CAPITALISATION

A business organization requires various types of funds to perform its operations. These
required funds can be broadly classifying into long term requirements, which are utilized for
fixed assets and the short-term requirements, which are utilized for financing the day-to-day
activities of the business. Funds can be raised through various sources of finance, the long-term
sources of finance include the shares, debentures and long-term loans. While the short-term
sources of finance include the bank credit, the public deposits and the short-term loans required
for the working capital financing.
The total amount of funds from the short-term sources and the long-term sources which are
employed in the business is called as Capitalization. While calculating the funds employed the
funds gathered from the owned and the borrowed sources are considered they also include the
reserves and surplus of the company. The profits which are made available for distribution to
the shareholders as dividends are to be included, the reserves which are built out of the revenue
profits can also be included while calculating the amount of capitalization. The term
capitalization is used only is respect of companies. This term is also used when bonus shares
are issued out of the profits, it is called as the capitalization of the profits.
The term capitalization has been interpreted as a broad as well as a narrow interpretation: -
Broad interpretation: -
It is the Macro interpretation of the term capitalization. It is like financial planning as in
includes
• The decisions relating to the total amount of capital to be raised.
• Decisions relating to the types of securities to be issued for the collection of the required
amount of capital.
• The planning and administration of the different types of securities issued for collecting
the capital.
As the study of the capital value is on a broad sense it is called the Macro interpretation of the
term capitalization. Thus, the Macro interpretation of the term capitalization includes the
process in which the amount required by the company as capital is ascertained. The timings for
the requirements are also ascertained. After deciding the required amount, the decisions
regarding the financing pattern are taken, it includes the modes of finance to be considered, the
quality of the options to be selected and the right timings of the requirements are carefully
considered. Thus the broad interpretation of capitalization includes the decisions regarding the
amount of finance, the timings of the requirement of the finance and the modes of finance to
be considered for satisfying the requirements.
Narrow interpretation: -
It is the micro interpretation of the term capitalization. It refers to the process of determining
the quantum of long-term funds the business would require for running the business. The
capital structure of the enterprise manifests the capitalization decisions. But in the narrow
interpretation the term capitalization includes the par value of the shares and the debentures.
Theoretically the reserves and surplus are excluded from the concept of capitalization but in
practice the reserves and surplus are included. Thus, in the micro interpretation, the capital
structure of the enterprise consisting of the par values of the shares and debentures, the reserves
and surplus and the long-term loans play a prominent role. So, this interpretation is more
popular as it has a very specific meaning.
The term capital is used in respect of all types of companies like the limited companies, the
sole proprietors and the partnerships. Capital in accounting sense means the net worth of the
company. The net worth means the total assets minus the total liabilities of the enterprise. This
term is also used while issuing the bonus shares of the company. As instead of paying the
dividends to the shareholders the reserves of the company are capitalized by issuing the bonus
shares.

Capitalization theories.
Cost theory: -
According to this theory the amount of capitalization of a newly started company should be
arrived by adding up the cost of the fixed assets, the amount required for the working capital
and the preliminary expenses i.e. the cost of establishment of the company. This amount was
useful for deciding the amount of securities the company must sell in form of shares and
debentures. So the cost theory is useful to the promoters to ascertain the amount of capital to
be raised, but it is been criticized that the real net worth of the company cannot be known if the
assets are being purchased at an inflated rate, or even if the assets have become obsolete and
the effect is not being considered in the value of capitalization as the original values of the
assets are considered. Thus, the original cost of the assets is the base for the amount of
capitalization in the cost theory.
Earnings theory: -
This theory links the value of the capitalization with the future earnings of the enterprise. The
true value or the value of capitalization depends on the earnings of the enterprise. So, the future
earnings of the enterprise are estimated and based on these estimations the value of the
capitalization is decided. The first step according to the earnings theory is that the new
enterprise should estimate the average annual future earnings and also the normal rate of return
which is prevailing in the industry. The normal rate of return is considered to be the
capitalization rate. In this way the enterprise can decide the amount of capitalization. (estimated
earnings are 500000 rate of return 10% so the amount of capitalization should be
500000*100/10 i.e. 5000000 ) This method is advantageous as it links the earning capacity of
the enterprise with the amount of capitalization, but the limitation of this theory is that for a
new enterprise it is very difficult to estimate the future earnings correctly. In case these future
earnings are estimated wrongly the value of capitalization based on these earnings would prove
to be very risky for the enterprise. Thus, the future earnings of the enterprise are the base of the
earnings theory.
In case of a newly started enterprise it is difficult to estimate the future earnings, so the cost
theory is adopted for the calculation of the amount of capitalization. But in case of established
companies it is very easy to estimate the stream of future earnings, but the enterprise may not
be able to disclose the fair worth due to the accounting reasons. So, the earnings theory is
adopted for the calculation of the value of capitalization.

