Capital

What Is Capital?

In economics, capital (equity, fund) is defined as those durable produced goods that are, in turn, used as productive inputs for further production of goods and services.

It can be categorized into two groups: tangible and intangible, and both types contribute to individuals' and groups' economic opportunities and quality of life.

As a general term, it includes anything that confers value or benefits to its owners, such as physical property like a factory or machinery, or intellectual property such as patents or financial assets held by an individual or business.

It includes a mix of skills, goods, and services that people share and exchange on an individual, community, and global level. Assets contribute to an organization or population's sustainable growth and success. 

It comes in many forms, contributing to a well-rounded and healthy society. Although it's commonly associated with money and finance, there are multiple forms of non-monetary funds. 

Financial, intellectual, human, manufacturing, natural, social, and relationship are its four major types. Generally speaking, it is critical to operating business day-to-day and financing its growth. 

Funds for a business are either raised through debt or equity financing or can be derived from the company's operations. 

Typically, businesses of all sizes focus on three types when budgeting: working, equity, and debt. In the financial industry, trading capital is identified as a fourth component.

Two ways are as a measure of wealth and a means of increasing wealth by investing in direct investments or capital projects. Net worth is the collective wealth of individuals. 

Economists examine financial one at the national and global levels to understand how it influences economic growth. 

Several metrics are monitored by economists, including income and consumption from the Commerce Department's Personal Income and Outlays report. Data on equity investment is also available from the GDP report.

Types of Capital

There are usually six types broadly defined ( financial, intellectual, human, manufacturing, natural, social, and relationship)

1. Financial

As defined by finance, accounting, and economics, it can be defined as any economic resource measured in terms of money used by entrepreneurs and businesses.

Generally, to purchase the materials, they need to manufacture their products or provide the services they provide to the economic sector on which their operation is based, e.g., retail, corporate, investment banking, etc.

Simply put, it's money generated by the entity or invested by investors to purchase necessary equipment or services for creating new products and services. 

It can be derived from a variety of sources, including 

• Long-term: It's usually calculated for above seven years; some examples are Share and Venture capital, Mortgage loan, Retained Profit, Project Finance, Debenture, etc. 
• Medium-term: It's calculated for usually between 2 and 7 years. Some examples are Term Loans, Revenue-based loans, leasing, hire purchase, etc. 
• Short term: It's usually calculated for under two years. Some examples are Bank overdrafts, Trade credits, Deferred Expenses, Factoring, etc.

2. Intellectual 

Information, competency, knowledge, and expertise are its major components. They are acquired through education, training, and hands-on experience. Its features include thinking critically, solving problems, and innovating.

3. Human 

The economic and social sciences use this term to describe individual characteristics valuable for production. It is generally referred to as the knowledge and skills of a worker.

A business utilizes skills and talents in the same way it uses intelligence to function and generate revenues. Besides mental capacity, skills may include manual labor, physical exertion, social influence, and more.

It is possible to determine its value by considering several factors. Among them are:

• Communication skills
• Higher education
• Working intelligence
• Technical and non-technical qualification
• Capacity of judgment
• Innovation in approach toward work

It can help boost the economy since there is a strong link between human labor and economic growth. Since people have diverse skills and knowledge, you can measure this relationship by how much is invested in people's education.

In response, several governments acknowledge this connection and provide free or low-cost higher education. Higher-educated workers tend to have higher salaries so that they can spend more.

Most often, it migrates, especially in global economies. Because of this, there is often a shift from developing places to more developed and urban areas.

Some economists call it a brain drain or flight of human capital. It describes the process that keeps certain areas underdeveloped for an extended period while others become even more developed.

4.  Manufacturing

It refers to material goods and infrastructure owned, leased, or controlled by an organization that contributes to production or service providers but does not become embodied in its output. 

The fact that they are physical assets makes them tangible. Businesses use them to produce products that other companies can use to deliver finished goods.

 As automotive, aircraft, and machinery manufacturers produce products from other industries, including manufacturing, shipping, and other services, their products are classified as capital goods.

They do not provide satisfaction (called utility in economics) per se to buyers but instead are used to produce the final product, which gives buyers pleasure.

Increasing efficiency and decreasing resource use are the benefits. To keep society functioning, the production and reproduction of these things require a continuous flow of energy and materials.

Its types include:

• Buildings
• Transportation
• Technology 
• Communication devices
• Machinery
• Tools
• Energy
• Cultivated ecosystem 

5. Social and Relationship 

It generally refers to a set of values that enable people to work together in a team and achieve a common goal. People with solid connections and relationships can effectively work together to achieve a common objective.

In a society or organization, such as a corporate or nonprofit organization, trust and shared identity, norms, values, and mutual relationships allow for the functioning of the entire group and achieving goals. 

Its two primary forms are bonding and bridging. 

• Bonding refers to relationships formed within a group through a shared sense of identity, values, and social norms. 
• Bridging is the creation of social equity across groups. It connects people between diverse groups, such as race, class, and religion. When bridging is successful, individuals in the two groups discover shared interests and goals and work together to achieve them.

