Chapter 3.

Capital Structure
Contents ...
3.1 Meaning of Capital
3.2 Capital Structure
3.3 Capital Structure and Financial Structure
3.4 Levered and Unlevered Companies
3.5 Trading on Equity
3.6 Criteria for determining Capital Structure
3.7 Capital Structure Decision
3.8 Capital Structure Practices in India
3.9 Meaning of Capitalisation
3.10 Definitions of Capitalisation
3.10.1 Broad Interpretation
3.10.2 Narrow Interpretation
3.10.3 Some other Interpretations of the term Capitalisation
3.11 Theories of Capitalisation
3.12 Overcapitalisation
3.12.1 Definition
3.12.2 Overcapitalisation Vs Excess Capital
3.12.3 Causes of Overcapitalisation
3.12.4 Consequences of Overcapitalisation
3.12.5 Remedies for Overcapitalisation
3.13 Undercapitalisation
3.13.1 Causes of Undercapitalisation
3.13.2 Consequences of Undercapitalisation
3.13.3 Remedial Measures
d.14 Overcapitalisation Vs Undercapitalisation
Points to Remember
Questions for Discussion

Questions from Previous

Pune University Examinations
(3.1)
Principles of Finance Capital Structure Princi

Learning Objectives: Structure

P
Structure and Financial value
Ondersfand the meaning of Capital, Capital
not F
l o know the difference between levered and unlevered companies
contin
To get acquainted with trading on equity face v
T o understand capital structure decision
in India
G
> develop an understanding to the capital structure practices
o amou

T o define capitalisation and the theories of capitalisation Pr

T o understand overcapitalisation and undercapitalisation and also comprehend the
if any
difference between the two.
forfeit
compa
3.1 MEANING OF CAPITAL De
creditc
Capital refers to the money or money's worth contributed by the proprietors of a
and t=
business and money contribution obtained from lenders for investing into business activities
The contribution of the owners is called the owned capital and the borrowings are called the
rights
In the
debt capital. In case of a Joint Stock Company, the owner's contribution is called share capital asset a
and the borrowings are called as debt capital. Owner's funds or network includes, besides Tern
share capital, the undistributed profits or retained earnings. i.e. for
Capital ofa Joint Stock Company may consist of the following: institut
1. Share Capital:
3.2
Ordinary/Equity Share Capital
The-
Preference Share Capital arrange
2. Reserves and Surplus: long-te
Share Premium structur

General Reserve
)
(i)
Profit and Loss Account Balance
(ii)
Capital Reserves etc.
(iv)
3. Secured LoansS (v)
Debentures (vi)
Term Loans (vi)
are the real owners of the
(vii)
Equity shareholders company. They enjoy voting rights on the Com
basis of proportionate voting share holdings. Ihey are entitled to receive residual profit afte
decisions
tax, interest and preference dividend, provided Directors of the company declare the overall e
dividend. Company
3.2
Principles of Finance Capital Structure
Preference shareholders are entitled to get dividend at a fixed percentage of the nominal
yalue of
value of sha,
shares, before any dividend is paid to equity shareholders. These shareholders do
not possess voting rights except when preference dividend has not been paid for a
not posse

rontinuous period of 2 years. Share premium represents the excess of issue price over the
continu

of shares.
face value
General Reserve is created out of the profits of the company by transterring some
amount on a more or less regular basis.
Profit and Loss Account contains the profit balance left after the distribution of dividends
if any and after transfer of reserves.
Capital Reserve is created out of such non-operating profits such as profit on re-issue of
forfeited shares, profit made by holding company while acquiring shares in the subsidiary
company.
Debenture is a form of borrowing by a company. The debenture holders are therefore
reditors to the company. It is mandatory for the company to pay interest at the fixed rate
and to repay the principal amount, as
agreed. The debenture holders do not have voting
rights but their claims are secured by a floating or fixed charge on the assets of the company.
In the event of non-payment by the company, they can take possession of the concerned
asset and realise their dues.
Term loans borrowed from the financial institutions for medium-term and long-term
are

ie. for a period beyond 5 years time. In the event of failure of the
company, the financial
institutions can nominate their Director in the Board of the company.

3.2 CAPTIAL STRUCTURE

w.w.wwa

The debt-equity mix of a firm is called capital structure. The

long-term financing
arrangements that a corporation has established is called the capital structure. It refers to th
long-term financing mix of a company. A company can have any of the following capital
structure:
0 Capital structure consisting of equity shares only;
Gi) Equity share capital and Preference capital;
Equity share capital and Debentures;
(iv) Equity share capital, Preference share capital and Debentures;
() Equity share capital, Reserves and Surpluses, Preference share capital, Debentures;
(vi) Equity share capital, Reserves and Surpluses, Term loans and Debenture
vii) Equity share capital, Reserves andSurplus and Term loans;
(vii) Equity share capital, Reserves and.Surpluses and Preference share capital.
Companies may plan their capital structure or it may be the result of various financial
decisions taken by the company over the years. Capital structure has a great
Overall earnings and earnings per share. It influences the impact on the
liquidity and hence, solvency
of a
Company.
3.3
Principles of Finance Capital Structure Princi

3.3 STRUCUTE AND FINANCIAL

STRUCTURE
CAPTIAL
compared to capital
structure. Financial structure
Financial structure is broader when
current assets. It includes share EBIT
reters to the way a firm's assets are financed, both fixed and
Overdraft, Bills Payable etc. On Less
capital, debt capital as well short-term credit like: Creditors,
as
debts like
owners fund and long-term Earr
tne otherhand, capital structure includes only the

Debentures, Term-loans etc. Less

Ear
3.4 LEVERED AND UNLEVERED COMPANIES
financial Les
structure of a company is called
Use of fixed charges bearing funds in the capital Eart
fixed charge sources of
leverage. Preference share capital, Debenture and Term loans are
Nur
of funds is called a levered company. On the other
funds. A company using these sources
EPS
share capital or debt in its capital
hand, a company, which doesn't use either preference
structure is called as an unlevered company. of de
Interest and Taxes) an unlevered
Upto a earning i.e. EBIT (Earning Before
certain level of prefe
benefits to the equity shareholders and beyond the point
of plan
company can pass on higher
EPS (Earnings Per Share). This point is
EBIT, it is a levered company which can provide higher
called as indifference point'. The shareholders of a company would be indifferent to debt bein
ded
equity mix, if the EBIT of the company is at this point. We can analyse the effect of change in less.
capital structure with the help of the following example. after
EBIT of the company is 8,00,000.
3.
Tax rate applicable on the profits of the company 35%.

