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Strategic Financial Management - Capitalsation - Notes - Finance, Study notes of Business Administration

Theories Of Capitalization, Cost Theory, Earnings Theory, Disadvantages, Over-Capitalisation, Differentbetween Book Value And Real Worth Of Assets, Promotional Expenses, Market Bsentiment, Under-Estimation Of Capital Rate, Disadvantages, Effects, On Corporation, On Owners, Remedies, Reduction Infunded Debt, Redemption Of Preferred Stock, Ifitcarriesa High Divid End Rate, Reductionin Number Of Sharesof Common Stock

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2011/2012

Uploaded on 02/17/2012

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CAPITALISATION
The capital structure or the capitalization of an undertaking refers to the way in which is
long-term obligations are distributed between different classes of owners and creditors. The
capitalization of an enterprise depends on its expected average net income. From the view
point of investors, the yield on the securities which have been issued should be comparable
to the yields of other securities which are subject to the same kinds of risk. The rate at which
prospective earnings are capitalized will vary, for it is a subjective measure of risk and
would, therefore, be different for firms in different fields of business activity. If the income
is expected to be regular, the rate would be lower than that for a highly speculative venture.
It would be higher for a new venture than for one which is well established. It would be
different for the same firm under different conditions of trade. It would be low then business
conditions are brisk, and high when they are slack, for then a greater risk is involved in
capitalization.
The need for capitalization arises in all the phases business cycle. Estimation of total funds
of capital arises in the initial stages to start the business unit. The requirement, Land &
Building etc. Funds are also needed to meet the working capital through which raw
materials, cash, components and stocks are provided.
At the time of growth stage, finance in needed for expansion, introducing technology,
modernization programmes. Hence arrangement of capital in made through proper planning.
Thought the firm enjoys highest reputation, goodwill and credit worthiness at the saturation
stage, it has to diversify its products to stay on in the market. Product
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CAPITALISATION

The capital structure or the capitalization of an undertaking refers to the way in which is long-term obligations are distributed between different classes of owners and creditors. The capitalization of an enterprise depends on its expected average net income. From the view point of investors, the yield on the securities which have been issued should be comparable to the yields of other securities which are subject to the same kinds of risk. The rate at which prospective earnings are capitalized will vary, for it is a subjective measure of risk and would, therefore, be different for firms in different fields of business activity. If the income is expected to be regular, the rate would be lower than that for a highly speculative venture. It would be higher for a new venture than for one which is well established. It would be different for the same firm under different conditions of trade. It would be low then business conditions are brisk, and high when they are slack, for then a greater risk is involved in capitalization.

The need for capitalization arises in all the phases business cycle. Estimation of total funds of capital arises in the initial stages to start the business unit. The requirement, Land & Building etc. Funds are also needed to meet the working capital through which raw materials, cash, components and stocks are provided.

At the time of growth stage, finance in needed for expansion, introducing technology, modernization programmes. Hence arrangement of capital in made through proper planning.

Thought the firm enjoys highest reputation, goodwill and credit worthiness at the saturation stage, it has to diversify its products to stay on in the market. Product

diversification , improvement in the existing products requires huge sums of money. this can be arranged through reorganizing the capital structure.

Now, the existing period in identified ―Era of mergers, acquisitions and Joint venture 2 01 6. The economy has influenced mergers of big giants in the country. Ex: Hindustan Levers with Brooke Bond India Ltd. and many others. the success of Mergers of the companies in European Countries encouraged the Indian Corporate to have same type of business policies. This increases the potentiality of business establishment to economies their scale of operation. Even at this stage, the concept of Capitalization in extensively used. This provides an acceptable formula for exchange their business terms and restructure the capital for its effective and efficient usage.

Theories of Capitalization

Identifying the requirement of capitalization, it is referred as determination of the value through which a company has to be capitalized. This helps the management in deciding number of securities that are to be offered, the appropriate mix that has To be designed between the debt and Equity. The final decision on this matter will be made by considering two popular Capitalisation Theories: They are

  1. Cost Theory: Under this theory, the total value of the Capitalisation in calculated by taking the total cost of acquiring fixed assets and the current assets. In a real life situation, the amount of capitalization for a new business is arrived at, by adding up the cost of fixed assets, the amount of working capital and the cost of establishing the business (Plant & machinery, land and building, cost & raw materials, Preliminary expenses, floatation cost of shares & debentures etc ……..)

