capital Adequacy

A bank maintains a Tier 1 capital ratio of 12% to satisfy Basel III regulations, ensuring it can absorb losses in economic downturns.

3. Startups and Venture Capital

An early-stage tech firm raises $5M in venture capital for product development, targeting a Series A at a higher valuation.

4. Corporate Valuation

An investment analyst calculates WACC as 9.2% using a firm’s capital structure to discount FCFs in a DCF valuation model.

References & Sources

• CFA Institute – Corporate Finance & Equity Curriculum

• OECD – Capital Formation Reports

• World Bank – Global Capital Markets Reports

• McKinsey & Co. – "Valuation: Measuring and Managing the Value of Companies"

• FASB – ASC 505 (Equity), ASC 470 (Debt)