Capital Structure

by Prasad Kulkarni
CA, CPA
Topics
• Meaning - criteria for determining capital structure

• Factors affecting capital structure

• Capitalization:- Meaning, Definition

• Over capitalization: Meaning, Advantages

• Over capitalization: Disadvantages, Remedies

• Under Capitalization: Meaning, Advantages

• Under Capitalization: Disadvantages, Remedies

• Difference between Overcapitalisation and Undercapitalisation

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Meaning

• Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization.

• It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-
term loans and retained earnings.

• The term capital structure refers to the relationship between the various long-term source financing such as equity
capital, preference share capital and debt capital.

• Deciding the suitable capital structure is the important decision of the financial management because it is closely
related to the value of the firm.

• Capital structure is the permanent financing of the company represented primarily by long-term debt and equity

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Meaning

Definitions :

According to the definition of Gerestenbeg, “Capital Structure of a company refers to the composition or make up of
its capitalization and it includes all long-term capital resources”.

According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-term financing represented
by debt, preferred stock, and common stock equity”.

According to the definition of Presana Chandra, “The composition of a firm’s financing consists of equity, preference,
and debt”.

According to the definition of R.H. Wessel, “The long term sources of fund employed in a business enterprise”.

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Meaning

FINANCIAL STRUCTURE

• The term financial structure is different from the capital structure. Financial structure shows the pattern total
financing. It measures the extent to which total funds are available to finance the total assets of the business.

Financial Structures Capital Structures

1. It includes both long-term and short-term
sources of funds
2. It means the entire liabilities side of the
balance sheet.
3. Financial structures consist of all
sources of capital.
4. It will not be more important while
determining the value of the firm.
1. It includes only the long-term sources of
funds.
2. It means only the long-term liabilities of
the company.
3. It consist of equity, preference and
retained earning capital.
4. It is one of the major determinations of
the value of the firm.

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 Meaning - Criteria for determining capital structure
The following criteria are considered while deciding the capital structure of the firm.

• Leverage - It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing such as debt, equity and preference share capital. It is
closely related to the overall cost of capital.

• Cost of Capital - Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally long- term finance such as equity and debt consist of
fixed cost while mobilization. When the cost of capital increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of
capital.

• Nature of the business - Use of fixed interest/dividend bearing finance depends upon the nature of the business. If the business consists of long period of operation, it
will apply for equity than debt, and it will reduce the cost of capital.

• Size of the company: It also affects the capital structure of a firm. If the firm belongs to large scale, it can manage the financial requirements with the help of internal
sources. But if it is small size, they will go for external finance. It consists of high cost of capital.

• Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure of a firm. For example, banking companies are restricted
to raise funds from some sources.

• Requirement of investors: In order to collect funds from different type of investors, it will be appropriate for the companies to issue different sources of securities.

• Government policy - Promoter contribution is fixed by the company Act. It restricts to mobilize large, long- term funds from external sources. Hence the company must
consider government policy regarding the capital structure.

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OPTIMUM CAPITAL STRUCTURE

Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and
thereby the value of the firm is maximum.

Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads to the
maximum value of the firm.

Objectives of Capital Structure

Decision of capital structure aims at the following two important objectives:

1. Maximize the value of the firm.

2. Minimize the overall cost of capital.

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Forms of Capital Structure

Capital structure pattern varies from company to company and the availability of finance. Normally the following
forms of capital structure are popular in practice.

• Equity shares only.

• Equity and preference shares only.

• Equity and Debentures only.

• Equity shares, preference shares and debentures.

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Capitalisation

Financial planning and decision play a major role in the field of financial management which consists of the major
area of financial management such as, capitalization, financial structure, capital structure, leverage and financial
forecasting.

Financial planning includes the following important parts:

● Estimating the amount of capital to be raised.

● Determining the form and proportionate amount of securities.

● Formulating policies to manage the financial plan.

