Capitalization-

Capitalization is one of the most important parts of financial decision. which is related to the total
amount of capital employed in the business concern. Understanding the concept of capitalization
leads to solve many problems in the field of financial management. Because. the confusion between
the concept of capital. capitalization and capital structure.

According to Guthman and Dougall,

“Capitalization 1s the sum of the par value of stocks and bonds outstanding”

Theories of capitalization

The problems of determining the amount of capitalization is necessary both for a newly started
company as well as for an established concern.

COST THEORY

Under this theory. the capitalization of a company 1s determined by adding the initial actual
expenses to be incurred in setting up a business enterprise as a going concern. It 1s aggregate of the
cost of fixed assets (plant. machinery. building, furniture. goodwill. and the like). the amount of
working capital (investments. cash.inventories. receivables) required to run the business, and the
cost of promoting. organizing and establishing the business.

Cost theory, no doubt. gives a concrete idea to determine the magnitude of capitalization. but it fails
to provide the basis for assessing the net worth of the business in real terms. The capitalization
determined under this theory does not change with earnings. Moreover, it does not take into
account the future needs of the business

. The earnings theory of capitalization:

This theory assumes that an enterprise 1s expected to make profit. According to it, its true value
depends upon the company’s earnings and/or earning capacity. Thus. the capitalization of the
company or its value is equal to the capitalized value of its estimated earnings. To find out this value.
a company. while estimating its initial capital needs. has to prepare a projected profit and loss
account to complete the picture of earnings or to make a sales forecast. having arrived at the
estimated earnings figures. the financial manager will compare with the actual earnings of other
companies of similar size and business with necessary adjustments.

After this the rate at which other companies in the same industry. Similarly situated are making
earnings on their capital will be studied. This rate 1s then applied to the company’s estimated
earnings for determining its capitalization.
Under the earnings theory of capitalization. two factors are generally taken into account to
determine capitalization (1) how much the business 1s capable of earning and 2. What 1s the fair
rate of return for capital invested in the enterprise. This rateof return is also known as ‘multiplier’
which is 100 per cent divided by theappropriate rate of return.
Though earning theory is more appropriate for going concerns. it is difficult to calculate the amount
of capitalization under this theory. It is based upon a ‘rate’ by which earnings are capitalized. This
rate is difficult to estimate in so far as it is determined by a number of factors not capable of being
calculated quantitatively.

Over capitalization

It 1s a situation where a firm has more capital than it needs. Assets are worth less than its issued
share capital. and earnings are insufficient to pay dividend and interest. This situation mainly arises
when the existing capital 1s not effectively utilized on account of fall in earning capacity of the
company while company has raised funds more than its requirements. The chief sign of
overcapitalization 1s the fall in payment of dividend and interest leading to fall in value of the shares
of the company.

According to Bonneville, Dewey and Kelly. over capitalization means. “When a business 1s unable to
earn fair rate on its outstanding securities”.

Symptoms-
1. High Proprietory ratio
2. Low earnings per share
3. Low assets utilization

Causes

1. Over issue of capital

2. Promotion, formation or development during inflation
3. Buying assets of lower value at higher prices
4. High Promotion expenses:
5. Inadequate depreciation
6. Liberal dividend policy:
7. Taxation Policy:
8. Inadequate demand for products:
9. Payment of high rate of interest:
10. Under-estimation of the capitalization rate:

Effects on company
1. Loss of goodwill:
2. Poor creditworthiness
3. Difficulties in obtaining capital:
4. Loss of market
5. Inflated profits:
6. Liqudation of company
7. Decline in efficiency of the company

Effects on Shareholders:

1. Reduced dividends:
2. Fall in the value of shares:
 3. Unacceptable as collateral security
4. Loss on speculation:
5. Loss on re-organisation

Effects on Society:

1. loss to Consumers:
2. Loss to Workers
3. Under or misutilisation of Resources
4. Gambling in Shares
5. Recession:
Remedies-an over-capitalized company must cut its dead weight before it becomes deep rooted and
almost impossible to get rid of. In this regard, various remedial measures such as increasing the
efficiency of management. reduction of high interest bearing funded debt, redemption of preference
shares. reduction in face value and number of shares, etc. have been suggested.

