UNIT II

CAPITALIZATION AND CAPITAL STRUCTURE

Capitalization: meaning, effects and remedies of under capitalization, over

capitalization and watered stock.
Capital structure: Meaning, importance and determination of capital structure.
Trading on equity: meaning, benefits and risks, operating leverage and financial
leverage: meaning and degree of combined leverage.
Sources of long-term finance: equity, debentures and preference shares: meaning,
advantages and limitations of each.
 CAPITALIZATION : MEANING
• Capital plays an important role in any business.
• Capitalization refers to the long term indebtedness and includes both the
ownership capital and borrowed capital
• Capitalization means decision regarding amount of Finance and the modes of
Finance.
• Capital and capitalization are two different terms.
• The term capitalization is used in terms of companies and not in partnership
firms or sole proprietorships.
• It is distinguished from capital which represents total investment or resources
of a company.
• It thus represents total wealth of the company.
 CAPITALIZATION : MEANING
• It should be distinguished from share capital which refers only to the paid up
value of the shares issued by the company and definitely excludes bonds,
debentures, loans and other form of borrowings.
• Capitalization means the total par value of all the securities, i.e. shares and
debentures issued by a company and reserves, surplus and value of all other
long term obligations.
• The term thus includes the value of ordinary and preference shares, the value
of all surplus – earned and capital, the value of bonds and securities still not
redeemed and the value of long term loans.
• Capitalization is thus the sum total of all long term funds available to the
firm along with the free reserves.
 OVERCAPITALIZATION

A company is said to be overcapitalized, when its total capital (both equity

and debt) exceeds the true value of its assets. It is wrong to identify
overcapitalization with excess of capital because most of the overcapitalized
firms suffer from the problems of liquidity.
A company is said to be over capitalized when its earnings are not sufficient
to yield a fair return on the amount of shares or debentures. In other words,
when a company is not in a position to pay dividends and interests on its
shares and debentures at fair rates, it is said to be over capitalized. It means
that an over-capitalized company is unable to pay a fair return on its
investment.
 CAUSES OF OVERCAPITALIZATION
1. Decline in the earnings of the company.
2. Fall in dividend rates.
3. Market value of company’s share falls, and company loses investors confidence.
4. Company may collapse at any time because of anemic financial conditions – it will affect its employees,
society, consumers and its shareholders.
5. Floating of excess capital.
6. Purchasing property at an inflated price.
7. Inflationary conditions.
8. High cost of promotion.
9. Borrowings at a higher than normal rate.
10. Purchase of assets in the boom period.
11. Incorrect capitalization rate applied.
12. Insufficient provision for depreciation.
13. High rates of taxation.
14. Liberal dividend policy.
15. Wrong estimation of future earnings.
16. Low production.
 REMEDIES FOR OVERCAPITALIZATION

Restructuring the firm is to be executed avoid the situation of company

becoming sick. It involves
1. Reduction of debt burden
2. Negotiation with term lending institutions for reduction in interest
obligation.
3. Redemption of preference share through a scheme of capital reduction.
4. Reducing the face value and paid-up value of equity shares.
5. Initiating merger with well managed profit making companies interested in
talking over ailing company
 UNDERCAPITALIZATION

• It is just the reverse of over- capitalization. A company is considered to be

under- capitalized when its actual capitalization is lower than its proper
capitalization as warranted by its earning capacity. However, it should not be
considered synonymous with inadequate capital. Infact, the real value of an
under capitalised company is more than its book value.
• “ A company may be under-capitalised when the rate of profits it is making
on the total capital is exceptionally high in relation to the return enjoyed by
similarly situated companies in the same industry, or when it has too little
capital with which to conduct its business”
 CAUSES OF UNDERCAPITALIZATION
The following are the causes of under-capitalization in a company:
1. Under-estimation of capital requirements.
2. Under-estimation of future earnings.
3. Promotion during depression.
4. Conservative dividend policy.
5. Very efficient management.
6. Desire of control and trading on equity.
REMEDIES FOR UNDERCAPITALIZATION
It can be corrected by taking any of the following measures:
1. Fresh Issue of Shares.
2. Issue of Bonus Shares.
3. Increasing the Par Value of Shares.
4. Splitting Stock.
DISADVANTAGES OF UNDERCAPITALIZATION
1. It induces the management to manipulate the market value of shares.
2. Earnings per share increase, which in turn, increases the marketability of
shares.
3. Employees press for higher wages and as a result, a rift between the
workers and employers takes place.
4. The burden of tax will be more since companies earnings are more.
5. The customers psychologically feel that they are over charged by the
company.
6. The higher earnings encourage competitors to enter into the same business.
7. It may result in over-trading by the company.
8. Eventually, it leads to over-capitalisation because of excessive profits.
 FAIR CAPITALIZATION
• The most important area of financial planning is to determine the right
proportion of debt and equity.
• The objective of a firm is to create value which can be performed
through proper mobilization and use of funds.
• So the right amount of capitalization is the basic objective of a finance
manager.
• Fair capitalization is that situation where the business has employed
the correct amount of capital and its earnings are same as the average
rate of earnings.
WATERED CAPITAL OR WATERED STOCK
• Watered Stock or Watered Capital means that the realizable value of the assets of a
company which is less than its book value.
• Generally, watered capital exists when the assets are purchased at a high price.
• For example; if the company purchase an asset for Rs.90,000. Later, it is found that the
realizable value of asset is only Rs.60,000, then excess payment of Rs.30,000 is treated
as watered capital. According to Hoagland “a stock is said to be watered when its true
value is less than its book value.”