Cost theory helps promoters to find the total amount of capital needed for establishing the business. According to Husband and Dockeray, cost principle may appear to give an assurance that capitalization would, at the best be representative of the value of the enterprise.

OVER-CAPITALISATION

Meaning: A business is said to be over-capitalised when: F 07 6 Capitalisation exceeds the real economic value of its assets: F 07 6 A fair return is not realized on capitalization; and F 07 6 Business has more net assets than it needs. Example of

overcapitalized situation

Balance Sheet

Liabilities Amount (Rs.) Assets Amount (Rs) Equity capital Debentures Current Liabilities

Fixed Assets Currents Liabilities

In the above example, the component of equity capital is more in relation debt; equity ratio. The long term funds are not optimally deployed on fixed assets. A porting of long term fends is allocated to current assets. The current liabilities are not sufficient to meet the requirement of current assets. Hence, it is in ferred that, the available funds are not judiciously utilized.

Over- capitalization may be considered to be in the nature of redundant capital. It is generally found in companies which have depleted assets such as oil and mining concerns. This condition is commonly known as ―water stock 2 01 6. a company is said to be over-capitalised when the aggregate of the par value of its shares and debentures exceeds the true value of its fixed assets, in other words, over-capitalization takes place when the stock is watered or diluted. It is wrong to identify over-capitalization with excess of capital, for there is every possibility that an over-capitalized concern may be confronted with problems of illiquidity. The correct indicator of over -capitalization is the earnings of the company. Over- capitalization does not imply a surplus of funds any more than under- capitalization indicates a shortage of funds. It is quite possible that the company

may have more funds and yet have low earnings. Often, funds may be inadequate, and capitalization. The average distributable income of a company may be insufficient to pay the contract rate of return on fixed income securities elsewhere. Over- capitalization may take place when:

F 07 6 Prospective income is over-estimated at the start; F 07 6 Unpredictable circumstances reduce down the income; F 07 6 The total funds requires have been over-estimated; F 07 6 Excess funds are not efficiently employed; F 07 6 The low yield makes it difficult for a firm to raise new capital, particularly equity capital; F 07 6 The market value of the securities falls below the issue price; F 07 6 Arbitrary occasions are taken on the charges against income arising form depreciation,

obsolescence, repairs and maintenance; F 07 6 The low yield may discourage competition and this limited competition becomes a social

disadvantage.

Over-capitalization may go unnoticed during the period a business flourishers and may be encouraged by prosperity. However , it may be productive of ill-consequences when the distributable income diminishes under the pressure of declining demand and falling prices.

Causes

The causes of Over-capitalization are:

  1. Different between Book Value and Real Worth of Assets: It is possible that a company may have purchased its assets at a value which is higher than their real worth. This gap between the book value and the real worth of assets may account for over-capitalization.

9. Under-estimation of Capital Rate: If the actual rate at which a company‘s earnings are capitalised, the capitalization rate is under- estimated, and this results into over-capitalization.

Advantages

  1. The management is assured of adequate capital for present operations.
  2. If conserved, an Excess of capital may preclude the necessity of financing some time in the future when capital is needed and can be obtained only with difficulty.
  3. Ample capital has a beneficial effect on an organisation‘s morale.
  4. ample capitalization gives added flexibility and latitude to the

corporation‘s operation.

  1. Allegedly, losses can be more easily observed without endangering the future of the corporations.
  2. The rate of profits tends to discourages possible competitors.
  3. For public utility companies, when the price of service is based upon a

―fair return to capital 2 01 6, a high captitalisation may be advantageous.

Disadvantages

  1. When Stock is issued in excess of the value of the assets received, a company‘s stock is said to be ―watered 2 01 6. Watered stock may arise by the issued of stock in any of the following ways.

a) For over-valued property or services;

b) As a bonus;

c) For cash at less than the par or stated value of the stock;

d) As a stock dividend when the surplus of the corporation is not offset by actual assets of at least an equal amount. If known to be watered, stock has a market value which is lower than it would

enjoy if it were not wantered – until the ―water 2 01 6has been

―squeezed out 2 01 6(until sufficient assets have been acquired from earnings to offset the excess of stock.

