Basic Business Finance

Unit – II (Capitalization)

CAPITALIZATION
Capitalization is one of the most important parts of financial decision, which is related to the total amount of capital
employed in the business concern.
Understanding the concept of capitalization leads to solve many problems in the field of financial management.
Because there is a confusion among the capital, capitalization and capital structure.
The term capital refers to the total investment of the company in terms of money, and assets. It is also called as total
wealth of the company. When the company is going to invest large amount of finance into the business, it is called
as capital. Capital is the initial and integral part of new and existing business concern. The capital requirements of
the business concern may be classified into two categories: (a) Fixed capital (b) Working capital.
Meaning of Capitalization
Capitalization refers to the process of determining the quantum of funds that a firm needs to run its business.
Capitalization is only the par value of share capital and debenture and it does not include reserve and surplus.
According to Guthman and Dougall, “capitalization is the sum of the par value of stocks and bonds outstanding”.
“Capitalization is the balance sheet value of stocks and bonds outstands”. — Bonneville and Dewey
According to Arhur. S. Dewing, “capitalization is the sum total of the par value of all shares”.
Types Of Capitalization
Capitalization may be classified into the following three important types based on its nature:
• Over Capitalization
• Under Capitalization
• Water Capitalization

Over Capitalization
Over capitalization refers to the company which possesses an excess of capital in relation to its activity level and
requirements. In simple means, over capitalization is more capital than actually required and the funds are not
properly used.
According to Bonneville, Dewey and Kelly, over capitalization means, “when a business is unable to earn fair rate on
its outstanding securities”.
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Example A company is earning a sum of Rs. 50,000 and the rate of return expected is 10%. This company will be
said to be properly capitalized. Suppose the capital investment of the company is Rs. 60,000, it will be over
capitalization to the extent of Rs. 1,00,000. The new rate of earning would be: 50,000/60,000×100=8.33% When
the company has over capitalization, the rate of earnings will be reduced from 10% to 8.33%.
Causes of Over Capitalization
Over capitalization arise due to the following important causes:
 Over issue of capital by the company.
 Borrowing large amount of capital at a higher rate of interest.
 Providing inadequate depreciation to the fixed assets.
 Excessive payment for acquisition of goodwill.
 High rate of taxation.
 Under estimation of capitalization rate.
Effects of Over Capitalization
Over capitalization leads to the following important effects:
 Reduce the rate of earning capacity of the shares.

 Difficulties in obtaining necessary capital to the business concern.

 It leads to fall in the market price of the shares.
 It creates problems on re-organization.
 It leads under or misutilization of available resources.
Remedies for Over Capitalization
Over capitalization can be reduced with the help of effective management and systematic design of the capital
structure. The following are the major steps to reduce over capitalization.

1. Efficient management can reduce over capitalization.

2. Redemption of preference share capital which consists of high rate of dividend.

3. Reorganization of equity share capital.

4. Reduction of debt capital.

Under Capitalization
Under capitalization is the opposite concept of over capitalization and it will occur when the company’s actual
capitalization is lower than the capitalization as warranted by its earning capacity. Under capitalization is not the so
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called inadequate capital.

Under capitalization can be defined by Gerstenberg, “a corporation may be undercapitalized when the rate of profit
is exceptionally high in the same industry”.
Hoagland defined under capitalization as “an excess of true assets value over the aggregate of stocks and bonds
outstanding”.
Causes of Under Capitalization
Under capitalization arises due to the following important causes:
 Under estimation of capital requirements.
 Under estimation of initial and future earnings.
 Maintaining high standards of efficiency.
 Conservative dividend policy.

 Desire of control and trading on equity.

Effects of Under Capitalization
Under Capitalization leads certain effects in the company and its shareholders.
 It leads to manipulate the market value of shares.
 It increases the marketability of the shares.
 It may lead to more government control and higher taxation.

 Consumers feel that they are exploited by the company.

 It leads to high competition.
Remedies of Under Capitalization
Under Capitalization may be corrected by taking the following remedial measures:
1. Under capitalization can be compensated with the help of fresh issue of shares.
2. Increasing the par value of share may help to reduce under capitalization.
3. Under capitalization may be corrected by the issue of bonus shares to the existing shareholders.
4. Reducing the dividend per share by way of splitting up of shares.

Watered Capitalization
If the stock or capital of the company is not mentioned by assets of equivalent value, it is called as watered stock. In
simple words, watered capital means that the realizable value of assets of the company is less than its book value.