END OF WATERED STOCK

This practice essentially came to an end when companies were compelled to issue shares
at low or no par value, usually under the advice of attorneys who were mindful of the
potential for watered stock to create liability for investors. Investors became wary of the
promise that par value of a stock represented the actual value of the stock. Accounting
guidelines developed so that the difference between the value of assets and low or no par
value would be accounted for as capital surplus or additional paid-in capital.
 CAPITAL STRUCTURE
• Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as
long-term finance. The capital structure involves two decisions-
• Type of securities to be issued are equity shares, preference shares and long term borrowings
(Debentures).
• Relative ratio of securities can be determined by process of capital gearing. On this basis,
the companies are divided into two-
a) Highly geared companies - Those companies whose proportion of equity capitalization is
small.
b) Low geared companies - Those companies whose equity capital dominates total
capitalization.
For instance - There are two companies A and B. Total capitalization amounts to be INR 2000
crores in each case.
The ratio of equity capital to total capitalization in company A is 500 crores, while in company
B, ratio of equity capital is 1500 crores to total capitalization, i.e, in Company A, proportion is
25% and in company B, proportion is 75%. In such cases, company A is considered to be a
 FACTORS DETERMINING CAPITAL STRUCTURE
1) Trading on Equity- The word “equity” denotes the ownership of the company.
Trading on equity means taking advantage of equity share capital to borrowed
funds on reasonable basis. It refers to additional profits that equity shareholders
earn because of issuance of debentures and preference shares. Trading on equity
becomes more important when expectations of shareholders are high.
2) Degree of control- In a company, it is the directors who are so called elected
representatives of equity shareholders. These members have got maximum
voting rights in a concern as compared to the preference shareholders and
debenture holders. Preference shareholders have reasonably less voting rights
while debenture holders have no voting rights.
3) Flexibility of financial plan- In an enterprise, the capital structure should be
such that there is both contractions as well as relaxation in plans. Debentures
and loans can be refunded back as the time requires. While equity capital cannot
be refunded at any point which provides rigidity to plans.
 FACTORS DETERMINING CAPITAL STRUCTURE

