Chayter

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INTRODUCTION
Financial planning and decision play a major role in the field of financial martagement
which consists of the major area of financial management sueh as, capitalization, finaneial
structurg capttal structurq leverage ald financial forecasting.
Financial planning includes the following important parts:
r Estimating the amourrt of capital to be raised-
r Determining the form and proportionate amount of securities.
o Formulating poiicies to rranage the financial p1an.
MEANING OF CAPITAL
Tlre term capital refers to the total investrnent of the company in terms of money, and
'When
assets. It is also called as total wealth of the company. the company is gorng to invest
large amount of finance into tle business, it is called as capital. Capital is the initial and
integral part of new and existing business corrcern.
The capital requirements of the business concern may be classified irrto two categories:
(u) Fixed capital
(b) Working capltal.
Fixed Capital
Fixed capital is the capital, which is nesded for meeting the perrrranent orlongi-term purpose
of the business concern. Fixed capital is required mairrly for *re purpose of meeting capital
expenditure of the business concern and it is used ov€r a long period,. It is the amount
invested in various fixed or permanent assets, which are necessary for a business 6oncern.

Definition af Fixed Capital

Accorfing to the definition of Iloagfland, "Fixed capital is comparatively easily defined to
include land, buililing, machinery and other assets having a relatively permanent existence'1
 42 Fiftarvial Management

Character of Fixed Capital

r Fixed capital is used to acquire the fixetl assets of the business concern.
r Fixed caprtal meets the capital expenditure of the business corrcefll.
r Fixed capital normally consists of long period-
r Fixed capitaT expenditure is of nonreeurring nature.
r Fixed caprtal can be raised only with the help of long-term sources of finance.
Working Capital
Working capital is the capital which is needed to meet the day-to-day transaction of tle
business concern. It may cross working capital and net working capital. Normally working
capital consists ofvarious compositions ofcurrent assets such as inventories,bills, receivable,
debtors, cash, aad bank balance and prepaid expenses.
According to the definition of Boanevi.lle, "any acquisition of funds which increases
ihe current assets increase the Workins Capltal also for they are one and the same'1
Working capital is needed to meet the following purpos€:
o Purchase of raw matenaT
o Payment of wages to workers
r Paym.ent of day-to-day expenses
e Maintenance experrditure ete.

Working Capital

Capitat Fixed Capital

Fig.4.1 Pasfion of Capital

CAPITALIZATION
Caprtalization is one of the most important parts of financial decision, which is related to the
total amount of capital employed in the business coricerrr.
Understanding the concept of capitalization leads to solve many problerns in the fie1d
of financial management. Because there is a confusion among the capital, capitalization
and capital strucflrre.
Meaning of Capitalization
Capitalization tefers to tke process of determining the quanhrm of funds that a firm needs
to run its business. Capitalization is only the par value of share capital and debenture and
it does not inc.lude reserye and surplus.
 I

Capitatization 43

Definition of Capitalization
Capitalizatton can be defined by the various financial management experfs. Some of the
definitions are mentioned below:
According to Guthman and DougaII , "capitalization is the strm of the par value of
stacks and bonds outstanding".
"Capitaliaatioa is the balance sheet value of stocks and bonds outstands".

According to Arhur. S. DepinE, "capltaTizatton is the

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*:l}ffi:tr#Tfi
shares'1

TYPES OF CAPITALIZATION
Cap:rtalizatiancLayhe classified into the followingithree important typesbased on its aature:
' . Over Capitalization
r Under Capitalization
r Water Capitalization
Over Capitalization
Over capitalizatronrefers to the company which possesses all excess of capital in relation
to its activity level and requirements. In simple means, ovet capitalization is more capital
than actually required and the funds are not properly used.
According to Bonneville, Dewey and Kelly, over capitalization means, "when a
husiness is unable to earn fairr rate on its outstanding securities".