1. To have Efficient Management

2. Redemption of Preference Shares
3. . Reduction of Funded Debts:
4. . Reorganization of Equity Share Capital

Under capitalization:

Under capitalization 1s the opposite concept of over capitalization and 1t will occur when the
company’s actual capitalization 15 lower than the capitalization as warranted by 1ts earning
capacity. Under capitalization 1s not the so called adequate capital. It 15 a state, when its actual
capitalization 15 lower than its proper capitalization as warranted by its earning capacity. This
situation normally happens with companies which have insufficient capital but large secret reserves
in the form of considerable appreciation in the values of the fixed assets not brought into the books.

According to Gersrtenberg. “A company may be under-capitalized when the rate of profits it is

making on the total capital is exceptionally high in relation to the return enjoyed by similarly situated
companies in the same industry, or when it has too little capital with which to conduct its business”.

Symptoms of undercapitalization

1. There 1s an unforeseen increase in earnings of the company.

2. Future earnings of the company were under-estimated at the time of promotion.
3. Assets might have been acquired at very low prices.

Causes of undercapitalization

1. nder-Estimation of Capital Requirements

2. Under-Estimation of Future Earnings:
3. Promotion during Depression:
4. Conservative Dividend Polic
5. Very Efficient Management:
6. Desire of Control and Trading on Equity:
Effects of undercapitalization:

1. Limited marketability of shares

2. ndustrial unrest:
3. Consumer dissatisfaction
4. Government interference:
5. Inadequacy of capital
6. Cut-throat competition:

Remedies for Under-Capitalization:

1. Fresh Issue of Shares

2. Issue of Bonus Shares
3. Increasing the Par Value of Shares:
4. Splitting Stock

Cost of Capital-

firm needs funds for various capital budgeting proposals. These tunds can be procured from
different types of investors Le, equity shareholders, preference shareholders, debt hold- ers,
depositors ete. These investors while providing the funds to the firm will have an expectation of
receiving a minimum return from the firm. The minimum return expected by the investors depends
upon the risk perception of the investor as well as on the risk-return characteristics of the firm.
There-fore, in order to procure funds, the firm must pay this return to the investors. Obviously, this
return payable to investors would be earned out of the revenues generated by the pro-posal
wherein the funds are being used. So, the proposal must earn at least that much, which is sufficient
to pay to the investors of the firm. This return payable to investor is therefore, the minimum return
the proposal must earn other- wise, the firm need not take up the proposal.

Cost of Capital is the rate of return the firm requires from investment in order to increase the
value of the firm in the market” * Hampton John J.

The importance and significance of the concept of cost of capital can be stated in terms of the
contribution it makes towards the achievement of the objective of maximization of the wealth of the
shareholders.’ If a firm's actual rate of return exceeds its cost of capital and if this return is earned
without of course, increasing the risk characteristics of the firm, then the wealth maximization goal
will be achieved. The reason for this is obvious. If the firm’s return is more than its cost of capital,
then the investor will no . doubt bereceiving their expected rate of return from the firm. The excess
portion of the return will however be available to the firm and can be used in several ways e.g, (i) for
distribution among the shareholders in the form of higher than expected dividends, and (ii) for
reinvestment within the firm for increasing further the subsequent returns. In both the cases, the
market price of the share of the firm will tend to increase and consequently will result in increase in
the shareholders wealth.
Moreover, the cost of capital when used as a discount rate in capital budgeting, helps accepting only
those proposals whose rate of return is more than the cost of capital of the firm and hence results in
increasing the value of the firm. Further, the cost of capital has a useful role to play in deciding the
financial plan or capital structure of the firm. It may be noted that In order to maximize the value of
the firm, the cost of all the different sources of funds must be minimized. The cost of
capital of different sources usually varied and the firm wi like to have a combination of these sources
in such a way so as to minimize the overall cost of capital of the firm.

Types-

Specific Cost and overall cost-

all these long term sources have their own specific costs. The combined cost of capital depends upon
these specific costs. The combined cost of capital is in fact, known as the overall cost of capital of the
firm, while the specific costs are known as the specific cost of capital of a particular source. The long
term sources of funds can be broadly categorized into (7) long term debt and loans, (77) preference
share capital (iii) equity share capital, and (iv) the retained earnings. The firm has a specific cost of
capital for each of these sources and on the basis of these specific cost of capital, the overall cost of
capital of the firm can be determined

Explicit Cost and implicit Cost-

The cost of capital of a firm can be analyzed as explicit cost and implicit cost of capital. The explicit
cost of capital of a particular source may be defined in terms of the interest or dividend that the firm
has to pay to the suppliers of funds. There is an explicit flow of return payable by the firm to the
supplier of fund.