Actual capitalization V/s Proper capitalization

The actual capitalization is calculated by the addition of the paid-up value of the company’s
shares and debentures, reserves and all other surplus. While the value of proper capitalization
is arrived at, by any of the two methods, discussed above. When the actual capitalization value
is more than the proper capitalization value the company is said to be over-capitalized. But if
the actual capitalization value is said to be less than the proper capitalization value then the
company is said to be under-capitalized.

OVER-CAPITALIZATION
The term over-capitalization signifies that the company posses, excess of capital in relation to
its activity level and its requirements. This is a situation faced by the company when the
available capital is excess to the requirements in the company. Such a situation arises when the
earning capacity of the company has fallen due to the internal and the external factors. But this
situation does not signify that the company has abundant capital, but due to the reduction in
the earning capacity of the company the company is not in a position to pay interest and
dividends at a proper rate. Thus, the over-capitalized companies fail to pay fair returns on its
capital investments. But over capitalization is different from excess capital. Over-capitalization
is a condition when the capital is raised, and the company can’t use the existing capital
optimally & effectively. But excess capital means that the company has raised excess capital
than its requirement. The prominent sign of an over-capitalized company is then the rates of
dividend decreases in the long run. Due to this the prices of the shares also decreases. The over-
capitalization is an alarming condition for the company and needs to be taken care of at the
earliest.

Causes of Over-capitalization: -
1. Rising of more money by use of shares and debentures than what the company can
use profitably.
2. Borrowing large sums of money at a rate of interest which is higher than the rate of
the company’s earnings.
3. Payment of huge amounts for the acquisition of intangible assets like Goodwill,
Patents and Copyrights.
4. The fixed assets are being purchased at an inflated rate and these investments do not
generate a desirable rate of return for the company.
5. Insufficient provision of depreciation on the fixed assets so the real value of the assets
is less than the book value.
6. Insufficient provision for replacement of assets so the funds are borrowed at a higher
interest rate when they are urgently needed thus reducing the earnings of the
company.
7. If the company has a lenient dividend policy the reserves are adversely affected.
8. Higher rates of taxed would lead to the reduction in the net earnings of the
shareholders.
9. Under-estimation of the capitalization rate or over-estimation of the earnings.

Evils of Over-capitalization: -
1. There is considerable reduction in the rates of dividends being paid to the equity
shareholders. The shareholders are dis-satisfied as the market prices of the shares go
on reducing.
 2. The investors lose their confidence in the company and the goodwill of the company
reduces.
3. The credit worthiness of the company is lost.
4. Due to liquidity problems faced by the company increase in the production activity is
not possible. The company may be forced to raise the cost of the product or reduce
the quality of the product.
5. Due to the locking of the funds, expansion and diversifications of the company are to
be postponed.
6. The company has to go for re-organization if the matters go worse.

Remedies of Over-Capitalization: -
1. The company must go through a complete re-organization.
2. Reduction in the claims made by the shareholders, debenture holders and creditors
3. The interest rates on the debentures and the dividend rates on preference shares shall be
reduced.
4. Early redemption of the Debentures and Preference shares through existing earnings or
through converting them to equity shares.
5. The number or value of the equity shares also may have to be reduced.
These remedies will result in leaving sufficient funds for the company and help it to carry on
its routine operations in a smooth manner, carry on replacements of assets and also for
expansion of the business, thus increasing the earning capacity of the company.