4) Choice of investors- The company’s policy generally is to have different

categories of investors for securities. Therefore, a capital structure should give
enough choice to all kind of investors to invest. Bold and adventurous investors
generally go for equity shares and loans and debentures are generally raised keeping
into mind conscious investors.
5) Capital market condition- In the lifetime of the company, the market price of
the shares has got an important influence. During the depression period, the
company’s capital structure generally consists of debentures and loans. While in
period of boons and inflation, the company’s capital should consist of share capital
generally equity shares.
6) Period of financing- When company wants to raise finance for short period, it
goes for loans from banks and other institutions; while for long period it goes for
issue of shares and debentures.
 FACTORS DETERMINING CAPITAL STRUCTURE
7) Cost of financing- In a capital structure, the company has to look to the factor of
cost when securities are raised. It is seen that debentures at the time of profit
earning of company prove to be a cheaper source of finance as compared to equity
shares where equity shareholders demand an extra share in profits.
8) Stability of sales- An established business which has a growing market and high
sales turnover, the company is in position to meet fixed commitments.
Interest on debentures has to be paid regardless of profit. Therefore, when sales are
high, thereby the profits are high and company is in better position to meet such
fixed commitments like interest on debentures and dividends on preference shares.
9) Sizes of a company- Small size business firms capital structure generally
consists of loans from banks and retained profits. While on the other hand, big
companies having goodwill, stability and an established profit can easily go for
issuance of shares and debentures as well as loans and borrowings from financial
institutions. The bigger the size, the wider is total capitalization
 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) Utilization of available funds:
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) Maximization 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
 IMPORTANCE OF CAPITAL STRUCTURE
4) 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.
5) 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.
6) Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on
business to be diluted.
 IMPORTANCE OF CAPITAL STRUCTURE
7) Minimization of cost of capital:
A sound capital structure of any business enterprise maximizes shareholders’
wealth through minimization 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
 TRADING ON EQUITY
• Trading on equity is also called financial leverage. Both these terms signify
that a corporate body leverages its financial standing to procure debt and
enhance the earnings of shareholders. In other words, a company utilises its
equity strength to avail debts from creditors, and thus the name of the strategy.
• Trading on Equity Example:
Company Y has borrowed Rs.100 crores as debt funds at a 10% interest rate.
Later, the company used the debt to buy an asset (factory) to generate more
income.
Here, company Y pays interest amounts of around Rs.10 crores while the
income generated from the asset amounts to Rs.20 crores.
We can say that the company was successful in using the trading on equity
strategy by enhancing its revenue-generating capacity.
 PURPOSE OF TRADING ON EQUITY
• In the capital structure, a company may fund itself with debt or equity. If the company
uses more debt to finance initiatives, it will have to pay fixed interest, which is less
expensive than the cost of equity capital.
• After paying the fixed interest on the debts, there will be profit left over for the current
shareholders.
• If additional shares are issued, more equity shareholders will benefit from the gain. As
a result, when profits are substantial, companies use low-cost debt rather than
increasing the number of shareholders to divide the earnings or raise money for a
project.
• The primary purpose is to increase the wealth of the shareholders.
• Trading on equity is employed when the company wants more finance from debt
sources rather than equity.
• The company uses this strategy to ensure that control over the company remains the
same.
• A company might also use the trading on equity strategy to increase the company’s
 ADVANTAGES & TYPES OF TRADING ON EQUITY

Advantages of Trading on Equity Include:

• It gives the company access to extra capital, which makes it possible to invest in assets that will generate
a profit.
• As the interest on a loan is tax deductible, the company pays less amount in taxes overall.

Types of Trading on Equity

1) Trading on thin equity
In trading on thin equity, the borrowed amount is significantly close to the company’s equity because the
company’s capital is lower than the debt capital.
For example, if company X’s equity capital amounts to Rs.100 crores whereas the debt capital amounts to
Rs.300 crores, company X is said to be trading on thin equity.

2) Trading on thick equity

In trading on thick equity, a company borrows a small amount close to its equity because the company’s
equity capital is higher than the debt capital.
For example, if company X’s equity capital amounts to Rs.300 crores whereas the debt capital amounts to
 DIFFERENCE BETWEEN TRADING ON EQUITY AND EQUITY TRADING

• There is a big difference between trading on equity and equity trading.

Trading on equity is about using debt in the capital structure, also known as
financial leverage, to raise earnings per share (EPS).
• Whereas equity trading involves selling and purchasing shares for more
profit. Companies use equity trading as a strategy to create value for their
shareholders by using their stock as security for loans.
• Since equity is so dependable, a company that already has equity and needs
additional funds might borrow money on favorable terms. With the help of
these funds, the company can purchase assets that generate returns higher
than the debt's interest rate.
• Many companies prefer to use this strategy over the trading on equity method
to raise the Earnings Per Share (EPS) of their shares.
 OPERATING AND FINANCIAL LEVERAGE

• In finance, Leverage implies that a given percentage change in one variable

leads to a more than proportionate change in the other related variable.
• In financial management, these variables will be financial variables like
Sales or operating income.
• Leverage analysis means use of fixed operating costs and use of sources of
funds which carry fixed financial cost to increase the potential return of an
investment.
• Operating, financial and combined leverage are three types of leverages.
 OPERATING AND FINANCIAL LEVERAGE
OPERATING LEVERAGE
• Operating leverage arises due to presence of fixed operating costs in the cost
structure of the company. It is the use of fixed operating costs to magnify the
effect of change in sales on operating profit i.e. 0% change in sales results
into more than proportionate change in operating profit (EBIT) of the
company in the same direction.
• Operating leverage is concerned with capital budgeting decision of the
company. This is because fixed assets gives rise to fixed operating costs
which in turn returns into operating leverage.
• It gives rise to “Operating risk”. Operating risk or Business risk is the risk of
not being able to meet fixed operating costs. Higher the costs, higher
operating leverage and higher the risk of the business.
 OPERATING AND FINANCIAL LEVERAGE
FEATURES OF OPERATING LEVERAGE
i. Concerned with fixed operating costs or fixed assets.
ii. Measures relationship between sales revenue and operating profit.
iii. Gives rise to operating risk or business risk.
iv. It is higher in manufacturing company having huge amount of fixed
operating costs rather than trading company.
APPLICATIONS
v. For selection of Investment projects
vi. For long term profit planning
vii. Capital structure decision
 COMPUTATION OF OPERATING LEVERAGE

