Financial Terms related to Capital This document is part of the valuable contents available at www.ftpall.com, a free online glossary with more than five thousand financial and business terms. This document can be copied and distributed freely Find thousands of financial terms at www.ftpall.com respecting its original format. It is forbidden its transcription, translation or change on its format without authorization of its author or editor. CAPITAL Average cost of capital • A firm's required payout to the bondholders and to the stockholders expressed as a percentage of capital contributed to the firm. Average cost of capital is computed by dividing the total required cost of capital by the total amount of contributed capital. Capital • Cash or goods accumulated and available for use in producing more cash or goods. • The long-term funds of the firm; all items on the right-hand side of the firm's balance sheet, excluding current liabilities. • Money invested in a firm. Capital account • Net result of public and private international investment and lending activities. www.ftpall.com 2|Page Capital adequacy • Banks have to maintain sufficient capital to be able to meet unforeseen contingencies. The capital requirements involve minimum equity (Type I capital, currently 4% of assets), or equity and long-term debt (Type II capital, currently 8% of assets). The minimum capital requirements are stipulated by law. Capital allocation decision • Allocation of invested funds between risk-free assets versus the risky portfolio. Find thousands of financial terms at www.ftpall.com Capital appreciation • A rise in the market price of an asset. • The rise in the value of an investment s principal. Capital asset • see Fixed Assets • All tangible property -- including securities, real estate, and other property -- held for the long term. • A fixed asset that is amortized; land; or financial asset (common shares, preferred shares, and fixed income securities like bonds) held by a corporation. Capital asset pricing model • Abbreviated CAPM. The basic theory that links together risk and return for all assets. The CAPM predicts a relationship between the required return, or cost of common equity capital, and the nondiversifiable risk of the firm as measured by the beta coefficient. • Abbreviated CAPM. An economic theory that describes the relationship between risk and expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification. The CAPM says that www.ftpall.com 3|Page the expected return of a security or a portfolio is equal to the rate on a risk-free security plus a risk premium. • Is a tool that relates an asset's expected return to the market's expected return. It combines the concepts of efficient capital markets with risk premiums. The idea of capital market efficiency assumes immediate instantaneous -response to perfect or near perfect information. The risk premiums relate an investment to the market's risk-free or riskless rate of return. Typically, this risk-free rate is viewed in terms of principal safety for short term U.S. government obligations. Here, beta relates the Find thousands of financial terms at www.ftpall.com volatility of an asset to the market. Capital budget • A firm's set of planned capital expenditures. Capital budgeting • The process of choosing the firm's long-term capital assets. • The process of evaluating and selecting long-term investments (expected life of greater than one year) that are consistent with the firm's goal of owner wealth maximization. • Consists of five distinct but interrelated steps proposal generation, review and analysis, decision making, implementation, and follow-up. Capital cost allowance • Abbreviated CCA. The term for the amortization system that must be used for income tax purposes when reporting to Canada Customs and Revenue Agency. It is a non-cash expense that increases cash flow. Capital expenditure • Funds used by a company to acquire or upgrade physical assets such as property, plants, or equipment. www.ftpall.com 4|Page • An outlay of funds by the firm that is expected to produce benefits over a period of time greater than one year. • Amount used during a particular period to acquire or improve long-term assets such as property, plant or equipment. • Expenditures for fixed assets Capital flight • The transfer of capital abroad in response to fears of political risk. Find thousands of financial terms at www.ftpall.com Capital gain • An increase in the value of a capital asset such as common stock. If the asset is sold, the gain is a realized capital gain. A capital gain may be short-term (if the security is held one year or less) or long-term (if the security is held more than one year). • The positive difference between the selling price of a capital asset and the asset's original cost plus the costs incurred to sell the asset. • When a stock is sold for a profit, it's the difference between the net sales price of securities and their net cost, or original basis. If a stock is sold below cost, the difference is a capital loss. Capital gains yield • The price change portion of a stock's return. Capital impairment rule • The legal rule governing Canadian companies that prevents the payment of dividends from the value of common shares on the balance sheet. Capital lease • A lease obligation that has to be capitalized on the balance sheet. www.ftpall.com 5|Page Capital loss • The loss incurred when a capital asset, such as a security, is sold for a lower price than the purchase price. See also: Capital Gain. • The difference between the net cost of a security and the net sale price, if that security is sold at a loss. Capital market • The market that trades long-term debt securities and common and