BACHELOR OF BUSINESS ADMINISTRATION (B.B.A.

)
FOURTH SEMESTER
BBA: 401 (FINANCIAL MANAGEMENT)
 Unit - II
 Capitalization:
Meaning of Capitalization:
Capitalization comprises a firm‟s ownership capital and borrowed capital as represented by
its long-term indebtedness. In this way, it includes all items shown on the liabilities side of
a Balance Sheet excluding items representing current liabilities. In this sense capitalization
can be considered an important step in the process of financial planning which determines
the total amount of capital funds needed to be employed regularly in an enterprise.

Definition of Capitalization:
According to Guthman and Dougal, “Capitalization is the sum of the par value of the stocks
and bonds outstanding.”
According to Gersternberg W.C., “For all practical purposes capitalization sometimes
means the total accounting value of all the capital regularly employed in the business.”
According to Guthman & Dougal, “Financial Management is the activity concerned with
planning, rising, controlling and administering of funds used in business.”

 Importance of Capitalization:
1- A high percentage of debt in comparison with equity helps to keep the ownership of a
company in check as debt holders are not owners of the company.
2- The interest paid on debt is an allowable expense in most jurisdictions and hence this
reduces the tax liability of the company.
3- Debt financing is relatively easy to source compared with the issuance of shares.
4- Capitalization ensures proper matching of revenues with expenses in that if an
expense serves more than one period it should be capitalized and allocated over the relevant
period.
5- Capitalization ensures that there is no large fluctuations in the earnings of a company
from one financial year to the next since if a large expense is not capitalized and allocated
over the relevant periods, it will result in a low or no profit in that financial year while the
next years report huge profits.

 Over Capitalization:
When a company has consistently been unable to earn the prevailing rate of return on its
capital employed, the situation is termed as over-capitalization. A corporation is said to be
over-capitalized when its earnings are not enough to yield a fair return on the amount of
securities outstanding or when the book-value of its securities exceeds the current value of
its assets.
Definition of Over-Capitalization:
According to Harold Gilbert, “when a company gas consistently been unable to earn the
prevailing rate of return on its outstanding securities (considering the earnings of similar
companies in the same industry and the degree of risk), it is to be over-capitalized”
For example, suppose the promoters kept the amount of total capitalization at
Rs. 40, 00,000, but after starting operations over the years. It was realized that the average
annual earnings (EBIT) were only 3, 20,000 (instead of Rs. 4, 80,000 as anticipated
initially). The current rate of capitalization in market is 12%.

Causes of Over- Capitalization:

1- Over-estimation of Future Earnings
2- Under-estimation of Capitalization Rate
3- High Promotion Expenses
4- Purchase of Assets During Inflationary Conditions
5- Liberal Dividend Policy
6- Shortage of Capital
7- Borrowing of Higher Interest Rate
Effect of Over- Capitalization:
I- Effect on the Company: 1. Decrease in the value of Goodwill
2. Difficulty in Obtaining Capital
3. Difficulty in Obtaining Loan
4. Demand for Liquidation
5. Lack of Competitive Strength
II- Effect on the Society: 1. Low Quality Product on Higher Price
2. Fear of Recession
3. Fear of Unemployment
4. Encouragement of Speculation
5. Reduction in Wage & Labor Welfare
III- Effect on the Share Holders: 1. Low Market value of Share
2. Loss on Re- organization
3. Low Rate of Dividend
4. Less Collateral Value of Securities
5. Encouragement to Gambling