UNDER-CAPITALIZATION
Under-capitalization is exactly opposite of over-capitalization. It is a situation when the
company’s actual capitalization is lower than the proper capitalization; this is due to the earning
capacity of the company. This is a peculiar situation faced by the well-established companies.
These companies have insufficient capital but large secret reserves. These reserves are in form
of considerable appreciation in the fixed assets which is not brought into books. An under-
capitalized situation is being defined by Gesternberg by,” a company may be under-capitalized
when the rate of profit is exceptionally high in relation to the returns enjoyed by a similarly
situated company in the same industry.” Such companies have assets whose worth is more
than the worth reflected in the books of the company. Overall an under-capitalized company is
said to be in a sound financial position. Such companies give good dividends and the sound
financial position is reflected by high share prices in the market. The market value of such
shares is higher than the value of the shares other similar companies and the earning rate is
much high than the prevailing rates of the securities. Under-capitalization is totally different
from inadequate capital, as when the company does not have sufficient funds to carry on its
activities then it is said to have inadequate capital and it is not under-capitalization. An under-
capitalized company can be easily ascertained by comparing the book value of the equity shares
and the real value of the equity shares. When the real value of the equity shares is more than
the book value the company is said to be under-capitalized.

Causes of under-capitalization: -
1. The initial earnings of the company are being under-estimated and so the actual
earnings seem to be greater thus the company is judged as under-capitalized.
2. The estimated capitalization rate derived by the company is on a lower side.
3. If the company is being set up in recessionary times and so when the recession is over
the company seems to be under-capitalized. As during the recessionary times the assets
are being purchased at exceptionally low prices and the rate of capitalization is also
estimated at a lower side but when the recession is over the earning capacity of the
company increases thus increasing the real value of the assets of the company.
4. If the company follows a conservative dividend policy, the profits of the company are
added up to the reserves, thus resulting in availability of large funds for the financial
development and the expansion of the company.
5. Maintaining high standards of efficiency.
6. Constant modernization of the fixed assets increases the real value of the assets making
it more than the book value.
Advantages of Under-capitalization: -
1. The company earns high profits.
2. The company can create a good reserve position.
3. The company has a good financial position, so it can present healthy Balance sheets.
4. The share market prices of the company are very high.
Effects of Under-capitalization: -
1. Due to high profits the under-capitalized companies attract acute competition. High
profitability encourages the new entrepreneurs to enter the same line of business.
2. In under-capitalized companies there is unrest among the workers, as high rates of
dividends give an opportunity to the workers to demand higher wages.
 3. Due to high earnings of the company the consumers are dis-satisfied, as the consumer
develops a feeling of being exploited by the company.
4. As the company earns high profits, the company has to pay high taxes and may lead to
more government control.
5. As the share prices in the share market rise the management may be encouraged to
manipulate with the share values.
Remedies of Under-capitalization: -
1. Splitting up of the shares: -Splitting the value of the shares will reduce the average
earning per share. Though the average earning rate of the company will remain the
same.
2. Issue of bonus shares: - The most appropriate remedy for an under-capitalized company
is to capitalize the reserves by issuing bonus shares; this will reduce the amount of the
reserves, reduce the average earning per share and also bring down the average rate of
earning of the company.
3. Increase the par value of the shares: - By increasing the par value of the shares and
issuing the shares which have higher par value the assets can be revised upwards.
4. Taking of fresh debt form the market.
5. Redemption of the old debentures and issue of fresh debentures at a higher interest rate.
Thus, both the over-capitalization and under-capitalization are bad situations for the company.
But over-capitalization is more dangerous to the company. Under-capitalization is a problem
of adjusting the capital structure. It is easier to correct the under-capitalization than over-
capitalization. But the object of the company should be to have proper and fair capitalization.

