F INA NC I A L

MA N A G E M E NT
BY

VIJAY ANANTH P
III BBA C
 UNIT – II

CAPITALISATION
• DEFINITION : CAPITALISATION IS SUM OF THE PAR VALUE OF THE STOCKS AND
BONDS OUTSTANDING.

• MEANING : THE TERM CAPITALISATION IS SYNONYMOUS WITH THE FINANCIAL

PLANNING. IT COVERS DECISION REGARDING THE TOTAL AMOUNT OF CAPITAL TO
BE RAISED, THE TYPES OF SECURITIES TO BE ISSUED FOR THE PURPOSE OF
RAISING SUCH CAPITAL AND THE RELATIVE PROPORTION OF THE DIFFERENT
SECURITIES AND THE ADMINISTRATION OF THE CAPITAL.
• THEORIES OF CAPITALISATION :
• I. EARNING THEORY :
ACCORDING TO THIS THEORY, THE TRUE VALUE OF AN ENTERPRISE DEPENDS
UPON ITS EARNINGS AND THE EXPECTED FAIR RATE OF RETURN ON ITS CAPITAL INVESTED.
THUS, THE VALUE OF CAPITALISATION IS EQUAL TO THE CAPITALISED VALUE OF THE ESTIMATED
EARNINGS.

II. COST THEORY :

ACCORDING TO THIS THEORY, THE TOTAL AMOUNT OF CAPITALISATION OF A NEW
COMPANY IS ARRIVED AT BY ADDING UP THE COST OF FIXED ASSETS, THE AMOUNT OF
WORKING CAPITAL, THE COST OF ESTABLISHING THE BUSINESS AND THE EXPENSES OF
PROMOTION.
OVER-CAPITALISATION

• DEFINITION : WHENEVER THE AGGREGATE OF THE PAR VALUE OF STOCK AND BONDS
OUTSTANDING EXCEEDS THE TRUE VALUE OF FIXED ASSETS, THE CORPORATION IS SAID TO BE
OVER-CAPITALISED.

• MEANING : OVER-CAPITALISATION MEANS MORE CAPITAL THAN ACTUAL REQUIREMENT. IN

TERMS OF EARNINGS, OVER-CAPITALISATION ARISES WHEN THE EARNINGS OF THE COMPANY
ARE NOT SUFFICIENT TO GIVE A NORMAL RETURN ON CAPITAL EMPLOYED BY IT.
CAUSES

• I. RAISING OF MORE MONEY BY ISSUE OF SHARES AND DEBENTURES THAN WHAT THE
COMPANY CAN PROFITABLY USE.
• II. INCURRING HIGH PROMOTIONAL EXPENSES, EXCESSIVE PRELIMINARY EXPENSES ETC..
MAY LEAD TO OVER-CAPITALISATION.
• III. BUYING ASSETS OF LOWER VALUE AT HIGHER PRICES LEADS TO OVER-
CAPITALISATION.
• IV. HIGHER RATE OF TAXATION.
• V. PROMOTION DURING BOOM PERIOD.
• VI. UNDER ESTIMATION OF THE CAPITALISATION RATE.
REMEDIAL MEASURES
I. REDEMPTION OF PREFERENCE SHARES :
IF A COMPANY HAS ISSUED REDEEMABLE PREFERENCE SHARES AND
IF THEY ARE FULLY PAID UP, THEY CAN BE REDEEMED.
II. ADJUSTMENT IN DEBT CAPITAL :
IF CAPITAL IS SUFFICIENT FOR OPERATIONS, SOME POSITION OF
DEBTS CAN BE REDEEMED AND THE BURDEN OF INTEREST MAY BE REDUCED.
III. RECAPITALISATION :
IF CONDITION HAS BECOME SERIOUS THE RECAPITALISATION
SHOULD BE ADOPTED.
ADVANTAGES & DISADVANTAGES
• ADVANTAGES :
• I. THE COMPANY HAS EXCESS CAPITAL OR CASH ON THE BALANCE SHEET, WHICH CAN SIMPLY PUT THE FUNDS
IN THE BANK AND CAN EARN A NOMINAL RATE OF RETURN ON IT, WHICH STRENGTHENS THE LIQUIDITY
POSITION OF THE COMPANY.

• II. IT RESULTS IN A HIGHER VALUATION OF THE COMPANY, WHICH MEANS THAT THE COMPANY, IN CASE OF AN
ACQUISITION OR A MERGER, CAN GET A HIGHER PRICE FOR ITSELF AS IT CAN TAKE EXCESS CAPITAL AND CASH
ON ITS BALANCE SHEET.

