UNIT 3

Capital Structure

Introduction

Every business requires large amounts of finance for starting, operating, expanding, and modernizing
its activities. These funds are raised from different sources such as shares, debentures, loans, and
retained earnings. The decision regarding the proportion of these sources is known as capital
structure.

Capital structure is one of the most important financial decisions because it directly affects the
profitability, risk, stability, and market value of a company. A company must maintain a proper
balance between owned funds and borrowed funds so that it can operate efficiently and achieve
long-term growth.

Meaning of Capital Structure

Capital structure refers to the composition or combination of various long-term sources of finance
used by a company. It shows the relationship between debt capital and equity capital in the total
financial structure of the business.

In simple words, capital structure indicates how much finance is obtained from owners and how
much is borrowed from outsiders for running the business.

Definition of Capital Structure

According to Gerstenberg,
“Capital structure refers to the composition or makeup of a firm’s capitalization including all long-
term capital resources such as loans, reserves, shares, and bonds.”

Another simple definition states that capital structure is the mix of debt and equity used by a
company to finance its assets and operations.

Components of Capital Structure

1. Equity Share Capital

Equity share capital represents the funds raised from equity shareholders who are the real owners of
the company. They receive dividends after all other obligations are paid.

2. Preference Share Capital

Preference share capital consists of funds raised through preference shares. Preference shareholders
receive fixed dividends and have priority over equity shareholders during repayment and dividend
distribution.

3. Retained Earnings

Retained earnings are profits kept in the business instead of distributing them among shareholders.
It is an internal source of long-term finance.
4. Debentures

Debentures are long-term borrowed funds raised by issuing debt instruments to the public or
financial institutions. Interest on debentures is fixed and compulsory.

5. Long-Term Loans

Companies also raise funds through long-term loans from banks and financial institutions for
expansion and capital investment purposes.

Factors Affecting Capital Structure

The capital structure of a company is influenced by various internal and external factors.
Management must carefully consider these factors before deciding the proportion of debt and equity
in the business. A proper capital structure helps maintain financial stability, reduce risk, and increase
profitability.

1. Cost of Capital

The company always tries to select the source of finance with the lowest cost. Debt is generally
cheaper than equity because interest on debt is tax deductible. Therefore, companies may prefer
debt finance if it reduces the overall cost of capital.

However, excessive debt increases financial risk, so management must maintain a proper balance
between debt and equity.

2. Risk Factor

Risk plays an important role in deciding capital structure. If a company uses more borrowed funds, it
must pay fixed interest regularly, which increases financial risk.

Companies with unstable earnings usually avoid heavy debt because they may face difficulty in
paying interest during low-profit periods.

3. Nature of Business

The type and nature of business influence the capital structure decision.

 Companies with stable income, such as public utility companies, can use more debt.

 Businesses with uncertain earnings generally prefer equity finance to avoid financial burden.

4. Stability of Earnings

Companies having stable and regular earnings can safely use more debt because they can easily pay
interest and loan installments.

On the other hand, companies with fluctuating profits prefer equity capital to avoid insolvency risk.

5. Control of Management

If management wants to retain control over the company, it may prefer debt finance rather than
issuing new equity shares.

Issue of additional equity shares may dilute ownership and voting rights of existing shareholders.
6. Flexibility of Capital Structure

The capital structure should be flexible enough to allow future expansion and financial adjustments.

A company should maintain borrowing capacity for future needs instead of using excessive debt at
present.

7. Trading on Equity

Trading on equity means using fixed interest-bearing securities such as debentures and loans to
increase returns for equity shareholders.

When the company earns more than the cost of debt, management may use borrowed funds to
increase EPS and shareholders’ returns.

8. Government Policies and Regulations

Government rules relating to taxation, interest rates, issue of securities, and financial regulations also
affect capital structure decisions.

For example, tax benefits on interest payments encourage companies to use debt finance.

9. Market Conditions

Capital market conditions influence the choice between debt and equity.

 During a bullish market, companies prefer issuing shares because investors are willing to
invest.

 During unfavorable market conditions, companies may depend more on loans and
debentures.

