Financial Management

Module 3
• Capitalization is one of the most important
constituents of financial plan
• The term capitalization has been derived from
the word capital and in common practice it
refers to the total amount of capital employed
in a business.
• However, financial scholars are not unanimous
regarding the concept of capital.
• The definition of the capitalization can be
classified in two ways, viz
1. Broad Interpretation
2. Narrow Interpretation
Broad Interpretation
Many authors regard capitalizations as synonymous with financial
planning
Broadly speaking , the term ‘Capitalization’ refers to the process of
determining the plan of financing.
The capitalization includes
1. Estimating the total amount t of capital to be raised
2. Determining the type of securities to be issued
3. Determining the composition or proportion of the various
securities to be issued.
Narrow Interpretation of Capitalization
In the narrow sense, the term ‘Capitalization’ is used in its
quantitative sense and refers to the process of determining the
quantum of funds that a firm needs to run its business
According the scholars holding this view, the decisions regarding
the form or composition of capital fall under the term capital
Structure.
Gilbert Harold refers to capitalization as any of the following
concepts
1. The total par value of all the securities- shares and debentures
outstanding at a given time
2. The total par value of all the securities outstanding at a given
time plus the valuation of all other long term obligations
3. The total amount of capital and liabilities of corporation , i.e
amount of capital stock plus bonds.
• Modern concept of capitalization
The modern thinkers consider that even short- term creditors
should be included in capitalization.
Thus, according to modern concept, capitalization includes :
i. Share capital
ii. Long term debt
iii. Reserves and Surplus
iv. Short term debt
v. Creditors
 Capital and Capitalisation
• Capital and capitalization are two different terms
• The term capitalization is used only in relation to companies and
not in relation to partnership firms or sole – proprietary
organizations.
• The term capital refers to the total investment of a company in
only, tangible and intangible assets. It is the total wealth of a
company.
• But , used in common parlance , capitalization refers to the par
value of securities , i.e shares and debentures plus any other
reserves kept to meet long – term and permanent need of a
company.
• The term capitalization should also be distinguished from the
share capital which refers to the paid up value of shares issued
by a company but excludes bonds, debentures and other form of
borrowings of a company
 Need of capitalization
• Need of capitalization arises not only at the time of
incorporation or promotion of a company but may also arise as a
going concern after promotion and during the life time of a
corporation.
• Generally, the capitalization arises in the following
circumstances
1. At the time of promotion/ incorporation of a company
2. At the time of expansion of an existing company
3. At the time of amalgamation and absorption of two or more
companies
4. At the time of re- organization of capital of a company
 Theories of Capitalization
1. The Cost theory of Capitalization
2. The Earnings Theory of Capitalization
 The Cost theory of Capitalization
According to this theory, the amount of capitalization is arrived at by
adding up the cost of fixed assets ( like plants, machinery, buildings, etc)
working capital required for the continuous operations of the company;
the cost of establishing the company and the promotional expenses.
Such calculation of capitalisation is useful in case of newly – formed
companies as it enables the promoters to know exactly the amount of
funds to be raised.
But, this theory is not totally satisfactory as it ignores the earning capacity
of the business.
the amount of capitalization is based on a figure which will not change
with changes in the earning capacity of the business.
For instance, if some of the fixed assets of a company become absolute ,
some remain idle and others are under employed , the total earning
capacity of the company will naturally fall in the earning capacity,
would not reduce the value of the investment made in the company’s
business.
 The Earnings Theory of Capitalization
• The earnings theory of capitalization recognizes
the fact that true value of an enterprise depends
upon its earning capacity.
• According to this theory , the capitalization of a
company depends upon its earnings and expected
fair rate of return on its capital invested.
• Thus, the value of capitalization of a company
depends upon its earnings and the expected fair
rate of return on its capital invested. Thus, the
value of capitalization equal to the capitalized
value of the estimated earnings .
For example , if a company is making net profit of 200000 per
annum and the fair rate of return is 10%.

The capitalization of the company will be

(200000× (100/10)) = 20,00000 RS.