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According to Hoagland’s definition, “A stock is said to be watered when its true value is less than its book value.”
Causes of Watered Capital
Generally watered capital arises at the time of incorporation of a company but it also arises during the life time of
the business. The following are the main causes of watered capital:
1. Acquiring the assets of the company at high price.
2. Adopting ineffective depreciation policy.
3. Worthless intangible assets are purchased at higher price.

THEORIES OF CAPITALIZATION

The two main theories of capitalization which are used to determine the amount of capitalization are as follows:

1. Cost Theory of Capitalization

According to the cost theory of capitalization, the value of a company is arrived at by adding up the cost of fixed
assets like plants, machinery patents, etc., the capital regularly required for the continuous operation of the company
(working capital), the cost of establishing business and expenses of promotion.

The original outlays on all these items become the basis for calculating the capitalization of company. Such
calculation of capitalization is useful in so far as it enables the promoters to know the amount of capital to be raised.
But it is not wholly satisfactory. On import objection to it is that it is based o a figure (i.e., cost of establishing and
starting business) which will not change with variation in the earning capacity of the company. The true value of an
enterprise is judged from its earning capacity rather than from the capital invested in it.

If, for example, some assets become obsolete and some others remain idle, the earnings and the earning capacity of
the concern will naturally fall. But such a fall will not reduce the value of the investment made in the company’s
business.

2. Earnings Theory of Capitalization

The earnings theory of capitalization recognizes the fact that the true value (capitalization) of an enterprise
depends upon its earnings and earning capacity.

According to it, therefore, the value or capitalization of a company is equal to the capitalized value of its estimated
earnings. For this purpose a new company has to prepare an estimated profit and loss account. For the first few year
of its life, the sales are forecast ad the manager has to depend upon his experience for determining the probable cost.
The earnings so estimated may be compared with the actual earnings of similar companies in the industry and the
necessary adjustments should be made. Then the promoters will study the rate at which other companies in the same
industry similarly situated are earnings. The rate is then applied to the estimated earnings of the company for finding
out the capitalization.

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CAPITAL STRUCTURE

Meaning and Concept of Capital Structure:

The term ‘structure’ means the arrangement of the various parts. So capital structure means the arrangement of
capital from different sources so that the long-term funds needed for the business are raised.

Thus, capital structure refers to the proportions or combinations of equity share capital, preference share capital,
debentures, long-term loans, retained earnings and other long-term sources of funds in the total amount of capital
which a firm should raise to run its business.

Importance of Capital Structure:

1. Increase in value of the firm: A sound capital structure of a company helps to increase the market price of
shares and securities which, in turn, lead to increase in the value of the firm.
2. Utilisation of available funds: A good capital structure enables a business enterprise to utilise the available
funds fully. A properly designed capital structure ensures the determination of the financial requirements of
the firm and raise the funds in such proportions from various sources for their best possible utilisation.
3. Maximisation of return: A sound capital structure enables management to increase the profits of a company
in the form of higher return to the equity shareholders i.e., increase in earnings per share. This can be done
by the mechanism of trading on equity i.e., it refers to increase in the proportion of debt capital in the capital
structure which is the cheapest source of capital. If the rate of return on capital employed (i.e., shareholders’
fund + long- term borrowings) exceeds the fixed rate of interest paid to debt-holders, the company is said to
be trading on equity.
4. Minimisation of cost of capital: A sound capital structure of any business enterprise maximises
shareholders’ wealth through minimisation of the overall cost of capital. This can also be done by
incorporating long-term debt capital in the capital structure as the cost of debt capital is lower than the cost
of equity or preference share capital since the interest on debt is tax deductible.
5. Solvency or liquidity position: A sound capital structure never allows a business enterprise to go for too
much raising of debt capital because, at the time of poor earning, the solvency is disturbed for compulsory
payment of interest to the debt- supplier.
6. Flexibility: A sound capital structure provides a room for expansion or reduction of debt capital so that,
according to changing conditions, adjustment of capital can be made.
7. Undisturbed controlling: A good capital structure does not allow the equity shareholders control on
business to be diluted.

Factors Determining Capital Structure:

The following factors influence the capital structure decisions:

1. Risk of cash insolvency: Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Generally,
the higher proportion of debt in capital structure compels the company to pay higher rate of interest on debt
irrespective of the fact that the fund is available or not. The non-payment of interest charges and principal amount
in time call for liquidation of the company.

