CHAPTER NO.

:-3 CAPITALIZATION Meaning: - Capital Structure ordinarily implies the proportion of debt and equity in the total capital of a company. Since company can tap any one or more source of funds to meet its total financial requirement .The total capital of a company may thus be composed of all such tapped sources. Capital may be defined as long term funds of the firm. Capital is the aggregation of the items appearing on the left hand side of balance sheet minus current liabilities (total liabilities current liabilities). Capital is also be expressed as total asset minus current liabilities. (Total asset Current liabilities).
Types of Capital:-

Total capital

Equity Capital Or Owned Capital

Debt Capital

Equity Capital:-

Equity
share capital

Equity capital
Preferen ce share capital Retained

earning

Why its necessary to study the capital structure theories : The basic objective of the financial management is to maximize the shareholders wealth and therefore all financial decision in any firm should be taken in light this objective. The decision regarding the capital structure or the financial leverage or the financial mix should also be based on the objective of achieving the maximization of shareholder wealth. The capital structure theories attempt to analyze the relationship between capital structure and the value of the firm in terms of different theories and models on the subject matter. Concept of value of the firm: - The value of firm depends on the earning of the firm and earning of the firm depends upon the investment decision of the firm. The earnings of the firm are capitalized at a rate equal to the cost of capital in order to find out the value of the firm. Thus the value of the firm depends on two basic factors. i. ii. The earning of the firm Cost of capital

The operating profit (i.e. EBIT) of the firm is mainly divided into three claimants A. Debt Holders (debenture, banks loan .Others loan,) :- By way of interest. B. Government : - By way of taxes. C. Shareholders : - By way of dividend. If we talk about size of EBIT, it is depend on investment decision of the firm. While capital structure of the firm determine how EBIT is to be sliced among three above claimants. The total value of the firm is sum of its value to the debt holder and to its shareholders and is determine by the amount of EBIT going to them respectively. Therefore the investment decision can increase the value of the firm by increasing the size of the EBIT where as the capital structure mix can affect the value only by reducing the share of the EBIT going to the Government in the form taxes.

Capital structure or financial leverage or financing mix of the firm does not affect the total earning of firm. However earnings available to the shareholders may be influenced by capital structure of the firm. For a given level of earnings lower the cost of capital, the higher would be the value of firm. But, what is the relationship between financing mix, cost of capital and the value of the firm? Is there any optimal capital structure? Can value of the firm be maximized by affecting the financing mix or by affecting the cost of capital? If leverage affects the cost of capital and the value of the firm, then the firm should try to achieve an optimal capital structure or optimal financing mix and minimizing the cost of capital .is there really a capital structure which may be called the optimal capital structure? Factors Determining Capital Structure 1) Control: - The mgt. control over the firm is one of the major determinants of capital structure decision. The equity shareholders are considered as the real owner of the company, since they can participate in decision making through the elected body of representatives called Boards of Director. The preference shareholders and debenture holder cannot participate in decision making. When the promoters do not wish to dilute their control, the company will rely more on debt fund. Any fresh issue of shares will dilute the control of the existing shareholders. 2) Risk: - Mainly two risks are involved in capital structure decision (a) Business Risk (BR) (it is influenced by demand, price, input, competition in market, fixed cost, etc.) (b) Financial Risk (FR represents the risk from financial leverage ) FR is least if the project is financed by equity capital, since equity dividend is payable only when there is sufficient fund for appropriation and equity capital need not to refunded during the life time of the company.

FR is high if the proportion of debt fund is more in capital structure, since the interest is to be paid to the financer even if profit is low and borrowed fund is to be paid off to them after certain period or at the time of maturity.

3) Income: - Increase of return on equity shareholders depends on the method of financing and its impact. (Explain at the time of theories of capital structure). 4) Tax consideration: - Under provision of income tax Equity & preference dividend paid to the shareholder are not eligible for deduction under income tax act. However interest paid for borrowed fund is deductible expenditure before calculation of income tax. The tax saving on interest charge reduces the cost of debt fund. 5) Cost of Capital :6) Trading on equity:-The firms wealth is increased, if after tax earning is increased. A co. can raise debt at low cost with a view to enhance the earning of equity share holder. The cost of debt is less due to tax advantage. 7) Investor attitude: - All investor have different expectation from their investment, so co. should tap that investor whose return expectation is low, so that it will decrease total cost of capital. 8) Flexibility: - One very important feature of debt fund is that debt fund may be raised and can be paid off as when desired. But in case of equity, once the fund is raised through issue of equity shares, it cannot ordinarily be reduced except permission of court and after by doing lot of compliances . 9) Timing: - Economic condition is also one of important consideration need to be take care at the time of capital structure decision. At the time of recession the equity share holder will not show much of interest in investing. But at the time of boom it would be easier for firm to raise equity capital. 10) Legal provision:-The legal formalities required before issuing equity share is more complicated than raising debt.

11) Profitability: - A co. with higher profitability will have low reliance on outside debt fund and it will meet its additional requirement through internal generation. 12) Growth rate: - The growing co. requires more and more funds for its expansion schemes which will meet through raising debt. The fast growing co. will rely more on debt fund than equity or internal earning. 13) Government policy: - Increase in lending rate by govt. may cause the companies to raise finance from capital market. Meaning of optimal capital structure:The optimal capital structure is the capital structure at which the weighted average cost of capital is minimum and there by maximum value of the firm. It also may be defined as the capital structure or combination of debt and equity that leads to the maximum value of the firm. Over capitalization & under capitalization Over capitalization:Generally over-capitalization implies that the capital of the company exceeds its requirements. A company is overcapitalized when its earning capacity does not justify the amount of capitalization. In other words, a company is said to be overcapitalized when its actual profits are not sufficient to pay interest (on debentures and borrowings) and dividends (on share capital) at fair rates. A concern is said to be over-capitalized if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures that have been issued. It is said to be over capitalized when total of owned and borrowed capital exceeds its fixed and current assets i.e. when it shows accumulated losses on the assets side of the balance sheet. 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.

