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Capitalization : Meaning

A company, in order to have successful operation, needs adequate amount of capital. The capital requirement starts right from the incorporation of the company. The foremost function of the finance manager is to make correct forecasting of financial requirements not only in present but future also. The required funds can be raised through various sources or forms.

 

Capitalization : Meaning

 

The term capitalisation is the sum total of all long term securities issued by a company and the surpluses not meant for distribution.

 

A.S Dewing defines “The term capitalisation is the valuation of the capital, which

includes the capital stock and debt.”

 

According to Gerrtenbeg, “For all practical purposes, capitalisation means the total

accounting value of all the capital regularly employed in the business.”

 

CAPITAL STRUCTURE

 

Capital structure of a company refers to the mix of its capitalisation. A company obtains funds by issuing different types of securities i.e., ordinary shares, preference shares, bonds and debentures. The combination, in which the various kinds of securities are issued is known as capital structure.

 

According to Gerrtenbeg, “Capital structure of a company (or financial structure) refers to the make-up of its capitalisation.”

 

According to Weston and Brighan, “Capital structure is the permanent financing of the firm, represented by long term debt, preferred stock and net worth”.

 

Basic Patterns of Capital Structure

 

(i) Issuing only equity shares

(ii) Issuing equity shares and preference shares

(iii) Issuing equity and debentures

(iv) Issuing equity shares, preference shares and debentures

 

Factors Affecting Capital Structure

 

The following factors govern the capital structure of a company.

 

(i) Trading on equity

(ii) Nature of enterprises

(iii) Legal restrictions

(iv) Purpose of financing

(v) Period of finance.

(vi) Market conditions

(vii) Size of the company

(viii) Need of investors

(ix) Government policy.

(x) Cost of capital and availability of Funds

 

 

(i)                 Trading on Equity. A company may mobilise capital either by issue of shares or by debentures. In any situation, the rate of return on total capital employed is more than the rate of interest on debentures or rate of dividend on preference shares. It is known as trading on equity. In a particular situation, a company can pay higher rate of dividend than the general rate of earnings on the total capital employed. It is the benefit of trading on equity.

 

(ii)               Nature of Enterprises. Foremost determinant of capital structure of a company is the nature of the business enterprise. Businesses having more risks but varying income prefer equity shares. Firms, engaged in public utility services, may prefer issue of debentures and preference shares.

 

(iii)             Legal Restrictions. Each and every company has to comply with provisions of the law regarding the issue of different kinds of securities. So the promoter of a company has to follow the legal provisions. Specially in India, banking companies are not allowed to issue any type of securities other than equity shares.

 

(iv)             Purpose of Financing. The purpose of financing for raising the fund must be taken into account at the time of formulating capital structure of the company. If funds are required for direct productive purpose, the company can afford to issue debentures. But the funds are required for non-productive purposes, the company should raise funds through issue of equity shares.

 

(v)               Period of Finance. Generally, the period of finance also determines the capital structure of companies. Short term commitment of companies are met out through borrowings. Some  times, if the funds are required for 8 to 10 years, it will be met by issue of debentures. If funds are required for more than 10 years, it can be met out by issue of equity shares.

 

(vi)             Market Conditions. Movement of the capital market also decides the capital structure of the company. During the periods of depression, the investors will look for their safety and they prefer to invest in debentures and not in equity shares. But during the boom period any type of securities can be sold very easily in the market, hence equities also get the better market.

 

(vii)           Size of the Company. The small scale organisations fully depend upon the owner’s fund to run their business. Such companies find it difficult to obtain long term debt. But, large scale organisations are generally considered to be less risky by the investors. So, they can issue different types of securities and mobilise resources from difference sources .

 

(viii)         Need of Investors. Some of the investors prefer to invest in debentures because they provide safety of investment and stable income. Preference shares will be preferred by those who want a higher and stable income with sufficient safety of investment. Those, who want to bear higher risk, higher return and capital appreciation prefer equity shares only. So capital structure of the company depends upon the financial status and psychological attitude of the investors.

 

(ix)             Government Policy. Any of the monetary, fiscal, financial policies, which are time to time announced by the union government, may straight away affect the capital structure decision of the company. For example, change in the lending policy of financial institutions may mean a complete change in the financial pattern. New provisions of the SEBI also affect the capital issue policies of various companies.

 

(x)               Cost of Capital and Availability of Funds. The appropriate term of financing is, at times, the result of the study of comparative cost of various types of financing in relation to the level of risk involved and the availability of various alternative forms of financing. But, sometimes, debentures may be issued because of their cheapness and availability, the danger of the financial position and so on.