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 2. Risk in variation of earnings: The higher the debt content in the capital structure of a company, the higher will
be the risk of variation in the expected earnings available to equity shareholders. If return on investment on total
capital employed (i.e., shareholders’ fund plus long-term debt) exceeds the interest rate, the shareholders get a
higher return. On the other hand, if interest rate exceeds return on investment, the shareholders may not get any
return at all.

3. Cost of capital: Cost of capital means cost of raising the capital from different sources of funds. It is the price
paid for using the capital. A business enterprise should generate enough revenue to meet its cost of capital and
finance its future growth. The finance manager should consider the cost of each source of fund while designing
the capital structure of a company.

4. Control: The consideration of retaining control of the business is an important factor in capital structure
decisions. If the existing equity shareholders do not like to dilute the control, they may prefer debt capital to
equity capital, as former has no voting rights.

5. Trading on equity: The use of fixed interest bearing securities along with owner’s equity as sources of finance
is known as trading on equity. It is an arrangement by which the company aims at increasing the return on equity
shares by the use of fixed interest bearing securities (i.e., debenture, preference shares etc.).

6. Government policies: Capital structure is influenced by Government policies, rules and regulations of SEBI and
lending policies of financial institutions which change the financial pattern of the company totally. Monetary and
fiscal policies of the Government will also affect the capital structure decisions.

7. Size of the company: Availability of funds is greatly influenced by the size of company. A small company finds
it difficult to raise debt capital. The terms of debentures and long-term loans are less favourable to such
enterprises. Small companies have to depend more on the equity shares and retained earnings. On the other hand,
large companies issue various types of securities despite the fact that they pay less interest because investors
consider large companies less risky.

8. Needs of the investors: While deciding capital structure the financial conditions and psychology of different
types of investors will have to be kept in mind. For example, a poor or middle class investor may only be able to
invest in equity or preference shares which are usually of small denominations, only a financially sound investor
can afford to invest in debentures of higher denominations. A cautious investor who wants his capital to grow
will prefer equity shares.

9. Flexibility: The capital structures of a company should be such that it can raise funds as and when required.
Flexibility provides room for expansion, both in terms of lower impact on cost and with no significant rise in risk
profile.

10. Period of finance: The period for which finance is needed also influences the capital structure. When funds are
needed for long-term (say 10 years), it should be raised by issuing debentures or preference shares. Funds should
be raised by the issue of equity shares when it is needed permanently.

11. Nature of business: It has great influence in the capital structure of the business, companies having stable and
certain earnings prefer debentures or preference shares and companies having no assured income depends on
internal resources.

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12. Legal requirements: The finance manager should comply with the legal provisions while designing the capital
structure of a company.

Optimal Capital Structure

Optimal capital structure is a financial measurement that firms use to determine the best mix of debt and equity
financing to use for operations and expansions. This structure seeks to lower the cost of capital so that a firm is less
dependent on creditors and more able to finance its core operations through equity.

In general, the optimal capital structure is a mix of debt and equity that seeks to lower the cost of capital and
maximize the value of the firm. To calculate the optimal capital structure of a firm, analysts calculate the weighted
average cost of capital (WACC) to determine the level of risk that makes the expected return on capital greater than
the cost of capital.

Factors Influencing Capital Structure

1. Internal factors.

2. External factors.

1. Internal Factors:

(i) Financial Leverage:

The use of fixed interest bearing securities, such as – debt and preference capital along with owner’s equity in the
capital structure is described as – ‘financial leverage’ or ‘trading on equity’. This decision is most important from
the point of view of financing decisions.

By having debt and equity in the capital mix, the company will have an opportunity to employ a certain amount of
debt with an intention to enjoy the benefits of reduction in percentage of tax. The benefits so enjoyed will be passed
to the equity shareholders in the form of a high percentage of dividend.

(ii) Risk:

Debt securities increase the financial risk while equity securities reduce it. A firm can avoid or reduces risk if it does
not employ debt capital mix, but compromising with the returns to equity shareholder. Hence a financial manager
must employ the debt capital in such a way that the benefits of that should maximize the returns to equity
shareholders.

(iii) Growth and Stability:

In the initial stages, a firm meets its financial requirements through long term sources like equity. Once the company
starts getting good response and cash inflow capacity increases, it can raise debt or preference capital for growth
and expansion.

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The company having high sales will opt for more debt for their financial requirements. A company having less sales
revenue must reduce its burden towards debt, because of its inability to pay interest on debt.

(iv) Retaining Control:

The attitude of the management towards retaining the control over the company will have a direct impact on the
capital structure. If the existing shareholder wants to continue the same holding on the company, they may not
encourage the issue of additional equity shares.

