MODULE 3

FINANCING DECISIONS
CAPITALIZATION, CAPITAL STRUCTURE AND
FINANCIAL STRUCTURE

• Capitalization – Quantitative aspect of financial planning. It

refers to the total amount of securities issued by the
company
• Capital structure – Qualitative aspect of financial planning.
• Capital structure refers to the proportionate amount that
makes up capitalization.
• Financial structure means the entire liabilities side of the
balance sheet.
 Example
Given the following information, you are required to compute:
1. Capitalization,
2. Capital structure and
3. Financial structure.
Liabilities Amt.
Equity share capital 10,00,000
Preference share capital 5,00,000
Long term loans and debentures 2,00,000
Retained earnings 6,00,000
Capital surplus 50,000
Current liabilities 1,50,000
25,00,000
1. Capitalization refers to the total amount of securities
issued by the company. It is computed as below:

Amt.
Equity share capital 10,00,000
Preference share capital 5,00,000
Long term loans and debentures 2,00,000
Capitalization 17,00,000
• 2. Capital structure refers to the proportionate amount that
makes up capitalization.

Amt. Proportion/Mix

Equity share capital 10,00,000 58.82%

Preference share capital 5,00,000 29.41%

Long term loans and debentures 2,00,000 11.77%

17,00,000 100%
 • 3. Financial structure means the entire liabilities side of
the balance sheet.

Amt. Proportion/Mix
Equity share capital 10,00,000 40%
Preference share capital 5,00,000 20%
Long term loans and debentures 2,00,000 8%
Retained earnings 6,00,000 24%
Capital surplus 50,000 2%
Current liabilities 1,50,000 6%
25,00,000 100%
 Optimal capital structure

Ezra Solomon “Optimum leverage can be defined

that mix of debt and equity which will maximize the
market value of of a company”
• Optimal capital structure is that capital structure
which leads to maximum value of the firm.
• It maximizes the market value of the firm.
• It maximizes the wealth of the owners.
• It minimizes the company’s cost of capital.
Features of Optimum Capital Structure:
• Profitability
• Risk
• Flexibility
• Conservatism
• Control
Cost of Capital

Equity Shares Dividends

Preference Shares Dividends

Debentures Interest
 How to achieve optimal capital structure

Four considerations to be kept in mind:

1. ROI > Fixed cost of capital, then company must raise funds
with fixed cost. Ex. Preference shares, debentures, long term
loan. This will increase EPS and market value of the firm.
2. If more debt is used as a source of finance, it reduces the tax
liability of the firm.
3. Avoid risk in order to increase the market price of the share.
4. Capital structure should be flexible.
 Over capitalization, under capitalization
and fair capitalization
• Capital gearing refers to the relationship between equity
capital and long term debt.

• Equity < Debt – Highly geared or under capitalization

• Equity > Debt – Low geared or over capitalization
• Equity = Debt – Fairly geared or fair capitalization
Over Capitalisation
A company is said to be over capitalized when the total of owned and
borrowed capital exceeds its fixed and current assets. This happens
when it shows accumulated losses on the assets side of the balance
sheet.
Causes of Over Capitalization:
• Idle funds
• Over-valuation of acquired assets
• Fall in value of fixed assets:
• Inadequate depreciation provision
Over Capitalisation-Continued
• Overcapitalization occurs when a company has more debt than its assets
are worth.

• A company that is overcapitalized may have to pay high interest and

dividend payments that will eat up its profits. This may not be
sustainable in the long term.

• Overcapitalization occurs when a company has more capital than it

needs to operate effectively. This can result from raising too much equity
or debt, leading to inefficient use of resources and a lower return on
investment.

• Ultimately, a company that is overcapitalized may face bankruptcy.

