CAPITAL

STRUCTURE
“Mix of different sources of long term
funds such as– equity shares, preference
shares, long term loans, retained
earnings.
Capital structure vs
financial structure
 Financial structure refers to the way the
firm’s assets are financed. i.e. long term +
short term sources of funds.
 Capital structure is the permanent
financing of the company--- long term
debt and shareholders funds
 Capital structure is only a part of its
financial structure.
Debt vs. equity

 Debt is a liability-payment of interest,

irrespective of profit.
 Equity- owner’s fund-dividend depends
upon profit.
 Higher content of debt increases the risk
 Raising debt is cheaper
Optimum capital structure
( Fair capital)
 Market value per equity share is the
maximum.
 Relationship of debt and equity which
maximizes the value of company’s
shares in the stock exchange.
 consideration-
 Management should take advantage of
favorable financial leverage, i.e. r >ke
 Take advantage of leverage offered by
the corporate taxes.
 Avoid a perceived high risk capital
structure.
Basis of capitalisation:-

 Cost theory:-
Total amount of capitalisation –
Cost of fixed assets + amount of
working capital + cost of establishing the
business say preliminary expenses,
underwriting commission etc.
 Earning theory:-
Depends upon earning capacity.

Capitalisation = average earnings /

Capitalisation rate.
Over capitalisation

 Earning’s capacity doesn't justify the

amount of capitalisation
 Actual profits are not sufficient to pay
interest and dividends at fair rates.
A business is said to be overcapitalized
when---
 Capitalisation exceeds the real
economic value of its net assets.
 A fair return is not realized on
capitalisation
 Business has more net assets than it
needs.
 Over capitalization may take place when-

a) Prospective income is overestimated at the start.

b) Unpredictable circumstances reduce the income.
c) The total funds required have been
overestimated.
d) Excess funds are not effectively employed.
e) The low yield makes it difficult for a firm to raise
new capital particularly equity capital.
f) The market value of securities falls below the
issue price.
 Evils of over capitalization-
On Company;
Market value of share will fall
Find it difficult to raise new capital
Increase in cost of production
Increase in the price of the products
Bad financial condition
 On the owners:
Shareholders are not in a position to sell
their shares profitably.
No dividends, no bonus shares.
• On consumers:
Products become costly
Quality may go down
 On Society:
An overcapitalized firm is a curse to the
society.
go into liquidation
liquidation would be great loss to the
society.
 Remedies:
1. reduction in funded debt.
2. Reduction in interest rate on bonds
3. Reduction of preference shares.
4. Reduction in par value of shares
5.Reduction in number of shares of
common stock
6. Increase in efficiency.
 Under capitalisation:-
Under capitalisation exits when a co. earns
sufficient income to meet its fixed interest and
and fixed dividend charges and is able to
pay considerable rate on its equity shares
than the prevailing rate on similar shares in
similar business.
Causes of Under capitalisation---
1. Under estimation of earnings
2. Underestimation of capital requirements by
promoters
3. Unforeseen increase in earnings
4. Efficient finance management
5. Efficient management of all resources
 Evils of under capitalisation:-
1.Higher dividend rates----excessive
speculation
2Reduction in marketability---
3.Cut throat competition
4Consumer may think , they are exploited
5.High tax, govt. interference
6. Labor unrest
 Remedies-
1. Shares split into small denomination to
bring down the amount of dividend
2. Capitalize reserve and surplus
3. Raise more capital

Inadequate capital vs undercapitalization—

Watered capital--
Features of an appropriate
capital structure
 1.Profitability---minimise cost and maximize
EPS
 2.Solvency—firm does not run the risk of
becoming insolvent
 3.Flexibility
 4.conservatism-debt content in the total capital
structure does not exceed the limit which the
company can bear.
 5 Control-minimum risk loss of control
Factors determining
capital structure:
 Trading on equity
 Retaining control
 Nature of enterprise
 Legal requirements
 Purpose of financing
 Period of finance
 Market sentiments
 Requirement of investors
 Size of the company
 Govt.policy
 Provision for the future