10. Cash Flow Position

A company with strong cash flow can easily meet fixed obligations such as interest and loan
repayment, so it can use more debt capital.

Companies with weak cash flow generally avoid excessive borrowing.

11. Growth and Expansion Plans

Rapidly growing companies require large funds for expansion. Such companies may use a
combination of debt and equity to meet financial requirements.

The future growth rate of the company directly affects capital structure planning.

12. Tax Considerations

Interest paid on debt is allowed as a tax-deductible expense, which reduces the tax burden of the
company.

Therefore, companies sometimes prefer debt finance to take advantage of tax savings.
Features of Capital Structure

1. Combination of Debt and Equity

Capital structure includes both owned capital and borrowed capital.

2. Long-Term Financial Decision

It mainly deals with long-term sources of finance required for business growth and expansion.

3. Affects Risk and Return

A higher proportion of debt increases financial risk but may also increase returns to shareholders.

4. Influences Cost of Capital

The proportion of debt and equity affects the overall cost of finance of the company.

5. Helps in Wealth Maximization

An optimum capital structure helps maximize shareholders’ wealth and increases company value.

Importance of Capital Structure

1. Helps in Financial Planning

Capital structure helps management decide the amount and type of finance required for business
activities.

2. Minimizes Cost of Capital

A proper balance between debt and equity reduces the overall cost of capital.

3. Increases Profitability

Appropriate use of borrowed funds can increase earnings available to shareholders.

4. Maintains Financial Stability

A balanced capital structure reduces financial risk and improves stability.

5. Improves Market Value

An optimum capital mix increases investor confidence and enhances the market value of the
company.

Objectives of Capital Structure

 To maximize shareholders’ wealth

 To minimize cost of capital

 To maintain financial stability

 To balance risk and return

 To ensure flexibility in financing

  To support business growth and expansion

Conclusion

Capital structure is the foundation of a company’s financial system because it determines the mix of
debt and equity used for financing business operations. An appropriate capital structure helps
reduce financial risk, improve profitability, maintain stability, and maximize the value of the firm.
Therefore, management should carefully design an optimum capital structure according to the
financial needs and earning capacity of the business.

Selection of Best Capital Mix based on EBIT–EPS Analysis

Introduction

One of the most important decisions in financial management is selecting the best capital structure
or capital mix for a company. A company can raise funds through equity shares, preference shares,
debentures, or loans. The management must decide the most suitable combination of these sources
to maximize shareholders’ earnings.

EBIT–EPS Analysis is an important technique used for selecting the best capital mix. It helps compare
different financing alternatives and identifies the option that provides the highest Earnings Per Share
(EPS) at a particular level of Earnings Before Interest and Tax (EBIT).

Meaning of EBIT–EPS Analysis

EBIT–EPS Analysis is a financial technique used to examine the effect of different financing plans on
the Earnings Per Share of a company under different levels of EBIT.

It helps management determine whether debt financing or equity financing will provide better
returns to shareholders. The analysis shows the relationship between EBIT and EPS under various
capital structures. ([Link])

Meaning of EBIT

EBIT means Earnings Before Interest and Tax. It represents the operating profit earned by the
company before deducting interest and taxes.

EBIT =Revenue−Operating Expenses

EBIT indicates the earning capacity of the business from its normal operations.

Meaning of EPS

EPS means Earnings Per Share. It represents the amount of profit available for each equity share.

EPS=Earnings Available ¿ Equity Shareholders ¿

Number of Equity Shares
A higher EPS indicates higher profitability for shareholders.
(WRITE THE FORMULA GIVEN BY SIR)

Objectives of EBIT–EPS Analysis

 To select the best financing alternative

 To maximize earnings per share

 To determine the effect of debt on shareholders’ earnings

 To compare different capital structures

 To identify the optimum capital mix

Importance of EBIT–EPS Analysis

1. Helps in Capital Structure Decision

It helps management choose the most profitable combination of debt and equity.

2. Maximizes Shareholders’ Wealth

The analysis identifies the financing plan that gives maximum EPS to shareholders.