The profits earned by the firm but not distributed among the equity shareholders are ploughed back
and reinvested within the firm. These profits gradually result in a substantial source of funds to the
firm. Had these profits been distributed to equity shareholders, they could have invested these
funds (return for them) elsewhere and would have earned some return. This return is foregone by
the investors when the profits are ploughed back. Therefore, the firm has an implicit cost of these
retained earnings and this implicit cost is the opportunity cost of investors.

Historical Cost and Future Cost.

Historical cost refers to the cost which has already been incurred for financing'a project. It is, thus,
calculated on the basis of past data. Future cost refers to the expected cost of funds to be raise for
financing a project.

Average Cost and Marginal Cost. Average cost of capital is the weighted average cost calculated on
the basis of cost of each source of capital and weights assigned to them in the ratio of their share in
total capital structure. ). Marginal cost of capital is also weighted average but it is weighted average
cost of new capital raised by the company.

Capital budgeting-

Capital budgeting decisions are related to the allocation of funds to different long term assets. The
capital budgeting decision denotes a decision situation where the lump sum funds are invested in
the initial stages of a project and the returns are expected over a long period.
The capital budgeting decision involves the entire process of decision making relating to acquisition
of long term assets whose returns are expected to arise over a. beyond one year. The role of a
finance manager in the capital budgeting basically lies in the process of critical and in-depth analysis
and. Various alternative proposals and then to select one out of these. The objective of capital
budgeting is to select those long term investment projects that are expected to make maximum
contribution to the wealth of the shareholders.

Significance

1. Long term effects- on the risk and composition of business. Affects future position of the
business.
2. Substantiial commitments- he capital budgeting decisions generally involve large
commitment of funds and as a result substantial portion of capital funds are blocked in the
capital budgeting decision. It is also possible that the return from a project may not be
sufficient enough to justify the capital budgeting decision.
3. Irreversible decisions-Most of the capital budgeting decisions are reversible decisions. Once
taken, the firm may not be in a position to revert back unless unless it is ready to absorb
heavy losses which may result due to abandoning a project in Midway.
4. Affect the capacity and strength to compete- The capital budgeting decisions affect the
capacity and strength of our form to face the competition. A firm may lose competitiveness
if the decision to modernize its delayed or not rightly taken. Similarly, a timely decision to
take over a minor competitor ultimately result even in the monopolistic position

Problems and difficulties-

1. Future uncertainty
2. Time element
3. Measurement problem

Types of capital budgeting decision-

From the point of view of firms existence

 Newly incorporated Firm

 Existing firm
1. Replacement and modernisation decision-If the existing plant is to be replaced because
the economic life of the plant is over, then the decision may be known as a replacement
decision. However, if an existing plant is to be replaced because it has become
technologically outdated, the decision may be known as modernization decision.
2. Expansion
3. Diversification-ometimes the firm may be interested to diversify into new product lines,
new markets, production of spare parts, etcetera. In such a case, the finance manager is
required to evaluate not only the marginal cost and benefits, but also the effect of
diversification on the existing market share and profitability. Both the expansion and
diversification decision may also be known as revenue increasing decision
 4. Contingent decisions. Sometimes the capital budgeting decision is a contingent decision
to some other decision. For example, computerization of a bank branch may require not
only air conditioning, but also transfer of some staff member to other branches. Any
capital budgeting decision must be evaluated by the finance manager in its totality. The
contingent decision, if any, must be considered and evaluated simultaneously.

Assumptions-

 Certainty with respect to cost and benefits-

 Profit motive
 No capital rationing

Steps

1. Estimation of costs and benefits of the proposal-he most important step required in the
capital budgeting decision is to estimate the cost and benefit associated with all the
proposals being considered. The cost of a proposal is generally the capital expenditure
required to install a project or to implement excision. However, the benefits of a
proposal may be in the form of increased output, increase sales, reduction in labor, cost
reduction, industries, etc.
2. Estimation of the required rate of return. The rate of return expected from our proposal
is to be estimated in order to access the future cost and benefit of a proposal for time
value of money and determining profitability of proposal. he required rate of return is
also known as cost of capital
3. Using the capital Budgeting decision criterion-proper capital budgeting technique is to
be applied to select the best alternative. So in the first instance, the technique itself is to
be selected and then it is to be applied for a better decision making.