Earnings theory of capitalization seems to be logical because it

correlates the value of a firm or the amount of capitalization
directly with its earning capacity.
However this theory can only be applied when the firm’s expected
income and capitalization rate can precisely be estimated .
In real life , it is very difficult to estimate correctly the future
earnings as well as to determine the capitalization rate.
The future earnings of a firm depend upon a number of
factors such as demand for its products, general price level
, efficiency of management and employee productivity.
Some of these factors are beyond the control of an
organization and may vary with changing circumstances .
Similarly, its very difficult to determine the capitalization
rate which depends mainly on the expectations of the
investors and the degree of risk in a particular enterprise,
In view of these difficulties, newly established firms prefer
cost theory of capitalization. However earnings theory may
provide better basis for capitalization of an existing
concern.
 Over Capitalization
• Over capitalization refers to that sate of affairs where
earnings of a company do not justify the amount of
capital invested in its business.
• Over capitalization means more capital than actually
required , and therefore in a over capitalized concern ,
the invested funds are not properly used .
• It is therefore , quite clear that over capitalization may be
explained in terms of earnings as well as cost of assets. In
terms of earnings , over capitalization arises when the
earnings of the company are not sufficient to give a
normal return on capital employed by it. Let us take the
example.
• Suppose, a company earns Rs 500000 and the normal rate of
return expected is 10%. Then capitalization at Rs 500000 would
be
(500000×100/10) = Rs 50,00,000. A fair capitalization situation .
But suppose , the capital employed by this company is 60,00,000.
then we will say that the company is over capitalized to the extent
of Rs 10,00,000. the new rate of earnings in this company now
would be
(500000×100 /6000000) = 8.333%
Thus we see that as a result of over capitalization, the rate of
earnings has dropped from 10% to 8.33%. Therefore, we can say
that the test of over capitalization is the low rate of return on
capital over long term.
 Over capitalization and Excess of capital
• It may be noted that over capitalization is not exactly
the same as excess of capital.
• Abundance of capital may be one of the reasons of
over- capitalization but it is not the only reason .
• In fact , in actual practice , many over – capitalized
companies have been found to be short of funds.
• Over capitalization arises when the existing capital of a
firm is not effectively utilised with the result that there
is a fall in the earning capacity of the company. Thus,
the main sign of over – capitalization is fall in the rate
of dividend and market value of shares of the company
in the long- run.
 Causes of Over Capitalization q
1.Over – Issue of Capital
2. Promotion, formation or development during inflation
3. Buying assets of lower value at higher prices
4. High Promotion expenses
5. Inadequate depreciation
6. Liberal Dividend Policy
7. Taxation Policy
8. Inadequate demand for products
9. Payment of high rate of interest
10. Under estimation of capitalization rate
 Effects or Evils of Over Capitalization
1. Effects of the company
i. Loss of goodwill – Low earnings, MP, Investors confidence
ii. Poor creditworthiness- Low earnings, difficult to get loans at low COC.
iii. Difficulties in obtaining Capital – investors lost confidence
iv. Decline in efficiency of the company – to cover the loss, other
losses
v. Loss of Market- fail to produce goods at competitive costs.
vi. Inflated profits- manipulation of accounts and over statements of their
profits
vii. Liquidation of company
2. Effects on Shareholders
i. Reduced dividends – unable to pay fair rate of
dividend
ii. Fall in the value of shares- low rate of earnings
and reduced dividends
iii. Loss on Speculation- over capitalized company
remain unstable
iv. Loss on reorganization- reorganization and
reduction of its capital in order to write off the
accumulated losses.
3. Effects on Society
i. Loss to consumers- increase in price and
reduction in quality
ii. Loss to workers- reduce wages and welfare
facilities
iii. Under or misutilization of resources
iv. Gambling in shares
v. Recession
Remedies for Over - Capitalization
1. To have an efficient management- reduce
expenditure and improve earning capacity