Total capital of the company -7 45,00,00o.

it wi
Company has to decide a capital structure out of the four plans given below:
retu
I Plan :Issue 45,000 shares of T 100 each; or deb
I Plan 35,000 shares of T 100 each and borrow 7 10,00,000 at 15% interest p.a. pron
deb
I Plan 30,000 ordinary shares of 100 each and 15,00,000 through long-term
borrowings at 16%.

Plan 35,000 ordinary shares of 100 each and 10,00,000 preference share

capital with 14% dividend.

which is,Ednings
available for
Net earningsavailable for equity shareholders
e
Let us calculate EPS Number of Equity shares

3.4
 Principles of Finance Capital Structure
Plans I I III

EBIT 8,00,000 8,00,000 8,00,000 8,00,000

Less: Interest p.a. 1,50,000 2,40,000
Earnings Before Tax (EBT) 8,00,000 6,50,000 5,60,000 8,00,000
Less: Tax @ 35% 2,80,000 2,27,500 1,96,000 2,80,000
Earnings After Tax (EAT) 5,20,000 4,22,500 3,64,000 5,20,000
Less: Preference Dividend 1,40,000
Earnings for Equity Shareholders 5,20,000 4,22,500 3,64,000 3,80,000
Numberof Equity Shares 45,000 35,000 30,000 35,000

EPS 11.56 12.07 12.13 10.86

It may be observed that EPS is the highest in the Il plan. Both the I and II plan make use
of debt in the capital structure. Compared to all the equity plans and plan with equity and
preference share capital, EPS is higher in the plans using debt. EPS is highest in case
plan because it uses more amount of debt, although the rate of interest is higher.
It may further be noted that in the V plan, the EPS is lowest despite the dividend rate
being lower than the interest rates on debts. The reason being, interest on debt is tax
deductible ie., tax is paid on the profit left after the payment of interest. Hence, tax liability is
less. On the other hand, preference dividend is not tax deductible, it is appropriation of profit
after payment of tax. The tax liability in such a case is higher than when the debt is used.

3.5 TRADING ON EQUITY

A levered company can borrow money on the basis of the equity base. While borrowing,
it will try to borrow such an amount on which the rate of interest is lower than the overall
return on investment. After paying the interest, it can pass on the remaining earnings in
debt to the equity shareholders. This is called as Trading on equity. Trading on equity is more
pronounced when debt is used, than when preference capital is used, because interest on
debt is tax deductible whereas preference dividend is not tax deductible.
In the example given above, the overall return investment is,
EAT
ROI Capital employed 1 0 0

5,20,000
45,00,000 X 100

= 11.55%

3.5
Principles of Finance Capital Structur Princip
The interest expense on debt in the I plan is 15% whereas it is 16% in case theof II
interest
I plan
plan,
Both the rates of interest 3. Fle
investment. After paying the
on debt, the
are lower than the return on
d to
transferred to
interest Fle
remaining profit capital gets
earned on the debt
Shareholders. Equity shareholders earning after tax is
equty
equity
5,20,000 on an investmentof en
7 45,00,000o. en
(a)
The 5,20,000 (b)
percentage of earnings 45,00,000
=

Th
When debt @ 16% is used the return to equity shareholders is 3,64,000 on an investment
de
of 30,00,000. ca
3,64,000 the
The percentage return 12.13%
on
equity funds is
30.00.000 100
=30,00,00o*
=

re
Thus, due to the use of debt the % return on equity shareholders' funds has increased the
This is called Trading on sta
Equity or Financial Leverage.
de-
3.6 CRITERIA FOR DETERMINING CAPTIAL STRUCTURE Fle
the
Financial manager needs to know the features of an appropriate capital structure. The
4. Ca
following standards may be set to have best capital structure.
Ca
1. Profitability
The most important criteria for determining appropriate capital structure is
(a
profitability.
Profitability here means maximise the EPS and thereby improve the value of share and
the firm. Profitability implies minimising cost of capital. Cost of capital to a firm is the
(b
minimum return which the suppliers of capital require. (c)
2. Solvency
Solvency is the financial state of a company or firm that is able to pay all debts as they Th
fall due for payment. Firms may earn high return on their co
capital but may not have liquid
assets to meet their financial obligations or to declare cash dividend. Even after Th
earning
profits, if a company fails to make payments of interest on borrowings, it may have to be of
en
closed for want of cash as the creditors may, as an extreme measure take hold of the
str
secured asset and realise their dues. In the absence of these assets, it would be difficult
for their firm to function. 3.7
Capital structure should be designed in such a way that risk of
insolvency is minimum. Ca
When companies make use of large amounts of debt, probably due to their incapacity to
raise long-term funds through other sOurces, the cost of
initiall-
borrowingincreases as lenders carefu
find it risky to lend to such firms. Besides excess use of debt may be
perceived risky by
eauity shareholders and their requirement of return may also increase. Hence, the object
Einancial Manager has to determine the right mix of debt and equity, by particu
besides other things, the aspect of solvency.
considering also co

