m



CAPITALIZATION (FAIR, OVER, UNDER)
Capitalization = sum of par value of the outstanding
stocks and bonds

Controversy over inclusion of short term fund providers in

capitalization

Capital structure and capitalization used

interchangeably

But two different theories of capitalization viz Cost and Earning

theory can bring out the difference
CAPITALIZATION (FAIR, OVER, UNDER)

Cost theory = total capitalization = cost of

acquiring fixed and current assets

Earning theory = capitalization = earnings of the

company capitalized at a representative rate of
return

(Annual earnings/ capitalization rate)* 100

CAPITALIZATION AND CAPITAL STRUCTURE

Capitalization hence = value of the firm

Capital structure = way in which the long term

obligations are distributed among different
classes of owned and borrowed funds
FAIR CAPITALIZATION

i.e. balancing the debt and equity component in

the capital structure

V
   




Equity Rs. 100 Fixed assets Rs. 300

Debentures Rs. 200 Current Rs. 10
assets
Current lia. Rs. 100
Rs. 400 Rs. 400
CAPITALIZATION NOT FAIR
V
   




Equity 100 Fixed assets 220

Debenture 150 Current 130
assets
Current lia 100
350 350

Equity 100 Fixed assets 400

Debentures 250 Current 100
assets
Current Lia. 150
500 500
OVER CAPITALIZATION (WATERED STOCK)

When ²

ð Business has more net assets than it needs

ð

 
  




 

 
  
  

 
   


  





It should not be mistaken with excess of funds

OVER CAPITALIZATION TAKES PLACE WHEN

Prospective income over estimated at beginning

Unpredictable circumstances reduce income

Funds required were over estimated

Funds are not efficiently employed

REASONS OF OVER CAPITALIZATION

Difference between book value and real worth

Promotional expenses

Shortage of capital

Inadequate depreciation policy

Over estimation of rate of return

EFFECTS OF OVER-CAPITALIZATION
Loss of goodwill.

Difficulty in obtaining capital.

Liquidation.

Loss of Market.

Low rate of dividend and so fall in the Market

value of shares
REMEDIES (THOUGH VERY DIFFICULT TO DO)

Reduction of debt

Reduction in interest rates

Redemption of preferred stock if it carries high rate

of dividend

Reduction in par value of share

Reduction in number of common stock shares

UNDER-CAPITALIZATION

When ²

ð Unforeseeable earnings result from later

developments

Should not be mistaken for lack of funds

REASONS FOR UNDERCAPITALIZATION

Efficiency of firm beyond expectations

Under estimation of earnings

Under estimation of funds

Windfall gains
EFFECTS OF UNDER-CAPITALIZATION
Limited marketability of shares

Cut-throat competition.

Industrial unrest.

Dissatisfaction of customers

Government control.

Inadequacy of capital

High taxes.

Manipulation of share value

REMEDY FOR TREATING UNDERCAPITALIZATION

Obtaining a long-term revolving credit

arrangement with a lending group

Access any forms of financing and replenish by

issuing stock or debt

Splitting up at the shares ² This will reduce the

dividend per share

Issue of bonus share: this will reduce both the

dividend per share and earning per share
FEATURES OF EQUITY

ð Ownership / permanent capital

ð Right to income (thru flexible dividends)

ð Right to control (voting rights)

ð Pre-emptive right (right over new issue)

ð Right in case of liquidation (last and residual

claimant)
MERITS OF EQUITY

ð No need to return the principle to investors

ð No compulsion of dividend

ð No accumulation of unpaid dividend

ð Possibility of huge amounts collected

LIMITATIONS OF EQUITY

ð Dilution of control

ð High cost of capital

ð No tax shield

ð Cost of issue heavy

FEATURES OF DEBT FUNDS

‰ Term loan ²
Security
Big-ticket provider
Interest and principle repayment
Restrictive covenants

‰ Debenture (small denomination loans from

multiple subscribers)) ²
Call and put option
Repayment terms
Security
Convertibility
Trustee
MERITS OF

Term loan / debenture ²

ð Tax shield
ð No dilution of control
ð Less cost as compared to equity
ð Fixed interest
ð Less issue cost
ð Quick access and easy process compared to IPO
LIMITATIONS OF

Term loans / debenture ²

ð Fixed obligation irrespective of profits

ð Raises cost of equity (because of increased risk of

bankrupcy)

ð Restrictions on extent of borrowing

FINANCE DEPARTMENT - FUNCTIONS

‰ Providing basic information for management

control
‰ Budgeting and budgetary control
‰ Inventory control
‰ Tax management
‰ Internal audit
‰ Cash and credit management
‰ Financial planning
‰ MIS for strategic decisions
FUNCTIONAL AREAS OF FM

Determining financial needs

Identifying sources of funds

Optimal capital structure

Financial analysis
Cost volume profit analysis

Profit planning and control

FUNCTIONAL AREAS OF FM
‰ Working capital management

‰ Project planning and control

‰ Capital budgeting

‰ Dividend policies
‰ Mergers and acquisitions

‰ Corporate taxation
OPTIMAL CAPITAL STRUCTURE

Combination of owned and borrowed funds

Objective is to minimize cost of capital and maximize

returns to equity holders

Optimal = one in which the marginal cost of each

available method of financing is same.

It occurs when WACC is at its lowest

MARGINAL COST OF CAPITAL (MCC)

A FIRM WHICH HAS A FOLLOWING CAPITAL STRUCTURE.

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CHOOSING THE OPTIMAL CAPITAL
STRUCTURE

How should a firm choose its debt-equity ratio?

The capital structure that produces the highest

firm value (or the lowest cost of capital) is the one
most beneficial to stockholders.

The value of the firm is maximized when the

WACC is minimized.

A particular debt-equity ratio represents the

optimal capital structure if it results in the
lowest possible WACC. The optimal capital
structure is sometimes called the firm's target
capital structure.
FACTORS INFLUENCING CAPITAL
STRUCTURE

Internal :
ð Cost of capital

ð Dilution of value

ð Acceptability

ð Transferability

ð Matching principle

ð Risk

ð Operational control
FACTORS INFLUENCING CAPITAL
STRUCTURE

External:

ð Level of business activity

ð Level of interest rates

ð Level of stock prices

ð Tax policies and dividends

ð Continuity of earnings
SOME OTHER IMPORTANT
CONSIDERATIONS

Business risk
1) Revenue stability
2) Cash flow

Agency costs
1) Contractual obligations
2) Management preference
3) Control

Asymmetric information
1) External risk assessment
2) Timing
 OPERATING LEVERAGE
Operating leverage results from the existence of fixed
operating costs in the firm·s income stream.
Degree of operating leverage (DOL)

      
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The higher the firm·s fixed operating costs relative to

variable operating costs, the greater the degree of
operating leverage.
FINANCIAL LEVERAGE

Financial leverage results from the existence of

fixed financial costs in the firm·s income
stream.

Measuringthe degree of financial

      §
 leverage
(DFL)
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 TOTAL LEVERAGE

The combined effect of operating and financial

costs
can be measured by total leverage.
Measuring the degree of total leverage (DTL)

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