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Financial Management Capitalization P-2

The document discusses capitalization and capital structure. Capitalization refers to determining the optimal capital requirement of a business based on cost and earnings theories. Over-capitalization and under-capitalization are undesirable, with over-capitalization being more dangerous due to issues like idle capital. Sources of funds include shares, debentures, term loans, and retained earnings. Capital structure refers to the proportion of borrowed capital and affects the cost of capital. Leverage magnifies the effects of changes in sales, operating profits, and earnings per share. Different theories guide determining the most efficient capital structure.

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3K views

Financial Management Capitalization P-2

The document discusses capitalization and capital structure. Capitalization refers to determining the optimal capital requirement of a business based on cost and earnings theories. Over-capitalization and under-capitalization are undesirable, with over-capitalization being more dangerous due to issues like idle capital. Sources of funds include shares, debentures, term loans, and retained earnings. Capital structure refers to the proportion of borrowed capital and affects the cost of capital. Leverage magnifies the effects of changes in sales, operating profits, and earnings per share. Different theories guide determining the most efficient capital structure.

Uploaded by

api-3747098
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Capitalization

The success of modern business depends


largely on the amount of capital employed in
the business.
Capitalization refers to the decision
regarding determining the optimal capital
requirement of the business.
Capitalisation

 Cost theory considers the amount of capitalisation


on the basis of cost of various assets required to set
up and run the business activities.
 Where as the Earnings Theory considers the future
expected earnings of the company on the basis of
appropriate capitalisation rate.
 Over-capitalisation refers to the excess of capital
compared to the requirement of the company where
as under-capitalisation indicates the real worth of
assets over the share capital and debentures.
Capitalisation

 Both over-capitalisation and under capitalisation are


undesirable, among which the over-capitalisation is
more dangerous to the business.
pitfall of Over-Capitalisation
 Idle & Unproductive Capital
 Unnecessary Cost of Carrying Capital
 Possibility of Misuse of Capital
 Repayment & Exit is difficult, tedious, costly & time
consuming
Sources of Funds

 After deciding the capital requirement of the


business the main task is to choose the
sources of Finances available so that there
is optimal balance between the sources.
 Following are some of the sources of
Financing:
3. Shares
4. Debentures
Sources of Funds

3.TermLoans
4.Public Deposits
5.Lease Financing
6.Hire Purchase
7.Retained Earnings.
Capital Structure

 Capital Structure refers to proportion of


sources of the capital to be borrowed as
required by the business. Often called as
Capital Mix
 Cost of Capital refers to the cost incurred by
the business in acquiring the capital from
various sources.
Capital Structure

 Cost of debt is the interest to be paid on the debt


funds.
9% Debentures worth Rs.1 crore and rate of Tax
40%. Then Cost of Debt is 5.4% and not 9%
9% * 1 Cr. - 40% ( 9% * 1 Cr. ) I.e. Tax Saving
 Cost of Equity is the expectations of the
shareholders towards the dividend paid by the
company on the shares.
Leverages &Theory of Capital
Structure

 Leverage refers to influence one financial variable


on the other. The variables are the costs, output,
sales revenue, earnings per share etc.
 Concepts: Explained by Example

Sale Price Rs.100 per unit, Variable Cost Rs.60 per


unit. EBIT = 75, EBT =60
1.Operating Leverage: It is the firm’s ability to use
fixed operating costs to magnify effects
Leverages & Theory of Capital
Structure

of changes in sales on its earnings before


interest and taxes.
 Operating Leverage is calculated as

Contribution i.e. (Sales-Variable costs)


Earnings before Interest & Tax.
= (90-40) / 75
Leverages &Theory of Capital
Structure

 Financial Leverage refers to the ability of


the firm to use its fixed operating costs to
magnify the effects of changes in operating
profits on the firm’s earnings per share.
It is calculated by:
Earnings before Interest and Taxes
Earnings before Tax
= 75 / 60
Leverages & Theory of Capital
Structure

 Combined Leverage refers to the effect of


percentage change in sales to percentage
change in Earnings Per Share.
Combined leverage is calculated by:

Contribution
Earnings before Taxes.
= 60 / 60
Leverages & Theories of Capital
structures

 The capital structure refers to the combination of


different financial sources for the capital of the
business in the most economical and efficient
manner.
 The theories of Capital structure includes

1.Net Income approach.


2.Net Operating income approach.
3.Traditional approach.
4.Modigliani-Miller Approach.

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