Capital (Finance)

Capital, in finance, is the money and other financial resources that a business, bank, government or investor uses to fund its operations and investments. A company raises capital from owners, who receive shares, and from lenders, who receive a promise of repayment; it then puts that capital to work in buildings, equipment, stock, staff and research. The term also describes the funds an investor commits to a market or fund.

Economists use a related but broader idea: capital as one of the factors of production, meaning produced goods such as machinery and infrastructure, measured in national accounts as gross fixed capital formation. Financial capital is the money that pays for those goods. In banking, capital has a narrower, regulatory meaning: the loss-absorbing funds a bank must hold against its risks. The economic system named after capital, capitalism, is one in which such productive assets are mainly privately owned and used to earn a profit.

Imagine opening a food truck. You need money before you sell a single taco: for the truck, the grill and the first week of ingredients. That start-up money is your capital. Some of it might be your own savings, some from a friend who takes a share of the business, and some from a bank loan that has to be paid back.

Your savings and your friend's stake are owners' capital: if the truck fails, that money is lost first. The bank loan is borrowed capital: the lender expects to be repaid whatever happens. Every company, however large, is funded by some mix of these two kinds of money.

Equity capital comes from owners. On a balance sheet it includes share capital (the amount investors paid for shares when they were issued, sometimes split into a nominal par value and a share premium) and retained earnings, the profits kept in the business rather than paid out as dividends. Equity holders, the company's shareholders, are paid last if the company fails but keep all the upside.

Debt capital comes from lenders through a loan, bonds or other debt. It carries a fixed claim to interest and repayment and ranks ahead of equity. Young firms usually rely on equity from venture capital funds or private equity; larger firms can tap the public capital market by listing shares or issuing bonds.

A firm's capital structure is its mix of debt and equity. Debt is usually cheaper, because lenders take less risk and, in many tax systems, interest is tax-deductible, but more debt raises leverage and the chance of default. Modigliani and Miller showed in 1958 that, in an idealised market with no taxes or bankruptcy costs, the mix would not change a firm's value; real-world taxes and distress costs are why the choice matters.

The average return a firm must pay its providers of capital is its weighted average cost of capital (WACC):

• $E$ is the market value of equity and $D$ the market value of debt.
• $V = E + D$ is the total capital.
• $r_E$ is the return equity investors require and $r_D$ the interest rate on debt.
• $t$ is the corporate tax rate.

For example, a company funded with 60 million in equity at a required return of 10% and 40 million in debt at 5%, with a 25% tax rate, has a WACC of $0.6 \times 10\% + 0.4 \times 5\% \times 0.75 = 6\% + 1.5\% = 7.5\%$. A new project is worth doing, in principle, only if it is expected to earn more than 7.5% a year. This is the core of capital allocation.

Working capital is the money tied up in day-to-day operations:

Current assets include cash, cash equivalents, receivables and inventory; current liabilities include supplier bills and short-term borrowing due within a year. A retailer with 30 million in current assets and 20 million in current liabilities has 10 million of working capital. Too little signals a liquidity squeeze; too much means money is sitting idle. Managing it is part of treasury management.

For banks, capital is the cushion of equity and certain other instruments that absorbs losses before depositors are hurt. International minimums are set by the Basel Committee: under Basel III, banks must hold Common Equity Tier 1 of at least 4.5% of risk-weighted assets, Tier 1 capital of at least 6% and total capital of at least 8%, plus a 2.5% conservation buffer and other buffers set by national supervisors. These rules are covered in detail under bank capital and regulatory capital.

The word also appears in cross-border finance. Capital flows are investment money moving between countries, and governments sometimes limit them with capital controls, while capital flight describes a rush of money leaving a country. In investing, a capital gain is the profit made when an asset is sold for more than it cost.

• Basel Framework — Bank for International Settlements