Capitalization, Capital Structure

Capitalization- It refers to the total amount of securities

issued by a company

 . Market capitalisation formula: outstanding shares

x share value = market cap
 So if a company had 100,000 outstanding shares and they were worth $10
each, then the market capitalisation would be $1,000,000

The market capitalisation therefore shows how much it would cost to purchase
the entire company at the current share value, in other words, buying all of
its shares. When a company's share price goes up or down, the market
capitalisation will increase or decrease respectively
 capital structure –It refers to the kinds of securities and
the proportionate amounts that make up capitalization. For
raising long-term finances, a company can issue three types
of securities viz. Equity shares, preference shares, and
Debentures. A decision about the proportion among these
type of securities refers to the capital structure of an
enterprise
a. Equity shares only

b. Debentures only

c. Equity and preference shares

d. Equity shares and debentures

e. Equity shares, preference shares, and

debentures
The optimal capital structure may be defined as, “that capital
structure or combination of debt and equity that leads to the
maximum value of the firm.” Optimal capital structure maximises
the value of the company and hence the wealth of its owners and
minimises the company’s cost of capital.
How a optimal capital structure can obtain:-

1. If the return on investment is higher than the fixed cost of funds, the
company should prefer to raise funds having a fixed cost, such as
debentures, loans and preference share capital. It will increase earnings
per share and market value of the firm.

2. When debt is used as a source of finance, the firm saves a considerable

amount in payment of tax as interest is allowed as a deductible expense
in computation of tax. Hence, the effective cost of debt is reduced,
called tax leverage. A company should take advantages of tax leverage.

3. The firm should avoid undue financial risk attached with the use of
increased debt financing. If the shareholders perceive high risk in using
further debt-capital, it will reduce the market price of shares.

4. The capital structure should be flexible.

Theories of capital structure

1. Net Income Approach

2. Net Operating Income Approach
3. The Traditional Approach
4. Modigliani and Miller Approach
 Net Income theory was introduced by David Durand. According to
this approach, the capital structure decision is relevant to the
valuation of the firm. This means that a change in the financial
leverage will automatically lead to a corresponding change in the
overall cost of capital as well as the total value of the firm.

 Assumptions of NI approach:
 There are no taxes
 The cost of debt is less than the cost of equity.
 The use of debt does not change the risk perception of the
investors
This theory as suggested by Durand . It is dramatically opposite to
the net income approach. According to this approach, change in
the capital structure of a company does not affect the market
value of the firm and overall cost of capital remains constant
irrespective of the method of financing.

Assumptions

i. The business risk remains constant at every level of debt equity

mix
ii. There are no corporate taxes.

So, according to Net Operating Income Approach, the financing mix

is irreverent and it does not affect the value of the firm.
Traditional approach . It is in between the other two
theories named as Net income theory and Net
operating income theory.

This approach has been formulated by Ezta Solomon and

Fred Weston. This theory gives the right and correct
combination of debt and equity shares and always lead
to enhanced market value of the firm. This approach
tells about the financial risk which will be undertaken
by the equity shareholders. This approach focuses
mainly on increasing the cost of equity capital which
will be done after a level of debt in the capital structure
Modigliani and Miller Approach

This theory suggest that change in the debt equity mix does not affect the capital structure
of company. This approach is similar to NOI Theory.

 Assumptions
 The capital market is perfect in the sense that investors have perfect knowledge of
market forces; they are free to buy and sell securities; the cost of transactions is zero;
and they behave rationally.

 Firms can be classified into different group consisting of firms having equal business
risks. They can be divided into equivalent risk class.

 All firms distribute the entire earning among their shareholders in the form of
dividend. It means dividend payout ratio is 100%.
 There are no corporate taxes
1. Financial leverage
2. Growth and Stability of sales
3. Cost of Capital
4. Risk
5. Cash flow Ability to service debt
6. Nature and size of a firm
7. Control
8. Flexibility
9. Requirements of investors
10. Capital market conditions
11. Purpose of Financing
12. Period of finance