CAPITAL STRUCTURE
There are two sources of finance in principle, the equity and the debt. The mix of the
principle sources of finance is called the capital structure of the enterprise. According to
Gerstenberg capital structure is defined as,” The make-up of the firm’s capitalization.” The
assets financing pattern followed in the enterprise decided the capital structure. The left
side of the balance sheet represents the financial structure of the company. Thus, the long-
term claims of the business are said to form the capital structure of the business.
The term capital structure is used to represent the proportionate relationship between the
debt and the equity. Equity includes the paid-up equity as preference share capital, the share
premium and the retained earnings. While debt includes the long-term loans in form of
debentures, term loans from the banks and financial institutions, unsecured creditors etc.
but the short-term credits and loans are excluded. The capital structure of the company
should be planned with the view of the Impact it causes on the value of the firm. The capital
structure should be framed in the way which maximizes the wealth of the shareholders. The
decisions regarding the financing of the capital structure are significant managerial
decisions and are taken at the formation of the enterprise. Subsequently when the funds are
needed to finance the investments the capital structure decisions are taken. These decisions
involve analysis of the existing capital structure, the factors which govern the present
decisions.
A firm should try to maintain a optimum capital structure with a view a achieve financial
stability in the enterprise. It can be obtained when the market value of the share is
maximum. When the company borrows, and these borrowings are used to increase the
prices of their shares in the market then the company is said to have a optimum capital
structure. But if these borrowings fail to show results and increase the share prices the
company is said to be far away from the optimum capital structure. Thus, the optimum
capital structure is that which has a minimum cost of capital and which maximizes the value
of the shares for the shareholders. The value of the equity share depends on the earning per
share of the company. When the return on investments is more than the cost of the
borrowings the earning per share is pushed up and every increase in the EPS increases the
market value of the share. It is very difficult to exactly find out the debt and equity mix,
but a range can be determined. The debt to equity ratios has been standardized to help the
managers to arrive at the decision e.g. For a private limited company, the ratio is 2:1.
The capital structure is said to be optimum if it possesses the following features: -
 1. Profitability : - The capital structure of the company must enhance the profitability
of the company. So, the profitable capital structure is that which tends to minimize
the cost of financing and increases the earning per share of the company

2. Solvency : - The capital structure should be designed in such a way that the
companies solvency is not threatened. Excess use of debt causes a threat to the
solvency of the company. So the amount of debt used in financing should not be
increased beyond a manageable limit.

3. Flexibility : - The capital structure should be designed in a way to incorporate the

changes to meet the requirements arising due to the changing conditions. It should
be able to provide funds to the company when required for profitable activities.

4. Conservatism : - A conservative approach means that the loan funds are kept at
the minimum, as excess use of the loan funds beyond the companies manageable
limits can bear a threat on the companies solvency. So, the capital structure should
contain optimum amount of debt funds and should commensurate with the
company’s ability to generate future cash flows.

5. Control : - The capital structure should be designed in such a way that the
shareholders have proper control over the management of the company.

Patterns of capital structure : -

• Equity share only: - When the total requirement of cash is satisfied by issuing equity
shares. The equity shareholders are the owners of the company. The equity
shareholders get dividend as a return on investment form the company. The
dividend rates are dependent on the profits the company earns; it is not a compulsion
on the part of the company to pay dividends every year.

• Equity shares and Preference shares: - The capital structure consist of some part
financed by equity shares and some part by preference shares. The shareholders
become the owners of the company. The preference shareholders also get dividend
 like the equity shareholders, but the rate of dividend is fixed. The liability of
payment of the preferential dividend can be postponed but is a compulsion on the
part of the company.

• Equity shares and debentures : - This combination of the capital structure consist of
some part financed by the equity shares and some part by way of debentures. The
debenture holders do not become the owners of the company as the shareholders,
but they get the status of a creditor. The debenture holders get interest in return or
their investment. The liability of the payment of interest is a compulsion for the
company and it cannot be postponed.

• Equity shares, Preference shares and Debentures: - This combination of the capital
structure consist of all the three options used for financing the requirements of the
company. The equity shareholders have the right to vote in the annual general
meeting, but the preference shareholders have the right to cast a contingent vote.
The debenture holders do not have a right to give vote in the annual general meeting.