Causes of Over Capitalization: Some of the important reasons of over-capitalization are: 1. Idle funds: The Company may have such an amount of funds that it cannot use them properly. Money may be living idle in banks or in the form of low yield investments. 2. Over-valuation: The fixed assets, especially good will, may have been acquired at a cost much higher than that warranted by the services which that asset could render. 3. Fall in value: Fixed assets may have been acquired at a time when prices were high. with the passage of time prices may have been fallen so that the real value of the asset may also have come down substantially even though in the balance sheet the assets are being shown at book value less depreciation written off. Then the book values will be much more than the economic value. 4. Inadequate depreciation provision: Adequate provision may not have been provided on the fixed assets with the result the profits shown by books may have been distributed as dividend, leaving no funds with which to replace the assets at the proper time. 5. Lack of reserves 6. High rate taxation 7. Borrowing money at high rates of interest 8. High promotional expenses Disadvantage of over capitalization from Investor's or shareholder's point of View: 1) Loss in the value of investment (shares) 2) Loss of easy marketability 3) Irregular, uncertain and lower earnings on the investment (dividend on shares) 4) Speculation is encouraged 5) Reduction in the liquidity of investment 6) Shares cannot be mortgaged easily as their utility as collateral security is reduce 7) Loss due to reorganization The point of view of the Society: 1) Increase in prices or reduction in quality of goods 2) Wage cuts or retrenchment of workers

3) 4) 5) 6) 7)

Increase in unemployment Encouragement to reckless speculation Misutilization and wastage of resources Reduced efficiency of the management Loss of public confidence in investment etc.

Remedies for overcapitalization 1) Reduction of debt burden(debt capital) 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. Advantages or merits of overcapitalization are: 1) Increase in the competitive power of the company. 2) Easy expansion of the company's activities. 3) Morale of the management is raised. 4) Risk-taking capacity is increased. 5) No fear of shortage of capital. 6) Power to face depression period is increased. Example:-

Under capitalization:-

Leverage Meaning (dictionary) : an increased means of accomplishing some purpose (Leverage allows us to accomplish certain things which are otherwise not possible ,viz; lifting of heavy object with the help of leverage). Meaning (in financial mgt.): the term leverage is used to describe the firm ability to use fixed cost asset or funds to increase the return to its owners. The fixed cost (also called fixed operating cost) and fixed charges (called financial cost) remaining constant irrespective of change in volume of output of sales. Thus employment of an asset or source of fund for which the firm has to pay a fixed cost or return has considerable influence on the earning available for equity shareholders. Example: As per the Income statement of XYZ Ltd. Sales is Rs.4, 00,000 .Variable cost is60%.Fixed cost is Rs.50, 000 Then EBIT is = Less: Sales = 4, 00,000 Variable cost = 2, 40,000 Contribution = 1, 60,000 Fixed cost = 50,000 =1, 10,000

Less:

(Operating profit) EBIT 1 If due to some reason sales is increased by 100% (doubled) Then EBIT will be = Less:

Sales = 8, 00,000 Variable cost = 4, 80,000 Contribution = 3, 20,000 Fixed cost = 50,000 EBIT 2 = 2, 70,000

Less: (Operating profit)

In above income statement you see the advantage of fixed cost in total cost is that, if the sales are double than operating profit will be more than double .this is happening due to sales work as lever to carry fixed cost, by increase in sales the distribution of fixed cost per unit start declining and it increases profit. That is known as leverage effect.

The advantages of leverage 1. If the sales are doubles operating profit will be more than double. 2. If the operating profit is the double then EBT to more than double. This to advantage also associated with leverages in case of following & also the operating profit will decrease more than decrease in sales. 3. If the EBIT is decrease than EBT will decrease more than decrease of EBIT. The first effect due to fixed cost is known as operating leverages &the second effect due to fixed interest is known as financial leverages the formulas are as below 1. Operating leverage = Contribution EBIT EBIT EBT Contribution EBT

2. Financial leverage

3. Combined leverages =

Operating Leverage is the responsiveness of the firms EBIT to the changes in sales value. It referred to the sensitivity of operating profit before interest and tax to the changes in quantity produced and sold. The firm OL is higher if the firm has quantum of fixed cost and low variable cost.

The firm OL is low if the firm higher variable cost.low fixed cost and higher variable cost.

Cost of capital: We are raising long term fund from various sources and we have to return these principal amount as per term and condition. In addition to this we are also paying some periodical payments to the supplier of funds these periodical payments we are paying because we are using these funds. Cost of capital is nothing but the periodical payments (other than principal amount) to the supplier of capital on account of use of capital. I. Cost of Debt capital (Kd) Kd = I (1- T) Amount Received Cost of debt is calculated as annual interest paid divided by actual amount received multiplied by (1- T).Cost of the debt is less than interest rate because when we pay interest we get advantage in the amount of tax reduced due to payment of interest. And i.e. the reason when cost of debt is less than the amount of interest paid. 2) Cost of preference Share (K p) Kp = Preference Dividend paid Amount Received Amount received = Issue price discount on issue of share + Premium on issue of share In case preference share capital we dont get any advantage of tax benefit because dividend is paid after payments of tax and so cost of preference share is some as dividend rate for preference share.

3) Cost of equity capital (K e) Ke = (i) E.P.S. M.P.S. D.P.S M.P.S.

(ii)

D.P.S. g M.P.S 4) Cost of retained earnings (Kre) is same as cost of equity

(iii)

Trading on equity :-