preferred equity Find thousands of financial terms at www.ftpall.com securities. • The market for trading long-term debt instruments (those that mature in more than one year). Capital market efficiency • Reflects the relative amount of wealth wasted in making transactions. An efficient capital market allows the transfer of assets with little wealth loss. See: efficient market hypothesis. Capital market imperfections view • The view that issuing debt is generally valuable but that the firm's optimal choice of capital structure is a dynamic process that involves the other views of capital structure (net corporate/personal tax, agency cost, bankruptcy cost, and pecking order), which result from considerations of asymmetric information, asymmetric taxes, and transaction costs. Capital market line • Abbreviated CML. The line defined by every combination of the risk-free asset and the market portfolio. Capital rationing • Placing one or more limits on the amount of new investment undertaken by a firm, www.ftpall.com 6|Page either by using a higher cost of capital, or by setting a maximum on parts of, and/or the entirety of, the capital budget. • The financial situation in which a firm has only a fixed number of dollars for allocation among competing capital expenditures. Capital stock • Refers to all the common and preferred shares, if any, for a corporation. • Ownership shares of a company, consisting of all common and preferred stock. Find thousands of financial terms at www.ftpall.com Capital structure • The mix of long-term debt and equity maintained by the firm. • The makeup of the liabilities and stockholders' equity side of the balance sheet, especially the ratio of debt to equity and the mixture of short and long maturities. • See Capitalization. Capital surplus • Amounts of directly contributed equity capital in excess of the par value. • Refers to the accounting difference between the amounts received by the initial sale of a corporation's stock less the par value of that stock. Since many new issues are sold at prices in excess of the par value, the proceeds component can be significant. Other related terms are Paid-In Capital or Paid-In Surplus. Capitalization • The debt and/or equity mix that fund a firm's assets. • Also known as Invested Capital or Capital Structure. The sum of a corporation's stock, long-term debt, and retained earnings. Capitalization method • A method of constructing a replicating portfolio in which the manager purchases a www.ftpall.com 7|Page number of the largest-capitalized names in the index stock in proportion to their capitalization. Capitalization rate • See Discount Rate. Capitalization ratios • Show how a firm has financed the investment in assets. There are three capitalization alternatives: debt, preferred equity and common equity. Find thousands of financial terms at www.ftpall.com • Also called financial leverage ratios, these ratios compare debt to total capitalization and thus reflect the extent to which a corporation is trading on its equity. Capitalization ratios can be interpreted only in the context of the stability of industry and company earnings and cash flow. Capitalization table • A table showing the capitalization of a firm, which typically includes the amount of capital obtained from each source -long-term debt and common equity -and the respective capitalization ratios. Capitalized • Recorded in asset accounts and then depreciated or amortized, as is appropriate for expenditures for items with useful lives greater than one year. Capitalized interest • Interest that is not immediately expensed, but rather is considered as an asset and is then amortized through the income statement over time. Capitalized lease • A financial (capital) lease that has the present value of all its payments included as an asset and corresponding liability on the firm's balance sheet, as required by generally accepted accounting principles as set out in the CICA Handbook. www.ftpall.com 8|Page Change in net working capital • The difference between the change in current assets and current liabilities associated with an investment project. Complete capital market • A market in which there is a distinct marketable security for each and every possible outcome. Cost of capital Find thousands of financial terms at www.ftpall.com • The required return for a capital budgeting project. • The minimum rate of return that a firm must earn on its project investments to maintain its market value and attract needed funds. This rate of return is based on the mix of debt and common equity financing. • This is the price of capital. When corporations borrow, they pay interest, which is called the cost of debt capital. In the context of valuing firms, the discount rate is called the cost of capital. Cost of limited partner capital • The discount rate that equates the after-tax inflows with outflows for capital raised from limited partners. Debt capital • All long-term borrowing incurred by the firm. Debt to capital ratio • The ratio of total debt to total capital ([short + long term debt] / capital). For long- term investors, a suggested acceptable percentage is up to 33%. Debt must be funded in good times and bad, so a company going through a bad slump has a better chance of recovering if its debt load is not too high. Keep in mind that debt serves the useful function of helping the company grow. It is up to management to www.ftpall.com 9|Page use it wisely and increase the sales and earnings. Dedicated capital • Total par value (number of shares issued, multiplied by the par value of each share). Also called dedicated value. Efficient capital market • A market in which new information is very quickly reflected accurately in share