• DISADVANTAGES :
• I. THE SHAREHOLDER’S CONFIDENCE IN THE COMPANY IS LOST BECAUSE OF THE UNDERUTILISATION OF FUNDS,
WHICH RESULTS IN A FALL IN THE PRICE OF A MARKET SHARE.

• II. IT LEADS THE UNDERUTILISATION OF AVAILABLE RESOURCES AND ALSO HIGHER RATE OF TAXATION ON THE
INCOME STATEMENT OF THE COMPANY.
UNDER-CAPITALISATION
• DEFINITION : A CORPORATION MAY BE UNDER-CAPITALISED WHEN THE RATE OF
PROFIT IS HIGH IN RELATION TO THE RETURN ENJOYED BY SIMILARLY SITUATED
COMPANIES IN THE SAME INDUSTRY.

• MEANING : UNDER-CAPITALISATION IS JUST THE REVERSE OF OVER-

CAPITALISATION AND OCCURS WHEN A COMPANY’S ACTUAL CAPITALISATION IS
LOWER THAN ITS PROPER CAPITALISATION AS WARRANTED BY ITS EARNING
CAPACITY.
CAUSES & REMEDIES
• CAUSES :
• I. UNDER ESTIMATION OF EARNINGS AND CAPITAL REQUIREMENTS OF THE COMPANY.
• II. PROMOTION DURING DEPRESSION.
• III. MAINTENANCE OF HIGH STANDARD OF EFFICIENCY.
• IV. IF THE COMPANY’S ASSETS ARE SOLD BY THE MANAGEMENT AT HIGHER PRICE THAN THEIR BOOK
VALUE, THE RESULTANT CAPITAL GAINS LEAD THE COMPANY TO UNDER-CAPITALISATION.

• REMEDIES :
• I. IF UNDER-CAPITALISATION IS DUE TO INADEQUACY OF CAPITAL, THEN FRESH UN-ISSUED SHARES MAY
BE ISSUED TO THE PUBLIC TO INCREASE THE TOTAL CAPITAL.

• II. THE SHARES OF THE UNDER-CAPITALISED COMPANY MAY BE SPLIT INTO SHARES OF SMALL
DENOMINATION TO BRING DOWN THE DIVIDEND PER SHARE.
Effects on Over-capitalisation Under-capitalisation

1. Share holders i. A low rate of return i. High rate of earnings per share
ii. Uncertain and irregular income ii. Capital value of the share is
iii. Capital value of the share is increased.
reduced.

2. Company i. The credit worthiness of such i. The high rate of earnings per
company is reduced. share may increase competition.
ii. Loss of goodwill, manipulation of ii. The employees demand high
accounts etc. share in the increased profits of
iii. Maintenance, renewals and the company.
replacement programmes are
suspended.

3. Society i. The quality of the product is i. The consumers are not

affected. benefited in this state.
ii. Loss of employment as well as ii. The government can charge
production company. excess profit-tax from such
companies.
WATERED CAPITAL

• DEFINITION : A STOCK IS SAID TO BE WATERED WHEN ITS TRUE

VALUE IS LESS THAN ITS BOOK VALUE

• MEANING : WHEN THE REAL VALUE OF THE ASSETS OF THE COMPANY

IS LESS THAN ITS PAID-UP SHARE CAPITAL, A PART OF THE CAPITAL IS
NOT REPRESENTED BY ITS ASSETS, THE COMPANY’S CAPITAL IS
TERMED AS “WATERED CAPITAL”.
CAUSES

• I. UNSUCCESSFUL ADOPTION OF THE DEPRECIATION POLICY.

• II. ACQUISITION OF A COMPANY’S POSSESSIONS AT A SIGNIFICANTLY
HIGHER PRICE.
• III. PURCHASE OF WORTHLESS INTANGIBLE ASSETS AT A MUCH
HIGHER PRICE.
CAPITAL STRUCTURE

DEFINITION : CAPITAL STRUCTURE REFERS TO THE KIND OF SECURITIES THAT MAKE UP

THE CAPITALISATION.

MEANING : IT MEANS THE COMPOSITION OF LONG-TERM SOURCES OF FUNDS SUCH

AS ORDINARY SHARES, PREFERENCE SHARES, DEBENTURES, BONDS, LONG-TERM DEBTS
AND THE LIKE. IT REFERS TO THE KIND AND PROPORTION OF SECURITIES FOR RAISING
LONG-TERM FUNDS.
FACTORS AFFECTING CAPITAL STRUCTURE
• I. INTERNAL FACTORS :
• A] NATURE OF BUSINESS : IT IS AN IMPORTANT FACTOR WHICH AFFECTS THE CAPITAL STRUCTURE OF THE
COMPANY. BUSINESS ENTERPRISES WHICH HAVE STABILITY IN THEIR EARNINGS CAN AFFORD TO RAISE
FUNDS THROUGH DEBENTURES OR PREFERENCE SHARES.

