Business Finance IV SEM BBA

MODULE: 3

CAPITALIZATION AND CAPITAL STRUCTURE

Syllabus Content:

Introduction to capitalization and capital structure, Meaning of Capital Structure, optimum capital
structure, factors determining capital structure, EPS calculations, EBIT – EPS Analysis.

Learning objectives:

After studying this unit, you should be able to

 Understand the meaning and concept of capital structure & capitalization.

 Explain the meaning and significance of optimum capital structure.
 Identify the factors affecting capital structure decisions.
 Understand the meaning and impact of leverages.
 Ascertainment of financial and operating leverages.
 Describe the different techniques of capital structure.
 Evaluate indifference point of various financial plans.
 Determine the financial break-even point.

Capitalisation

The term “Capitalization” refers to the total amount of capital employed in a business.
Capitalisation is used in its quantitative sense and refers to the process of determiningthe
quantum of funds that a firm needs to run its business.

According to Guthman and Dougall, “Capitalization” is the sum of the par value ofstocks and
bonds outstanding.”

Over-capitalisation

Over-capitalisation refers to that situation where earnings of company do not justify the amount of
capital invested in its business. Over - capitalisation means more capital thanrequired, and
therefore, in over-capitalised concern, the invested funds are not properlyused. 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.

According to Gerstenberg, “a company is over-capitalised when its earnings are not large
enough to yield a fair return on the amount of stock and bonds that have been issued, or when
the amount of securities outstanding exceeds the current value of theassets”.
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Causes of over – capitalization:

1. Over - issue of Capital: Sometimes, while floating a new company, the promoters over -
estimate the financial requirements, and as a result, they raise more capital thanwhat is needed,
resulting in over -capitalisation.

2. Promotion, Formation or Development during Inflation: If a company is to be floated

during an inflationary period, or any development activity is carried out in such aperiod, it will be
victim of over - capitalisation because it has to spend huge amounts.

3. Buying Assets of Lower Value at Higher Prices: If promoters buy assets of lower values at
higher prices; they are led to a situation of over - capitalisation because assetsof lower value will
be shown at higher value in the Balance sheet.

4. High Promotion Expenses: Incurring high promotional expenses, excessive

preliminary expenses etc. may lead to over - capitalisation.

5. Inadequate Depreciation: Providing inadequate depreciation results in over -

capitalisation as it leaves insufficient provision for replacement of assets.

6. Liberal Dividend Policy: Many companies prefer to declare a higher rate of dividendinstead
of retaining a part of the profits and ploughing them back or reinvesting them. Such a practice
should be discouraged as it leads to over - capitalisation, because liberal dividends are paid at the
cost of inadequate provision for depreciation.

7. Taxation Policy: High rates of taxation may leave little in the hands of managementto
provide for depreciation, replacements and dividends. This will adversely affect earnings
capacity and thus leads to over -capitalisation.

3.1.1 Under - capitalisation

The real value of an under - capitalised company is more than its book value. The profits are
higher than warranted by the book value of its assets. Such a company canpay a higher rate of
dividend and the market value of its shares is much higher than itsface value.

In the words of Gerstenberg, “A company may be under - capitalised when the rate ofprofits it
is making on the total capital is exceptionally high in relation to the return enjoyed by similarly
situated companies in the same industry, or when it has too little capital with which to conduct
its business.”

Causes of under - capitalisation

1. Under - Estimation of Capital Requirements: If the future capital requirements areunder -

estimated by the promoters, the inadequacy of capital is experienced at a later stage. The
company may arrange cheaper debt at lower rate of interest at that stageresulting in increased
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earnings per share. This leads the company to a situation of under - capitalisation.

2. Under - Estimation of Future Earnings: While preparing the financial plan, if the future
earnings of the company are underestimated and the actual earnings turn out to be higher than the
estimated figure, the company may find itself in a condition of under -capitalisation.

3. Promotion During Depression: Companies promoted during a period of depression often

experience under - capitalisation when inflation sets in because of a sudden rise intheir earnings.

4. Conservative Dividend Policy: If the management of a particular company adoptsan

orthodox dividend policy, i.e. where it follows a cautious policy regarding the distribution of
dividend and keeps a major part of its earnings for re - investment purpose, it results into higher
earnings and conditions of under -capitalisation.