3. Measures Financial Risk

It shows how the use of debt affects financial risk and profitability.

4. Facilitates Financial Planning

Management can evaluate different financing alternatives before raising funds.

Steps in EBIT–EPS Analysis

1. Prepare Different Financing Plans

Different alternatives of debt, equity, and preference capital are prepared.

2. Estimate EBIT

Expected EBIT levels are calculated for the business.

3. Calculate EPS under Each Plan

EPS is calculated for every financing alternative at different EBIT levels.

4. Compare EPS

The financing plan providing the highest EPS is selected.

Assumptions of EBIT–EPS Analysis

 EBIT can be estimated accurately

  Corporate tax rate remains constant

 Cost of debt remains fixed

 Business risk remains unchanged

 Financing alternatives are clearly available

Advantages of EBIT–EPS Analysis

1. Simple Technique

The method is easy to understand and apply.

2. Helps Select Best Financing Plan

It helps identify the capital structure that maximizes EPS.

3. Useful for Financial Decision-Making

Management can compare different financing alternatives effectively.

4. Focuses on Shareholders’ Earnings

The analysis mainly aims at increasing returns to equity shareholders.

Limitations of EBIT–EPS Analysis

1. Ignores Business Risk

The analysis mainly considers financial risk and ignores business risk.

2. Assumes Constant EBIT

EBIT may fluctuate due to market conditions.

3. Does Not Consider Market Value

The method focuses on EPS and ignores the market price of shares.

4. Excessive Debt Increases Risk

Higher debt may increase financial burden and insolvency risk.

Conclusion

EBIT–EPS Analysis is an important tool used for selecting the best capital structure of a company. It
helps management compare different financing alternatives and identify the option that provides
maximum earnings per share. Although the technique has certain limitations, it is widely used for
making effective financing and capital structure decisions.
Leverages

Introduction to Leverage

In modern business, companies require large amounts of funds for production, expansion,
modernization, and other business activities. To increase profitability and shareholders’ returns,
businesses often use fixed cost sources such as fixed operating expenses and borrowed funds. The
use of these fixed costs in business is known as leverage.

Leverage is an important concept in financial management because it helps measure the relationship
between sales, costs, and profits. It shows how a small change in sales can create a larger change in
earnings. Proper use of leverage can increase the profitability of the business, but excessive leverage
may increase financial risk and instability. Therefore, management must use leverage carefully while
making operating and financing decisions.

Meaning of Leverage

Leverage refers to the use of fixed costs in a business to increase the returns to shareholders. These
fixed costs may be operating fixed costs or financial fixed costs. Leverage helps measure the effect of
changes in sales on the profitability of the business. ([Link])

A small change in sales may lead to a larger change in profits because of leverage. Therefore,
leverage is considered an important tool for measuring business risk and financial risk.

Types of Leverage

1. Operating Leverage

2. Financial Leverage

3. Combined Leverage

1. Operating Leverage

Meaning

Operating leverage arises because of fixed operating costs such as rent, depreciation, salaries, and
insurance. It measures the effect of changes in sales on Earnings Before Interest and Tax (EBIT).

A company having high fixed operating costs will have high operating leverage.

Formula of Operating Leverage

Operating Leverage = Contribution / EBIT

OR

Degree of Operating Leverage (DOL)

= Percentage Change in EBIT / Percentage Change in Sales
Interpretation

 High operating leverage increases business risk.

 Small increase in sales leads to large increase in EBIT.

 Companies with high fixed operating costs generally have high operating leverage.

2. Financial Leverage

Meaning

Financial leverage arises because of fixed financial charges such as interest on debentures, loans, and
preference dividends. It measures the effect of changes in EBIT on Earnings Per Share (EPS).

A company using more debt capital has higher financial leverage.

Formula of Financial Leverage

Financial Leverage = EBIT / EBT

OR

Degree of Financial Leverage (DFL)

= Percentage Change in EPS / Percentage Change in EBIT

Interpretation

 High financial leverage increases financial risk.

 Debt financing may increase returns to shareholders when profits are high.

 Excessive debt creates interest burden on the company.