6. Natural  

It refers to the Earth's naturally occurring resources essential to maintaining life. It refers to a type of commodity capital that involves mining, storing, or producing natural resources.

It includes crucial environmental goods for human survival, such as food, water, oxygen, and other vital resources. It also provides ecosystem processes such as climate regulation.

On futures exchanges, it is traded along with agricultural capital. Options and futures on public market exchanges are written using similar operational procedures for both types of commodities. Neither kind of capital is excluded from the balance sheet assets of a company.

The materials provided by these assets are needed for various services, including food, construction, transportation, and health care. A country's economic output and overall quality of life are directly linked to its natural assets. Minerals, plants, soil, and animals, among others, are some of its examples.

Money Vs. Capital

Capital's Importance in Business

Companies use it to fund the ongoing production of goods and services to generate profit. As a result of investing their funds in all kinds of things, companies create value. Capital expenditure on labor and expansions of buildings are typical examples. 

A business's capital is the money it has on hand to sustain its day-to-day operations and future expansion plans. One source of capital is the company's profits.

The word "capital assets" is a bit of a misnomer. Real estate, cars, long-term and short-term investments, and other valuable things are examples of capital assets for an individual or a corporation. 

A company's assets may include expensive machinery, inventory, warehouse space, office equipment, and patents that it owns. Many capital assets are illiquid. 

It plays a vital role in the modern productive system as follows:

1. Without it, production is impossible. Current production requires sophisticated tools and equipment.

2. It increases the productivity of employees and, thus, the economy. Due to a growing population and the importance of technology, manufacturers have had to find more capital and allied resources to meet the demands.

3. Capital accumulation is said to be the core of economic development. The economy can be a free enterprise economy, as is the case in America, a socialist economy, as is the point in Soviet Russia, or a mixed economy, as is the case in India. Irrespective of these types, economic development needs critical ingredients, such as capital formation.

4. It helps create employment opportunities. Consumer goods and capital goods are both made by workers.

What Is the Cost Of Capital?

It is the return a company needs to justify the investment, such as purchasing new equipment or building a new facility. It is an essential component of business accounting and financial analysis. 

Businesses that successfully manage their finances should have a low Cost of Capital.

A business's cost of capital is heavily influenced by its financing. Companies can be financed by debt or by equity. However, most firms use a combination of equity and debt financing. Therefore, it comes from the weighted average cost of all capital sources(WACC)

The formula is:

First, calculate the cost of debt and equity to calculate the WACC.

Interest rates on debt, such as mortgages and bonds, constitute the cost of debt. The interest paid on current debt is the interest expense.

Cost of Debt = (Total Debt ÷ Interest Expense) × (1−T)​

where:

• Interest Expense = Int. paid on the firm's current debt
• T =The company's marginal tax rate

The cost of equity is the return needed to determine whether the investment will meet its capital requirements. Similarly, the cost of equity is what the market demands in exchange for owning the asset and holding the risk.

The cost of equity is approximated by the capital asset pricing model (CAPM):

CAPM = Rf + β (Rm + Rf ) 

Where:

• Rf = risk-free rate of return
• Rm = market rate of return
• β = risk estimate

Now, 

WACC = [(E/V) * R_e)] + [(D/V) * R_d)] * (1 - T_c)

In this formula:

• E = the market value of the firm's equity
• D = the market value of the firm's debt
• V = the sum of E and D
• Re = the cost of equity
• Rd = the cost of debt
• Tc = the income tax rate 

Capital Calculations

The Brilliant Company is debating whether to upgrade its warehouse system or purchase equally risky bonds. The renovation will cost $50 million and is expected to save $10 million annually. Renovations will cost $60 million, and there will be an estimated savings of $20 million per year over the next five years.

A second option would be to use the $60 million to buy 5-year bonds from Kimichi Company. The company is expected to return 22% annually. The renovation will generate a 30% return ($10,000,000 / $50,000,000). 

There is a risk associated with the expected return here. Because the 30% return on investment outweighs the 22% return that Brilliant Company could have gained from investing in Kimichi Company, renovation is the better use of capital. 

Conclusion

Capital serves as the lifeblood of economic systems, fueling growth, innovation, and prosperity. From financial resources to intellectual prowess and human skills, diverse forms of capital converge to drive productivity and enhance living standards.

The interplay between different types of capital underscores the complexity and dynamism of modern economies.

Furthermore, the prudent management of capital, reflected in decisions such as capital expenditure and financing strategies, is critical for business success and sustainability.

Companies must carefully evaluate investment opportunities, considering factors like risk, return, and the cost of capital, to allocate resources efficiently and maximize shareholder value.

By harnessing the power of capital and fostering conducive environments for its growth and utilization, societies can strive towards inclusive and sustainable development.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Capitalism
• Capital Controls
• Capital Flows
• Credit Rating
• Debt