  1. There is the possibility of stockholders‘ liability to creditors in case a court should conclude that the stock was heavily watered, that the corporation did not receive ―reasonable 2 01 6or ―proper 2 01 6value for the stock. This liability would attach only to such stock as was received as a result of an unreasonably excessive valuation of properties or services given in exchange for such stock.
    1. There may be a possible difficulty of raising new capital funds. This may

be obviated. However, by the use of ―no-par 2 01 6stock.

  1. In some States, the rate of the annual franchise tax depends on the amount of outstanding stock. Large capitalization‘s in such states may attract correspondingly large franchise taxes.
  2. There is a tendency to raise the prices of a company‘s products and/or to lower their quality. This may be partly or wholly forestalled, however, by competition and would apply more to public utility services than to others, for public utility rates are based, in part, upon a ―reasonable 2 01 6return on capital.
  3. Over-capitalization may include a failure, and the failure of a corporation may bring about an unhealthy economic situation.
  4. The ethical atmosphere of a business is not improved by over- capitalization.
  5. The almost necessary ―rigging 2 01 6of the market for the securities which first offered to the public usually results in market value losses to the investors after this support is removed. (This is not to condemn the legitimate support of the market in the above- board floatation of a security issue).

Moreover, because of a fall in dividends, shareholders lose heavily. They develop the feeling that the corporation is funded on shifting sands.

3. On Consumers: A corporation cannot resist the temptation of increasing the prices of its products to inflate its profits. At the same time, there is every possibility that the quality of the product would go down. The Consumer may thus suffer doubly. 4. On Society: over-capitalized concerns often come to gr5ief in the course of time. They lose the backing of owners, customers and society at large. They suffer multi-pronged attacks from various sections of society. They are not in a position to face competition. No wonder, therefore, that they gradually draw closer to a situation ordering liquidation. While the existence of such corporation cannot be justified, their extinction would cause irreparable damage to society.

Remedies

Over-capitalization is not easily rectified, chiefly because the factors which lead to it in the first place do not entirely disappear.

In many cases, over-capitalization and excessive debts co-exist and an attack on one often involves the other. Indeed, a correction of the former usually involves the latter. With this co-relationship in mind, it may be said that correction of over-capitalization may involve one or more of the following procedures:

1. Reduction in Funded Debt: This is generally impossible unless the company goes through re-organization. Funds have to be raised for the redemption of bonds; and the Sale of large quantities of stock, presumably at low prices, would probably do more damage than good. Moreover, the creation of as much stock as the bonds retired would not reduce the total captilisation. A true reduction in capitalization can be effected only if the debts are retired from earnings.

2. Reduction in Interest Rate on Bonds: Here again, without a through re- organisation, it would probably not be practicable to effect a reduction in the interest rate on bonds. A refunding operation, however, might be performed; but the saving in interest payments on the lower-rate refunding bonds would hardly offset the premium the company would be forced to allow the bond-holders in order to induce them to accept the refunding bonds; and, moreover, this procedure would not really reduce capitalization. However, it would alleviate the situation. 3. Redemption of Preferred Stock, if it carries a High Dividend Rate: Funds for redemption would probably have to come from the sale of common stock sufficient to increase somewhat the earnings from the Common stock, even if this common stock is increased substantially. If, however, the preferred stock is cumulative, and if dividends on such stock are in arrears, this avenue of escape would appear to be a ―dead-end street‖ 4. Reduction in par value of Stock: This is a good method but is sometimes impossible because of the stockholders‘ tenacious belief in the importance of par value. If the stockholders are convinced of the desirability of the move, it might be somewhat effective, though not nearly as much as the reduction in high fixed. 5. Reduction in Number of Shares of common Stock: This likewise is a good method but, again, is difficult of implementation because of the average stockholders‘ unwillingness to turn in several shares in order to receive one, thought it does happen occasionally. Since this procedure does not Decrease the stockholder‘s proportionate interest in the equity, it is sometimes used.

In some cases, several of these methods may be used, but unless a company goes through re-organisation (a rather complicated an legally involved affair), the consent of the Security-holders should be obtained.