CAPITAL STRUCTURE

Capital Structure Composition or

make up of its capitalization and it
includes all long term capital
resources viz: loans, reserves, shares
and bonds.
A decision about the proportion among
these types of securities refers to the
capital structure.

CAPITALISATION, CAPITAL
STRUCTURE, FINANCIAL
STRUCTURE
Capitalization: Total amount of
securities issued by a company
Capital Structure: Kinds of securities
and the proportionate amounts that
make up capitalization.
Financial Structure: Entire liabilities
side of the balance sheet.
CAPITALISATION
According 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
STRUCTURE
Equity shares only
Equity and preference shares
Equity shares and Debentures
Equity shares, Preference shares and
Debentures.
TRADING ON EQUITY
The use of long term fixed interest
bearing debt and preference share
capital along with equity shares is
called Financial Leverage or Trading
on Equity.
IMPORTANCE
The 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 owners 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 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 companys 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-CAPITALIZATION
Definition : 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 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

REMEDIES
Over-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 CAPITALISATION
Reverse of Over capitalization
Actual 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-
capitalization
1. 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-
capitalization
1. 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-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.