This document discusses capitalization and capital structure. It defines capitalization as the total value of capital employed in a business. Capital structure comprises ownership capital and borrowed capital. An optimum capital structure balances risk and return with minimal cost of capital. Both over-capitalization and under-capitalization are disadvantageous, though under-capitalization can increase returns. Determinants of capital structure include cost of capital, firm size and nature, financial leverage, cost of raising funds, growth and stability of sales, and legal/tax factors.

1. CAPITALIZATION AND CAPITAL
STRUCTURE
Amal Benny
Mar Ivanios College Trivandrum

2. CAPITALISATION
• Has been derived from the word capital.
• Refers to the magnitude of capital employed
• DEFINITION: According to Gerstenbug,”capitalisation is the total amounting value of all the
capital regularly employed in the business.”
• Comprises of
Ownership capital
Borrowed capital

3. Theories of Capitalization
 Earning Theory : Capitalisation depends upon its earnings and the expected fair rate of
return on its capital invested.
 Cost Theory : Capitalisation is arrived by adding the cost of fixed assets.

4. Over Capitalization
 Occurs when:-
• a company has consistently been unable to earn the prevailing rate of return on its
outstanding securities.
• The amount of shares,debentures,public deposits and loans exceed the current value of the
assets.

5. Causes of over capitalization
• High promotion expenses
• Buying assets of lower value at higher price
• Over issue of capital
• High rate of taxation
• Charging inadequate depreciation
• Under estimation of capitalisation rate
• Inadequate demand for production
• Production, formation or development during inflation
• Liberal dividend policy
• Payment of high rate of interest

6. Disadvantages
• Poor credit worthiness
• Decline in the efficiency of the company
• Loss of goodwill
• Loss of shareholders
• Loss of workers
• Reduced dividend
• Liquidation of the company

7. Under Capitalization
Occurs when a company’s actual capitalisation is lower than proper
capitalisation as warranted by its earning capacity.
DEFINITION: Gerstenbug defines undercapitalisation as a situation in which the rate of
profit of a company with respect to the total capital is exceptionally high in relation to the
return enjoyed by the similarly situated companies in the same industry or when it has too
little capital with which it can conduct its business.

8. Causes of under capitalization
• Companies floated at the time of deflation can become undercapitalised at the time of
inflation.
• The promoters may underestimate the capital requirements.
• Orthodox dividend policy adopted by the company.
• If the management of the company is very inefficient.
• If the funds are procured at a lower rate than expected.

9. Disadvantages
• Employers may feel that they are exploited to make more profit.
• Earnings per share and Dividends per share may increase. It can increase the marketability
of shares.
• Customers may feel that they are being exploited for making more profit.
• Higher earnings may encourage competitors to enter into a cut throat competition.
• Over trading by the company as a result of undercapitalisation may result in excessive
businesses that what the financers can allow.

10. Over Capitalisation
• It involves a great strain on the
financial resources of the
company.
• The remedial procedure of over
capitalisation is more difficult
and over expensive.
• This adversely affects the
shareholders and endangers the
economic stability and social
prosperity.
• Its a common phenomenon.
Under Capitalisation
• It is beneficial to the shareholders
as it provides high rate of return.
• The remedial procedure of under
capitalisation is easier than over
capitalisation.
• It accelerates cut throat competition
among the companies ,unrest
among the employees.
• Its a rare phenomenon.

11. Optimum Capital Structure
It is that capital structure or combination of debt and equity that leads to the
maximum value of the firm.

12. Features
1. Must balance risk and return within acceptable limits. There should be a balance between
owner’s capital and debt capital.
2. Should have the minimum cost of capital
3. It should confirm to the industrial norms. The debt-equity ratio of the firm must not vary
widely from that of a similar firm in the industry .
4. Must be flexible so as to tune with the changing economic conditions inside and outside
the firm.
5. Must take into account which form the basis for servicing of debt.

13. Determinants of Capital Structure
1. Cost of capital : Refers to the minimum return expected by its suppliers. The capital
structure should provide for minimum cost of capital.
2. Nature and size of the firm: A public utility firm may employ more of debt because of their
stability and regularity of their earnings. But a manufacturing firm require more equity
capital.
3. Financial leverage or trading on equity : A firm can increase its EPS by the use of more
preference share capital and debentures.

14. 4. Cost of floatation: This should also be considered while raising
funds. The cost of floating a debt is generally less than the cost of
floating an equity.
5. Growthand stability of sales : If the sales of the firm is expected to
remain fairly stable, it can raise a higher level of debt.
6. Flexibility : It should be capable of being adjusted according to the
needs of changing conditions.

15. 7. Capital market conditions : The security must be chosen according to
the market conditions.
8. Purposeof financing : Debt financing can be used for productive
purposes and equity capital must be preferred for general
development on a permanent basis.
9. Legal requirements : The legal restrictions regarding the issue of
shares and debentures are to be considered before fixing the capital
structure.

16. 10. Corporatetax rates : High rate of corporate taxes compel the
companies to prefer debt financing.
11. Requirements of investors : The requirements of investors is another
factor that influences capital structure of a firm.
12. Cash flow ability to service debt : A firm having larger and more
stable cash flow can employ more debt in its capital structure than
the other firms.
13. Period of finance : If the period of finance is more instruments like
debentures can be used. If the funds are needed on a permanent
basis shares are more suitable.