Degree of operating leverage (DOL) is the percentage change in a company’s operating profit (EBIT) resulting
from a percentage increase in sales.
DOL = % change in operating profit
% change in sales
OR
DOL = (ΔEBIT)
(Δ sales)
OR
DOL = Contribution
EBIT
OR
DOL = (Sales – Variable cost)
(Sales – Variable cost – Fixed operating cost)
Contribution = Sales revenue – Variable costs
EBIT = Contribution- Fixed operating costs
 FINANCIAL LEVERAGE
• Financial leverage arises due to presence of fixed financial costs (such as
interest) in the cost structure of the company.
• It is the use of fixed financial costs to magnify the effect of change in
operating profit (EBIT) on Earnings Per Share (EPS).
• Higher the fixed financial, higher the financial leverage.
• Financial leverage is concerned with capital structure decision of a
company.
FEATURES
i. Concerned with Fixed financial cost or debt capital of a company
ii. Measures relationship between EBIT and EPS
iii. Gives rise to financial risk
iv. Higher in a company using higher amount of debt.
 COMPUTATION OF FINANCIAL LEVERAGE

DFL measures the percentage change in EPS for a given percentage change in operating income or income
before interest and taxes (EBIT).
DFL= % change in EPS
% change in EBIT
OR
DFL= (ΔEPS)
(ΔEBIT)
OR
DFL= EBIT
EBIT- Interest Expense
OR
DFL= EBIT
PBT
Where, EBIT = Sales revenue- variable costs- Fixed operating costs
EBT= EBIT- Interest. EBT is also known as PBT (Profit Before Tax)
 COMBINED LEVERAGE
Total risk of the company is captured by Combined Leverage.
It shows the effect of change in sales revenue on EPS of a company.
DCL = % change in EPS
% change in sales
OR
DCL = DOL * DFL
OR
DCL = (ΔEPS)
(Δ Sales)
 SUMS
1) Given below the following data for two companies:
PARTICULARS R Ltd. S Ltd.
Sales (₹) 40,00,000 35,00,000
Variable Cost 30 % of sales 30 % of sales
Fixed Cost (₹) 2,50,000 3,00,000
Interest (₹) 14,00,000 1,50,000

Calculate the value of Operating Leverage and Financial

Leverage.
2) Calculate Operating Leverage and Financial Leverage
from following data of Gogna Ltd.: ₹ 20,00,000
Earning before Interest and Taxes (EBIT)
Profit After Tax (PAT) ₹ 9,00,000
Operating Fixed Cost ₹ 15,00,000
Tax Rate 40%

If the company wants to increase its PAT by 40 %, what

 SUMS
3) Calculate the DOL, DFL and DCL for the following
firms:
PARTICULARS FIRM X FIRM Y FIRM Z
Output ( Units) 80,000 30,000 1,00,000
Fixed Cost (₹) 1,00,000 25,000 5,000
Variable cost per unit (₹) 2 1.5 1
Interest on Borrowed Funds(₹) 80,000 10,000 --
Selling Price Per Unit (₹) 5 6 2.5