The factors determining the capital structure of the company: -

Internal factors
1.Trading on equity : - A company can raise funds by way of shares or by the way of
debentures. The debentures and the preference shares bear a fixed rate of return.
But the preference dividend depends on the profitability of the company. If the
return on the total capital employed is more than the rate of interest paid on the
debenture and the rate of dividend to be paid to the preference shareholders, then it
is said that the company is trading on equity. In other words, using the borrowed
funds for enhancing the expectations of the equity shareholders is called trading on
equity. The company can have trading on equity only when the return on total
capital employed is more than the rate of interest and preference dividend. It is
beneficial only to those companies who have stable earnings. Borrowing increases
the risk to the company and thus the borrowings become costlier thus reducing the
amount of profit earned.
2. Cost of capital : - It is the return on investment a company must earn form the capital
invested. It is the minimum return required from the invested amount. It is necessary
so that the expectations of the investors are satisfied. Thus, while deciding the
capital structure the cost of capital is to be considered.

3. EPS analysis : -This is the most commonly known and widely used way to judge the
alternatives in a financial plan. Earnings Per Share (EPS) is the amount of profit
available per equity share for distribution. this alternative is more advantageous as
it is calculated on the operating profits of the company, but the risk is ignored, eg.
Debt funds increases the profitability of the company also increases thus increasing
the EPS for the company, but the debt fund also increases the risk for the company.
The increase in debt reduces the value of the company.

4. Retaining Control : - The capital structure decisions are also affected by the
promoters decisions to retain control over the management of the company. It is the
equity shareholders who select the team of managerial personnel so it is necessary
that the promoters should own the majority of the equity share capital. So to retain
their right they tend to take more debt. But the risk involved due to compulsory
interest payment and at the time of repayment has to be taken care of and the
liquidity problems have to be solved by the company.

5.Legal requirements : - While deciding about the capital structure of the company
the promoters have to take care of the legal requirements which bind the industry.
eg. The banking companies cannot issue any other type of securities except the
equity shares as per the Banking regulation act.

6.Interest coverage ratio : - This ratio can help the management to decide the limit of
the loan capacity which can be utilized. The judgment is based on the present and
estimated income.
7.Purpose of financing : - The purpose of financing also plays a role to some extent
in deciding the capital mix. If the finance is to be gathered for purchasing machinery
then the management will issue debentures for this purpose as the interest burden
can be taken care of from the profits earned. But if the funds are required for a
 welfare activity like building of employee quarters then the alternative of equity
shares can be utilized.

8.Period of financing : - The period for which the finance is required also affects the
financing decisions. If the finance is required for a period of 3 to 10 years, then the
option of debentures is useful. But if the funds are raised by issuing equity shares
then after their use they cannot be repaid back, and these funds will remain ideal in
the company.

External factors
1.Flexibility : - It means the ability of the firm to raise funds from various sources. But
the management should keep some flexibility in raising the funds, so that when the
company needs funds it has an option of using the alternatives by taking advantage
of the market situations.

2.Market sentiments : - The sentiments in the capital market also decide the capital
structure of the company. Sometime the investors want to play absolutely safe, in
these cases the funds can be appropriately raised by way of debentures, this is the
time when the market is in the bearish phase. But when the investors are interested
in earning high speculative income, it is appropriate to raise the funds by issuing
the equity shares, this is the time when the market is in the bullish phase.

3.Requirements of the investors : - The funds required by the company are to be

collected by the company form various resources. The requirement of various
customers is different, equity shares are best suited to bold investors who wish to
take risk and earn high, but the investors who are cautious and want steady income
by taking less risk can select the option of debentures and preference shares. So the
company has to keep various types of securities for various types of investors. This
is possible only if the company needs heavy funds.

4.Size of the company and its growth rate : - Small companies totally rely upon the
owners funds for financing. But large-scale companies collect funds from various
sources. The growth rate of the company also helps in deciding the capital structure
mix. If the company is growing at a very fast rate, then equity share capital is not
 enough for financing its requirements. So, the company can collect the extra needed
funds by way of debt.

5.Interest rates : - If the prevailing interest rates in the market are high the company
can delay the decision of raising the funds by way of loans from the market till the
market rates reduce and stabilize.

6.Government policies : - The government policies like the lending policy, fiscal
policy, monetary policy affect the capital structure decisions. The rules made by the
Securities exchange board of India also affect the capital structure decisions.