5. Efficient Management: In companies, where the management is very efficient, the rate of
return may be quite high as compared to other companies in the same industry,and such a high
rate of return may eventually lead towards under - capitalisation.

6. Desire of Control and Trading on Equity: In many companies, the promoter desires to retain
control over the company and raises lesser amount of share capital. However, later when the funds
are required, they resort to trading on equity. This raisingof funds at lower rate of interest than the
earnings of the company eventually leads to under -capitalisation.

Sources of Finance

1. Long-term sources:

 Issue of shares
 Loans/Debentures
 Public deposits / fixed deposits
 Lease financing etc.
 Ploughing back of profits
 Loans from specialized financial institutions, etc

2. Short-term sources:

 Bank credit
 Overdraft
 Customer advances
 Trade credit
 Hiring and Leasing
 Factoring
 Cash credit

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  Call Money Market
 Treasury Bill Market
 Commercial paper etc.

Capital structure

The term „capital structure‟ refers to the relationship between various long-term sourceof
financing such as debentures, preference share capital and equity share capital. In other words,
capital structure is the composition of long-term investments of a businessorganization. It is
made-up of debt and equities that form permanent financing of a firm.It is composed of
shareholders’ funds, long-term debts, and preference share capital.
The form in which total capitalization of the company is made up of is called the capitalstructure
of the company.

3.1.2 Definition:

According to Gestenberg, “Capital structure of a company refers to the composition ormake-up

of its capitalization and it includes all long-term capital resources, viz., loans, reserves, shares
and bonds”.

In the words of Schwartz, “The capital structure of a business can be measured by theratio of
various kinds of permanent loan and equity capital to total capital”.

According to Weston and Brigham, “Capital structure is the permanent financing of the firm
represented by long-term debt, preferred stock, and net worth”.

3.1.3 Optimum capital structure:

The optimal capital structure may be defined as “that capital structure or combination ofdebt and
equity that leads to the maximum value of the firm”. Optimal capital structure maximizes the
value of the company and hence the wealth of its owners and minimisesthe company’s cost of
capital.

Capital structure policy involves a choice between risk and expected return. The optimum capital
structure strikes a balance between these risks and return and thusexamines the price of the stock.
It is very important for the financial manager to
determine the proper mix of debt and equity. The optimum capital structure is obtainedwhen the
market value per equity share is the maximum.

3.1.4 Objectives of Capital Structure Planning:

The main objectives of the capital structure planning are to minimize the cost of capitaland
maximize the value of the concern. Capital structure planning is quite essential forthe successful
promotion and smooth functioning of any business undertaking. While planning the capital
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structure, the following objects of the capital structure planning come into consideration:

(a) To maximize the profits of the owners of the company. This can be ensured byissuing
the securities carrying less cost of capital.

(b) To issue the securities which are easily transferable. This can be ensured by listingthe
securities on the stock exchange.

(c) To issue the further securities in such a way that the value of shareholding of thepresent
owners is not affected.

Factors determining Capital-Structure Decision:

1. Growth and Stability

The capital structure of a firm is highly influenced by the growth and stability of its sales.If the
sales of a firm are expected to remain stable, it can raise a higher level of debt.
Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments
of interest payment and repayments of debts. Similarly, the rate of growthin sales also affects the
capital structure decision. Usually, greater the rate of growth ofsales, greater can be the use of debt
in the financing of the firm

2. Cost of Capital

Every rupee invested in a firm has a cost. It refers to the minimum return expected by itssuppliers.
The capital structure should provide for the minimum cost of capital. The mainsources of finance
for a firm are equity, preference share capital and debt capital. The return expected by the suppliers
of capital depends upon the risk they must undertake.

3. Nature and Size of a Firm

Nature & size of the firm also influence its capital structure. All public utility concern has
different capital structure as compared to other manufacturing concern. Public utility concerns
may employ more of debt because of stability and regularity of their earnings.Similarly, small
companies must depend mainly upon owned capital as it is very difficult for them to raise long-
term loans on reasonable terms and also cannot issue equity andpreference at ease to the public.

4. Control

Whenever additional funds are required by a firm, the management of the firm wants toraise the
funds without any loss of control over the firm. In case the funds are raised through the issue of
equity shares, the control of the existing shareholders is diluted.
Preference shareholders and debenture holders do not have the voting rights. Hence, from the point
of view of control, debt financing is recommended. But depending largelyon debt financing may
create other problems, such as too many restrictions imposed upon by the lenders and ultimate

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bankruptcy of the firm due to heavy burden of interestand fixed charges.