In normal practical situations, the existing equity shareholder directs the management to raise the additional sources
only through debentures or preference shares which are also influenced by the reputation that the company enjoys.

(v) Cost of Capital:

The cost of capital refers to the expectation of the suppliers of funds. A firm should earn sufficient profits to repay
the interest and installment of principal to the lenders. It is the maximum rate of return a firm should earn on its
investment, so that market value of the shares of the company does not fall.

Different types of sources of funds will have different types of costs. Comparatively debt is a cheaper source of
funds. Careful decisions have to be made in selecting the size of debt as it increases the risk of the firm.

(vi) Cash Flow:

Cash flow generation capacity of a firm increases the flexibility of the financial manager in deciding the capital
structure. Sound cash flow facilitates the raising of funds through debt, insufficient cash takes a company to a
disastrous situation, it loses its creditworthiness and many times goes into liquidation. Yearly cash inflow matters
much to decide the capacity of a company to borrow debt.

(vii) Flexibility:

It means the firm’s ability to adopt its structure to the needs of the changing conditions; its capital structure should
be flexible so that without much practical difficulty, a firm can change the securities in capital structure. It mainly
depends on flexibility in fixed charges, restrictive covenants, terms of redemption and the debt capacity.

(viii) Purpose of Finance:

The purpose of finance influences the capital structure. If a firm is engaged in a business transaction, it can make
use of debt and equity mix or can enjoy leverage benefits. For non-profit organization funds may be raised through
only equity. For existing company’s growth and expansion may be financed through retained earnings, debenture or
preference capital.

(ix) Assets Structure:

Fixed assets investment can be met by longer sources like issue of equity, debenture etc. A portion of current assets
are also financed through long term sources, short term sources are used for meeting the working capital requirement.

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2. External Factors:

(i) Size of the Company:

If a company plans to raise a smaller amount of capital, it selects only few securities in its capital structure. If it
needs more capital, a number of different securities will be selected to raise funds in the capital structure.

(ii) Factor of Industry:

A public utility company which has support from state and central government can raise funds through preference
share or debenture. A capital intensive company engaged in manufacture may have high equity and less debt capital.
A trading company having less assets structure has to depend mainly on equity or preference capital.

(iii) Investors:

Investors are cautious over all the investments. Capital market is moving from equity to debt and from debt to deep
discount bonds. The finance manager must be careful in selecting the securities for capital structure.

(iv) Cost of Flotation:

It refers to the expenses of a firm incurred during the process of public issue. Cost of flotation of debt is
comparatively less when compared to the cost of flotation of equity. One should try to reduce this cost by a proper
mix of debt and equity in the capital structure.

(v) Legal Requirements:

The legal and statutory requirements of the government, SEBI guidelines on investor protection, equity ratio,
promoter’s contributions etc., will have direct bearing on capital structure and also monetary and fiscal policies of
the government.

(vi) Period of Finance:

Short term funds, required to meet working capital requirements can be raised through commercial banks. Medium
term finance, required to meet expansion and diversification purpose, can be raised through issue of preference or
debenture capital- Long term or permanent funds required to meet capital expenditure can be raised by issuing equity
shares.

(vii) Lever of Interest Rate:

The rate of interest will have a direct impact on borrowed funds. If the expectation of the banker or financial
institutions is to get a high rate of interests then the firm can postpone the mobilization of funds or make use of
retained earnings. Hence it affects the capital structures.

(viii) Lever of Business Activity:

When the level of activity of a firm is rising, the additional funds required for expansion and diversification can be
raised through issue of debentures, preference shares or borrowing terms loans.
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(ix) Availability of Funds:

Free flow of money in the economy encourages a corporate to raise funds through securities without much difficulty.
The finance manager has to study the flow and availability of funds before he decides about the capital structure.

(x) Taxation Policy:

High corporate taxes. Taxes on dividend and capital gains directly influenced the decision of capital structure. High
taxes discourage the issue of equity and encourage issuing more debt instruments.

(xi) Level of Stock Prices:

If the general price level of stocks or raw material is constant over a period of time, management prefers to invest
such funds through long term or medium term financing. If the prices are fluctuating widely Short term sources are
the best alternative for investments.

10 .Financial Structure

Financial structure of a company is concerned with both long term and short term sources of funds. Hence financial
structure is the mix of all sources of funds whether long term such as debt and equity or short term such as bank
overdraft, short term loans etc.

11. Capital Gearing

Capital gearing has great importance in maintaining a strong financial position and organised capital structure of a
company. Capital gearing is defined as a ratio between equity share capital and fixed cost capital bearing securities
i.e., long-term debts, debentures and preference share capital.