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MEANING OF CAPITAL

• The term capital refers to the total investment of the company in terms of money, and assets.

• It is also called as total wealth of the company.

• When the company is going to invest large amount of finance into the business, it is called as capital.

• Capital is the initial and integral part of new and existing business concern.

• The capital requirements of the business concern may be classified into two categories:

(a) Fixed capital

(b) Working capital.

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Fixed Capital

Fixed Capital

• Fixed capital is the capital, which is needed for meeting the permanent or long-term purpose of the business
concern.

• Fixed capital is required mainly for the purpose of meeting capital expenditure of the business concern and it is
used over a long period.

• It is the amount invested in various fixed or permanent assets, which are necessary for a business concern.

Definition of Fixed Capital

According to the definition of Hoagland, “Fixed capital is comparatively easily defined to include land, building,
machinery and other assets having a relatively permanent existence”.

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Fixed Capital

Definition of Fixed Capital

According to the definition of Hoagland, “Fixed capital is comparatively easily defined to include land, building,
machinery and other assets having a relatively permanent existence”.

Character of Fixed Capital

● Fixed capital is used to acquire the fixed assets of the business concern.

● Fixed capital meets the capital expenditure of the business concern.

● Fixed capital normally consists of long period.

● Fixed capital expenditure is of nonrecurring nature.

● Fixed capital can be raised only with the help of long-term sources of finance.

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Working Capital

• Working capital is the capital which is needed to meet the day-to-day transaction of the business concern.

• Normally working capital consists of various compositions of current assets such as inventories, bills, receivable,
debtors, cash, and bank balance and prepaid expenses.

According to the definition of Bonneville, “any acquisition of funds which increases the current assets increase the
Working Capital also for they are one and the same”.

Working capital is needed to meet the following purpose:

● Purchase of raw material

● Payment of wages to workers

● Payment of day-to-day expenses

● Maintenance expenditure etc.

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CAPITALIZATION

• Capitalization is one of the most important parts of financial decision, which is related to the total amount of
capital employed in the business concern.

• Understanding the concept of capitalization leads to solve many problems in the field of financial management.
Because there is a confusion among the capital, capitalization and capital structure.

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Meaning of Capitalization

• Capitalization refers to the process of determining the quantum 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 include reserve and surplus.

Definition of Capitalization

Capitalization can be defined by the various financial management experts. Some of the definitions are mentioned
below:

• According to Guthman and Dougall, “capitalization is the sum of the par value of stocks and bonds outstanding”.

• “Capitalization is the balance sheet value of stocks and bonds outstands”. — Bonneville and Dewey

• According to Arhur. S. Dewing, “capitalization is the sum total of the par value of all shares”.

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TYPES OF CAPITALIZATION

Capitalization may be classified into the following three important types based on its nature:

• Over Capitalization
• Under Capitalization
• Watered Capitalization

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Over Capitalization

Over Capitalization

• Over capitalization refers to the company which possesses an excess of capital in relation to its activity level and
requirements.

• In simple means, over 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 business is unable to earn fair rate on its outstanding securities”.

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Over Capitalization

Causes of Over Capitalization

Over capitalization arise due to the following important causes:

• Over issue of capital by the company.

• Borrowing large amount of capital at a higher rate of interest.

• Providing inadequate depreciation to the fixed assets.

• Excessive payment for acquisition of goodwill.

• High rate of taxation.

• Under estimation of capitalization rate.

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Over Capitalisation

Effects of Over Capitalization

Over capitalization leads to the following important effects: •

• Reduce the rate of earning capacity of the shares.

• Difficulties in obtaining necessary capital to the business concern.

• It leads to fall in the market price of the shares.

• It creates problems on re-organization.

• It leads under or misutilisation of available resources.

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Over Capitalisation

Remedies for Over Capitalization

Over capitalization can be reduced with the help of effective management and systematic design of the capital
structure.