Causes:
• Excessive Fundraising: Raising more funds than necessary
through equity or debt.
• Declining Business Performance: Reduction in profits or
earnings while capital remains unchanged.
• Overvaluation of Assets: Inflating asset values leading to
excessive capitalization.
• Inadequate Investment Opportunities: Lack of profitable
investment avenues for the excess capital.
Effects:
• Low Return on Equity: Excess capital dilutes earnings,
reducing returns for shareholders.
• High Dividend Payouts: Pressure to distribute excess profits,
potentially leading to unsustainable dividend policies.
• Inefficiency: Capital tied up in unproductive assets or low-
yield investments.
• Market Perception: Negative investor sentiment due to
perceived inefficiencies.
Remedies:
• Buyback of Shares: Reducing equity base by repurchasing
shares.
• Debt Reduction: Using excess cash to repay outstanding
debts.
• Reinvestment: Investing in high-yield projects or diversifying
into new areas.
• Dividend Adjustment: Adjusting dividend policies to reflect
sustainable earnings.
Under- Capitalization
• If the owned capital of the firm is disproportionate to the
size of business operations and the firm has to depend upon
borrowed money and trade creditors it is a sufficient
indicator of undercapitalization
• Undercapitalization occurs when a company does not have
sufficient capital to carry out its operations efficiently.
This often leads to difficulties in meeting operational
expenses, funding growth, or investing in new
opportunities..
Causes of Undercapitalization
• Inadequate Initial Capital: Starting with insufficient funds to
support the business operations.
• Rapid Expansion: Expanding operations or markets too quickly
without adequate funding.
• Poor Financial Planning: Ineffective management of working
capital and cash flow.
• Economic Downturns: Adverse economic conditions leading to
reduced revenue and profitability.
1
Effects:
• Liquidity Issues: Struggling to meet short-term obligations and
pay suppliers.
• High Borrowing Costs: Dependence on short-term loans at
high interest rates.
• Stunted Growth: Inability to invest in growth opportunities or
take advantage of market conditions.
• Operational Challenges: Frequent cash flow problems
impacting daily operations.
Remedies:
• Equity Financing: Raising funds through the issuance of
shares.
• Debt Restructuring: Refinancing existing debts to better
terms.
• Improved Cash Flow Management: Enhancing working capital
efficiency.
• Cost Control: Implementing cost-saving measures to improve
liquidity.
Key Differences
• Capital Adequacy:
• Undercapitalization: Insufficient capital for operations.
• Overcapitalization: Excess capital beyond operational needs.
• Financial Health:
• Undercapitalization: Leads to liquidity issues and stunted growth.
• Overcapitalization: Results in inefficient capital use and low
returns.
• Investor Impact:
• Undercapitalization: Can erode investor confidence due to
operational struggles.
• Overcapitalization: Can lead to negative perceptions due to
inefficient capital management.
Factors determining the capital structure
• Business Risk:
The risk associated with the firm's operations, excluding financial
risk.
• Impact: Higher business risk typically leads to a preference for lower
debt levels to avoid the added risk of fixed interest obligations.

• Company Size and Growth Stage:

The size and stage of development of a company.
• Impact: Larger, established companies often have more predictable
earnings and can afford to take on more debt, whereas smaller or
growth-stage companies may rely more on equity.
• Cost of Debt and Equity:
The cost associated with borrowing funds (interest) versus the
cost of issuing equity (dividends or dilution of ownership).
• Impact: Companies compare the after-tax cost of debt with
the cost of equity. Generally, if debt is cheaper, they might
prefer debt financing.

Tax Considerations:
The tax implications of debt versus equity.
• Impact: Interest on debt is tax-deductible, making debt
financing more attractive from a tax perspective.
Market Conditions:
Prevailing economic and market conditions.
• Impact: Favorable market conditions may make equity
issuance more attractive, while in downturns, companies
might prefer debt if equity valuations are low.

• Financial Flexibility:
The ability of a company to adapt its capital structure to
changing conditions.
• Impact: Companies prefer a mix of debt and equity that
allows them to remain flexible and responsive to market
changes and opportunities.
Control Considerations:
The desire of existing owners to retain control over the
company.
• Impact: Issuing equity can dilute ownership, so companies
might prefer debt to avoid diluting control.

• Regulatory Environment:
Legal and regulatory requirements that influence financing
decisions.
• Impact: Regulations might impose limits on the amount of
debt a company can incur, or offer incentives for certain types
of financing.
Asset Structure:
The composition of a company's assets.
• Impact: Companies with significant tangible assets might use
these as collateral to secure debt financing, whereas
companies with more intangible assets might rely more on
equity.

Profitability and Cash Flow:

The company’s ability to generate profits and cash flow.
• Impact: More profitable companies with stable cash flows
can afford higher levels of debt due to their ability to meet
interest obligations.
Trading on Equity

Trading on equity, also known as financial leverage, refers to

the practice of using borrowed funds (debt) to amplify the
potential returns to equity shareholders. By leveraging debt, a
company aims to increase its earnings per share (EPS),
assuming that the returns from the borrowed funds exceed the
cost of borrowing.
Mechanism of Trading on Equity
• Borrowing Funds: The company borrows funds through loans,
bonds, or other financial instruments.
• Investing in Operations: The borrowed funds are invested in
business operations or new projects aimed at generating
higher returns.
• Generating Returns: The goal is for the returns on the
investment to exceed the interest cost of the borrowed funds.
• Increasing EPS: The increased earnings from the investment
are distributed among the shareholders, thereby increasing
EPS.
Advantages of Trading on Equity
• Increased Returns: When used effectively, leverage can
significantly boost returns for equity shareholders.
• Tax Benefits: Interest payments on debt are tax-deductible,
reducing the company's taxable income.
• Retained Control: Raising funds through debt rather than
equity helps existing shareholders maintain control over the
company.
Business risk and financial risk
• Business risk refers to the shortage of funds to meet the
operating expenses.