3.6
Principles of
Finance Capital Structure

3. Flexibility
to respond to changes in the
Flexibility Is the ability to adapt an operating system
environment. "Flexibility' gives competitive advantage to a firm in a rapidly changing
environment. It has two dimensions
(a) How quickly can an organisation change?
(b) How far can it change?
when change is
The capital structure should not be rigid. It must give room for changes,
share
desirable. Equity capital is not returned during the lifetime of the company. Equity
excessive use in
capital, hence, can provide, permanent capital to the company and its
use of
the capital structure of a company might lead to inflexibility. On the other hand,
threaten
redeemable preference share provides flexibility and at the same time doesn't
after the
the solvency of the company. Term loans and Debentures are to be repaid
stated time and hence, provide flexibility to the capital structure. But excessive use o
debt might threaten the solvency of the firm.
Flexibility means capacity to raise finance whenever it is required and capacity to redeem
the capital whenever not required.
4. Control
Control means to manage the business. A company may face dilution of control:
more number of ordinary shares areissued to finance the long-term
(a) When
requirements of the firm, to the public.
(b) When the company fails to pay preference dividend for a period of 2 years
consecutively.
(c)When it fails to pay the interest on its borrowing or to return the principal amount of
debt as per the agreement.
The appropriate capital structure is one which does not involve much risk of loss of
control of the company.
There is no best capital structure for all companies. It depends on the particular condition
of business and may change from time to time. Financial Manager has to understand the
environment and particular conditions of business while deciding about the capital
structure of a company.

3.7 CAPTIAL STRUCUTRE DECISION

Capital structure decision is an ongoing work in a firm. The capital structure is planned

initially when company is incorporated. The initial capital structure should be designed very
carefully. While taking these decisions, the management must keep in view the overall
objectives of the organisation in general and the financial management objective in
Particular. Company needs finance continuousily and hence capital structure decisions are

also continuous.
3.7
 Capital Structure
Principles of Finance
The determination of capital structure is a complicated task. It
involves the
nsideration
cons

structure decision:
to capital
Oa number of factors. There are three main approaches
1. Operating and Financial leverage.
2. Cost of capital.
3. Cash flow.
1. Financial leverage or Trading on Equity
capital to
debt and preference share
The use of fixed cost sources of finance, such as

on Equity or
Financial leverage. If the
Tinance the assets of the company is known as Trading
or preference dividendon
retun on investment is higher than the interest rate on borrowing
investment and without
preference the EPS increases without increase in the owner's
capital,
improvement in the operating efficiency of the firm.
Financial leverage is.one of the most important considerations of capital structure
decision as it affects the EPS. All firms cannot make profitable use of financial leverage. A
company with high level of earnings before interest and taxes (EBIT) can make use of high
low EBIT and companies under unfavourable conditions
degree of leverage. Companies with
may find that the rate of return on total assets is less than the cost of debt, the EPS will fall
with the degree of leverage. It can be proved with the following illustratioon:
to make a total investment of ? 5,00,000. Following are the
Suppose a company wants
other details.
Plans EBIT Tax Rate

|L All equity shares of 100 each 2,50,000 50%

I. 75,000
L 7 3,00,000 in equity shares and 2,00,000 brings at
18%
We can analyse the relationship between EBIT-EPS under two different plans, at two
different EBIT levels.
(A) When EBIT is 2,50,000:
Plan I Plan I
EBIT 2,50,000 2,50,000

Less: Interest 36,000

EBT 2,50,000 2,14,000

Less: Tax 50% 1,07,000

1,25,000
EAT/Income available to equity shareholders
1,25,000 1,07,000

EPS T25 35.67

3.8
pinciples of Finance
Capital Structure
Company's ROI2,50,000 1,25,000x 100
5,00,000
25%
But the rate of interest payable on borrowings is 18%. Thus, it can be proved that when
the companies EBIT Is very high, it can make use of debt capital, where cost is less than its
overall earming percentage and can increase EPS.
) When EBIT is 75,000:

Plan I Plan I
EBIT
75,000 75,000
Less: Interest
36,000
EBT 75,000 39,000
Less: Tax @50%
37500 19,500
EAT 37,500 19,500
EPS 7.5 6.5
It can be observed that when EBIT is 75,000 the EPS is less in the I plan where debt has
been used.

The ROI of the company iS 37,500 Xx 100 = 7.5%

5,00,000

Company's ROI is much less than the rate of interest on borrowings which is 18%. Hence,
company cannot use financial leverage to the advantage of its shareholders. There is a point
of EBIT where EPS is same, irrespective of whether debt is used or not. Such a point is called
Break-even point. If EBIT earned by the company is less than the break-even point, the
company should not use fixed cost sources of finance. On the other hand, if the EBIT level is
more than the break-even point, a company can use debt capital or preference capital to
increase the EPS. Break-even point can be shown by way of a graph as shown below.
E q u i t y+ D e b t

E q u i t y( n od e b t )

