PM- Capitalization and its components, importance and limitations

PM- Capitalization and its components, importance and limitations

• 1.
  WHAT IS CAPITALISATION Capitalisationis an important constituent of the financial plan of a business. In common parlance, the term ‘capitalisation’ refers to the total amount of capital employed in a business. In this sense, it includes the following: The value of the shares of different classes issued; The value of the surpluses, whether capital surpluses (i.e. capital gains) or earned surpluses (i.e. undistributed profits in the form of reserves) The value of bonds and debentures issued by the company and still outstanding; and The value of long-term loans secured by the company other than bonds and securities.
• 2.
  THUS, THERE AREFOUR SOURCES OF CAPITALISATION: a) Share Capital- Funds raised by a company through the issuance of shares to investors. b) Reserves and Surplus- The portion of profits that are retained by the company after paying out dividends. c) Long-term Loans- Borrowings that a company takes on for a period typically exceeding one year. used to finance significant investments such as infrastructure, machinery, or expansion projects. d) Short-term Loans and Trade Credits- Borrowings that need to be repaid within a year. These loans are typically used for working capital needs, such as purchasing inventory or managing cash flow. Trade credits refer to the credit extended by suppliers allowing the company to buy goods or services now and pay for them later. Trade credit is a common source of short-term financing for businesses.
• 3.
  FACTORS AFFECTING CAPITALIZATIONDECISION Cost of Capital: One of the most important factors in capitalization decisions is the cost associated with raising funds. Debt is generally cheaper than equity because interest payments are tax-deductible. However, higher debt increases financial risk. Risk and Return: Equity financing does not carry the obligation of fixed payments like debt, but it requires sharing ownership and profits. Companies must balance the potential risk of increased debt with the return on equity. Control Consideration: Issuing new equity might dilute the ownership of existing shareholders, impacting control. Debt financing does not affect control, but higher debt can lead to increased financial risk. Flexibility: Companies need flexibility in their capital structure. Firms that rely heavily on debt may find it difficult to raise further capital if needed, while firms with more equity have greater flexibility
• 4.
  TYPES OF CAPITALIZATIONDECISIONS Over-capitalization: A situation where a company has more capital than is required for its operations. This often leads to lower returns on capital and reduced shareholder value. Under-capitalization: When a company has insufficient capital to sustain its operations or fund its growth, leading to the inability to meet current obligations or to finance expansion. OPTIMAL CAPITAL STRUCTURE The optimal capital structure is the one that minimizes the company’s cost of capital while maximizing the value of the firm. It is a balance between debt and equity that results in the lowest overall cost of funds.
• 5.
  It refers tothe rate of return that a company must earn on its investments to maintain its market value and attract funds. Understanding the cost of capital is essential for businesses, as it affects investment decisions, capital budgeting, financial planning, and the overall financial strategy of the organization. Definition of Cost of Capital Cost of Capital: It is the minimum rate of return required by investors or lenders for providing capital to a company. It is the opportunity cost of making an investment in a company instead of other investments with similar risk. Components: It typically includes the cost of debt, cost of equity, and, in some cases, the cost of preferred stock. COST OF CAPITAL
• 6.
  Cost of Debt(Kd): The cost of debt is the effective interest rate that a company pays on its borrowed funds (loans, bonds, etc.). Cost of Equity (Ke): The cost of equity is the return required by equity investors for investing in a company's shares. Unlike debt, equity does not have fixed payments, but investors expect a certain rate of return. Cost of Preferred Stock (Kps): The cost of preferred stock is the return required by preferred stockholders. Preferred dividends are fixed and usually have priority over common stock dividends. COMPONENTS
• 7.
  Question: A company issuedbonds with an annual interest payment of ₹100,000. The net proceeds from the debt were ₹950,000, and the corporate tax rate is 30%. Calculate the cost of debt (Kd).
• 8.
  Question: A company’s beta(β) is 1.2, the risk-free rate is 5%, and the expected market return is 12%. Calculate the cost of equity (Ke).
• 9.
  Question: A company issuespreferred stock that pays an annual dividend of ₹8 per share. The net proceeds from issuing the preferred stock are ₹90 per share. Calculate the cost of preferred stock (Kps).
• 10.
  WEIGHTED AVERAGE COSTOF CAPITAL (WACC) The weighted average cost of capital (WACC) represents a company’s overall cost of capital, taking into account both debt and equity, and their respective proportions in the company’s capital structure. It is the average rate of return required by all investors (both equity holders and debt holders).
• 12.
  Question: A company hasthe following capital structure: Market value of equity (E): ₹1,000,000 Market value of debt (D): ₹500,000 Market value of preferred stock (P): ₹200,000 Cost of equity (Ke): 12% Cost of debt (Kd): 8% Cost of preferred stock (Kps): 10% Corporate tax rate: 30% Calculate the Weighted Average Cost of Capital (WACC) for the company.
• 13.
  IMPORTANCE OF COSTOF CAPITAL Investment Decision (Capital Budgeting): Companies use the cost of capital as a hurdle rate to evaluate investment projects. Only projects with an expected return higher than the cost of capital should be undertaken, ensuring that investments increase shareholder value. Capital Structure Decision: A company must decide on the optimal mix of debt and equity to minimize the overall cost of capital (WACC). Debt is cheaper because of tax benefits (interest is tax-deductible), but it increases financial risk. Equity is more expensive but doesn't involve fixed payments like debt.
• 14.
  Valuation of aCompany: Cost of capital is used in discounted cash flow (DCF) valuation models. Future cash flows are discounted using the WACC to determine the present value of a company or an investment. Financing Decision: Companies assess the cost of capital when choosing between debt and equity financing. If debt is cheaper, companies may prefer borrowing. If equity is more favorable, companies might issue more shares.
• 15.
  FACTORS AFFECTING COSTOF CAPITAL Market Conditions: Interest rates and stock market volatility impact the cost of both debt and equity. When interest rates rise, the cost of debt increases, affecting the WACC. Risk Profile of the Company: Companies with higher operational or financial risks tend to have a higher cost of capital. Investors demand higher returns for taking on more risk, increasing both Ke and Kd. Capital Structure: The proportion of debt and equity in the capital structure influences the WACC. While debt is cheaper due to tax benefits, too much debt increases financial risk, which may lead to a higher cost of equity. Credit Rating: Companies with high credit ratings typically have a lower cost of debt because lenders consider them less risky. A lower credit rating raises the cost of borrowing. Corporate Tax Rate: A higher corporate tax rate reduces the after-tax cost of debt due to tax deductibility of interest payments. Thus, changes in tax rates affect the overall WACC.
• 16.
  LIMITATIONS OF COSTOF CAPITAL Difficult to Estimate the Cost of Equity: Accurately estimating the cost of equity can be challenging, especially for companies that do not pay dividends. The CAPM model depends on market risk premium and beta, which are estimates. Assumptions of Constant Debt and Equity Proportions: WACC assumes that the proportions of debt and equity remain constant over time. In reality, companies often change their capital structure based on funding needs and market conditions. Impact of Inflation: Rising inflation can affect the cost of capital by increasing interest rates, thus raising the cost of debt. Non-Consideration of Flotation Costs: When issuing new equity or debt, companies incur flotation costs (such as underwriting fees). These are not accounted for in the basic cost of capital calculations.