• Financial risk refers to the shortage of funds to meet the

interest obligation.
LEVER.

A lever is simply a plank or ridged beam that is free to rotate on a

pivot. It is perfect for lifting or moving heavy things. It is a very
useful simple machine, and you can find them everywhere. Good
examples of levers include the seesaw, crowbar, fishing-line, oars,
wheelbarrows and the garden shovel.
Leverage in financial management refers to the use of various
financial instruments or borrowed capital (debt) to increase
the potential return on investment. The concept of leverage is
crucial in financial management as it affects the capital
structure and overall risk of the business.
LEVERAGES
Leverage refers to the employment of assets or sources of fund
bearing fixed payment to magnify EBIT or EPS respectively.
Format - Master Table of Leverages
Particulars Amount
Sales xxxx
(-) variable Cost xxxx
Conribution xxxx
(-) Fixed Cost xxxx
EBIT ( Earnings before interst and tax xxxx
(-) Interest xxxx
EBT ( Earnings before tax) xxxx
(-) Corporate Tax xxxx
EAT ( Earnings after tax) xxxx
(-) Preference Dividend xxxx

EAESH (Earnings avialable to equity shareholders) xxxx

No. of Equity Shares xxxx

EPS = EAESH/No. of ES xxxx
 Types of Leverage
Leverage can be classified into three main types: operating
leverage, financial leverage, and combined leverage.
Operating leverage

Operating leverage is concerned with the investment activities of

the firm. It relates to the incurrence of fixed operating costs in the
firm’s income stream.

The operating cost of a firm is classified into three types:

Fixed cost, variable cost and semi-variable or semi-fixed cost.

Investment decision goes in favour of employing assets having

fixed costs because fixed operating costs can be used as a lever.
Operating leverage measures the proportion of fixed costs in a
company's cost structure. High operating leverage means that a
company has a higher proportion of fixed costs relative to
variable costs.
 Contribution
Operating leverage =
EBIT

Hence the firm’s ability to use fixed operating costs to magnify the effects of
changes in sales on its earnings before interest and taxes is termed as
operating leverage

% of Change:
∆𝑬𝑩𝑰𝑻
DOL =
∆𝑺𝒂𝒍𝒆𝒔
• ∆ in change
Financial Leverage
Financial leverage refers to the use of debt to finance the assets of
the company. The goal is to amplify the returns to equity
shareholders by using borrowed funds.

• Financial leverage is mainly related to the mix of debt and

equity in the capital structure of a firm.
• It exists due to the existence of fixed financial charges that do not
depend on the operating profits of the firm.
• Financial leverage results from the existence of fixed financial
charges in the firm’s income stream. With the use of fixed
financial charges, a firm can magnify the effect of change in
EBIT on change in EPS
 EBIT
Financial leverage = =
EBT

Hence financial leverage may be defined as the firm’s ability to

use fixed financial charges to magnify the effects of changes in
EBIT on its EPS.

% of Change:
∆𝑬𝑷𝑺
DFL =
∆𝑬𝑩𝑰𝑻
It is to be noted here that these two leverages are not independent
of each other; rather they form a part of the whole process. So we
want to know the combined effect of both investment and
financing decisions. The combined effect of operating and
financial leverage is measured with the help of combined
leverage.
Combined Leverage
Combined leverage considers both operating and financial
leverage. It measures the overall risk and potential return by
taking into account the fixed costs in operations and financing.

• A firm incurs total fixed charges in the form of fixed

operating cost and fixed financial charges.
• Operating leverage is concerned with operating risk
• Financial leverage is associated with financial risk
• Both the leverages are concerned with fixed charges.
• If we combine these two we will get the total risk of a firm
that is associated with total leverage or combined leverage
of the firm. Combined leverage is mainly related with the
risk of not being able to cover total fixed charges.
 Combined Leverage = OL x FL

Contribution EBIT
= x
EBIT EBT

% of Change:
∆𝑬𝑷𝑺
DCL =
∆𝑺𝒂𝒍𝒆𝒔