 Under-Capitalization:
Under- capitalization is a state of capitalization in which a company, by and large, has been
earning a rate of return on its capital employed which is higher than the current rate of
capitalization in the market.
In other words, an under-capitalized company is one whose earnings have been higher in
relation to the size of the invested capital. It can also be said that the real value of its fixed
assets (as reflected in its high earning power) is more than their values shown in the books.
In the capital market, the market prices of its shares will be high in the eyes of investors
with the result that the market prices of its shares will be far above their par value.
According to C.W. Gerstenben, “A corporation is under-capitalised when the rate of profits
it is making on the total capital, is exceedingly high in relation to the return enjoyed by
similarly situated companies in the same industry, or when it has too little capital with
which to conduct its business.”
Causes of Under- Capitalization:
1- Under Estimation of Earnings
2- Low Promotion Expenses
3- Liberal Taxation Policy
4- Capital Gains
5- Unforeseen Increase in Earnings
6- Conservative Dividend Policy
Effects of Under-Capitalization:
I- Effects on the Company: 1- Encouragement to Speculation
2- Government Interference
3- Inadequacy of Capital
4- Limited Marketability of Shares
5- Industrial Unrest
II- Effects on the Society: 1- General Welfare
2- Employees Advantages
3- More Production
4- More Employment
III- Effects on the Share Holders: 1- Higher Dividend
2- Capital Gains
3- Easy Loans
 Optimum Capitalization:
An optimum capitalization can be defined as a financial plan having an appropriate debt-
equity mix which minimizes overall cost of capital of the firm and maximizes the market
price per share or the total value of the firm. Accordingly, if a debt-equity mix in financial
plan results in achieving the above two objectives, it can be termed as an optimum capital
structure. If such a capital structure can be designed and maintained over a period of time,
then certainly it will achieve the basic objective of maximizing wealth or economic welfare
of the owners.
Essentials of Optimum Capitalization:
An optimum capital structure for a company has to be designed taking into account the
circumstances specific to that company. There can be no common template for optimum
capital structure for all companies. However, an optimum capital structure should have
following qualities-
1- Simplicity
2- Flexibility
3- Full Utilization
4- Liquidity
5- Minimization of Cost
6- Maximization of Return
7- Minimization of Risk
8- Maximization of Control
 Capital Structure:
Meaning:
Capital Structure is an issue concerned with the determination of debt equity mix or debt
equity ratio. The basic pattern of capital structure may take anyone of these forms: (I) only
equity shares (II) equity and preference shares, (III) equity shares and debentures and (IV)
equity shares, preferences shares and debentures. There are no hard fast rules to indicate
what pattern would be ideal. In the case of an ongoing firm, retained earnings or past
accumulated profits also constitute an integral part of its capital structure; as these are
internally generated funds which are long-term in future.
Definition Capital Structure:
According to Weston and Brigham, “Capital structure is the permanent financing of the
firm, represented primarily by long-term debt, preferred stock and common equity but
excluding all short-term credit. Common equity includes common stock, capital surplus
and accumulated retained earnings.”
According to I M Pandey, “Capital structure includes long-term financial sources i.e.
debenture, long-term debts, preference share capital, reserves, surplus, etc.”
Determinants of Capital Structure: 1- Nature of Business
2- Purpose of Finance
3- Amount of Risks
4- Cost of Capital
5- Income of Business
6- Flexibility
7- Attitude of Management
8- Control
9- Conditions of Capital Market
10- Psychology of Investors
 Leverages:
Leverage is a term drawn from the science of engineering which indicates mechanical
advantage or effectiveness gained by the action of a lever. In financial terminology,
leverage is indicative of advantage or disadvantage due to which a slight increase or
decrease in the volume of output or debt financing causes a much more increase or
decrease in the profits of the company. The concept of leverage is used to assess the risks
associated with „high fixed cost‟ or with a „high debt-equity ratio‟.
According to Solomon Ezra, “Leverage is the ratio of the rate of return on shareholders‟
equity and the rate of return on total capitalization.”
  Operating Leverage:
When a firm operates with heavy fixed costs in relation to its total operating costs; it is said
to be using operating leverage. Use of high fixed operating costs does magnify a change in
profits relative to a given change in sales. In other words, it can be said that when operating
leverage is high (or fixed costs are high in total costs), a slight favorable or unfavorable
change in sales will cause a much more favorable or unfavorable change in operating
profits (OP) or pitch, the having a high operating leverage may have an edge over the firm
having a low operating leverage. But as soon as the income from sales goes up for the
income from sales goes down, the corresponding disadvantage or risk also goes up for the
former as compared to the later.
Definition of Operating Leverage:
According to E.F. Brigham, “If a high percentage of a firm‟s total costs are fixed costs,
then the firm is said to have a high degree of operating leverage.”
According to Soloman Ezra, “Operating leverage is the tendency of the operating profit to
vary disproportionately with sales.”
Contribution
Operating Leverage = ---------------------
EBIT
Or,
N (SP – VC)
Operating Leverage = -------------------------
N (SP – VC) - FC

Here, EBIT = Earnings Before interest & Tax

Contribution C = Sales-Variable Cost
N = Number of Unit Sold
SP = Selling Price per Share
VC = Variable Cost per Unit
FC = Total Fixed Cost

