Financial Management UNIT-2

Financial Management UNIT-2

CHAPTER-4 Financing Decision

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We have 3 chapters in UNIT-1
Notes for other two chapters are here

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Capitalization

Capital means the total amount of money employed for a business.
Capitalization is basically the expansion of the word "capital" which can be defined as "the total amount of fund attained by a firm from different long term sources."
Need of capitalization
At the time of :
  • Promotion & incorporation  stage
  • Expansion stage
  • Amalgamation & absorption stage
  • Capital reorganisation

Reasons for change in capitalization

  • Making financial plan balanced (The change in capitalization may be required if current capital structure is not balanced)
  • For simplifying the capital structure
  • For meeting investors requirement
  • For funding current liabilities
  • For covering the deficit
  • For capitalizing the retained earning (Firm may issue bonus shares)
  • For utilization of retained earnings

Theories of capitalization

1. Cost theory

According to this theory, the value of firm is determined by the sum total of the value of its fixed asserts, its working capital, promotional expenses and setup cost.

2. Earnings theory

According to this theory the value of company depends upon its earning capacity. This process entails determination of probable sales and related cost.

Types of capitalization

1. Over Capitalization

When a firm's earning are not enough to provide a fair rate of return on the capital employed, then it indicates that the firm may be overcapitalized.
This happens in the case when the firm is not able to pay dividends on its shares or service the interest on its debentures.

Symptoms of overcapitalization

  1. Larger investment
  2. Reflection of wrong picture
  3. No full utilization

Causes of overcapitalization

  1. Availability of excess capital
  2. Purchase of assets at higher price
  3. High promotional expenses
  4. Borrowings at higher late
  5. Buying assets during boom phase
  6. High taxation rate

Consequences/ Effects of overcapitalization

Effects on the company
  • Loss of goodwill
  • Low creditworthiness
  • Obstacles in obtaining further capital
  • Lower efficiency
  • Inflated profit
Effects on shareholders
  • Reduction in dividend
  • Lower share value
Effects on society
  • Loss to consumers
  • Loss to workers
  • Under utilization or miss-utilization of resources
  • Gambling in shares

Remedies for over capitalization

  1. Efficient management to reduce the excessive expenditures
  2. Redemption of preference share (As these shares generally carry the highest interest rate so management can redeem them by using retained earnings.)
  3. Reduction of funded debt (Debentures and public deposits have high interest rates. Hence, repaying them in an accumulated amount can reduce the problem of overcapitalization.)
  4. Reorganization of equity share can also reduce the face value of equity shares.

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2. Under capitalization

This is the opposite situation to over capitalization.
Under capitalization may show efficient management of resources as well as it can lead to high amount of dividend and earnings per share.
In simple language, this situation usually indicates the positive impact on the market value of the shares.

Symptoms of under capitalization

  1. Sudden rise in earnings
  2. Pessimistic forecast
  3. Low cost

Causes of under capitalization

  1. Under estimation of capital requirements
  2. Under estimation of future earnings
  3. Promotion during deflation
  4. Narrow dividend policies(company may adopt conservative policy for paying dividends)
  5. Desire of control (in the urge of holding the control of a company, the members may decide to raise funds only by using debt capital instead of raising equity and hence after some time the company will automatically become under capitalized)

Consequences/ Effects of under capitalization

  1. Manipulation of shares
  2. Marketability of shares
  3. Industrial unrest (the workers may ask for higher wages, the staff may ask for increment in salary, etc)
  4. Increase in government control (due to increasing profit rates in undercapital company)
  5. Unsatisfied consumers (the news of a company making higher levels of profit may make the customers think that the goods are over priced)
  6. Higher competition (higher profit margins attracts new businesses in the same industry)
  7. Overtrading and undercutting of the products
  8. Can lead to overcapitalization

Remedies for under capitalization

  1. Fresh issue of shares
  2. Issue of a bonus shares
  3. Increasing the far value of share (This can reduce the earnings per share)
  4. Stock split (This method increases the numbers of share of a firm which consequently decreases the value of each share)
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Concept of cost of capital/opportunity cost

The cost of capital is the minimum rate of return which enables a company to make such an amount of profit on its investment so as to ensure that the market value of the company's equity shares either increases or remains at the same level.
This is in conformity with any company's goal of "wealth maximization for its shareholders".

Wealth maximization for shareholders of a company is a concept in which the company focuses upon the overall development of the wealth of its shareholders by providing them their expected rate of return on their investment.
In simple terms, cost of capital is the minimum required rate of earning or the cut off rate of capital expenditure or it is the minimum rate of return expected by the investors of a business on the project.

"Opportunity cost of capital is the lost value of an investment due to the investment made in some other project."

For an investor, it is the choice offered to him to invest in one project over another.
Opportunity cost of the investment is also known as minimum required rate of return OR cost of capital OR discount rate OR Interest rate

Characteristics of cost of capital

●It is not necessarily a cash cost
●It indicates the minimum rate of return
●It considers the risk factor

Classification of cost

1. Future cost versus historical cost
Future costs are the basis on which financial decisions are taken and they are only used as projections whereas historical costs are like guiding tools for future forecasting.

2. Specific cost versus composite cost
Specific cost is the cost of individual source of capital whereas composite cost also known as overall cost is the cost of capital of all the sources taken together.

3. Average cost versus marginal cost
The average of costs of capital taken together is average cost whereas the change in the total cost that arises when the quantity produced at increment by unit is marginal cost.

4. Implicit cost versus explicit cost
Instant cash payments are associated with explicit cost, for example, rent OR payment of wage, salary, etc these are also known as out of pocket cost whereas no cash payments are associated with implicit cost, for example, loss of interest rate OR wages forgone by owner of company, etc. This is also known as economic cost or opportunity cost.

Factors affecting cost of capital

1. General economic conditions

These are factors external to the company's operational boundaries and beyond its control. The general conditions prevailing in an economy are largely responsible for the demand and supply of the capital.

2. Market conditions

The prevailing market conditions at a particular point of time are responsible for the level of risk and a rate of return associated with a financial decision.

3. Company's operations and financing decisions

These decision affects the cost of capital & these decisions involve business risk as well as financial risk.
NOTE: 
Business risk are the outcome of the company's investment decision.
Financial risks are an increase in fluctuation in the return to the equity shareholders.

4. Amount of financing

The cost of capital OR the cost of funds is directly proportional to the required amount of funds or capital.

Importance of cost of capital

  1. It is important in taking capital budgeting decisions.
  2. It is important while making capital structure decisions.
  3. It helps in the evaluation of profitability of any project.
  4. It is helpful while taking other decisions such as dividend distribution, working capital requirement, etc.

Problems in determination of cost of capital

1. Influence of the mode and quantum of financing
It is a very controversial issue which has been a matter of debate between the traditional theorist and modern theorist.
2. Calculation of cost of equity capital
Calculation poses a number of hurdles even when theoretical definition of cost of capital is very easy but its calculation is always difficult.
3. Computation of cost of retained earnings and debentures funds is quite difficult to understand.

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