EPS

B
-Break-even point/
Point of indifference

EBIT

of the Break-even Point

Fig. 3.1: Graphical Representation
3.9
 Principles of Finance Capital Structure
At point B, which is also known as indifference point, the EPS will remain the same
same
irrespective of whether company uses debt or not. It may be noted that when EB EBIT is less
is
less
structure. whereas, when
nan that at point A, EPS is higher by using no debt in the capital
EB IS more than that at point A, EPS is higher with the use of EBI.
2. Cost of Capital Approach
Cost of capital refers to the rate of return expected by the suppliers of finance. Each
Source has its own cost. For example, the cost of borrowing is the rate of interest minus the
tax advantage cost of preference share is the preference dividend, floatation cost and
premium if any payable on redemption etc. Financial Manager may have to consider the
impact of overall cost of capital on the value of the firm rather than considering the cost of
in debt has an
eacn component of capital structure in isolation. This is because, change
impact on the risk of equity shareholders and hence their expected return. When debt
component in the capital structure increases, the risk of the lenders increases and hence,
beyond a certain point, the lenders would demand higher rate of interest. As the debt
component increases, the risk of the ordinary shareholders also increase, who in turn expect
higher rate of return. Thus, cost of equity capital also increases. The overall cost of capital
also increases with the increase in cost of both the component capitals. The value of the firm
decreases with an increase in cost. An optimum capital structure minimises the cost of capital
lending to maximising value of the firm. EBIT remaining the same, an increase in the overall
cost of capital reduces the value of the firm and a decrease in the cost of capital will increase
the overall cost of capital.
3. Liquidity consideration / Approach (Cash Flow Analysis)
This approach considers liquidity as an important consideration for determining capital
structure. The capital structure should be designed in such a way that the firm doesn't have
to face liquidity crisis, i.e. shortage of cash to meet various obligations. Besides, it should
supply minimum required cash even in times of adverse situations (low market demand).
Some cash flows are obligatory like interest and principle amount whereas some others
are discretionary like dividend payment. in times of liquidity crisis, company can avOId
making dividend payment but not interest payment. Hence, if a firm expects to earn non-
uniform profits, it may have to keep its debt proportion very low and try to trade on equity
by using preference capital. On the other hand, if future cash outflows are expected to be
uniform, then a firm could use debt to take advantage of trading on equity without being
threatened by insolvency.
4. Control
Capital structure decision is guided by the extent of control the management and
shareholders want to retain. lssue of preference shares and debentures and borrowing term
loans doesn't interfere with the
existing control by equity shareholders
voting rights. But if company fails
as providers o
the
capital do not possess any to tions, control
meet its obligations, contro
may get diluted. Issue of equity share dilutes control of existing shareholders as equity
shares, carry voting rights.
3.10
 PrinclplesofFinance Capital Structure

5. Marketability
Marketability means the capacity of the firm to sell its securities such as shares and
debentures to the investors. It is the readiness of investors to purchase a security in a given
oeriod of time at a reasonable return. The capital markets are changing continuously.
pe
Sometimes, equity shares are demanded and other times debentures are readily bought.
Afirm must consider not only the internal conditions but also general market conditions.
When share market is at its low, company should not issue common shares but issue debt.

6. Floatation Costs
Floatation cost refers to the cost incurred when funds are externally raised. The cost of
floating debt is generally less than the cost of floating shares. Use of retained earnings
doesn't involve any floatation cost. These costs are not an important factor for determining
capital structure, but they do affect the size of money raised through various issues. The
costs tend to decline with larger amount of funds.
7. Size of the company
A small size company may find it difficult to raise fund. On the other hand, it is easy for
large size firms to obtain loan or issue shares and debentures. Small size companies may find
that the restrictive convenants in the long-term loan agreements, have made the capital
structure very inflexible. Issue of further share dilute control as their shares are not widely
sold/bought.
8. Period of Finance
The period for which finance is required also affects the determination of capital
structure of companies. For less than 3 years, public deposits or short-term loans from banks
may be an appropriate source of funds. On the other hand, if finance is required for a long
period beyond 5 years time debentures, redeemable preference shares, or term loans may be
best options. On the other hand, for permanent capital requirements issue of equity shares
may be appropriate source of funds.
9. Purpose of Financing
The capital structure or changes in the capital structure are determined by the purpose
for which funds are required. For example, for purchase of machine, issue of debenture or
term loan may be better, as the profit generated by this productive asset can be used to pay
9 interest as well as to repay the principle amount. On the other hand, when purpose of raising
tinance is 'unproductive in nature, such as weltare expenditure for the employees in the form
of contribution of school, hospital etc. can be financed by the issue of equity shares.
nd
rm
10. Government Policy
Government policy is also an important factor in planning the company's capital
Structure. For example, a change in the lending policy of financial institution on the basis of
trol
the monetary policy adopted by the Government, may change the availability of loan and
uity
rate of interest.
3.11
Principles of Finance Capital Structure Principl

11. Nature of
Industry 3.10

T nature of industry is one of the most important elements in determining the debt.
1.
c q u y ratio. If the sales of an industry show lot of fluctuations, the company should use low

Everage Since the risk of non-payment of interest may cause problems of insolvency. On the
Otner hand, if industry faces a high degree of steady sales, the debt-equity ratio can be high,
2.
.e. company can use financial leverage.
12. Tax Planning 3
Tax planning is likely to have a significant bearing on capital structure decisions. The
interest on borrowed funds is allowed as a deduction under the Income Tax Act, 1961; while
dividend on shares is not deductible from the operating profits of a company 4.

A host of factors influence the determination of capital structure of a company. Some of

these factors are conflicting in nature. The management of a company will have to evolve the It

optimum capital structure considering these factors, by assigning weightage to different opinica
divide
factors on the basis of the particular facts of the case.
3.10-
In
3.8 CAPITAL STRUCUTRE PRACTICES IN INDIA
financ
The capital structure practices in India have the following features:
equit
1. Indian companies use substantial amount of debt in their capital structures in terms words
of debt-equity ratio as well as total debt to total assets ratio. 3.10-
2.
2. Companies prefer long-term borrowing to short-term borrowing. A=
3 Due to use of debt, Indian companies are exposed toa high degree of risk. of the
4. The debt service capacity of the a large segment of corporate borrowers is capita
inadequate and unsatisfactory. 3.10
Retained earnings are the most favoured source of finance. T
5.
6. The hybrid securities are the least popular source of finance. 1

7. Equity capital as a source of funds is not preferred across the board.

3.9 MEANING OF CAPITALISATiON

Capital refers to the sum total of long-term funds invested in the assets of the company
and
including equity share capital, preference share capital, debentures and long-term fund
Canitalisation in parlance is the act of capit
common providing capital for a company or
otne Sole
organisations.
reso
According to Dewing, "Capitalisation includes capital stock and debt". Capitalisation the te
therefore includes shares and debentures ISSued by the company and also the long-ter
reser
financial institutions.
loans taken from
3.12
principles ofFinance Capital Structure

