Capital in narrow and broad uses
In classical economics, capital is one of three (or four, in some formulations) factors of production. The others are land, labor and (in some versions) organization, entrepreneurship, or management. Goods with the following features are capital:
It can be used in the production of other goods (this is what makes it a factor of production). It was produced, in contrast to "land," which refers to naturally occurring resources such as geographical locations and minerals. It is not used up immediately in the process of production unlike raw materials or intermediate goods. (The significant exception to this is depreciation allowance, which like intermediate goods, is treated as a business expense.) These distinctions of convenience carried over to neoclassical economics with little change in formal analysis for an extended period. There was the further clarification that capital is a stock. As such, its value can be estimated at a point in time, say December 31. By contrast, investment, as production to be added to the capital stock, is described as taking place over time ("per year"), thus a flow.
Earlier illustrations often described capital as physical items, such as tools, buildings, and vehicles that are used in the production process. Since at least the 1960s economists have increasingly focused on broader forms of capital. For example, investment in skills and education can be viewed as building up human capital or knowledge capital, and investments in intellectual property can be viewed as building up intellectual capital. These terms lead to certain questions and controversies discussed in those articles. Human development theory describes human capital as being composed of distinct social, imitative and creative elements:
Social capital is the value of network trusting relationships between individuals in an economy. Individual capital which is inherent in persons, protected by societies, and trades labor for trust or money. Close parallel concepts are "talent", "ingenuity", "leadership", "trained bodies", or "innate skills" that cannot reliably be reproduced by using any combination of any of the others above. In traditional economic analysis individual capital is more usually called labour. Further classifications of capital that have been used in various theoretical or applied uses include:
Financial capital which represents obligations, and is liquidated as money for trade, and owned by legal entities. It is in the form of capital assets, traded in financial markets. Its market value is not based on the historical accumulation of money invested but on the perception by the market of its expected revenues and of the risk entailed. Natural capital which is inherent in ecologies and protected by communities to support life, e.g. a river which provides farms with water. Infrastructural capital is non-natural support systems (e.g. clothing, shelter, roads, personal computers) that minimize need for new social trust, instruction, and natural resources. (Almost all of this is manufactured, leading to the older term manufactured capital, but some arises from interactions with natural capital, and so it makes more sense to describe it in terms of its appreciation/depreciation process, rather than its origin: much of natural capital grows back, infrastructural capital must be built and installed.) In part as a result, separate literatures have developed to describe both natural capital and social capital. Such terms reflect a wide consensus that nature and society both function in such a similar manner as traditional industrial infrastructural capital, that it is entirely appropriate to refer to them as different types of capital in themselves. In particular, they can be used in the production of other goods, are not used up immediately in the process of production, and can be enhanced (if not created) by human effort.
There is also a literature of intellectual capital and intellectual property law. However, this increasingly distinguishes means of capital investment, and collection of potential rewards for patent, copyright (creative or individual capital), and trademark (social trust or social capital) instruments.the word capital is what you have as a wealth.
Capital in classical economics and beyond
Within classical economics, Adam Smith (Wealth of Nations, Book II, Chapter 1) distinguished fixed capital from circulating capital, including raw materials and intermediate products. For an enterprise, both were kinds of capital.
Karl Marx adds a distinction that is often confused with David Ricardo's. In Marxian theory, variable capital refers to a capitalist's investment in labor-power, seen as the only source of surplus-value. It is called "variable" since the amount of value it can produce varies from the amount it consumes, i.e., it creates new value. On the other hand, constant capital refers to investment in non-human factors of production, such as plant and machinery, which Marx takes to contribute only its own replacement value to the commodities it is used to produce. It is constant, in that the amount of value committed in the original investment, and the amount retrieved in the form of commodities produced, remains constant.
Investment or capital accumulation in classical economic theory is the production of increased capital. In order to invest, goods must be produced which are not to be immediately consumed, but instead used to produce other goods as a means of production. Investment is closely related to saving, though it is not the same. As Keynes pointed out, saving involves not spending all of one's income on current goods or services, while investment refers to spending on a specific type of goods, i.e., capital goods.
The Austrian economist Eugen von Böhm-Bawerk maintained that capital intensity was measured by the roundaboutness of production processes. Since capital is defined by him as being goods of higher-order, or goods used to produce consumer goods, and derived their value from them, being future goods.
Capital Controversy
The Cambridge capital controversy was a 1960s debate in economics concerning the nature and role of capital goods.The debate was largely between economists such as Joan Robinson and Piero Sraffa at the University of Cambridge in England and economists such as Paul Samuelson and Robert Solow at the Massachusetts Institute of Technology, in Cambridge, Massachusetts. The two schools are often labeled "neo-Ricardian" (or "Sraffian") and neoclassical, respectively.
