Capital Structure: Unit Iii Financial Management

CAPITAL
STRUCTURE
UNIT III
FINANCIAL MANAGEMENT
 Definition of Capital Structure
 The combination of long-term sources of funds, i.e. equity

capital, preference capital, retained earnings and debentures in
the firm’s capital is known as Capital Structure.
 It focuses on choosing such a proposal which will minimize

the cost of capital and maximize the earnings per share. For
this purpose a company can opt for the following capital
structure mix:
CAPITAL STRUCTURE
Definition of Financial Structure
 The mix of long term and short term funds employed by the
company to procure the assets which are required for day to
day business activities is known as Financial Structure.
 Trend Analysis and Ratio Analysis are the two tools used to
analyze the financial structure of the company.
 The composition of the financial structure represents the whole
equity and liabilities side of the Balance Sheet, i.e. it includes
equity capital, preference capital, retained earnings,
debentures, short-term borrowings, account payable, deposits
provisions, etc.
The following factors are considered at the time of designing the
financial structure:
 Leverage: Leverage can be both positive or negative, i.e. a modest

rise in the EBIT will give a high rise to the EPS but simultaneously it
increases the financial risk.
 Cost of Capital: The financial structure should focus on decreasing
the cost of capital. Debt and preference share capital are cheaper
sources of finance as compared to equity share capital.
 Control: The risk of loss and dilution of control of the company
should be low.
 Flexibility: Any firm cannot survive if it has a rigid financial
composition. So the financial structure should be such that when the
business environment changes structure should also be adjusted to
cope up with the expected or unexpected changes.
 Solvency: The financial structure should be such that there should be
no risk of getting insolvent.
 Capitalization comprises of share capital, debentures, loans,
free reserves , etc. Capitalization represents permanent
investment in companies excluding long-term loans.
 Capitalization is generally found to be of following types-
 Normal
 Over
 Under
 Overcapitalization is a situation in which actual profits
of a company are not sufficient enough to pay interest on
debentures, on loans and pay dividends on shares over a
period of time. This situation arises when the company
raises more capital than required. A part of capital
always remains idle
The causes can be-
 High promotion cost-
 Purchase of assets at higher prices-
 A company’s floatation n boom period-
 Inadequate provision for depreciation-
 Liberal dividend policy-
 Over-estimation of earnings-
 Undercapitalization
 An undercapitalized company is one which incurs
exceptionally high profits as compared to industry. An
undercapitalized company situation arises when the estimated
earnings are very low as compared to actual profits. This gives
rise to additional funds, additional profits, high goodwill, high
earnings and thus the return on capital shows an increasing
trend
The causes can be-
 Low promotion costs
 Purchase of assets at deflated rates
 Conservative dividend policy
 Floatation of company in depression stage
 High efficiency of directors
 Adequate provision of depreciation
 Large secret reserves are maintained.

Bases of Capitalization:
 The major problem faced by the financial manager is
determination of value at which a firm should be capitalized
because it have to raise funds accordingly there are two
theories that contain guidelines with which the amount of
capitalization can be summarized;
1. Cost Theory of Capitalization
According to this theory capitalization of a firm is regarded as the sun of cost actually incurred in
setting of the business. A film needs funds to acquire fixed assets, to defray promotional and
organizational expenses and to meet current asset requirements of the enterprise sum of the costs
of the above asset gives the amount of capitalization of the firm, acquiring fixed assets and to
provide with necessary working capital and to cover possible initial losses, it will capitalized
under this method more emphasis is laid on current investments. They are static in nature and do
not have any direct relationship with the future earning capacity. This approach is given as the
value of capital only at a particular point of time which would not reflect the future changes.
2. Earning Theory of Capitalization
According to this theory, firm should be capitalized on the basis of its expected earning A firm is
profit is seeking entity and hence its value is determiner according to What it earns. The probable
earning are forecast and them they are capitalized at a normal representative rate of return.
Capitalization of a company as per the earning theory can thus be determined with help following
formula.
Capitalization = Annual Net Earnings X Capitalization Rate
Thus for the purpose of determining amount of Capitalization in an enterprise the financial
manager has to fist estimate of annual net earnings of the enterprise where after he will have to
determine the capitalization rate. The future earning cannot be forecast exactly and depend to a
large extent on such external factors which are beyond the control of management.

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CAPITAL

 The combination of long-term sources of funds, i.e. equity

 It focuses on choosing such a proposal which will minimize

 Leverage: Leverage can be both positive or negative, i.e. a modest

 Purchase of assets at higher prices-

 A company’s floatation n boom period-

 Inadequate provision for depreciation-

 Liberal dividend policy-

 Purchase of assets at deflated rates

 Conservative dividend policy

 Floatation of company in depression stage

 High efficiency of directors

 Adequate provision of depreciation

 Large secret reserves are maintained.

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