3.10 DEFINITIONS OF CAPITALISATION

1. According to Gerstenburg, "Capitalisation comprises of a company's ownership
and
capital which include capital stock and surplus in whatever form it may appear
borrowed capital which consists of bonds or similar evidence of long-term debt".
values of stocks
Bonneville and Capitalisation is the balance sheet
"

2. Deway define,
and bonds outstanding".
3.
3. According to Walker and Baughn, "Capitalisation refers only to long-term debt and
In
capital stock and short-term creditors do not constitute suppliers of capital reality
total capital is furnished by short-term creditors and long-term creditors
value of
4. According to Guthmann and Dougall, "Capitalisation is the sum of the par
the outstanding stocks and bonds
of
It canbe observed from the above mentioned definitions that there is no unanimity
These definitions can be
opinion among the authors regarding the concept of capitalisation.
divided into two categories: Broad interpretation and Narrow interpretation.
3.10.1 Broad Interpretation
of
In the broad sense capitalisation is the act of determining the total requirement
of
finance in the company as well as the determination of the capital mix i.e. the proportion
of the company. In other
equity, preference, debenture and term loan in the capital structure
words, it not only includes the quantity of capital but also the quality of capital.
3.10.2 Narrow Interpretation
As per the narrow interpretation, the term capitalisation includes only the
determination
of the amount of long-term funds in the business. The decision about the mix of capital is
capital structure decisions.
the term Capitalisation
3.10.3 Some other Interpretations of
The term capitalisation can also be interpreted as:

1. Conversion of the retained earnings or the company by issue of Bonus shares i.e.

ploughing back of profits.

2. The accounting practice of treating an expenditure as asset rather than charging it to

profit and loss account

the long-term indebtedness and includes both the ownership
Capitalisation thus refers to
and the borrowed capital. Capital and Capitalisation are two different terms. The term

capitalisation' is used only in relation to companies and not in respect of partnership firms or
sole proprietorships. It is distinguished from 'capital' which represents total investment or
resources of a company. It thus represents TOtai wealthn of the company. Capitalisation means
the total par value of all the securities, 1.e. shares and debentures issued by a company and

of all other long-term obligations.

eserves, surplus and value
3.13
Principles of Finance Capital Structure Princ

3.11 THEORIES OF CAPITALISATION 3.1

he theories of capitalisation quide a new company in determining tne quality of

investment: need

1. Cost Theory chare

n i s theory helps in determining the total investment
required in establishing tha
the on th

Dusiness. The total investment consists of the total

finance required for acquiring:
that
1. Fixed assets like land, building, machinery etc.
Over
2. Working capital amount - The part of the capital required for carrying day-to-day
stock, debtors, cash etc. less resu
trading operations. It consists of current assets such as

current liabilities viz. trade creditors. earn

3.12
3. The cost of establishing the business such as cost of floatation of shares and

debentures, preliminary expenses etc.

AS per the cost theory, capitalisation is the sum total of all the costs incurred to acquire large
assets etc. But if the cost of asset does not match with the worth of the asset in the or w

sense. If the assets generate less profit than that expected, there may be over
capitalisation. Thus, this theory fails to consider the earning capital of the investment.
2. Earnings Theory
This theory emphasises the earning capacity of a business. Earning is the basis of
capitalisation. Thus, according to this theory earnings are capitalised at a representative 3.12
rate of return. This method involves the following steps:
(a) Determination of future earnings: A number of factors are considered for
mea-
determining the future earnings of the company such as firms capacity and capacity
utilisation, market demand and share in the total market demand, non-recurring exist

factors, state of the economy, government policy etc. since there is uncertainty
involved, lot of precaution is required to be taken while estimating future returns. the
More than one estimation can be made and weighted average of the returns may be hanc
found out.
Ovec
(b) Determination of capitalisation rate: Capitalisation rate can be the cost of capital
i.e. the expected rate of return of the investors, rate of earnings of similar firm in the
same industry, etc.
(c) Capitalise the returns at the rate determined. Sha

Amount of capitalisation can be found out by Re

applying the following formula:
Future expected earnings x 100 Ter
Capitalisation rate Surn
The earnings theory of capitalisation iS considered as the best method for existing
companies, and cost method is considered suitable for a new company.

3.14
principles of Finance Capital Structure

3.12 OVERCAPITALISATION
Overcapitalisation is a condition in which an organisation has too much capital for the

needs of the business. In such a situation a company is likely to be overburdened by

interest

the earnings
charged by the need to spread profits by way of dividend. It is a situation where
It also means
on the total capital employed is less than the normal rate of return expected.
that the real value of total is less than the book value of the total assets.
assets

Overcapitalisation is an indication that the existing capital has not been effectively utilised
resulting in fall in the earnings. Thus, is a relative term. Capital in relation to
overcapitalisation
earnings is what measures overcapitalisation.
3.12.1 Definition

According to Gerstenburg, "A corporation is overcapitalised when its earnings are not

large enough to yield a fair return on the amount of stocks and bonds that have been issued
or when the amount of securities outstanding exceeds the current value of assets".
A firm is said to be overcapitalised when:
(a) a fair return cannot be obtained on capitalisation;
(b) capitalisation exceeds the real economic value of its net assets.

available with the business are more than what are needed.
(c) assets
3.12.2 Overcapitalisation Vs Excess Capital

capital. Overcapitalisation is a relative term, which

Overcapitalisation doesn't mean excess

measures the earnings with that of the capital employed. It may be an indication of the

existence of idle or obsolete capital.

