Terms to Know: Debt and Equity Capital

Asset Utilization: Efficiency in how a business uses its assets. Key driver of profitability, return on capital and return on equity. Can be measured by sales/average assets. The more sales a business can generate from a given level of assets, the more productive and profitable it should be.

Capital: Sum total of debt and equity, which is the same as total book value of asset. (Note that some use the term capital synonymously with equity, which differs from our use here.)

Cost of Capital:

Def. 1: Rate of return required by an investor (see also "Hurdle Rate").

Def. 2: Blended cost of debt and equity contributed to a business. One method for calculating overall cost of capital to a firm is the weighted average cost of capital (WACC) formula, as follows:

WACC = (Cost of equity x % of total capital that is equity + [Cost of debt x % of total capital that is debt x (1 - tax rate)]

In calculating WACC, non-interest-bearing debt is ignored.

Example: Company A has total equity of $250,000 and total interest-bearing debt of $250,000. As such, 50% of A's capital is debt and 50% is equity. Let's assume that the required rate of return on the equity is 30% (for an explanation, see "Required Rate of Return" below) and the average rate of interest charged by interest-bearing debt providers is 8%. Here's the calculation:

WACC        =     (.5 x .30) + [.5 x .08 x (1 - .35)]

=     .150 + .026

=     .0176 or 17.6%

Debt: Amount owed; general term for financial obligations such as notes, bonds, mortgages, etc.

Equity: Ownership; residual interest that remains after deducting all liabilities.

Hurdle Rate: Minimum rate of return acceptable. In the example above for "Cost of Capital," the WACC of Company A is 17.6%. As such, the business owner should invest monies of the company only into projects that earn 17.6% or more annually. If lower returns are earned, equity holders are undercompensated for the risk they bear. If the business does not earn at least a rate of return that equals the cost of its debt (8% pretax in our example) financing, no value (or return) will accrue to the owner(s).

Return on Assets (ROA, aka Return on Total Capital): Measure of company profitability in how efficiently it uses its assets. Calculated as follows:

Return on Equity (ROE): Measure of efficiency in how a company uses its equity. Calculated as follows:

ROE = Net Profit/Average Net Worth) x 100

Return on capital: See Return on Assets.

Risk: Degree of uncertainty as to whether expected cash flow will be realized. For an established company, risk can be simplified to be the volatility of earnings. Companies with very predictable earnings are considered less risky and can afford to use higher levels of debt. Companies with volatile earnings have, of course, a higher degree of uncertainty in predicting their ability to meet fixed obligations and therefore a lower tolerance for fixed obligations (i.e., debt).

Required Rate of Return: Return that the rational investor requires based on perceived risk of a particular investment. For assets traded publicly in an efficient market, required rate of return equals actual rate of return. This is so because investors dictate their own rate of return by the price they are willing to pay for the asset. Rates of return generated for ownership in small public companies have averaged around 19% per year over the past 90 years. Required rates of return for private companies are not as evident because they are not publicly traded, but it is presumed that - due to the illiquidity, lower levels of diversification and higher overall risk - equity in private companies merits annual returns well north of 25%.