The following are the major steps to reduce over capitalization.

• Efficient management can reduce over capitalization.

• Redemption of preference share capital which consists of high rate of dividend.

• Reorganization of equity share capital.

• Reduction of debt capital.

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Under Capitalization

Under capitalization is the opposite concept of over capitalization and it will occur when the company’s actual
capitalization is lower than the capitalization 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 capitalized when the rate of profit
is exceptionally high in the same industry”.

Hoagland defined under capitalization as “an excess of true assets value over the aggregate of stocks and bonds
outstanding”.

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Under Capitalization

Causes of Under Capitalization

Under capitalization arises due to the following important causes:

• Under estimation of capital requirements.

• Under estimation of initial and future earnings.

• Maintaining high standards of efficiency.

• Conservative dividend policy.

• Desire of control and trading on equity.

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Under Capitalization

Effects of Under Capitalization

Under Capitalization leads certain effects in the company and its shareholders.

• It leads to manipulate the market value of shares.

• It increases the marketability of the shares.

• It may lead to more government control and higher taxation.

• Consumers feel that they are exploited by the company

• It leads to high competition.

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Under Capitalization

Remedies of Under Capitalization

Under Capitalization may be corrected by taking the following remedial measures:

• Under capitalization can be compensated with the help of fresh issue of shares.

• Increasing the par value of share may help to reduce under capitalization.

• Under capitalization may be corrected by the issue of bonus shares to the existing shareholders.

• Reducing the dividend per share by way of splitting up of shares.

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Leverage

Financial decision is one of the integral and important parts of financial management in any kind of business
concern. A sound financial decision must consider the board coverage of the financial mix (Capital Structure), total
amount of capital (capitalization) and cost of capital (Ko).

Deciding the debt-equity mix plays a major role in the part of the value of the company and market value of the
shares.

The debt equity mix of the company can be examined with the help of leverage.

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Meaning of Leverage

• The term leverage refers to an increased means of accomplishing some purpose.

• Leverage is used to lifting heavy objects, which may not be otherwise possible.

• In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase the
return to its shareholders.

James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or
fixed return.

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Types of Leverage

Leverage can be classified into three major headings according to the nature of the finance mix of the company.

OPERATING LEVERAGE

FINANCIAL LEVERAGE

COMBINED LEVERAGE

The company may use financial leverage or operating leverage, to increase the EBIT and EPS.

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Budgeting

Budgeting

Budgeting is a critical part of the event planning process. It is important to develop an effective budget on which you
can rely so appropriate decisions and adjustments, if necessary, can be made.

Before making a commitment to hold the event, examine the financial elements involved, considering all expense
estimates and the funds you have on hand for this event. If there is a shortage of funds, revisit your expectations and
determine whether you wish to scale down or change the overall approach. You may also wish to consider whether
financial assistance can be obtained from other sources (e.g., ticketing or registration fees, and co-sponsorships with
other departments/sponsors etc).

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Event Budgeting

Predicting the financial outcome of an event

The event budget is a projection (forecast) of the income and expenditure that the event will incur based on plans
made and information gathered.

The preparation of a budget is an essential part of event management. It is fundamentally important that Event
Directors are able to predict with reasonable accuracy whether the event will result in a profit, a loss or will break-
even. This is achieved by identifying and costing all probable expenditures and by totaling all expected revenues
(income). By comparing expenditures and revenues, it then becomes possible to forecast the financial outcome of
the event.

The prediction of financial outcomes of the event need to take place very early in the planning stages. There is no
use on setting dates, booking venues, preparing plans until there has been some attempt to determine whether the
event is financially viable.

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Event Budgeting

Importance of financial control of an event

Once the Event Budget has been constructed, the Event Director has a means to exercise control of the event
finances. Many organisations have run into severe financial difficulty and even bankruptcy as a result of staging
events. The budget therefore enables the Event Director to make sound financial decisions about the choice of
venue, and expenditure on a whole range of things including promotion, equipment and stafffing. The process of
budgeting also enables the Event Director to calculate how much revenue is needed to stage the event in
accordance with the planned level of expenditure.