prices. Find thousands of financial terms at www.ftpall.com Equity capital • The long-term funds provided by the firm's owners, the shareholders. • see Owners' Equity Exchange rate risk capital budgeting • Danger that an unexpected change in the exchange rate between the dollar and the currency in which the project's cash flows are denominated can reduce the market value of that project's cash flow. Financial or capital lease • A longer-term lease than an operating lease that is noncancelable and obligates the lessee to make payments for the use of an asset over a predefined period of time; the total payments over the term of the lease are greater than the lessor's initial cost of the leased asset. Gigo garbage in, garbage out in capital budgeting • If cash inflows are overestimated and/or the cost of capital underestimated, then decisions that prove to be very costly for the firm and the shareholders can result; poor forecasts can result in poor capital budgeting decisions. Hard capital rationing www.ftpall.com 10 | P a g e • Capital rationing that under no circumstances can be violated. Human capital • The unique capabilities and expertise of individuals. Invested capital • See Capitalization. Issued share capital • Total amount of shares that are in issue. Related: outstanding shares. Find thousands of financial terms at www.ftpall.com Legal capital • Value at which a company's shares are recorded in its books. Leveraged recapitalization • A takeover defense in which the target firm pays a large debt-financed cash dividend, increasing the firm's financial leverage and deterring the takeover attempt. Long term debt to capitalization • A ratio that indicates a company's financial leverage. It is calculated by dividing long term debt by the capital available to the company. The available capital is the sum of long term debt, preferred stock and stocholders' equity. Long term debt/capitalization • Indicator of financial leverage. Shows long-term debt as a proportion of the capital available. Determined by dividing long-term debt by the sum of long-term debt, preferred stock and common stockholder equity. Marginal cost of capital • Abbreviated MMC. The firm's weighted average cost of capital (WACC) associated with its next dollar of total new financing. Marginal cost of capital schedule www.ftpall.com 11 | P a g e • Graph that relates the firm's weighted average cost of capital (WACC) to the level of total new financing. Market cap or market capitalization • Is a value placed on a company. It is computed by multiplying the number of outstanding shares by the current share price. Market capitalization • The total dollar value of all outstanding shares. Computed as shares times current Find thousands of financial terms at www.ftpall.com market price. It is a measure of corporate size. • The dollar valuation of the total number of shares times the current price. This value is sometimes used by investors to classify stocks by size. It is not as reliable as classifying by sales dollar value because the price of a stock can be inflated by the market and not accurately representative of its size. Market capitalization rate • Expected return on a security. The market-consensus estimate of the appropriate discount rate for a firm's cash flows. Net working capital • Current assets minus current liabilities. Often simply referred to as working capital. • A measure of liquidity calculated as the difference between the firm's current assets and its current liabilities, or, alternatively, the portion of current assets financed with long-term funds; can be positive or negative. • Net Working Capital refers to the net non-interest bearing short term assets: Hence, net working capital equals cash plus inventories plus accounts receivables minus accounts payables. Net working capital recapture • A positive cashflow benefit in a capital budgeting analysis that arises with the www.ftpall.com 12 | P a g e termination of a project. At termination, sales associated with the project cease, and the company will recover the originally invested net working capital. Nondiversifiability of human capital • The difficulty of diversifying one's human capital (the unique capabilities and expertise of individuals) and employment effort. Opportunity cost of capital • Expected return that is foregone by investing in a project rather than in comparable Find thousands of financial terms at www.ftpall.com financial securities. Optimal capital structure • The capital structure at which the weighted average cost of capital is minimized, thereby maximizing the firm's value. Other capital • In the balance of payments, other capital is a residual category that groups all the capital transactions that have not been included in direct investment, portfolio investment, and reserves categories. It is divided into long-term capital and short- term capital and, because of its residual status, can differ from country to country. Generally speaking, other long-term capital includes most non-negotiable instruments of a year or more like bank loans and mortgages. Other short-term capital includes financial assets of less than a year such as currency, deposits, and bills. Outstanding share capital • Issued share capital less the par value of shares that are held in the company's treasury. Pecking order view of capital structure • The argument that external financing transaction costs, especially those associated www.ftpall.com 13 | P a g e with the problem of adverse selection, create a dynamic environment in which firms have a preference, or pecking-order of preferred sources of financing, when all else is equal. Internally generated funds are the most preferred, new debt is next, debt- equity hybrids are