6. Flexibility

Capital structure of a firm should be flexible. It should be possible to raise additional funds,
whenever the need be, without much of difficulty and delay. A firm should arrange its capital
structure in such a manner that it can substitute one form of financingby another. Redeemable
preference shares and convertible debentures may be preferred on account of flexibility.
Preference shares and debentures which can be redeemed at the discretion of the firm offer the
highest flexibility in the capital structure. It should be capable of adjusting to different changing
conditions.

7. Capital Market Conditions

Capital market conditions do not remain the same. Sometimes there may be depressionwhile at
other times there may be boom in the market. The choice of the securities is also influenced by the
market conditions. If the share market is depressed and there arepessimistic business conditions,
the company should not issue equity shares as investors would prefer safety. But in case there is
boom period, it would be advisable toissue equity shares.

8. Purpose of Financing

If funds are required for a productive purpose, debt financing is suitable, and the company
should issue debentures as interest can be paid out of the profits generatedfrom the investment.
However, if the funds are required for unproductive purpose or general development on
permanent basis, we should prefer equity capital.

9. Period of Finance

The period for which the finances are required is also an important factor to be kept inmind
while selecting an approximate capital mix. If the finances are required for a
limited period, of say, 7 years, debentures should be preferred to shares. Redeemablepreference
shares may also be used for a limited period finance, if found suitable otherwise. However, in
case funds are needed on a permanent basis, equity share capital is more appropriate.

10. Corporate Tax Rate

High rate of corporate taxes on profits compels the companies to prefer debt financing, because
interest is allowed to be deducted while computing taxable profits. On the otherhand, dividend on
shares is not an allowable expense for that purpose.

EBIT-EPS Analysis:

EBIT - Earnings Before Interest and Taxes or Net Operating Income. It is the amount ofincome

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Business Finance IV SEM BBA

that a company has after subtracting operating expenses from sales (hence theterm net operating
income). Another way of looking at it is that this is the income that the company has before
subtracting interest and taxes (hence, EBIT).

EAT - Earnings After Taxes or Net Income or Net Profit After Taxes.

EPS - Earnings Per Share. This is the amount of income that the common stockholdersare entitled
to receive (per share of stock owned). This income may be paid out in the form of dividends,
retained and reinvested by the company, or a combination of both.

Financial Break- Even Point:

Financial break-even point denotes the level of EBIT for which the firm’s EPS just equals zero. It
is the minimum level of EBIT needed to satisfy all fixed financial chargesi.e., interest and
preference dividends. If EBIT is less than financial break-even point, then EPS will be negative.
But if the expected level of EBIT exceeds than that of break-even point, more fixed costs
financing instruments can be inducted in the capital structure. Otherwise, the use of equity would
be preferred. In simple, Financial Break- even point is a point at which a firm’s ROE (Return on
Equity) is zero.

The Financial Break- Even Point can be calculated as follows:

FBEP = I + PD
(1-T)

Where,
I = Interest
PD = Preference DividendT =
Tax rate.
Point of Indifference:

Point of Indifference or Indifference Point means points at which two financing strategies
provide the same ROE. Indifference analysis is a profit planning technique used to forecast the
EPS-EBIT relationships under different financing scenarios. It refers to that level of operating
profit or EBIT (Earnings Before Interest & Tax) at whichEPS (Earnings Per Share) remains
same irrespective of the debt-equity mix. At this point, rate of return on capital employed is
equal to the rate of interest on debt. This is also known as „Break-Even Level of EBIT‟ for
alternative financial plans.

In case, the expected level of EBIT exceeds the indifference point, the use of debt financing
would be advantageous to maximize the EPS. The indifference point is where:

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EPS (Financing strategy 1) = EPS (Financing strategy 2)

The point of indifference can be calculated with the help of the following formula:

(X- I1) (1-T) - PD = (X- I2) (1-T) - PD

S1 S2

Where,

X = EBIT Indifference or Break-Even Point.I1 =

Interest under alternative 1
I2 = Interest under alternative 2T =
Tax rate
PD = Preference Dividend
S1 = Number of Equity shares or amount of equity share capital under alternative 1S2 =
Number of Equity shares or amount of equity share capital under alternative 2

Leverages:

In general sense, the term „leverage‟ refers to force or means of accomplishing power for gaining
an advantage. In financial management, it represents the impact of one financial variable over
some other related financial variable. Leverage refers to the ability of a firm in employing long-
term funds having a fixed cost, to enhance returns to the owners. In other words, leverage is the
employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of
interest obligation irrespective of thelevel of activities attained or the level of operating profit
earned. The higher the leverage, higher the profits and vice-versa.

