Capitalisation Part 4

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The term capitalisation has various connotations. In common parlance, it refers to the amount at which a company is valued based on its capital employed. Some of the experts on finance used this concept in a narrower sense and defined it as the par value of a company’s shares and debentures, while some of them interpreted it as the par value of its total long-term funds which includes owners fund, borrowed funds, reserves and surplus earnings. In the context of financial planning however, it refers to the process of determining the amount of capital required by a company.

The capital estimation is arrived at by using the following two theories.

  • Cost theory

  • Earning theory

Let us have a brief about these two theories.

Theories-Cost and Earning

Theories-Cost and Earning

Theories-Cost and Earning

Cost Theory

According to the cost theory of capitalisation, the amount of capital required by the company is calculated by adding up the cost of its fixed assets, the amount of its working capital and the cost of establishing the business. This approach is simple and used widely in case of new companies.

Earning Theory

According to earning theory, the capital requirement of a company is calculated on the basis of the capitalised value of its earning. For example, if the average annual earning of a company is Rs. 5 lakh and the normal rate of return on the capital employed in case of companies in the same industry is , then the amount of capitalisation is Rs. 50 lakhs. For a new company the amount of capitalisation is calculated on the basis of its estimated earnings. For example, if a new company expects to earn an average annual income of Rs. 3 lakh and the normal rate of return of the industry is , then the amount of capitalisation or the quantum of fund it would require to run the business is Rs. 60 lakhs. This approach of capitalisation is considered more rational and relevant because it helps in evaluating as to how far the actual capital employed is justified by the earning of the company. If the actual rate of return is same as the normal rate of return then it is said to be proper capitalised.

Over-Capitalisation

A company is said to be over-capitalised if its capital employed is more than its proper capitalisation. For example, if a company’s average annual earnings are Rs.2,00,000 and the normal rate of return is . Then its proper capitalisation is Rs.20,00,000. Now, if the actual capital employed (total long-term funds) is Rs.25,00,000 it will be treated as over-capitalised. You can also put it in another simpler way i.e., if a company’s actual rate of earnings is less than the normal rate of return, it is treated as a case of over-capitalisation. In the above example, the company’s actual rate of earnings works out as which is less than the normal rate of return i.e., . So, it is considered as over-capitalised and the company is not in a position to pay interest and dividends at a fair rate. Such a situation may be caused by the following factors:

  • Excessively high price paid for the purchase of goodwill and other fixed assets.

  • Underutilisation of production capacity.

  • Raising more capital in the form of shares and debentures than required.

  • Liberal dividend policy.

  • Higher rate of corporate taxation.

  • Underestimation of capitalisation rate or overestimation of earnings while deciding on the amount of capital to be raised. Over-capitalisation is not desirable in the long run interest of the shareholders and the company.

Under-Capitalisation

Under-capitalisation is just the reverse of over-capitalisation. In other words, a company is said to be under-capitalised if its capital employed is less than its proper capitalisation i.e., the amount of capital invested is not justified by its annual earnings. In the earlier case, for example, if the company’s actual capital employed is Rs. 16,00,000 it shall be treated as under-capitalised as it is less than Rs. 20,00,000, the proper capitalisation. Alternatively, if a company’s actual rate of earnings is more than the normal rate of return, it is treated as a case of under-capitalisation. This does not imply that the company suffers from inadequacy of capital. In fact, such a situation may be the result of underestimation of expected earnings while deciding on the amount of capital to be raised or using low capitalisation rate for the purpose or by following a conservative dividend policy. Of course, improvement in earnings can also be the result of cost reduction exercise or high efficiency. Thus, under-capitalisation is indicative of a sound financial position and may lead to increase in the market value of company’s shares.

Capital Structure

The financial requirement of a firm can be met through ownership capital and/or borrowed capital. The ownership capital refers to the amount of capital contributed by the owners. In case of a company, it refers to the amount of funds raised by issuing shares. The main characteristic of the ownership capital is that its contributors are entitled to get dividend out of earnings after the payment of interest and taxes. Hence, the rate of return on such capital depends upon the level of profits earned, and, if there are no profits, no dividend may be paid.

Borrowed capital, on the other hand, refers to the amount of funds raised through long term loans and debentures on which its contributors are entitled to a fixed rate of interest which has to be paid at regular intervals (half-yearly or yearly) irrespective of the profits earned. There is also a commitment that the principal amount shall be repaid on maturity.

Capital Structure
Capital Structure

Capital Structure

Illustration - ‘A’ Total Capital Rs. 50 lakhs (Rs. 20 lakh owners fund+ Rs. 30 lakhs borrowed fund)

Illustration - ‘B’ Total Capital Rs. 50 lakhs (Rs. 50 lakh owners fund + no borrowed fund

Earnings before interest and tax (EBIT)

Less: Interest @ 10% on borrowed fund

-

Profit/Earnings after interest but before tax

Less: Tax on profit @ 40%

Profit after tax (PAT)

Return on owners’ funds

Suppose the total investment in a business is Rs. 50 lakhs, to which owners contribute Rs.20 lakh and the remaining amount of Rs.30 lakh is funded through loans at interest per annum. Assuming expected annual earnings before interest and tax are Rs. 10 lakh ( on total investment) the profit after payment of interest but before tax will be Rs.7 lakh (Rs.10 lakh –Rs.3 lakh). Let us assume that the tax is payable on profits at the rate of , the profit after tax will be Rs.4.20 lakh (Rs.7 lakh Rs.2.80 lakh tax) and the return on owners’ funds will be .

Now, suppose the whole amount of required investment of Rs.50 lakh is contributed by the owners and no loan is taken. Since no interest is payable, the amount of tax will be Rs.4 lakh (40% on Rs.10 lakh) and the profit after tax Rs.6 lakh (Rs.10 lakh – Rs.4 lakh tax). This shall result in return on owner’s funds. Thus, you observe that owners get higher return when a part of capital required is funded by borrowings. This is called ‘Trading on Equity or Leverage Effect’. But there is also an element of risk in using borrowed funds because when the profits decline, interest being a fixed charge, the return on owners’ funds is likely to decline. This implies that dependence on borrowings should be kept within reasonable limits. Therefore, most companies generally plan to raise the required amount of long-term funds by using a judicious mix of ownership capital (called equity) and borrowed capital (called debt). The mix of equity and debt actually used by a company for meeting its requirement of capital is known as its capital structure. Thus, the term capital structure refers to the makeup of a firm’s capital in terms of the planned mix of different kinds of long-term funds like equity shares, preference shares, debentures and long-term funds. So capital structure involves two basic decisions:

  • The type of securities to be issued or raised; and

  • The relative proportion of each type of security.