2. Redemption of Preference shares- high rate of

dividend – redeemed- raise equity capital
3. Reduction of funded debts- repayment of
high cost of debt – fresh borrowings with low
COC.
4. Reorganization of equity share capital
 Under Capitalization
• In simple words , we can say that under –capitalization
is the reverse phenomenon of over capitalization and
occurs when a company’s actual capitalization is lower
than its proper capitalization as warranted by its
earning capacity. The term under capitalization should
never be considered synonymous with inadequate
capital
• 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 can pay a higher rate of dividend and the
market value of its shares is much higher than its face
value.
• Causes for under capitalization
1. Under estimation of capital requirements
2. Under estimation of future earnings
3. Conservative dividend policy
4. Very efficient management
5. Desire of control and trading on Equity
 Effects of Under Capitalization
1. Induces management to change and manipulate the market value of shares
and expanding the business
2. EPS increase and so does the dividend per share , which is in turn, increases
the marketability of shares.
3. When the employees find that the company is earning high profits they press
for higher wages.
4. The company earn huge profits and as result , the burden of tax is great.
5. High profits- Give psychological feeling to the customers that they are being
over –charged
6. Higher earnings may encourage competitors to enter into a cut- throat
competition amongst themselves
7. A situation of over trading by the company may arise as a result of under
capitalization, where the company does excessive business than what its
finances can allow.
8. As a result of over trading, creditors will not be paid timely and company will
effect its creditworthiness adversely.
9. Under capitalization eventually leads to over – capitalization because of
excess profits, huge retained earnings and long term debt financing.
 Remedies for Under capitalization
1. fresh issue of shares
2. Issue of Bonus shares
3. Increasing the par value of shares
4. Splitting Stock.
Particulars Over Capitalization Under Capitalization
Involves A great Strain on the High rate of earnings on
financial resources of a its shares
company
Remedial Procedure Difficult and Expensive Comparatively easier and
not expensive
Accelerates Cut throat competition Adversely effects the
amongst companies shareholders and
results in discontentment enlarges the economic
among employees and stability and social
grouse amongst prosperity.
customers
Phenomena Common Relatively rare
phenomena
1. Example Illustrates the over capitalization situation of a company.

Balance Sheet
Liabilities Rs Assets Rs
Share Capital 10,00,000 Fixed Assets 12,00,000
Debentures 5,00,000 Current assets 13,00,000
Current 10,00,000
Liabilities
25,00,000 25,00,000

Fixed Liabilities = 10,00000 + 500000= 1500000

Fixed Assets = 12,00,000
The excess of fixed liabilities over fixed assets is
(15,00,000-12,00,000)= Rs 3,00,000
Thus, we say that the firm is over capitalized to the extent of Rs.
3,00,000
2. Example Illustrates the Under capitalization situation of a company.

Balance Sheet
Liabilities Rs Assets Rs
Share Capital 10,00,000 Fixed Assets 16,00,000
Debentures 5,00,000 Current assets 9,00,000
Current 10,00,000
Liabilities
25,00,000 25,00,000

Fixed Liabilities = 10,00000 ( SC) + 500000 ( Dbn)= 1500000

Fixed Assets = 16,00,000
The excess of fixed Assets over fixed liabilities is
(16,00,000-15,00,000)= Rs 1,00,000
Thus, we say that the firm is under capitalized to the extent of Rs.
100,000
3. Example Illustrates the Fair capitalization situation of a company.

Balance Sheet
Liabilities Rs Assets Rs
Share Capital 10,00,000 Fixed Assets 15,00,000
Debentures 5,00,000 Current assets 10,00,000
Current 10,00,000
Liabilities
25,00,000 25,00,000

Fixed Liabilities = 10,00000 ( SC) + 500000 ( Dbn)= 1500000

Fixed Assets = 15,00,000
The excess of fixed Assets over fixed liabilities is
(15,00,000-15,00,000)= 0
Hence, the firm is said to be fairly Capitalized.
4.An Under capitalized concern really over capitalized.
Balance Sheet
Liabilities Rs Assets Rs
Share Capital 10,00,000 Fixed Assets 16,00,000
Debentures 5,00,000 Current assets 19,00,000
Reserve Funds 3,00,000
Current Liabilities 7,00,000

