CAPITAL STRUCTURECAPITAL STRUCTURE

Capital Structure Capital Structure – Composition – Composition or make up of its capitalization or make up of its capitalization and it includes all long term and it includes all long term capital resources viz: loans, capital resources viz: loans, reserves, shares and bonds.reserves, shares and bonds.

A decision about the proportion A decision about the proportion among these types of securities among these types of securities refers to the capital structure.refers to the capital structure.

CAPITALISATION, CAPITAL CAPITALISATION, CAPITAL STRUCTURE, FINANCIAL STRUCTURE, FINANCIAL

STRUCTURESTRUCTURECapitalization: Total amount of

securities issued by a companyCapital Structure: Kinds of

securities and the proportionate amounts that make up capitalization.

Financial Structure: Entire liabilities side of the balance sheet.

CAPITALISATIONCAPITALISATIONAccording to Gerstenbug,

capitalization is that which "comprises of a company's ownership capital which includes capital stock and surplus in whatever form it may appear and borrowed capital which consists of bonds or similar evidences of long-term debt“.

PATTERN OF CAPITAL PATTERN OF CAPITAL STRUCTURESTRUCTURE

Equity shares onlyEquity and preference sharesEquity shares and DebenturesEquity shares, Preference shares

and Debentures.

TRADING ON EQUITYTRADING ON EQUITYThe use of long term fixed

interest bearing debt and preference share capital along with equity shares is called Financial Leverage or Trading on Equity.

IMPORTANCEIMPORTANCEThe long term fixed interest

bearing debt is employed by a firm to earn more from the use of these sources than their cost so as to increase the return on owner’s equity.

Capital structure cannot affect the total earning of a firm but it can affect the share of earnings available for equity shareholders.

IMPACT OF LEVERAGEIMPACT OF LEVERAGE ABC company has currently an all equity capital

structure consisting of 15,000 equity shares of Rs.100 each. The management is planning to raise another Rs.25 lakhs to finance a major programme of expansion and is considering three alternative methods of financing:

To issue 25,000 equity shares of Rs.100 each To issue 25,000, 8% debentures of Rs.100 each To issue 25,000, 8% preference shares of Rs.100 each

The company’s expected earnings before interest and taxes will be Rs.8

lakhs. Assuming a corporate tax rate of 50%, determine the EPS in each

alternative.

Particulars Alternative I

Alternative II

Alternative III

EBIT 8.00 8.00 8.00

Less: Interest - 2.00 -

Earning after Interest and before Tax

8.00 6.00 8.00

Less: Tax 50% 4.00 3.00 4.00

EAT 4.00 3.00 4.00

Less: Preference Dividend

- - 2.00

Earnings available to Equity Shareholders

4.00 3.00 2.00

No. of Equity Shares 40,000 15,000 15,000

4,00,000 3,00,000 2,00,000

EPS Rs.10 Rs.20 Rs.13.33

OVER-CAPITALIZATIONOVER-CAPITALIZATIONDefinition : When an enterprise

possesses excess of assets in relation to its requirement. An over capitalized company can be like a very fat person who cannot carry his weight properly. Such a person is prone to many diseases and is certainly not likely to be sufficiently active. Unless the condition of overcapitalization is corrected, the company may find itself in great difficulties.

A company is said to be over capitalized when its earnings are not sufficient to yield a fair return on the amount of shares or debentures. In other words, when a company is not in a position to pay dividends and interests on its shares and debentures at fair rates, it is said to be over capitalized. It means that an over-capitalized company is unable to pay a fair return on its investment.

CAUSES OF OVER CAPITALIZATIONCAUSES OF OVER CAPITALIZATION

Some of the important reasons of over-capitalization are:

Idle funds Over-valuation Fall in value Inadequate depreciation provision Floating of excess capital. Purchasing property at an inflated price. Borrowings at a higher than normal rate. Purchase of assets in the boom period. High rates of taxation. Liberal dividend policy. Wrong estimation of future earnings. Low production

REMEDIESREMEDIESOver-capitalization can be remedied

by reducing its capital.Reduction of funded debts.Reduction of interest on debentures

and loans.Reduction of preference shares.Reduction of face value of the shares.Reduction in the number of equity

shares.Ploughing back of profits.

UNDER CAPITALISATIONUNDER CAPITALISATIONReverse of Over capitalizationActual capitalization is lower than

the proper capitalization.

Under-capitalization is just reverse of over-capitalization. The state of under-capitalization is where the value of assets are much more than it appears in the books of the company. In well established companies, there is a large appreciation in assets, but such appreciation is now shown in the books. As against over-capitalization, under-capitalization is associated with an effective utilization of investments, an exceptionally high rate of dividend and enhanced prices of shares. In other words, the capital of the company is less in proportion to its total requirements under the state of under-capitalization.

Causes of Under-Causes of Under-capitalizationcapitalization1. Under estimation of capital

requirements.2. Under estimation of future

earnings.3. Promotion during deflation.4. Narrow dividend policy.5. Desire of control.6. Excessive depreciation provided.7. Maintenance of high efficiency.8. Secret reserves.9. Difficulty in procurement of capital.

Remedies of under-Remedies of under-capitalizationcapitalization1. Splitting up of shares. 2. Increasing the number of

shares.3. Increase in the par value of

shares.4. Issue of Bonus shares.5. Fresh issue of shares.

Effects of Under-Effects of Under-capitalization.capitalization.

1. Limited marketability of shares.2. Cut-throat competition.3. Industrial unrest.4. Dissatisfaction of customers.5. Government control.6. Inadequacy of capital.7. Secret reserves and window

dressing of accounts.8. High taxes.9. Manipulation of share values.