4) A firm has sales of ₹ 10,00,000. Contribution margin of

30%, fixed costs of ₹ 1,50,000 and debt of ₹ 8,00,000 at
10% rate of interest. What are the operating, financial and
combined leverages? If the firm wants to double its
Earning Before Interest and Tax (EBIT), how much rise in
sales would be needed on a percentage basis ?
 PRACTICE YOURSELF
1) Distinguish between operating leverage and financial leverage. How
are they measured?
2) What do you mean by Operating Leverage? How is it calculated?
Explain its relationship with operating risk.
3) What do you mean by Financial Leverage? How is it calculated?
Explain its relationship with financial risk.
4) What is combined leverage? How is it calculated?
5) Define leverage? What are the types of Leverages ? Explain.
 EQUITY SHARES
• The other name of ‘equity share’ is ‘ordinary share’.
• It is a subset under the fractional ownership or part ownership in
which the shareholder tackles the maximum business risk as a
fractional owner.
• Generally, the members of the company with voting rights are the
holders of Equity Shares.
• Long-term capital is raised with the aid of Equity shares. Equity
shareholders are called ‘residual owners’. They are paid the residual
amount after the settlement of claims on the company’s income and
assets. These shareholders can take part in the management of the
company through their voting rights.
 ADVANTAGES OF EQUITY SHARES
I. Equity capital is the building block of a company. It is the last thing
added in the list of claims and it produces a cushion for creditors.
II. Equity capital generates creditworthiness to the company and boosts up
the confidence of various loan producers.
III. Equity shares are preferred by investors who are willing to take larger
risks.
IV. It is not compulsory to pay the dividend to the equity shareholders. So,
the company will not face any burden for this.
V. The funds are raised by equity issues without generating any charge on
the assets of the company.
VI. The management of the company may be controlled by the equity
shareholders by their voting rights.
 DISADVANTAGES OF EQUITY
SHARES
I. Risk-averse investors with the preference of fixed income will not
like equity shares.
II. The cost of raising funds from other sources is lower than the cost
of equity shares.
III. The voting rights and earnings of existing equity shareholders are
dismissed by the issue of the additional equity shares.
IV. Equity share is a time-consuming process as it involves various
formalities and administrative delays.
 PREFERENCE SHARES
• Preference shares are those shares which carry certain special or priority
rights. Firstly, dividend at a fixed rate is payable on these shares before
any dividend is paid on equity shares.
• Secondly, at the time of winding up of the company, capital is repaid to
preference shareholders prior to the return of equity capital. Preference
shares do not carry voting rights. However, holders of preference shares
may claim voting rights if the dividends are not paid for two years or
more on cumulative preference shares and three years or more on non-
cumulative preference shares.
• Preference shares are similar to debentures in the sense that the rate of
dividend is fixed and preference shareholders do not generally enjoy
voting rights. Therefore, preference shares are a hybrid form of financing.
ADVANTAGES OF PREFERENCE SHARES
• Appeal to Cautious Investors
• No Obligation for Dividends
• No Interference
• Trading on Equity
• No Charge on Assets
• Flexibility
• Variety
DISADVANTAGES OF PREFERENCE SHARES
I. The amount dividend is higher than the rate of interest on debentures.
II. The dividend on these shares is regulated by the revenue of the
company.
III. Risk lovers will not prefer this kind of share.
IV. Claims of equity shareholders diluted by the preference capital.
V. It is not possible to deduct the dividend paid from the profits as an
expense.
VI. So, in a nutshell, shares of certain companies are based on two types
of shares namely equity shares and preference shares. Both the shares
are equally important in respect of shareholders of companies and both
of them have certain merits and demerits.
 DEBENTURES
• The word debenture is derived from the Latin word ‘debere’, which means to
borrow or take a loan.
• It is a debt instrument that may or may not be secured by any collateral.
• Governments or companies use them for raising capital by borrowing money
from the public. In simple words, it is a legal certificate that shows the
investment amount (principal amount), the interest rate and the schedule of
payments. The investor receives the principal and interest at the end of
maturity.
• They are like unsecured loans where the investor has no claim to the
company assets if a default occurs.
• The repayment solely depends on the company creditworthiness of the
issuing company.
• However, before paying stock dividends to its shareholders, the issuing
company will fix the debt interest payments.
 ADVANTAGES OF DEBENTURES
• Debentures are debt instruments issued by the company that promises a fixed
interest rate on the due date.
• Issuing debentures is one of the most effective ways to raise funds for a
company compared to equity or preference shares.
• These instruments are liquid and can be traded on the stock exchange.
• The debenture holders do not have voting rights in the company meetings.
Thus, it does not dilute the interest of equity shareholders.
• During inflation, issuing debentures can be advantageous as they offer a
fixed interest rate.
• The holders bear minimum risk because interest is payable even in case of
loss of the company.
• The company can quickly redeem funds when they have surplus funds.
 DISADVANTAGES OF DEBENTURES
• The payment of interest and principal becomes a financial burden for the
company in case of no profits.
• The debenture holders are the creditors of the company. They cannot
claim profits beyond the interest rate and principal amount.
• During the depression, the company’s profit declines, and it becomes
difficult to pay interest.
• The debenture holders have no voting rights. Hence, they do not have
control over management decisions.
• During the redemption process of debenture, there is a large amount of
cash outflow.
• Default payment has adverse effects on the creditworthiness of the
company.
THANK YOU !!!