For example: A company earns 3,00,000 on a total capital investment of 30,00,000. If

the return expected is 10%, than the business is said to be properly capitalised. On the other
hand if the return expected is 12% i.e. 3,60,000, then the company would be said to be

ovecapitalised.
This can be explained with the help of the following illustration:
Balance
Sheet
ShareCapital@ 10 2,50,000 Assets 4,00,000
Reserves 50,000
Term loan 75,000
25,000
Sundry Creditors
4,00,000 4,00,000
3.15
Principles of Finance Capital Structure Principles
Let the
capitalisation or the normal rate of earning by 15%. The net earnings of the
Solution
company be 20,000.
1. C
Capital invested in the business is 2,50,000
+50,000
Gi) Fi-
75,000
37
3.75,000 (ii) Prm
2. Net earnings 1,000. Ca
3. Capitalised value of earnings is 20,000x
15
1001,33,333. TH
3.12.3 C=
Conclusions:
1. Ina
1. On the investment company should have earned @15% of 56,250. But the earnings fut
of the company is low. Hence, the
company is overcapitalised. cap
2. Further as per the capitalisation of earnings the required capital is only un
R1,33,333, whereas the actual investment in the
business is 3,75,000. reg
3. .00.000
The book value of equity capital is 0 0 = 7 12. Ove
25,00 tha
are is 1,33.000
whereas the real value of an equity share 5.33
2. Ov
25 000 per share.
=

mo
3.12.2.A Estimating Capital Requirement of a Business (a)
The capital requirements of a firm can be determined based on the sales
forecast. Additional
sales may require additional investment in technology, machine, building etc.
Illustration
The Balance sheet of Shriyan Ltd shows the following assets and liabilities: (b)
Net Fixed Assets Rs 130,00,000
Current Asset 65,00,000
Long term debt Rs 25,00,000
Current liability T 50.00,000
3. Wre
Share capital 7 100,000
rate
Other information include: rate
1. The sales forecast for the coming year is 200,00,000, which is 25% more than the cap
current year.
cap
2. The profit margin is 7%. wou

3. The dividend payout ratio if 50%. Ove

4. Fau
Calculate the capital requirement.
sho
3.16
Principles of Finance Capital Structure
Solution
(0 Current working capital = 15,00,000
The working capital requirement will increase by 25% i.e., F 3,75,000
(i) Fixed asset investment (assuming the assets are fully used) will increase by 25% =
37,50,000
(Gii) Profit on total sales is 7% of7 200,00,000 14,00,000
Cash required for Dividend is 50% of 7 14,00,000 7 7,00,000
The requirement for funds would
be 3,75,000
3.12.3 Causes of Overcapitalisation
+ 37,50,000+ 7,00,000 T49,25,000
1. Inaccurate estimation of earnings: The earning capitalisation method makes use of
future expected net earnings and expected rate of return to compute the quantity of
capitalisation. The estimation of future earnings is a difficult task due to the
uncertainty present in the market. If the estimation is inaccurate, the capital
the basis of
requirement calculated on estimation is bound to be incorrect.
erroneous
Overcapitalisation results when future expected earnings is estimated at a higher level
than the actual earnings.
2. Overvaluation of assets: The book value of assets shown in the Balance Sheet is
more than the real value of assets. This can happen in the following situations:
(a) Inadequate depreciation: If the fixed assets have not been sufficiently
depreciated, the asset may be overstated in the Balance Sheet. The company
may not have judged properly the wear and tear in the assets, or else the
method of depreciation adopted by the company may be inaccurate.
(b) Vendor company is paid higher consideration: When a partnership firm is
converted into a company, the company might have paid more amount of
Durchase consideration than the real worth of the assets. The value placed on
the asset., while taking over, may not be on the basis of the earning capacity of
the assets. Overvaluation of asset results in overcapitalisation.
3. Wrong estimation of the capitalisation rate: Determination of the capitalisation
rate is a very important step in the determination of capitalisation. If the capitalisation
rate is estimated at a figure lower than the actual rate, it would result in over
capitalisation. If the earnings are capitalised at a lower rate than the actual rate,
capitalised amount would be higher. Thus, the estimated capital of the company
would be more than what it should be. Hence, there may be a situation of

overcapitalisation.
4. Faulty Financial Plan: Improper financial planing may lead to lack of capital. The
shortage of capital may be made good by resorting to costlier sources of finance.

3.17
Principles of Finance Capital Structure
ost of
These kind of financial decisions may result in an unnecessary highco of debt
debt
service leading to reduction in the earnings of the shareholders. This will lead to
reduction in the value of shares. One of the indicators of overcapitalisation is when
the real value of shares is less than the book value.
5. Market conditions: When the capital market is favourable, a company might raise
huge funds to make use of the convenient and less costly capital. But if this huge
finance could not be used by the firm due to non-availability of opportunities for
profitable investment, or it uses the funds in low earnings securities of the
Government, the overall return on capital invested would fall and there would be
overcapitalisation.
6. Improper plan for replacement of asset: A firm must start providing for
replacement of an asset, when an asset is purchased. If it doesn't create provision or
sinking fund for its replacement, it might find it tough to arrange for the purchase of
a new fixed asset in place of the old, from cash generated out of operations. In such a
situation thee company might be forced to borrow at a high rate of interest
resulting
in low returns of overcapitalisation.
7. Inflationary conditions: If assets are
bought during inflation, the total value placed
on the asset may be more than its real worth.
During rising prices firms pay for goods
and services at higher prices than they are worth. As a result the return on investment
declines leading to overcapitalisation.
8. Improper dividend policy: When a company follows a liberal policy of paying cash
dividends without creating reserves and without planning cash flows properly, the
funds deplete and the company may resent
borrowing to repay its sold debts. This
may lead to reduction in net earnings and also overcapitalisation.
9. Taxation policy: If a firm does not plan its tax
properly, it may land up paying huge
amounts of taxes, depleting the funds needed of renewal and
The efficiency of the assets would
replacement of assets.
get adversely affected ultimately decreasing the
value of the asset.
10. Existence of absolute asset: If the assets include unused and
assets overcapitalisation may occur.
obsolete (outdated)
3.124 Consequences of Overcapitalisation
Overcapitalisation has the following evil effects:
1. Return on investment is low in situations of overcapitalisation. After payment o
interest and taxes out of the low earnings what is
left is meant for equiy
shareholders. The EPS falls and hence there is a considerable reduction in the rate or
dividend on equity shares.
2 Due to fall in EPS and fall in the real value of shares of the company, shareholders
lose confidence in the company. Consequently, the market
This reduces the prospects of capital gain to the shareholders.price of the share fals