Types of leverages:
There are three types of leverages. viz:

(a) Financial leverage.

(b) Operating leverage
(c) Composite/combined leverage.

(a) Financial leverage:

The use of long-term fixed interest-bearing securities i.e. debt and preference sharecapital
along with equity share capital is called financial leverage. The degree of financial leverage
is an attribute of the firm’s exposure to financial risk.

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Business Finance IV SEM BBA

The financial leverage is also termed as ‘Trading on Equity’. The use of fixed return bearing
securities like preference share capital, debentures, bonds, term loans etc., toincrease the
earnings available to equity shareholders is termed as Trading on Equity.

The company is said to be trading on equity when, by employing preference share capital and
long-term debt along with equity share capital, it is enabled to pay higher dividend on equity
share capital than would be possible, if only equity share capital isemployed.

Financial leverage is expressed as follows:

Financial leverage = EBIT / EBT

(b) Operating leverage:

The leverage associated with the employment of fixed cost assets is referred to as operating
leverage. It is concerned with the operation of any firm. This leverage relatesto the sales and
profit variations. The operating leverage may be defined as the tendency of the operating profit
to vary disproportionately with sales. It is said to exist when a firm must pay fixed cost
regardless of volume of output or sales.

The firm’s operating leverage would be higher if the firm has high quantum of fixed costand low
variable cost. The operating leverage is an attribute of the firm’s risk. It is the responsiveness of
firm’s EBIT to the changes in sales. Operating leverage can be expressed as follows:

Operating leverage = Contribution / EBIT or Operating profit

(c) Composite leverage:

Composite leverage or combined leverage is the combined effect of both financial andoperating
leverages. This leverage focuses attention on the entire income of the concern. It may be defined
as the potential use of fixed costs, both operating and financial, whichmagnifies the effect of
sales volume change on the EPS of the firm. It is also called as
„total leverage‟ and it can be calculated as follows:

Composite leverage = Financial leverage x Operating leverage.Or

Composite leverage = Contribution / EBT

Gearing:

The term “gearing” refers to the amount of debt finance a company uses relative to its equity
finance. A company with high level of debt component in its capital structure is said to be
„highly geared‟ and vice-versa. The gearing of a company can be calculated with the help of
financial ratios like debt-equity ratio and capital gearing ratio. The interest cover is considered
as ratio to ascertain the level of income gearing. While calculating capital gearing ratio, market

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values of debt and equity are considered to bemore appropriate than book values.

PRACTICAL PROBLEMS

EBIT - EPS ANALYSIS

1. Calculate the EPS from the following information of X Company:

(i) 20,000 equity shares of Rs.10 each amounted to Rs.2,00,000
(ii) 10%,10,000 preference shares of Rs.10 each Rs.1,00,000
(iii) Profit before tax 1,00,000
(iv) Rate of tax is 20%.

2. A firm requires total capital funds of Rs. 25,00,000 and has two options:
 All Equity
 50% equity and 50% debt @ 15%
The equity can currently be issued at Rs. 10 per share. The expected EBIT of the company is Rs.
2,50,000 with tax rate at 25%. Find out the EPS under both financial plans.

3. ABC Limited has currently an all-equity structure consisting of 1,50,000 equity shares of Rs
10 each. The management is planning to raise another Rs 25,00,000 to finance a major
programme of expansion and is considering three alternative methods of financing:
(i) To issue 2,50,000 equity shares of Rs 10 each.
(ii) To issue 25,000; 15% debentures of Rs 100 each.
(iii) To issue 2,50,000; 5% preference shares of Rs 10 each.
The company’s expected earnings before interest and taxes will be Rs 3,70,000. Assuming
a corporate tax rate of 30%, determine the earnings per share in each alternative and
comment which alternative is best and why?

