Definition of optimal mix of capital

optimal mix of capital

the combination of capital sources at which the lowest weighted average cost of capital is achieved

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

Money invested in a firm.

Capital account

Net result of public and private international investment and lending activities.

Capital allocation

decision Allocation of invested funds between risk-free assets versus the risky portfolio.

Capital asset pricing model (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 the expected return of a security or a portfolio is equal to the rate on a risk-free security
plus a risk premium.

Capital budget

A firm's set of planned capital expenditures.

Capital budgeting

The process of choosing the firm's long-term capital assets.

Capital expenditures

Amount used during a particular period to acquire or improve long-term assets such as
property, plant or equipment.

Capital flight

The transfer of capital abroad in response to fears of political risk.

Capital gain

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 lease

A lease obligation that has to be capitalized on the balance sheet.

Capital loss

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 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 (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, either
by using a higher cost of capital, or by setting a maximum on parts of, and/or the entirety of, the capital
budget.

Capital structure

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.

Capital surplus

Amounts of directly contributed equity capital in excess of the par value.

Capitalization

The debt and/or equity mix that fund a firm's assets.

Capitalization method

A method of constructing a replicating portfolio in which the manager purchases a
number of the largest-capitalized names in the index stock in proportion to their capitalization.

Capitalization ratios

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.

Complete capital market

A market in which there is a distinct marketable security for each and every
possible outcome.

Cost of capital

The required return for a capital budgeting project.

Cost of limited partner capital

The discount rate that equates the after-tax inflows with outflows for capital
raised from limited partners.

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.

Hard capital rationing

capital rationing that under no circumstances can be violated.

Human capital

The unique capabilities and expertise of individuals.

Issued share capital

Total amount of shares that are in issue. Related: outstanding shares.

Legal capital

Value at which a company's shares are recorded in its books.

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.

Market capitalization

The total dollar value of all outstanding shares. Computed as shares times current
market price. It is a measure of corporate 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.

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 financial securities.

Optimal contract

The contract that balances the three types of agency costs (contracting, monitoring, and
misbehavior) against one another to minimize the total cost.

Optimal portfolio

An efficient portfolio most preferred by an investor because its risk/reward characteristics
approximate the investor's utility function. A portfolio that maximizes an investor's preferences with respect
to return and risk.

Optimal redemption provision

Provision of a bond indenture that governs the issuer's ability to call the
bonds for redemption prior to their scheduled maturity date.

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 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)

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.

"Soft" Capital Rationing

capital rationing that under certain circumstances can be violated or even viewed
as made up of targets rather than absolute constraints.

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.

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

Expected return on a portfolio of all the firm's securities. Used as a hurdle
rate for capital investment.

Working capital

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 shortterm liquidity.

Working capital ratio

Working capital expressed as a percentage of sales.

CAPITAL

The money, raised by selling stock or bonds or taking out loans, that you use to start, operate, and grow a business.

CAPITAL IN EXCESS OF PAR VALUE

What a company collected when it sold stock for more than the par value per share.

Capital

The shareholders’ investment in the business; the difference between the assets and liabilities
of a business.

Capital employed

The total of debt and equity, i.e. the total funds in the business.

Capitalize

To make a payment that might otherwise be an expense (in the Profit and Loss account) an asset
(in the Balance Sheet).

Capital market

The market in which investors buy and sell shares of companies, normally associated with a Stock Exchange.

Cost of capital

The costs incurred by an organization to fund all its investments, comprising the risk-adjusted
cost of equity and debt weighted by the mix of equity and debt.

Product/service mix

See sales mix.

Return on capital employed (ROCE)

The operating profit before interest and tax as a percentage of the total shareholders’ funds plus
the long-term debt of the business.

Sales mix

The mix of product/services offered by the business, each of which may be aimed at different customers, with each product/service having different prices and costs.

Weighted average cost of capital

See cost of capital.

Working capital

Current assets less current liabilities. Money that revolves in the business as part of the process of buying, making and selling goods and services, particularly in relation to debtors, creditors, inventory and bank.

Additional paid-in capital

Amounts in excess of the par value or stated value that have been paid by the public to acquire stock in the company; synonymous with capital in excess of par.

Capital in excess par

Amounts in excess of the par value or stated value that have been paid by the public to acquire stock in the company; synonymous with additional paid-in capital.

Contributed capital

The amount put into the business by the owners by purchasing stock and by paying more than the par value for the stock (additional paid-in capital or capital in excess of par).

capital

A very broad term rooted in economic theory and referring to
money and other assets that are invested in a business or other venture
for the general purpose of earning a profit, or a return on the investment.
Generally speaking, the sources of capital for a business are
divided between debt and equity. Debt, as you know, is borrowed money
on which interest is paid. Equity is the broad term for the ownership
capital invested in a business and is most often called owners’ equity.
Owners’ equity arises from two quite different sources: (1) money or
other assets invested in the business by its owners and (2) profit earned
by the business that is retained and not distributed to its owners (called
retained earnings).

capital budgeting

Refers generally to analysis procedures for ranking
investments, given a limited amount of total capital that has to be allocated
among the various capital investment opportunities of a business.
The term sometimes is used interchangeably with the analysis techniques
themselves, such as calculating present value, net present value,
and the internal rate of return of investments.

