Concepts of Capital

Business Finance
Capital
 From the point of view of a business man, who has just
started his own business, capital refers to the resources he
has accumulated and invested in his venture.
 From the point of view of the business itself, capital refers to
all the resources available for its use as an economic entity
regardless of their sources.
 Thus, in a broad sense, the total capital of a business would
refer to its total assets whether provided by creditors of by its
owners.
Sources of Capital
 Equity Capital refers to the financial resources provided by
owners of the business, it may be in the form of initial and
additional investments plus earnings retained in the
business. The amount thereof is computed by subtracting
total liabilities from total assets of a business.
 Owner’s Equity (Sole Proprietorship)
 Partner’s Equity (Partnership)
 Stockholder’s Equity (Corporation)
Sole Proprietorship
Owner’s Equity:
A. Natu, Capital January 1, 20B P 30,000
Add: Net Income for 20b 12,000
P 42,500
Less: Drawings 7,000
A. Natu, Capital, December 31, 20B P 35,000
Partnership
Partner’s Equity:
Yato Gami P 75,000
Natsume Takashi 45,000
Sanzo Hoshi 55,000
Total partner’s equity P175,000
Corporation
Stockholder’s Equity
Contributed Capital
12% Preferred stock, non participating
Issued 18,000 shares of which 200 shares
are in treasury P 1,800,000
Common Stock
Authorized 40,000 share, par value P50
Issued 30,000 share P 1,500,000
Additional Contributed Capital
Premium on preferred stock 200,000
Premium on common stock 300,000
Total contributed capital P 3,800,000
Retained Earnings
Appropriated for:
Plant expansion P 1,500,000
Cost of treasury stocks 19,000
Total appropriated P 1,519,000
Unappropriated 2,000,000 3,519,000
Total P 7,319,000
Less: Cost of treasury stock
- Common 19,000
Total stockholder’s equity P 7,300,000
Effects of Dividends on Equity Capital. Dividends, with the
exception of liquidating dividends, are distribution of corporate
earning. Not all dividends reduce equity capital. The effects
are summarized as follows:

EFFECTS ON
Equity Retained Other Accounts
Capital Earnings Affected
a. Cash Dividends Decrease Decrease Cash-Decrease
b. Property Dividends Decrease Decrease Assets-Decrease
c. Stock Dividends No Effect Decrease Capital Stock-Increase
d. Scrip Dividends Decrease Decrease Liabilities-
Increase
e. Bond Dividends Decrease Decrease Liabilities-
Increase
f. Liquidating Dividends Decrease - Capital stock-Decrease
Assets-Decrease
Retention or Ploughing Back of Earnings. It has been emphasized
that one way of increasing equity capital is by retaining earnings in the
business. This is effected as follows:

 Sole Proprietorship: the owner withdraws only a portion of his

business earning so that earnings not withdrawn are added to his
capital account.
 Partnership: although partnership net income is distributed by
credits to partners’ personal or drawing accounts, actual withdrawals
are limited to only a portion thereof so that the personal or drawing
accounts left with credit balances.
 Corporation: the board of directors declares only a portion
of retained earnings as dividends. In most cases, the board opts to
declare stock dividends so as not to reduces the equity capital and
avoid cash outlay or decrease in total financial resources.
Example..
Dr. Stone Company had 1,000,000 shares of common stock
outstanding as of December 31, 2013 and has adopted the
policy of paying annual cash dividends of P0.08 per share. Its
board of directors declared stock dividends of 20% on January
1, 2014 and 30% as of January 1, 2015. The number of
outstanding shares and the corresponding cash dividends
would be as follows:
 Number of Cash
Shares Dividends
Outstanding, December 31, 2013 1,000,000
20% stock dividend, January 1, 2014
(1,000,000 shares x 20%) 200,000
Outstanding, 2014 1,200,000
Cash dividends, 2015 (P0.08 x 1.2M shares) P 96,000
30% stock dividend, January 1, 2015
(1,200,000 shares x 30%) 360,000
Outstanding, 2015 1,560,000
Cash Dividends, 2015 (P0.08 x 1,560,000 shares) P 124,800
Borrowed Capital
Capital acquired that gives rise to a liability (or debtor-creditor relationship) is
borrowed capital.