3. Combined Leverage

Meaning

Combined leverage is the combined effect of operating leverage and financial leverage. It measures
the effect of changes in sales on Earnings Per Share (EPS).

It indicates the total risk of the company arising from both operating fixed costs and financial fixed
costs.

Formula of Combined Leverage

Combined Leverage = Operating Leverage × Financial Leverage

OR

Combined Leverage = Contribution / EBT

OR

Degree of Combined Leverage (DCL)

= Percentage Change in EPS / Percentage Change in Sales

Difference between Operating Leverage and Financial Leverage

Basis Operating Leverage Financial Leverage

Meaning Arises due to fixed operating costs Arises due to fixed financial costs

Measures Effect of sales on EBIT Effect of EBIT on EPS

Related Risk Business risk Financial risk

Fixed Cost Type Operating fixed cost Interest and financial charges

Formula Contribution ÷ EBIT EBIT ÷ EBT

Importance of Leverage

1. Helps in Profit Planning

Leverage helps management estimate the impact of sales changes on profits.

2. Assists in Capital Structure Decisions

Financial leverage helps management decide the proper mix of debt and equity.

3. Measures Risk

Leverage measures business risk, financial risk, and total risk.

4. Increases Shareholders’ Returns

Proper use of leverage can increase earnings per share.

5. Useful in Financial Decision-Making

Leverage supports investment and financing decisions of the company.

Advantages of Leverage

 Increases profitability of shareholders

 Helps in effective utilization of borrowed funds

 Provides tax benefits on debt interest

 Assists in financial planning and control

Limitations of Leverage

 Excessive leverage increases financial risk

 Fixed costs must be paid even during low sales

 High debt may lead to insolvency risk

 Decline in sales may reduce profits rapidly

Conclusion

Leverage is an important concept in financial management that measures the relationship between
sales, costs, and profits. Operating leverage measures business risk, financial leverage measures
financial risk, and combined leverage measures total risk. Proper use of leverage can improve
profitability and shareholders’ earnings, but excessive leverage may create financial instability.
Therefore, businesses should maintain a balanced level of leverage according to their financial
capacity and risk-bearing ability.

Operating Leverage

Meaning

Operating leverage arises because of fixed operating costs such as rent, salaries, insurance, and
depreciation. It measures the effect of changes in sales on Earnings Before Interest and Tax (EBIT). A
company having high fixed operating costs will have high operating leverage. ([Link])

Operating leverage shows how a small change in sales can result in a larger change in operating
profit. Therefore, it is used to measure business risk.

Formula of Operating Leverage

Operating Leverage = Contribution ÷ EBIT

OR

Degree of Operating Leverage (DOL)

= Percentage Change in EBIT ÷ Percentage Change in Sales

Features of Operating Leverage

1. Related to Fixed Operating Costs

Operating leverage arises because of fixed operating expenses in the business.

2. Measures Business Risk

It helps measure the business risk arising from fixed operational expenses.

3. Affects EBIT
Operating leverage directly affects Earnings Before Interest and Tax.

4. Higher Sales Increase Profits

A small increase in sales may lead to a larger increase in operating profits.

Importance of Operating Leverage

1. Helps in Profit Planning

Operating leverage helps management estimate the impact of sales changes on profits.

2. Measures Operating Efficiency

It shows how efficiently fixed operating costs are utilized.

3. Assists in Decision-Making

Management can make better pricing, production, and sales decisions.

4. Helps in Cost Control

It helps identify the impact of fixed costs on profitability.

Advantages of Operating Leverage

 Increases operating profits during high sales

 Helps improve return on investment

 Assists in better utilization of fixed assets

 Useful for profit forecasting and planning

Limitations of Operating Leverage

 High operating leverage increases business risk

 Decline in sales can reduce profits rapidly

 Fixed costs must be paid even during low sales

 Excessive fixed costs may create financial pressure

Financial Leverage

Meaning

Financial leverage arises because of fixed financial charges such as interest on loans, debentures, and
preference dividends. It measures the effect of changes in Earnings Before Interest and Tax (EBIT) on
Earnings Per Share (EPS). ([Link])
A company using more debt capital in its capital structure will have higher financial leverage.
Financial leverage helps increase the returns to equity shareholders when the company earns more
profit than the cost of borrowed funds.