capital expenditures

Refers to investments by a business in long-term
operating assets, including land and buildings, heavy machinery and
equipment, vehicles, tools, and other economic resources used in the
operations of a business. The term capital is used to emphasize that
these are relatively large amounts and that a business has to raise capital
for these expenditures from debt and equity sources.

capital investment analysis

Refers to various techniques and procedures
used to determine or to analyze future returns from an investment
of capital in order to evaluate the capital recovery pattern and the
periodic earnings from the investment. The two basic tools for capital
investment analysis are (1) spreadsheet models (which I strongly prefer)
and (2) mathematical equations for calculating the present value or
internal rate of return of an investment. Mathematical methods suffer
from a lack of information that the decision maker ought to consider. A
spreadsheet model supplies all the needed information and has other
advantages as well.

capital recovery

Refers to recouping, or regaining, invested capital over
the life of an investment. The pattern of period-by-period capital recovery
is very important. In brief, capital recovery is the return of capital—
not the return on capital, which refers to the rate of earnings on the
amount of capital invested during the period. The returns from an
investment have to be sufficient to provide for both recovery of capital
and an adequate rate of earnings on unrecovered capital period by
period. Sorting out how much capital is recovered each period is relatively
easy if you use a spreadsheet model for capital investment analysis.
In contrast, using a mathematical method of analysis does not
provide this period-by-period capital recovery information, which is a
major disadvantage.

capital stock

Ownership shares issued by a business corporation. A business
corporation may issue more than one class of capital stock shares.
One class may give voting privileges in the election of the directors of the
corporation while the other class does not. One class (called preferred
stock) may entitle a certain amount of dividends per share before cash
dividends can be paid on the other class (usually called common stock).
Stock shares may have a minimum value at which they have to be issued
(called the par value), or stock shares can be issued for any amount
(called no-par stock). Stock shares may be traded on public markets such
as the New York Stock Exchange or over the Nasdaq network. There are
about 10,000 stocks traded on public markets (although estimates vary
on this number). In this regard, I find it very interesting that there are
more than 8,000 mutual funds that invest in stocks.

capital structure, or capitalization

Terms that refer to the combination of
capital sources that a business has tapped for investing in its assets—in
particular, the mix of its interest-bearing debt and its owners’ equity. In a
more sweeping sense, the terms also include appendages and other features
of the basic debt and equity instruments of a business. Such things
as stock options, stock warrants, and convertible features of preferred
stock and notes payable are included in the more inclusive sense of the
terms, as well as any debt-based and equity-based financial derivatives
issued by the business.

capitalization of costs

When a cost is recorded originally as an increase
to an asset account, it is said to be capitalized. This means that the outlay
is treated as a capital expenditure, which becomes part of the total
cost basis of the asset. The alternative is to record the cost as an expense
immediately in the period the cost is incurred. capitalized costs refer
mainly to costs that are recorded in the long-term operating assets of a
business, such as buildings, machines, equipment, tools, and so on.

cost of capital

Refers to the interest cost of debt capital used by a business
plus the amount of profit that the business should earn for its equity
sources of capital to justify the use of the equity capital during the
period. Interest is a contractual and definite amount for a period,
whereas the profit that a business should earn on the equity capital
employed during the period is not. A business should set a definite goal
of earning at least a certain minimum return on equity (ROE) and compare
its actual performance for the period against this goal. The costs of
debt and equity capital are combined into either a before-tax rate or an
after-tax rate for capital investment analysis.

market capitalization, or market cap

Current market value per share of
capital stock multiplied by the total number of capital stock shares outstanding
of a publicly owned business. This value often differs widely from
the book value of owners’ equity reported in a business’s balance sheet.

weighted-average cost of capital

Weighted means that the proportions of
debt capital and equity capital of a business are used to calculate its
average cost of capital. This key benchmark rate depends on the interest
rate(s) on its debt and the ROE goal established by a business. This is a
return-on-capital rate and can be applied either on a before-tax basis or
an after-tax basis. A business should earn at least its weighted-average
rate on the capital invested in its assets. The weighted-average cost-ofcapital
rate is used as the discount rate to calculate the present value
(PV) of specific investments.

Capital Asset Pricing Model (CAPM)

A model for estimating equilibrium rates of return and values of
assets in financial markets; uses beta as a measure of asset risk
relative to market risk

Capital Budgeting

The process of ranking and selecting investment alternatives and
capital expenditures

Capital Market

A market that specializes in trading long-term, relatively high risk
securities

Capital Structure

The combination of debt, preferred stock, and common stock used
by a company to provide capital for the purchase of its fixed
assets

Cost of Capital

The minimum rate of return a company must earn in order to meet
the rate of return required by the investors (providers of capital) of
the company

Weighted Average Cost of Capital (WACC)

The weighted average of the costs of the capital components
(debt, preferred stock, and common stock)

capital asset

an asset used to generate revenues or cost savings
by providing production, distribution, or service capabilities
for more than one year

capital budget

management’s plan for investments in longterm
property, plant, and equipment

capital budgeting

a process of evaluating an entity’s proposed
long-range projects or courses of future activity for
the purpose of allocating limited resources to desirable
projects

capital rationing

a condition that exists when there is an
upper-dollar constraint on the amount of capital available
to commit to capital asset acquisition

cost of capital (COC)

the weighted average cost of the
various sources of funds (debt and stock) that comprise a
firm’s financial structure

intellectual capital

the intangible assets of skill, knowledge,
and information that exist in an organization; it encompasses
human, structural, and relationship capital

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