next, and new equity is the least preferred source. Perfect capital market • A market in which there are never any arbitrage opportunities. Perfect market view of capital structure Find thousands of financial terms at www.ftpall.com • Analysis of a firm's capital structure decision, which shows the irrelevance of capital structure in a perfect capital market. Personal tax view of capital structure • The argument that the difference in personal tax rates between income from debt and income from equity eliminates the disadvantage from the double taxation (corporate and personal) of income from equity. Pie model of capital structure • A model of the debt/equity ratio of the firms, graphically depicted in slices of a pie that represent the value of the firm in the capital markets. Planned capital expenditure program • Capital expenditure program as outlined in the corporate financial plan. Pro forma capital structure analysis • A method of analyzing the impact of alternative capital structure choices on a firm's credit statistics and reported financial results, especially to determine whether the firm will be able to use projected tax shield benefits fully. Real capital • Wealth that can be represented in financial terms, such as savings account balances, financial securities, and real estate. www.ftpall.com 14 | P a g e Real options capital budgeting • Opportunities that are embedded in capital projects that enable managers to alter their cash flows and risk in a way that affects project acceptability (NPV). Also called strategic options. Regulatory capital • Is the amount of capital available for trading or position taking purposes by financial institutions. The total capital base is adjusted for memberships, various fixed assets, type and/or maturity of securities as well as other factors. Find thousands of financial terms at www.ftpall.com Risk capital budgeting • The chance that the inputs into the analysis of an investment project will prove to be wrong. Soft capital rationing • Capital rationing that under certain circumstances can be violated or even viewed as made up of targets rather than absolute constraints. Sophisticated approaches to capital budgeting • Capital budgeting techniques that integrate time value procedures, risk and return considerations, and valuation concepts to select capital projects that are consistent with the firm's goal of maximizing owners' wealth. Static theory of capital structure • Theory that the firm's capital structure is determined by a trade-off of the value of tax shields against the costs of bankruptcy. Target capital structure • The desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain. Taxable capital gain www.ftpall.com 15 | P a g e • The percentage of net capital gains (the difference between capital gains and capital losses) that are included as taxable income, currently 50 percent. Total capital • Gives information about how the company is financed or capitalized. This can be a combination of stock -- preferred and common shares -- and debt. Uniform net capital rule • Securities and Exchange Commission requirement that member firms as well as Find thousands of financial terms at www.ftpall.com nonmember broker-dealers in securities maintain a maximum ratio of indebtedness to liquid capital of 15 to 1; also called net capital rule and net capital ratio. Indebtedness covers all money owed to a firm, including margin loans and commitments to purchase securities, one reason new public issues are spread among members of underwriting syndicates. Liquid capital includes cash and assets easily converted into cash. Venture capital • An investment in a start-up business that is perceived to have excellent growth prospects but does not have access to capital markets. Type of financing sought by early-stage companies seeking to grow rapidly. Weighted average cost of capital • Abbreviated WACC. Reflects the expected average future cost of funds for the upcoming year; found by weighting the cost of each specific type of capital by its proportion in the firm's capital structure. • The average cost of all capital used by a firm. In the context of valuing firms, if the capital is a mixture of debt and equity. The discount rate is called weighted average cost of capital. WACC = (1 - tc) * Rd * D/(D+E) + Re * E/ (D+E) Where tc is the corporate tax rate , Rd is the contractual interest rate on (new) debt, www.ftpall.com 16 | P a g e Re is the discount rate on equity, D and E are the market values of debt and equity respectively. The return of all projects accepted by the corporation must exceed the weighted average cost of capital (WACC) to create value for the shareholders. • Expected return on a portfolio of all the firm's securities. Used as a hurdle rate for capital investment. Working capital • Current assets, which represent the portion of investment that circulates from one form to another in the ordinary conduct of business. Find thousands of financial terms at www.ftpall.com • Current assets minus current liabilities • Also known as net working capital. It is calculated by subtracting current liabilities from current assets. If a company's current assets do not exceed its current liabilities, then it may be unable to meet its short-term liabilities with its current assets (such as cash, accounts receivable, and inventory). • Defined as the difference in current assets and current liabilities (excluding short- term debt). Current assets may or may not include cash and cash equivalents, depending on the company. Working capital management • The management of current assets and current liabilities to maximize short-term liquidity. Working capital ratio • Working capital expressed as a percentage of sales.