3. Understanding the cost of capital

What is “capital”?

You will find in economics a broad use of the term “capital”. It is used to distinguish the factors of production, labor and capital, where capital refers to the assets that exist in the economy that are combined with labor to create production. Capital can be asserted as the capacity to acquire assets for production. Capital may also be used to refer to the possession of financial assets (such as cash or deposits), or to fixed assets (such as machinery), capacity production or facilities or factories. Combining the widespread uses of capital brings it to a notion of an asset that is held with the purpose of creating an added value. You will hold a bank deposit in the expectation of earning its interest, just like a business owns productive capital (the fixed assets) with the expectation of generating wealth through production.

While a company owns productive capital (its fixed assets), it is itself a capital asset for the entities who finance the company and, inherently, the purchase of its productive capital. The company obtains an economic advantage of holding its fixed assets and putting them into production; and it is expected to provide a return to its financers. From the company’s position, the return paid to its financers, is the cost that it is paying for being given the financial capacity to invest in assets. So, one needs to identify the capital that was put into the company under the strict perspective of delivering a return to financers.

If we are trying to know how a business is financed, we have to look to the equity and liability sections of the balance sheet. Owners of the company expect a return from investing in the company. Ownership is present in the equity, as it comprehends the capital that has been invested by shareholders (either through issued capital and through other equity instruments). On the liabilities side not everything corresponds to a financing of the company with the purpose of obtaining an economic return. Lets take the balance sheet accounts used at CASFLO APP:

Account Is it financing capital? Why?
Debt Yes Debt accounts includes loans from banks as well as bonds (CASFLO APP only estimates bank financing). It is capital that is provided to the company with the purpose of being invested on fixed assets or operational assets. Banks and bond holders demand a return for this financing.
Other noncurrent liabilities No For its nature, these liabilities do not correspond to financing and do not provide an income to the holders of the rights.
Suppliers No While being a duty that the company holds to its suppliers it arises from transactions made by the company and do not provide any added return than that for acquisition of products of services. Even when suppliers implement payment plans with interest, that mostly corresponds to a commercial policy. And while it is known that many companies try to stretch their days of accounts receivables as mean of financing its operations (and even assets) without a cost, as suppliers do not demand a return for the time being of the liability, this account cannot be set as financing capital of the company.
Shareholders Yes Loans from shareholders can be with or without interest and for that reason to expect that an inflow from a shareholder loan may be considered as a financing capital, just like bank loans, and for that reason it may be included within Debt.
Government payables No Although some situations of government payables sub-accounts do include interest (take for instance a company that is paying interest for being behind with their duties to Social Security), by nature this account is excluded being financing capital.
Other accounts payables No Most of other payables do not accrue interest and therefore, this account is not a financing capital.
Other current liabilities No The justification is like that of the non-current liabilities.

Summing up, the capital that is used to finance a company’s investments includes Equity and Debt. Although it is explained further ahead, you should keep in mind that because Equity and Debt are different forms of financing the company the cost of capital is different for each.

Next Section: 3.1. The cost of capital