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Event Budgeting

Continual adjustment of the event budget

The preparation of an event budget is one of the earliest tasks to be undertaken in the event management process.
However, it should be expected that there will be numerous adjustments and refinements to the budget throughout
the whole project life-cycle. It is not possible to know every cost from the start, nor is it possible to know whether
efforts to secure sponsorship and government funding will be successful. Event budgets by the event management
team as better information comes to hand.

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Basic event budgeting rules

Although the budget takes time to develop, there are some basic rules that should be followed from the outset:

Budget to avoid making a loss

If an event looks likely to make a loss, it calls into question whether the event should go ahead according to the existing
plan. If it is not to late, plans should be changed so that the event will at least break-even.

Be realistic about event incomes

Far too often, event plans are far too optimistic about the amount of sponsorship to ge gained, or the number of people who
will attend as spectators or participants. Over optimistic predictions are often a cause for financial loss as a result of staging
an event.

Have a contingency plan

In thinking through what could possibly go wrong with an event, it is a good idea to determine what must be done if
something does go wrong. For example, what happens if the sponsorship pull out, or there is very bad weather?

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 Typical event expenditure
Travel and Accommodation Costs associated with officials needed to run the event may have to be borne by the event organisers. Event participants are generally responsible for their own travel
and accommodation costs. In minor or local events travel and accommodation costs are unlikely.

Trophies, Awards The cost of medals, trophies and other awards requires detailed knowledge about the number of competitors, the categories of divisions of the competition and the
format of the competition.

Salaries Applies only events are organised by professional staff.

Postage and telephone Events usually require considerable communications with participants and the event management team.

Stationery and Photocopying Special event stationery may be printed but otherwise there is always a lot of photocopying and usage of organisation letterheads to write correspondence.

Medical Fees Events require persons with at least First Aid training to be in attendance. Larger events may also warrant the employment of a doctor and physiotherapists.

Venue Hire A critically important aspect of the budget. Information about the probable cost of the venue needs to be obtained as early as possible. Beware that there some hidden
costs such as security and supervision costs, and heating and lighting costs.

Insurance Additional insurance can be taken out to cover risks of injury and/or financial losses associated with events.

Printing Event programmes, posters, fliers and other promotional documents may need to be printed - especially where quality and colour is required.

Promotion Expenditure on promotion may be considerable where a significant proportion of the event revenue is likely to be earned through spectators. Promotion covers items such
as advertising, give-aways, costs associated with promotional events and sponsors' signage.

Equipment Hire Includes equipment directly used by participants in the event and also any equipment used by the event management staff including sound systems, computers, mobile
phones, two way radios, etc.

Transport Includes costs of transporting equipment and hire of buses.

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Components of Event Budget

A event budget will have various components and the components will vary depending on the type, nature, size of the budget.

1. there will be an overall budget and various components of it, such as a catering budget and/or a travel budget.

2. The budget can be classified in to two components

• A Revenue Budget – Can be further divided in to revenues from different sources like Ticketing, Sponsorship, Corporate Ticketing etc. This is
very important to understand the cash inflows and the sources of funds for the event.

• A Expenditure Budget – The expenditure budget is important to understand the various heads of expenses required for the event like
Location expenses, Food and Beverages, Travel and Fuel etc. This is also an indication of the cash outflows for the event.

Event Planning Checklist

This sample event planning checklist provides a general guide to all of the tasks you may need to perform for an event and a timeline
of when they should ideally be done.

Event Sheet

This a complete story outlining every detail of the event include the planning, the resources, and the day(s) of the event.

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Event budgeting is mainly about having a structured plan in place that can help you manage your finances in
the best possible way to ensure event success.

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