THEORIES OF CAPITAL STRUCTURES

NET INCOME APPROACH

Net Income Approach was presented by Durand. The theory suggests increasing value of the firm by decreasing the
overall cost of capital which is measured in terms of Weighted Average Cost of Capital. This can be done by having
a higher proportion of debt, which is a cheaper source of finance compared to equity finance.

Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts where the weights are
the amount of capital raised from each source.

According to Net Income Approach, change in the financial leverage ofa firm will lead to a corresponding change
in the Weighted Average Cost of Capital (WACC) and also the value of the company. The Net Income Approach
suggests that with the increase in leverage (proportionof debt), the WACC decreases and the value of firm increases.
On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the value of the firm
decreases.

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Assumptions Of Net Income Approach

Net Income Approach makes certain assumptions which are as follows.

 The increase in debt will not affect the confidence levels of the investors.

 There are only two sources of finance; debt and equity. There are no sources of finance like Preference
Share Capital and Retained Earning.
 All companies have uniform dividend pay out ratio; it is 1.
 There is no flotation cost, no transaction cost and corporate dividend tax.

 Capital market is perfect, it means information about all companiesare available to all investors and there
are no chances of over pricing or under pricing of security. Further it means that all investors are rational.
So, all investors want to maximize their return with minimization of risk.

 All sources of finance are for infinity. There are no redeemable sources of finance.

NET OPERATING INCOME APPROACH

This approach was put forth by Durand and totally differs from the Net Income Approach. Also famous as traditional
approach, Net Operating Income Approach suggests that change in debt of the firm/company or the change in
leverage fails to affect the total value of the firm/company. As per this approach, the WACC and the total value of a
company are independent of the capital structure decision or financial leverage of a company.

Assumptions / Features Of Net Operating Income Approach:

The overall capitalization rate remains constant irrespective of the degree of leverage. At a given level of EBIT, the
value of the firm would be “EBIT/Overall capitalization rate”

Value of equity is the difference between total firm value less value of debt
Value of Equity = Total Value of the Firm – Value of Debt

WACC (Weightage Average Cost of Capital) remains constant; and with the increase in debt, the cost of equity
increases. An increase in debt in the capital structure results in increased risk for shareholders. As a compensation
of investing in the highly leveraged company, the shareholders expect higher return resulting in higher cost of equity
capital.

MODIGLIANI AND MILLER’S APPROACH

Modigliani and Miller devised this approach during the 1950s. The fundamentals of the Modigliani and Miller
Approach resemble that of the Net Operating Income Approach.

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Modigliani and Miller advocate capital structure irrelevancy theory, which suggests that the valuation of a firm is
irrelevant to a company’s capital structure. Whether a firm is high on leverage or has a lower debt component in the
financing mix has no bearing on the value of a firm.

The Modigliani and Miller Approach further state that the operating income affects the firm’s market value, apart
from the risk involved in the investment. The theory states that the firm’s value is not dependent on the choice of
capital structure or financing decisions of the firm.
Assumptions of Modigliani and Miller Approach

 There are no taxes.

 Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
 There is a symmetry of information. This means that an investor will have access to the same information that
a corporation would, and investors will thus behave rationally.
 The cost of borrowing is the same for investors and companies.
 There is no floatation cost, such as an underwriting commission, payment to merchant bankers, advertisement
expenses, etc.
 There is no corporate dividend tax.

The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm that has a mix of debt and
equity) is the same as the value of an unleveraged firm (a firm wholly financed by equity). Suppose the operating
profits and future prospects are the same. If an investor purchases shares of a leveraged firm, it would cost him the
same as buying the shares of an unleveraged firm.

TRADITIONAL APPROACH TO CAPITAL STRUCTURE:

The traditional approach to capital structure advocates that there is aright combination of equity and debt in the
capital structure, at which the market value of a firm is maximum. As per this approach, debt should exist in the
capital structure only up to a specific point, beyond which, any increase in leverage would result in the
reduction in value of thefirm.

Assumptions Under Traditional Approach:

 The rate of interest on debt remains constant for a certain period and thereafter with an increase in
leverage, it increases.
 The expected rate by equity shareholders remains constant or increase gradually. After that, the equity
shareholders starts perceiving a financial risk and then from the optimal point and the expected rate
increases speedily.
 As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and then
increases. The lowest point on the curve is optimal capital structure.

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Difference between Capital Structure and Capitalization

The important differences between Capital Structure & Capitalization are as under:

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