Increases in liabilities are effected in a number of ways and some of them are
as follows:
 Purchasing goods, property and equipment and availing of other parties’
services on account or charge basis.
 Obtaining loans from financing companies.
 Receiving advances from offices and affiliate companies.
 Issuing commercial papers.
 Discounting notes receivable (or promissory notes received from customers
and other parties).
 Floating bonds.
Classification of Liabilities in
Periodic Financial reports:
 Current Liabilities are those maturing within one year.
 Long term Liabilities are liabilities that will mature beyond
one year.
Classification of Loans:
 Short term loans are those maturing within one year.
 Medium (or intermediate) loans are those maturing after one
year up to within five years.
 Long term loans are those maturing beyond five years (up to
10, 20 or more years).
Financial Leverage
 Making use of borrowed capital is an example of financial leverage.
 The term leverage has been defined by Webster as “the mechanical
advantage of power gained by using a lever”.
 Lever, in turn, is defined as “a bar or rigid piece”, rotating about a
fixed axis or fulcrum, which lifts or sustains weight at one point by
means of applied force at a second point.
 Financial Leverage, refers to the financial advantage derived from
having additional funds may be expressed in terms of increased
capacity to produce and sell, to create other sources of income, and
to take advantage of business opportunities as they arise, and the
increased ability to offset or meet possible losses or downtrend in
economic activities.
Cost of Borrowed Capital. Interest is paid on borrowed capital. In as much as
it is deductible for income tax purposes, the corresponding tax benefit is
treated as adjustment to interest expense in computing for the cost borrowed
capital. It is therefore computed as:

cost of borrowed capital = interest x ( 1-tax rate)

Example..
OMEGAVERSE Corp. Obtained a 20%, P200,000, one year loan from
ALPHA Financing Company. Income tax rate is 35%. The cost of capital from
this source is computed as follows:
Cost of borrowed capital = 20% * (1-35%) = 13%

Proof:
Interest of 20% on 200,000 P 40,000
Tax benefit (35% of 40,000) 14,000
Interest expense net of tax benefit P26,000
Percentage (P26,000)/P200,000) 13%
Invested Capital vs. Borrowed Capital
In determining whether a business entity should have more of invested
capital or borrowed capital, the following differences should be
considered:
a. Invested capital relatively permanent
b. Dividends are paid on invested capital while financing charges are
paid on borrowed capital.
c. In managing the capital of a business, management tries to
maximize earning on invested capital and minimize financing
charges on borrowed capital.
d. Upon the dissolution of a business entity, invested capital is
returned to its owners after the claims of third parties have been
fully paid.
Example..
OMEGAVERSE is planning to undertake a certain project that
will require investment of P200,000 from which it expects to
realize a 25% rate of returns. Loans may be obtained at the
interest rate of 18% per annum. Income tax rate is 35%

Cost of borrowed capital = 18% (1-35%) = 11.7%

 At Present From Total
Proposed Project
Net Income P30,000 (P200,000x13.3%)=P26,600 P56,000
Owner’s Equity P100,000 P100,000
Rate of return on
owner’s equity 30% 56.6%
EPS
P30,000/10,000 shrs P3
P56,000/10,000 shrs
P5.66
In the foregoing illustration, the owner’s equity remains at P100,000 despite
the additional resources made available for its use because they come from
creditors. The additional resources generate additional income thereby raising
the rate of return on owner’s equity and the earnings per share. They also
raise the debt/equity ratio from 0:1 to 2:1 computed as follows:
 At Present Per Proposal Total

Total Liabilities 0 P200,000 P200,000

Owner’s EquityP100,000 - 100,000
Debt/Equity Ratio 0:1 2:1