3.18
principlesofFinance
Capital Structure
3 In order to hide their inefficiency the Board of Directors may resort to window-
dressing by various means.
4. The company may have to go in for internal re-organisation or else may have to
resort to liquidation.
3.12.5 Remedies for Overcapitalisation
1. Internal Reconstruction: A company may have to go in for a reorganisation of
capital structure. This is also known as 'Capital reduction' since the equity
shareholders, debenture holders, lenders and creditors may be asked to reduce their
claim in the assets of the company. The amount so saved would be used to write off
all accumulated losses, goodwill and obsolete assets. In order to convince these
suppliers of finance to agree for a lesser claim, the company might offer a higher rate
of interest of preference dividend.
2. Repayment of loan or debts: If the company doesn't have problems of shortage of
cash, it may repay its long-term debts, thereby reducing the idle cash on one hand
and the idle capital on the other hand. The repayment of loan and debt would
increase the net earnings of the company due to the absence of interest payment
The rate of return on capital would rise, partly due to reduction in total capital and
partly due to increase in net earnings.
3. Buy-back shares: A company can buy-back its own shares for restructuring of its
reduces the retained profits (part of owner's capital) on one hand
capital. Buy-back
and cash on the other hand. It reduces the share capital of the company. Total capital
reduces, leading to increase in the rate of earnings on capital invested.

3.13 UNDERCAPITALISATION

Undercapitalisation is the state of the company that does not have sufficient capital or

reserve for the size of its operations. A growing company might find that such a company is
into cash to pay its debts.
making profits but is unable to convert these profits quickly
Under capitalisation is said to exist when:
1. the rate of earnings are much higher than the normally expected rate of returns.
2. the increase in the market value of shares is much more than other similar

companies.
According to Gerstenburg, "A corporation may be under capitalised when the rate of
the return enjoyed by similar suitable companies in
profit is exceptionally high in relation to
the same industry. The assets may be worth more than the values reflected in the books.

is the reverse of overcapitalisation. It does not imply shortage of

Undercapitalisation
is earning more than what is normally expected on similar
funds. It that the company
means
circumstances. when compared to the earnings the capital
Capital emploved in the given
Investment is low.
3.19
Principles of Finance Capital Structure
3.13.1 Causes of Undercapitalisation
Conservative Estimate of Earning: Initially, while computing the ruture earnings,
ne company might have made very conservative estimates. This leads to lower

capitalisation, thus leading to undercapitalisation.

2. Use of High Capitalisation rate: While determining capitalisation, a high

capitalisation rate might have been used resulting in low capital and then to
undercapitalisation.
3.
3. Setting-up during recession: Recession is a period of slow down in the economy

Prices tend tofall.If a company was set up during recession it would have purchased
the assets at low prices. Such a company becomes undercapitalised after recession is
over, due to the purchase of assets at exceptionally low prices and due to a low
capitalisation rate. As soon as the recession is over, the earning capacity of the
company increases which results in increasing the real value of the assets of the
company.
4. Conservative dividend policy: Conservative dividend policy means a company has
been paying very low cash dividends leading to building up of internal sources of
finance for expansion. This improves the earning capacity of the company.
5. Efficiency: The management in a company might have been very efficient in
operations. There might have been optimum utilisation of every asset, labour and
management time. This might have resulted in a high rate of return on investment
6. Excessive Provision for depreciation: If depreciation is provided in excess of the
requirements, there would be creation of secret reserves and the real value of the
asset would be more than their book values. This would result in
undercapitalisation.
3.13.2 Consequences of Undercapitalisation
1. Encouraged by the high earnings, new entrepreneurs would enter the same industry
which might make the competition very intense.
2. Labour might be dissatisfied that the benefits of their efficiency is not passed on to
them. This would create unnecessary labour unrest.
3. Consumers might feel exploited. They might feel that the
company is making high
profits by charging a igh price from them.
Government may interfere to safeguard the interest of the dissatisfied consumers,
employees and investors etc.
5. Higher earnings would make the companybear the heavy burden of
taxation.
6. The market price of the share may become very high which may bring restrictions on
its marketability.
3.13.3 Remedial Measures
1. Issue of bonus shares: his Is
the best method usually followed for correcting
undercapitalised situation. This would result in increasing the number of shares
although total capitalisation remains the same. But this has the effect of reducing the
EPS
3.20
Principles of Finance Capital Structure
2. Increasing par value of shares: Par value of shares might be increased. This will
bring down the percentage of equity earnings although earnings per share may not
reduce.
3. Increasing the number of shares: Number of shares might be increased by stock
split up. This would increase the number of shares and therefore would decrease the
earnings per share.