4. Tisco company has equity share capital of Rs 5,00,000 divided into shares of Rs 10 each. It
wishes to raise further Rs 3,00,000 for expansion cum modernisation plans. The company plans
the following financing schemes:
a) All Equity Shares.
b) Rs one lakh in Equity Shares and Rs two lakhs in debt @ 10%
c) All debt @ 10%
d) Rs one lakh in common stock and Rs two lakhs in preference capital with rate of
dividend @ 8%.The company’s existing earnings before interest and taxes (EBIT) are Rs
1,50,000. Assuming a corporate tax rate of 30%. Determine the earnings per share in each
plan and comment alternative is best and why?

5. Advaith Co.Ltd has a capital of Rs.8,00,000 divided into shares of Rs.10 each .It
requires an additional capital of Rs.4,00,000 for a further investment programme.
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Business Finance IV SEM BBA

Following are the alternatives available for the company to raise additional capital:
a) Issue of 40,000 equity shares of Rs.10 each.
b) Issue of 40,000,15% preference shares of Rs.10 each.
c) Issue of 12% debentures of Rs.4,00,000
The company’s present Earnings Before Interest & Tax (EBIT) or Operating Profit
(O.P) is Rs.2,50,000 p.a. You are required to calculate the effect of each of the above
modes of financing on the earnings per share (EPS) presuming:
i) EBIT continues to be the same even after expansion
ii) EBIT increases by Rs.50,000
iii) Assume tax liability as 30%

6. The existing capital structure of R.Co.Ltd. is as follows: The

existing share of Rs.10 each Rs. 10,00,000
Retained Earnings Rs.5,00,000
9% Preference Shares Rs.6,00,000
7% Debentures Rs.4,00,000
Total Rs.25,00,000
The company earns a return of 12% and the tax on income is 30%. Company wants
to raise Rs.12,50,000 for its expansion project for which it is considering following
alternatives:
• Issue of 10,000, equity shares at a premium of Rs.25 per share.
• Issue of 10%, preference shares.
• Issue of 8% debentures.
Projected that the Profit /Earning ratio (P.E Ratio) in the case of equity, preference and debenture
financing would be 20.2, 15, and 14.82 respectively.
Which alternative would you consider to be the best? Give reasons for your choice.

7. A company needs Rs 10,00,000 for development of a new product. It would yield an annual
operating profit of Rs 2,40,000; share price is Rs 50. The company has the objective of
maximising the EPS. Company is in the tax bracket of 30%. Funds can be raised at the
following interest rates:
• Upto Rs 1,00,000 @ 8%
• Over Rs 1,00,000 to Rs 5,00,000 @ 12%
• Over Rs 5,00,000 @ 15%
The company has developed three financing plans that are given below:
• Raise Rs 1,00,000 debt; with expected operating profit Rs 3,40,000
• Raise Rs 3,00,000 debt; with expected operating profit Rs 4,40,000
• Raise Rs 6,00,000 debt; with expected operating profit Rs 5,90,000
Calculate EPS for all the above financing plans and choose the best plan based on higher EPS.

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INDIFFERENCE POINT AND FINANCIAL BREAKEVEN POINT

8. X Ltd has a total capitalisation of Rs 10 lakhs consisting entirely of equity share capital of Rs
50 each. It wishes to raise another 5 lakhs for expansion through one of its possible financial
plans.a) All equity shares of Rs 50 each; b) All debentures of 9%.
Present leverage of EBIT is Rs 1,40,000 and tax 30%. Calculate the EBIT level at which EPS
would remain the same irrespective of raising funds through equity or debentures. Also calculate
the financial breakeven point for different plans.

9. ABC Co.Ltd. is considering three financial plans for which the following information is
available:
(a) Total investment to be raised Rs.8,00,000
(b) Plans of Financing proportion:
Plans Equity Debt Preference
A 100% - -
B 50% - 50%
C 50% 50% -

(c) Cost of debt is 10%

(d) Cost of preference shares 8%
(e) Tax rate 30%
(f) The face value of equity share is Rs.10 each will be issued at a premium of Rs.10 per
share.
(g) Expected EBIT is Rs. 3,20,000
Determine for each plan:
(1) Earnings per share (EPS)
(2) Financial Break-even Point.
(3) Compute the EBIT range among the plans for point of difference.

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