25,00,000 25,00,000
Fixed Liabilities = 10,00000 ( SC) + 500000 ( Dbn)= 1500000
Fixed Assets = 16,00,000
The excess of fixed Assets over fixed liabilities is
(16,00,000-15,00,000)= 1,00,000 (concern seems to be under capitalized )
But, in case reserve fund is taken in to consideration , the fixed liabilities are Rs
18,00,000 then
The excess of fixed liabilities over fixed assets of Rs 2,00,000 ( 18,00,000- 16,00,000)
Hence, in reality, the concern is over capitalized.
4.An Under capitalized concern really over capitalized.
Balance Sheet
Liabilities Rs Assets Rs
Share Capital :
2000 Equity Shares of of Rs100 each 2,00,000 Fixed Assets 3,00,000
500 10% preference shares of Rs. 100 50,000 Current assets 1,00,000
each
Reserve and Surplus 1,00,000
Current Liabilities 50,000
4,00,000 4,00,000
The normal rate of return in case of similar business is 10% Ascertain
whether the company is over – capitalized , under capitalized or fairly
capitalized when earnings available for equity shareholders are:
(i). Rs.25000
(ii). Rs. 40,000
(iii). Rs. 30000
4.An Under capitalized concern really over capitalized.
Balance Sheet
Liabilities Rs Assets Rs
Share Capital :
4000 Equity Shares of of Rs100 each 4,00,000 Fixed Assets 6,00,000
1000 10% preference shares of Rs. 100 1,00,000 Current assets 2,00,000
each
Reserve and Surplus 2,00,000
Current Liabilities 1,00,000
8,00,000 8,00,000
The normal rate of return in case of similar business is 20% Ascertain
whether the company is over – capitalized , under capitalized or fairly
capitalized when earnings available for equity shareholders are:
(i). Rs.50000
(ii). Rs. 80,000
(iii). Rs. 60000
 Watered stock or capital
When the stock or capital of a company is not
represented by assets of equivalent value, it is
termed as ‘ watered stock’ signifying presence of
water in the capital of the company.
In simple words, watered capital means that
realisable value of assets of a company is less than its
book value.
In the words of Hoagland “ A stock is said to be
watered when its true value is less than its book
value .
 Causes of Watered stock
• The problem of watered stock generally arises at the time
of incorporation of a company, but in some cases , it may
also arise latter during the life time of the company.
• The following are the main causes of watered stock
situation
i. Valuing the services of the promoters at unduly high
values and paying for their services in the form of stocks
ii. Acquiring the assets of the company at too high a price.
iii. Acquisition of intangible assets such as patents,
copyrights, goodwill etc at high values which later prove
worthless.
• Watered Stock vs Over – capitalization
The situation of watered stock arises , usually , at
the time of incorporation of a company, but it gets
over – capitalized only when it fails to earn
sufficient earnings to justify its funds
However , it may be noted that watered stock
eventually causes over – capitalization but it is not
always so because the earnings of the company
may justify its capitalization although the stock may
remain watered.
Over Trading
In simple words, over trading means a situation where a
company does more business than what its finances allow.
It is related to the cash position of the enterprise, and it
occurs when the company expands its scale of operations
with insufficient cash resources.
The result is disastrous as over – trading gives rise to
increase in size, diminishing margin of safety and feeling a
sense of stress and strain.
Thus, is advisable for every company to carry on its
business in terms the financial resources it has at its
command and not to do more business or excessive trading
than what its finance permit.
• Causes of Over Trading
1. Inflation and rising prices
2. High incidence of Taxation
3. Increased lock up of funds in stocks
4. Over – expansion
• Consequences of Over trading
1. Inability of the management to pay wages to the
employees and taxes to the government.
2. Decline in sales and costly purchases
3. Difficulty in raising funds because of poor
creditworthiness
4. Problems with debtors and creditors
5. Inability of the management to carry out timely
repairs and maintenance resulting in efficient
working.
• Remedies of Overtrading
1. The company should cut down its business and
over spending or it should arrange for more
funds
2. Preventing a situation of over trading by taking
precautionary steps.
• Under – trading
Under trading is just the opposite of over trading where
the funds of a company are not utilised fully because of
inefficient management.
Too much amount invested in current assets and too low
an amount due to creditors will be the symptoms of
under – trading. The consequences of under – trading are
reduced profits, low rate of return on investment ,
decline in the share prices in the share market and
eventually loss of goodwill.