Capital Structure-
Capital structure means the arrangement of capital from different sources so that the long- term
funds needed for the business are raised. Capital structure refers to the proportions or combinations
of equity share capital, preference share capital. debentures. long-term loans. retained earnings and
other long-term sources of funds in the total amount of capital which a firm should raise to run its
business. Decisions relating to financing the assets of a firm are very crucial in every business. The
finance manager 1s regularly fixed in the difficulty of what the optimum proportion of debt and
equity. As a general rule. there should be a proper mix of debt and equity capital in financing the
firm's assets. Capital structure 1s usually considered to serve the interest of the equity shareholders.
The capital structure of a company 1s made up of debt and equity securities that include a firms
financing of its assets. It 1s the permanent financing of a firm represented by long-term debt.
preferred stock and net worth. It relates to the arrangement of capital and excludes short-term
borrowings. It denotes some degree of permanency as it excludes short-term sources of financing.

In short, Capital structure refers to the percentage of capital (money) at work in a business by type.
There are two forms of capital: equity capital and debt capital. Each type of capital has its own
benefits and drawbacks

Gerestenberg, ‘Capital structure of a company refers to the composition or make up of its

capitalization and 1t includes all long term capital resources viz. loans, reserves. shares and bonds’.

The capital structure involves two decisions-

a. Type of securities to be issued is equity shares, preference shares and long term

borrowings (Debentures).

b. Relative ratio of securities can be determined by process of capital gearing. On

this basis, the companies are divided into two-

i. Highly geared companies - Those companies whose proportion of equity

capitalization is small.

i. Low geared companies - Those companies whose equity capital dominates total

capitalization.

Cardinal Principles of Capital Structure’

A) Cost Principle: According to this principle. an ideal pattern of capital structure is one that
minimizes cost of capital structure and maximizes earnings per share. For example. Debt
capital is cheaper than equity capital from the point of its cost and interest being deductible
for income tax purpose. whereas no such deduction is allowed for dividends.
B) Risk Principle: The finance manager attempts to plan the capital structure in such a manner.
that risk and cost are the least and the control of the existin management is diluted to the
least extent. According to this principle. reliance is to be found more on common equity for
financing capital requirements than excessive use of debt. Use of more and more debt
means higher commitment in form of interest payout. Two risks-
1. Business Risk: it is an unavoidable risk because of the environment in which the firm has
to operate and it is represented by the variability of earning before interest and tax.
2. Financial risk: it is a risk associated with the availability of earnings per share caused by
use of financial leverage. Risk of cash insolvency, risk of variation in eps.
C) Control Principle:

Along with cost and risk principles. the control principle 1s also important consideration in planning
the capital structure. When a company issues further equity shares. automatically dilutes the
controlling interest of the present owners. Similarly. preference shareholders can have voting rights
and thereby affect the composition of the Board of Directors. mn case dividends on such shares are
not paid for two consecutive years. Financial institutions normally require that they shall have one or
more directors on the Boards. Hence. when the management agrees to raise loans from financial
institutions by implication it agrees to sacrifice a part of its control over the company. It is
noticeable. therefore. that decision concerning capital structure are taken after keeping the control
factor in mind.

D) Flexibility Principle:

Flexibility 1t means that the management chooses such a combination of sources of financing which
1t finds easter to adjust according to changes in need of funds m future. While debt could be
interchanged (if the company is loaded with a debt of 18% and funds are available at 15% it can
return old debt with new debt, at a lesser interest rate) but the same option may not be available in
case of equity investment. The capital structures of a company should be such that it can raise funds
as and when required. Flexibility provides opportunity for expansion, both in terms of lower impact
on cost and with no significant rise in risk profile. Debentures and loans can be refunded back as the
time requires. While equity capital cannot be refunded at any pont it provides inflexibility to plans.
E) Timing Principle:

Proper timing of a security 1ssue often brings sustainable savings because of the dynamic nature of
the capital market. Hence, the issue should be made at the right time so as to mmimize effective
cost of capital. The management should constantly study the trend mn the capital market and time
1ts 1ssue carefully.

Competition in industry is also a factor. The finance manager should weigh different options and
then take decisions.