• B] SIZE OF THE COMPANY : COMPANIES WHICH ARE OF SMALL SIZE FIND IT DIFFICULT TO OBTAIN LONG-TERM
DEBT. LARGE COMPANIES ARE GENERALLY CONSIDERED TO BE LESS RISKY BY THE INVESTORS. THEREFORE,
THEY CAN ISSUE DIFFERENT TYPES OF SECURITIES AND COLLECT THEIR FUNDS FROM DIFFERENT SOURCES.

• C] DEVELOPMENT AND EXPANSION PLANS : CAPITAL STRUCTURE IS AFFECTED BY ITS DEVELOPMENT AND
EXPANSION PROGRAMMES IN FUTURE. WHILE PLANNING CAPITAL STRUCTURE THE PROVISION FOR FUTURE
SHOULD ALSO BE VIEW. IT WILL ALWAYS BE SAFE TO KEEP THE BEST SECURITY TO BE ISSUED IN THE LAST,
INSTEAD OF ISSUING ALL TYPES OF SECURITIES IN ONE INSTALMENT.
• II. EXTERNAL FACTORS :
• A] CONDITIONS OF CAPITAL MARKET : CONDITION OF CAPITAL MARKET HAS AN IMPORTANT
BEARING ON THE CAPITAL STRUCTURE OF THE COMPANY BECAUSE INVESTOR IS VERY OFTEN
INFLUENCED BY THE GENERAL MOOD OR SENTIMENT OF THE CAPITAL MARKET.
• B] COST OF CAPITAL : COST OF CAPITAL IS AN IMPORTANT DETERMINANT OF CAPITAL
STRUCTURE. IT INFLUENCES THE PROFITABILITY AND GENERAL RATE OF EARNINGS, A COMPANY
MUST RAISE CAPITAL FUNDS BY BORROWING WHEN RATE OF INTEREST IS LOW AND BY
ISSUING OF EQUITY SHARES WHEN RATE OF EARNINGS AND SHARE PRICES ARE HIGH.
• C] LEGAL REQUIREMENTS : EVERY COMPANY HAS TO COMPLY THE LAW OF THE COUNTRY
REGARDING THE ISSUE OF DIFFERENT TYPES OF SECURITIES. THEREFORE, HANDS OF THE
MANAGEMENT ARE TIED BY THESE LEGAL RESTRICTIONS.
BALANCED CAPITAL STRUCTURE

• MEANING : AN OPTIMAL OR BALANCED CAPITAL STRUCTURE IS THE IDEAL COMBINATION OF DEBT AND
EQUITY THAT ATTAINS THE STATED MANAGERIAL GOAL IN THE MOST RELEVANT MANNER. THAT IS
MAXIMISING OF MARKET VALUE PER SHARE OR MINIMISATION OF COST OF CAPITAL.
• CHARACTERISTICS :
• I. SIMPLICITY : A SOUND CAPITAL STRUCTURE CLEARLY DEFINES THE RIGHTS ATTACHED TO EACH TYPE
OF SECURITIES FOR EASY MANAGEMENT.
• II. ECONOMY : CAPITAL MIX SHOULD BE IN SUCH A WAY AS TO ENTIL THE MINIMUM COST OF ISSUE OF
SECURITIES AND COST OF FINANCING ETC..
• III. CONTROL : SOUND CAPITAL STRUCTURE SHOULD PROVIDE MAXIMUM CONTROL OF THE EQUITY
SHAREHOLDERS ON THE COMPANY’ AFFAIRS.
TRADING ON EQUITY
• MEANING : THE USE OF LONG-TERM FIXED INTEREST BEARING DEBT AND PREFERENCE SHARE
CAPITAL ALONG WITH EQUITY SHARES IS CALLED TRADING ON EQUITY.
• LIMITATIONS :
• I. ONE CRITICAL DISADVANTAGE IS THE UNCERTAINTY OF WHETHER A BUSINESS WILL BE ABLE
TO SERVICE DEBT.
• II. IF THE BORROWED AMOUNT AND OVERALL COST OF CAPITAL ARE NOT DOWN TO THE LEVEL OF
REASONABLE RISK A COMPANY CAN DIGEST, THAN TRADING ON EQUITY CAN PROVE
DISADVANTAGEOUS.
THANK YOU…