3.14 OVERCAPITALISsATION vs UNDERCAPITALISATIOON

Both overcapitalisation and undercapitalisation are harmful to the firm.
However, if observed carefully, one will find that the effects of overcapitalisation are
more serious. It hurts and affects the company, shareholders, consumers and society. t can
result in liquidation and winding-up off the company, which can be a very high cost to pay
for the company.
Undercapitalisation on the other hand increases congestion for the company, leads to
discontentment among the employees and the consumers feel exploited.
The harmful effects may be compared as follows:
1. In case of overcapitalisation earnings decline and much of the investment is idle or
underutilised.
On the other hand in case of undercapitalisation, the rate of earnings is high, but
once the new entrepreneurs enter the field, much of the market share and earnings
might be snatched away by the competitions.
2. Overcapitalisation might have taken place due to the existence of fictitious and
worthless assets. On the other hand in undercapitalisation, the real value of the assets
is much more than what is stated in the books.
3. In case of overcapitalisation there might be retrenchment of employees, whereas in
case of undercapitalisation there might be labour unrest.
4 It is easy to correct undercapitalisation than overcapitalisation.
Undercapitalisation is a lesser evil when compared to overcapitalisation.

Points to Remember
Capital refers to the money or money's worth contributed by the proprietors of a
business and money contribution obtained from lenders for investing into business
activities. The contribution of the owners is called the owned capital and the

borrowings are called the debt capital.

Capital Structure: A company can have the following capital structures:

) Capital structureconsisting of equity shares only

(ii) Equity share capital and preference capital
debentures
Gii) Equity share capital and
(iv) Equity share capital, preference share capital and debentures
3.21
Principles of Finance Capital Structure Princi
(v)
Cuy share capital, reserves and surpluses, term loans and debentures
Equity share capital, reserves and surpluses, and tem loans
(
(VI) Equity share capital, reserves and surpluses, term loans and debentures
(Vin) Equity share capital, reserves and surpluses and preference share capital
)
Levered and Unlevered Companies: A company using sources of funds is called a
levered company. A company which doesn't use either preference share capital or
(i
debt in its capital structure is called an unlevered company. (iv
Criteria for
determining capital structure:
Profitability (v
Gi) Solvency (v=
(ii) Flexibility (v
(iv) Control (v
Three main approaches to capital structure decision are: Operating and financial
leverage, Cost of capital, Cash flow, Others include: Control, Marketability, Floatation
Costs, Size of company, Period of Finance, Purpose of financing, Government Pliy,
Nature of Industry, Tax Planning. I. Q
Capitalisation is the balance sheet values of stocks and bonds outstanding.
Theories of capitalistaion:
) Cost Theory
Gi) Earnings Theory 4.

A firm is said to be overcapitalised when: 5.

6.
) Afair return cannot be obtained on capitalisation
(Gi) Capitalisation exceeds the real economic value of its net assets
8.
() Assets available with the business are more than what are needed
.Undercapitalisation is said to exist when: 9
1C
)The rate of earnings are much higher than the normally expected rate of returns
(i) The increase in the market value of shares is much more than other similar Que:
Companies. 1
Ans.
Unit Internal Evaluation (30 Marks) Suggested Add 2.
on Course
Unit I MCQ on determinants of capital structure. Basic course in Ans.
Cases study on over and under capital structure. 3.
Financial
Designing on over and under capital structure.
markets
Practical problems on estimating capital requirements of a firm.
Ans.
3.22
Principles of Finance Capital Structure
Questions for Discussion
ot
L State whether the following statements are True or False
) The term Capital structure' includes 'Financial structure' also.
(i) Optimum Capital structure is obtained when the market value of the firm is
maximised and cost is minimised.
(ii) The value of a levered firm is always more than that of an unlevered firm.
(iv) If the EBIT is below the indifference point, a company should use owned funds to
maximise EPS.
(vPreference dividend is tax deductible.
(vi) Capital structure refers to the debt-equity ratio.
(vii) Capital and Capitalisation mean the same.
(vii) Overvaluation of assets leads to undercapitalisation.
(ix) Insuficient depreciation earns overcapitalisation.
(x) Overcapitalisation means excess capital.
(xi)A company which is set-up during recession may suffer from overcapitalisation,
after the recovery.
IL Questions:
1. Explain the term 'Point of Indifference'.
2. What is optimum capital structure?
3 Explain the factors that determine the capital structure of a firm.
Explain the cost theory approach to capital structure determination.
5. Explain the EBIT-EPS approach for determining the capital structure of a firm.
6. What are the criteria of appropriate capital structure?
7. What are the causes of overcapitalisation? How can it be corrected?
8 Compare overcapitalisation and undercapitalisation.
9 What are the causes of undercapitalisation? What are the remedial measures?
10. Analyse the impact of the state of economy on capitalisation.

Questions from Previous Examinations

0w0wwww
1. Write short note on Capitalisation. [Oct. 2011, Oct. 2012]
Ans. Refer Article 3.9.
2. What do you mean by Capital Structure? What are the factors influencing the
Structure?
Composition of Capital [Oct. 2011]
Ans. Refer Article 3.7.
3."As between Under and Over-capitalisation, the former is the lesser evil of the two but
still both should be discouraged and the ideal should be fair capitalisation". Comment.

[Oct. 2011]
3.14.
Ans. Refer Articles 3.12, 3.13 and
3.23
Principles of Finance Capital Stru-
4.Write short note on April 20
Overcapitalisation.
Ans. Refer Article 3.12.
5. Write short note on Factors Influencing Capital Structure. IApril 20
Ans. Refer Article 3.7.
6. What do you mean by Capital Structure? What are the factors that influence
composition of Capital Structure. [Oct. 201
Ans. Refer Article 3.7.
7. What is Undercapitalisation? Explain the causes of Undercapitalisation. What are t
remedial measures? [Oct. 2012, April 201
Ans. Refer Article 3.13.
8. What do you mean by Capital Structure? Explain in detail criteria for determinir
Capital Structure. [April 2016, 2017, 2018
Ans. Refer Article 3.7.
9. Define Capitalization. Explain Under Capitalization with causes, effects and remedies.
[April 2018
Ans. Refer Articles 3.10 and 3.13.
10. What do you mean by Capitalization? April 2016]
Ans. Refer Articles 3.9 and 3.10.

3.24