Factors influencing the capital structure

1. Risk of cash insolvency: Risk of cash insolvency arises due to failure to pay fixed interest
habilities. Generally. the higher proportion of debt in capital structure compels the company
to pay higher rate of interest on debt urrespective of the fact that the fund is available or
not
2. . Risk in variation of earnings: The higher the debt content in the capital structure of a
company. the higher will be the risk of variation in the expected earnings available to equity
shareholders.
3. Cost of capital: Cost of capital means cost of raising the capital from different sources of
funds. It 1s the price paid for using the capital. A businessenterprise should generate enough
revenue to meet its cost of capital and finance its future growth.
4. Trading on equity: The word “equity” denotes the ownership of the company. Trading on
equity means the taking advantage of equity share capital t borrowed funds on reasonable
basis. It refers to additional profits that equity shareholders eam because of issuance of
debentures and preference shares.
5. Government policies: Capital structure 1s influenced by Government policies. rules and
regulations of SEBI and lending policies of financial institutions which change the financial
pattern of the company totally. Monetary and fiscal policies of the Government will also
affect the capital structure decisions.
6. Size of the company: Availability of funds is greatly influenced by the size of company. A
small company finds 1t difficult to raise debt capital. The terms of debentures and long-term
loans are less favourable to such enterprises. On the other hand. large companies issue
various types of securities despite the fact that they pay less interest because investors
consider large companies less risky.
7. Needs of the investors: While deciding capital structure the financial conditions and
psychology of different types of mvestors will have to be kept in mind.
8. Period of finance: The period for which finance 1s needed also influences the capital
structure. When long-term funds (say 10 years) are needed, 1t should be raised by issuing
debentures or preference shares. But if the funds are for permanen requirement, it will be
appropriate to raise them by the issue of equity shares. For Medium term 1t should be raise
by debt.
9. . Nature of business: It has great influence in the capital structure of the business.
companies having stable and certain earnings prefer debentures or preference shares and
companies having no assured income depends on internalresources.
 10. Purpose of financing: Capital structure of a company 1s also affected by the purpose of
financing. Funds are required for long term productive purposes like manufacturing; setting
up new plant etc. may be procure through issue of long- term sources. But, the funds are
required for non-Productive purposes like welfare facilities to employees, such as school,
hospital etc. internal sources of financing may have to be procured.

11. Corporate taxation: Interest on borrowed capital 1s a tax- deductible expense. But, dividend
1s not. Also the cost of raising finance through borrowing 1s deductible in the year in which
1t 1s incurred. If 1t 15 incurred during the pre- commencement period, it 1s to be
capitalized. Due to the tax saving advantage, debt has a cheaper effective cost than
preference shares or equity shares.

12. Cash inflows: The selection of capital structure 1s also affected by the capacity of the
business to generate cash inflows. It analyses solvency position and the ability of the
company to meet its charges.

13. Provision for future: The provision for future requirement of capital 1s also to be considered
while planning the capital structure of a company. Future growth considerations and further
requirements of capital should also be considered

14. EBIT-EPS analysis:

Trading on equity-

Trading on equity means to raise fixed cost capital (borrowed capital and preference share capital)
on the basis of equity share capital so as to increasing the income of equity shareholders. Trading on
equity occurs when a corporation uses bonds, other debt. and preferred stock to increase its
earnings on common stock. The term trading on equity means debts are contracted and loans are
raised mainly on the basis of equity capital. Those who provide debt have a limited share in the
firm's earning and hence want to be protected in terms of earning and values represented by equity
capital. Since fixed charges do not vary with firms earning before interest and tax a magnified effect
1s produced on earning per share. Whether the leverage 1s favourable, in the sense, increase in
earning per share more proportionately to the increased earning before interest and tax. depends
on the profitability of mvestment proposal. If the rate of returns on investment exceeds their explicit
cost, financial leverage 1s said to be positive. In a company. 1t 1s the directors who are so called
elected representatives of equity shareholders. These members have got maximum voting rights in a
concern as compared to the preference shareholders and debenture holders. Preference
shareholders have reasonably less voting rights while debenture holders have no voting rights. If the
company’s management policies are such that they want to retain their voting rights in their hands.
the capital structure consists of debenture holders and loans rather than equity shares.
Factoring-‘

Definition: Factoring implies a financial arrangement between the factor and client, in which the firm
(client) gets advances in return for receivables, from a financial institution (factor). It is a financing
technique, in which there is an outright selling of trade debts by a firm to a third party, i.e. factor, at
discounted prices.
Factoring is a financial alternative, in financing and management of account receivables. It states the
terms and conditions of the sale in the factoring agreement.
In finer terms factoring is a relationship between the factor and the client, in which the factor
purchases the client’s account receivables and pay up to 80% (sometimes 90%) of the sum
immediately, at the time of entering into the agreement. The factor pays the balance sum, i.e. 20%
of the amount which includes finance cost and operating cost, to the client when the customer pays
the obligation.