&xamylc
A company is earning a sum of Rs. 50,000 and the rate of return expected is 107o. This
company will'be said to be properly capitalized. Suppose tle capital investment of the
colnpany is Rs. 60,000, it will be over capitaTizabon to the extent of Rs. 1,00,000. The new
rate of earning would be:
50,000/60,000 x 100 : 8.337o
W'hen tle company has over caprrtaltzatton, the rate of earnings will be reduced from
10% to 8.33%.

Causes of Over Capitalization

Ovet capitahzation arise due to the following important causes:
e Over issue of capital by the company.
r Borrowins large amount of capital at a higher rate of interest.
. Providing inadequate depreciation to the fixed assets.
 I Excessive paFment for acquisition of goodwill.
. Hi$h rate of taxafign.
o Under estimation of capitaTaation rate.
Effects of Over Capitalization
Over capitalization leads to the following important effects:
. Reduce the rate of earning capacity of &e shares.
r Diffi.culties in obtaining necessary capital to the business coflcerr"
r It leads to fall in the market price of the shares.
. It creates problem* on re-organization.
r It leads under or misutilisation of available lesources.
Remedies for Ouer Capitalization
Over capitahzation can be reduced with the hefu of effective management and systematic
design of the capital structure. The following are the major steps to reduce over capitalization.
o Efficient manageffiert can reduce over capitalization.
r Redemption of preference share capital which corsists of high rate af dividend.
r ReorEiaaization of e+dty share capital.
. Reduction of debt capttal.
Under Capitalization
Under capitaliaation is the opposite concept of over capitalizatian and it will occur whec
tlre company's actual capital:z;at:ran is lower than the capitaiization as warranted by its
earning capacity. Under capitalization is not the so called inadequate capital-
Under capitalization can be defined by Gerstenberg, "a corporation may be under
eapitahzed. when &te rate ofprofit is exceptionaliy hi& in the sa:ne industry".
I{oagland defined under capitalization as "an excess of true assets value over the
aggregate of stocks and bonds outstanding".

Causes of Unaer Capitatization

Under capitalization arises due to the following important causes:
r Under estimation of capital requirements.
r Under estimation of initial and future earaings.
o Maintaining high standards of effrctenq.
r Conseryative dividend policy.
r Desire of control and trading on equity.
Effects of Under Capitalization
Under Capitalization leads certain effects irr the company aad its shareholders.
o It leads to manipulate t}'e market value of shares.
o It increases the marketability of the shares.
 Capitalization 45

I It rcay lead to flore governmeat control and higher taxation.

r Consumers feel that they are exploited by the company.
. It leads to high competition.
Remedies of Under Capitalization
Under CapitalizatiorL frny tre coffected by taking the following remedial measures:
1. Under capitalizattott {,an be cornpensated with the help of fresh issue of shares.
2. Increasirg the par value of share may help to reduce under capitalization.
3. Under capitalazatrofl rnay be eorrected by the issue of bonus shares to the existiag
shareholders.
4. Reducing the dividend per share by way of splitting up of shares.

Watered Capitalization
If the stock or capital of the colnpalry is not mentioned by assets of equivalent valuq it is
called as watered stock. In simple words, watered capital rlears that the realizable value of
assets of the colapany is less than its book value.
o1{.
According to lloagfand's definition, stock is said to be watered when its true value
is less than its book value."

Causes of lfifatered Capital

Generally watered capital arises at the time of incorporation of a compaay but it also arises
during the lif'e time of the business. The following are the main causes of watered capital:
1. Acquiriag the assets of the comrpany at lnifo, piee-
2. Adoptingi ineffective depreciation policy.
3. Worthless intangil:1e assets are purchased at higfter price.

MODEL SUESI/OTVS

1. What is capltal and define the capital?

2. Explain the types of capital.
3. What is capitalization?
4. 'lVhat are the kinds of capitalization?
5. Explain the effects of uader capitalization.
6. Discuss the causes of over capitalization.