In neoclassical economics capitalist income is the rate of profit multiplied by the amount of capital, but the measurement of the "amount of capital" involves adding up quite incompatible physical objects, for example, adding trucks to lasers. Neoclassical economists assumed that there was no real problem here — just add up the money value of all these different capital items to get an aggregate amount of capital. But Sraffa (and Joan Robinson before him) pointed out that this financial measurement of the amount of capital depended partly on the rate of profit. There was thus a circularity in the argument. To date most economists continue to measure capital in the traditional neoclassical sense, but the controversy continues even if under the radar of most in the economics profesion.

Capital asset pricing model
An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years for monthly data.In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.
The model was introduced by Jack Treynor (1961, 1962)[1], William Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field of financial economics.

The formula The Security Market Line, seen here in a graph, describes a relation between the beta and the asset's expected rate of return. The CAPM is a model for pricing an individual security or a portfolio. For individual securities, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:
The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).
where:
is the expected return on the capital asset is the risk-free rate of interest such as interest arising from government bonds (the beta coefficient) is the sensitivity of the asset returns to market returns, or also , is the expected return of the market is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return).
Restated, in terms of risk premium, we find that:
which states that the individual risk premium equals the market premium times β.
Note 1: the expected market rate of return is usually estimated by measuring the Geometric Average of the historical returns on a market portfolio (i.e. S&P 500).
Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return and not the current risk free rate of return.
For the full derivation see Modern portfolio theory.
Asset pricing
Once the expected return, E(Ri), is calculated using CAPM, the future cash flows of the asset can be discounted to their present value using this rate (E(Ri)), to establish the correct price for the asset.
In theory, therefore, an asset is correctly priced when its observed price is the same as its value calculated using the CAPM derived discount rate. If the observed price is higher than the valuation, then the asset is overvalued (and undervalued when the observed price is below the CAPM valuation).
Alternatively, one can "solve for the discount rate" for the observed price given a particular valuation model and compare that discount rate with the CAPM rate. If the discount rate in the model is lower than the CAPM rate then the asset is overvalued (and undervalued for a too high discount rate).
The CAPM returns the asset-appropriate required return or discount rate - i.e. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than average. Thus a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. Given the accepted concave utility function, the CAPM is consistent with intuition - investors (should) require a higher return for holding a more risky asset.
Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the market - and in that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as a mutual fund) therefore expects performance in line with the market.
[edit] Risk and diversificationThe risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk common to all securities - i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific risks "average out"). The same is not possible for systematic risk within one market. Depending on the market, a portfolio of approximately 30-40 securities in developed markets such as UK or US will render the portfolio sufficiently diversified to limit exposure to systematic risk only. In developing markets a larger number is required, due to the higher asset volatilities.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e. its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor.
The efficient frontier
Main article: Efficient frontier The (Markowitz) efficient frontier. CAL stands for the capital allocation line.The CAPM assumes that the risk-return profile of a portfolio can be optimized - an optimal portfolio displays the lowest possible level of risk for its level of return. Additionally, since each additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset, (assuming no trading costs) with each asset value-weighted to achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios, i.e., one for each level of return, comprise the efficient frontier.
Because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as beta.
The market portfolio
An investor might choose to invest a proportion of his or her wealth in a portfolio of risky assets with the remainder in cash - earning interest at the risk free rate (or indeed may borrow money to fund his or her purchase of risky assets in which case there is a negative cash weighting). Here, the ratio of risky assets to risk free asset does not determine overall return - this relationship is clearly linear. It is thus possible to achieve a particular return in one of two ways:
By investing all of one's wealth in a risky portfolio, or by investing a proportion in a risky portfolio and the remainder in cash (either borrowed or invested). For a given level of return, however, only one of these portfolios will be optimal (in the sense of lowest risk). Since the risk free asset is, by definition, uncorrelated with any other asset, option 2 will generally have the lower variance and hence be the more efficient of the two.
This relationship also holds for portfolios along the efficient frontier: a higher return portfolio plus cash is more efficient than a lower return portfolio alone for that lower level of return. For a given risk free rate, there is only one optimal portfolio which can be combined with cash to achieve the lowest level of risk for any possible return. This is the market portfolio.
Assumptions of CAPM
All Investors:
Aim to maximize economic utility. Are rational and risk-averse. Are price takers, i.e., they cannot influence prices. Can lend and borrow unlimited under the risk free rate of interest. Trade without transaction or taxation costs. Deal with securities that are all highly divisible into small parcels. Assume all information is at the same time available to all investors.
Shortcomings of CAPM
The model assumes that asset returns are (jointly) normally distributed random variables. It is however frequently observed that returns in equity and other markets are not normally distributed. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect. The model assumes that the variance of returns is an adequate measurement of risk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors' preferences more adequately. The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption). The model assumes that the probability beliefs of investors match the true distribution of returns. A different possibility is that investors' expectations are biased, causing market prices to be informationally inefficient. This possibility is studied in the field of behavioral finance, which uses psychological assumptions to provide alternatives to the CAPM such as the overconfidence-based asset pricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001)[2]. The model does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong – indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market). The model assumes that given a certain expected return investors will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well. The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model. The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual investors, and that investors choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted. The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital...) In practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the inobservability of the true market portfolio, the CAPM might not be empirically testable. This was presented in greater depth in a paper by Richard Roll in 1977, and is generally referred to as Roll's critique. The model assumes just two dates, so that there is no opportunity to consume and rebalance portfolios repeatedly over time. The basic insights of the model are extended and generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and the consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.