Financial Leverage:
Financial Leverage indicates the impact of debt-financing on the earning (profit before tax)
of the firm. High financial leverage represents a higher proportion of borrowed funds in the
total capitalization of the company.
According to Solomon Ezra, “Financial Leverage refers to the mix of debt and equity used
to finance the firm.
According to Weston Host, “Financial Leverage is defined by either the ratio of total debt
to net worth or by the ratio of total debt to total assets.”
Financial Leverage can be computed as follows:

EBIT EBIT
Financial Leverage = ---------------- OR = --------------------
PBT EBIT - INT

Here, FL = Financial Leverage

EBIT = Earning before interest and Tax
PBT = Profit before Tax (EBIT - INT)

Combined Leverage:
Both these leverage (Financial & Operating) exercise a combined impact on the earnings of
a firm. Operating leverage causes considerable accelerating impact on the rate of return on
overall investment in relation to change in the size of sales; which involves business risk is
the result of assets-mix in a firm. On the contrary, financial leverage (FL) is the result of
capital-mix of a firm and is mainly concerned with the liabilities side of the balance sheet
of the firm. Financial leverage (FL) imparts an accelerating or decelerating impact on the
rate of return on owner‟s funds or on earnings per shares (EPS).
Contribution
Combined Leverage = ---------------------
PBT
Or,
S – VC S – VC – FC
Combined Leverage = ------------------------- X ------------------------
S – VC – FC S – VC – FC – INT

Or
Contribution EBIT
Combined Leverage = --------------------- x ---------------------
EBIT PBT

Here, EBIT = Earnings Before interest & Tax

Contribution C = Sales-Variable Cost
S = Sales
VC = Variable Cost
FC = Fixed Cost
  Planning the capital Structure by EBIT-EPS Analysis:
EBIT/EPS Analysis can provide a very useful measure for designing an appropriate capital
structure of a firm. This analysis reveals the impact on EPS of the firm at various levels of
EBIT under various alternative financial plans. Given a particular level of EBIT every
financial manager will try his best to design a capital structure (or a debt-equity mix) which
can provide the highest EPS is a yardstick to measure the firm‟s performance and a major
contributory factor in determining the value of the firm. As maximization of the value of
the firm is one of the basic objectives of financial management, it becomes imperative for a
financial manager to design a capital structure which can succeed in minimizing the overall
cost of capital of the firm and can at the same time maximize the market value of the shares
of the firm. At the higher level of EBIT a financial manager can induct more debt-capital in
the capital structure, which will certainly give added benefit to equity-holders by way of
higher EPS, ultimately resulting in increasing the value of the firm. This creates the
necessity of computing EPS at various levels of EBIT, under alternative financial plans.
Can there be an EBIT at which EPS would be the same irrespective of any debt-equity
mix? Certainly such an EBIT level can be computed which can provide equal EPS under
any debt-equity mix. This level of EBIT will be indicative of indifference point or break-
even level of EBIT.
Numerical Problems:

1. A firm sells its products for Rs. 100 per unit. its variable cost Rs. 50 per unit and
fixed costs Rs. 25,000 per year. Show the various levels of EBIT that would result
from sale (I) 1,000 units (II) 250 units (III) 750 units. Calculate operating leverage.
2. A company has estimated that for a new product its selling price is Rs. 28 per unit,
variable cost is Rs. 18 and fixed cost is Rs. 20,000. Calculate the operating leverage
for sales volume of 6,000 units and 8,000 units.
3. The following data are available in respect of a company:

Equity Share Capital (Dividend into shares of Rs. 10 each) 50, 00,000
Debenture (12%) 20, 00,000
Earnings before Interest & Tax (EBIT) 16, 00,000
You are required to calculate the Financial Leverage (FL) of the company:
4. Find out financial leverage from the following data:
Net Worth Rs. 25, 00,000
Debt/Equity 3:1
Interest Rate: 12%
Operating Profit Rs. 20, 00,000
5. Calculate operating leverage, financial leverage and combined leverage form the
following data.
Sales 2, 00,000 units @ Rs. 2 per unit 4, 00,000

Variable cost per unit @ Rs. 0.70 per unit

Fixed Cost Rs. 2, 00,000

Interest Charge on Debt Capital Rs. 7,336

6. Profitability statement of Vijay & Company Ltd. compute the (I) operating
leverage (II) financial leverage (III) combined leverage.

Sales - 4, 80,000/- , Variable Cost- 2, 80, 000/- , Fixed Cost- 1, 20,000/-

Interest- 30,000/-

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