Cash flow
Cash Flow (CNBC Asia). For the song, see Cash Flow (song). Accountancy Key concepts AccountantBookkeepingTrial balanceGeneral ledgerDebits and creditsCost of goods soldDouble-entry systemStandard practicesCash and accrual basisGAAP / IFRS Financial statements Balance sheetIncome statementCash flow statementOwnership equityRetained earnings
Auditing Financial auditGAASInternal auditSarbanes-Oxley ActBig Four auditors
Fields of accounting Cost • Financial • ForensicFund • Management • Tax This box: view • talk • edit Cash flow refers to the movement of cash into or out of a business, a project, or a financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used
to determine a project's rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return, and net present value. to determine problems with a business's liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable. as an alternate measure of a business's profits when it is believed that accrual accounting concepts do not represent economic realities. For example, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares, or raising additional debt finance. cash flow can be used to evaluate the 'quality' of Income generated by accrual accounting. When Net Income is composed of large non-cash items it is considered low quality. to evaluate the risks within a financial product. E.g. matching cash requirements, evaluating default risk, re-investment requirements, etc. Cash flow is a generic term used differently depending on the context. It may be defined by users for their own purposes. It can refer to actual past flows, or to projected future flows. It can refer to the total of all the flows involved or to only a subset of those flows. Subset terms include 'net cash flow', operating cash flow and free cash flow.

Statement of Cash Flow in a Business's FinancialsCash flows are classified into:
Operational cash flows: Cash received or expended as a result of the company's internal business activities. It includes cash earnings plus changes to working capital. Over the medium term this must be net positive if the company is to remain solvent. Investment cash flows: Cash received from the sale of long-life assets, or spent on capital expenditure (investments, acquisitions and long-life assets). Financing cash flows: Cash received from the issue of debt and equity, or paid out as dividends, share repurchases or debt repayments All three together - the net cash flow - are necessary to reconcile the beginning cash balance to the ending cash balance.
[edit] Ways Companies Can Augment Reported Cash FlowCommon methods include:
Sales - Sell the receivables to a factor for instant cash. (leading) Inventory - Don't pay your suppliers for an additional few weeks at period end. (lagging) Sales Commissions - Management can form a separate (but unrelated) company act as its agent. The book of business can then be purchased quarterly as an investment. Wages - Remunerate with stock options. Maintenance - Contract with the predecessor company that you prepay five years worth for them to continue doing the work Equipment Leases - Buy it Rent - Buy the property (sale and lease back, for example). Oil Exploration costs - Replace reserves by buying another company's. Research & Development - Wait for the product to be proven by a start-up lab; then buy the lab. Consulting Fees - Pay in shares from treasury since usually to related parties Interest - Issue convertible debt where the conversion rate changes with the unpaid interest. Taxes - Buy shelf companies with TaxLossCarryForward's. Or gussy up the purchase by buying a lab or O&G explore co. with the same TLCF.[1]
[edit] Example of a positive $40 cash flowTransaction In (Debit) Out (Credit) Incoming Loan +$50.00 Sales (which were paid for in cash) +$30.00 Materials -$10.00 Labor -$10.00 Purchased Capital -$10.00 Loan Repayment -$5.00 Taxes -$5.00 Total.......................................... .......+$40.00.......
In this example the following types of flows are included:
Incoming loan: financial flow Sales: operational flow Materials: operational flow Labor: operational flow Purchased Capital: Investment flow Loan Repayment: financial flow Taxes: financial flow Let us, for example, compare two companies using only total cash flow and then separate cash flow streams. The last three years show the following total cash flows:
Company A:Year 1: cash flow of +10MYear 2: cash flow of +11MYear 3: cash flow of +12M
Company B:Year 1: cash flow of +15MYear 2: cash flow of +16MYear 3: cash flow of +17M
Company B has a higher yearly cash flow and looks like a better one in which to invest. Now let us see how their cash flows are made up:
Company A:
Year 1: OC: +20M FC: +5M IC: -15M, total = +10MYear 2: OC: +21M FC: +5M IC: -15M, total = +11MYear 3: OC: +22M FC: +5M IC: -15M, total = +12M
Company B:
Year 1: OC: +10M FC: +5M IC: 0, total = +15MYear 2: OC: +11M FC: +5M IC: 0, total = +16MYear 3: OC: +12M FC: +5M IC: 0, total = +17M
OC = Operational Cash, FC = Financial Cash, IC = Investment Cash Now it shows that Company A is actually earning more cash by its core activities and has already spent 45M in long term investments, of which the revenues will only show up after three years. When comparing investments using cash flows always make sure to use the same cash flow layout.