However, excessive use of debt increases financial risk because interest must be paid regularly even if
profits are low.

Formula of Financial Leverage

Financial Leverage = EBIT ÷ EBT

OR

Degree of Financial Leverage (DFL)

= Percentage Change in EPS ÷ Percentage Change in EBIT

Where,

EBIT = Earnings Before Interest and Tax

EBT = Earnings Before Tax
EPS = Earnings Per Share

Features of Financial Leverage

1. Related to Fixed Financial Costs

Financial leverage arises because of fixed financial expenses such as interest on borrowed funds.

2. Measures Financial Risk

It helps measure the financial risk arising from the use of debt capital.

3. Affects EPS

Financial leverage directly affects earnings available to equity shareholders.

4. Use of Debt Capital

It exists when the company uses debentures, loans, or preference shares in its capital structure.

Importance of Financial Leverage

1. Helps in Capital Structure Decisions

Financial leverage helps management decide the proper mix of debt and equity.

2. Increases Shareholders’ Returns

If the company earns higher profits than interest costs, EPS increases.

3. Useful in Financial Planning

It helps estimate the impact of financing decisions on shareholders’ earnings.

4. Measures Financial Stability

It helps evaluate the company’s ability to meet fixed financial obligations.

Advantages of Financial Leverage

 Helps increase earnings per share

 Debt financing provides tax benefits

 Helps maintain ownership control

 Useful for expansion and growth of business

Limitations of Financial Leverage

 Excessive debt increases financial risk

 Interest must be paid even during losses

 High leverage may lead to insolvency risk

 Decline in EBIT reduces EPS rapidly

Combined Leverage

Meaning

Combined leverage is the combined effect of operating leverage and financial leverage. It measures
the effect of changes in sales on Earnings Per Share (EPS). ([Link])

Combined leverage arises because of both fixed operating costs and fixed financial costs. It shows
how a small change in sales can result in a larger change in EPS. Therefore, combined leverage helps
measure the total risk of the company.

A company having high operating leverage and high financial leverage will also have high combined
leverage.

Formula of Combined Leverage

Combined Leverage = Operating Leverage × Financial Leverage

OR

Combined Leverage = Contribution ÷ EBT

OR

Degree of Combined Leverage (DCL)

= Percentage Change in EPS ÷ Percentage Change in Sales

Where,
Contribution = Sales – Variable Costs
EBT = Earnings Before Tax
EPS = Earnings Per Share

Features of Combined Leverage

1. Combination of Two Leverages

Combined leverage includes both operating leverage and financial leverage.

2. Measures Total Risk

It helps measure the total risk arising from operating and financial fixed costs.

3. Affects EPS

Combined leverage shows the impact of sales changes on earnings per share.

4. Related to Fixed Costs

It arises because of both fixed operating expenses and fixed financial charges.

Importance of Combined Leverage

1. Helps in Risk Measurement

Combined leverage helps measure the overall risk of the business.

2. Assists in Profit Planning

Management can estimate the effect of sales changes on EPS.

3. Useful in Financial Decisions

It helps management make better operating and financing decisions.

4. Improves Financial Planning

Combined leverage helps in selecting suitable capital structure and cost structure.

Advantages of Combined Leverage

 Helps increase earnings per share

 Useful for measuring total business risk

 Assists in better financial and operating decisions

 Helps management in profit forecasting

Limitations of Combined Leverage

 High combined leverage increases total risk

  Decline in sales can reduce EPS significantly

 Excessive fixed costs create financial pressure

 Difficult to maintain stability during low sales periods

Understood. From now on, every topic will start with an Introduction.

Over Capitalization

Every company raises capital for carrying out business activities such as production, expansion,
modernization, and growth. The amount of capital raised should be properly balanced with the
earning capacity of the business. If a company raises excessive capital and is unable to generate
sufficient profits from it, the company faces a condition known as over capitalization.

Over capitalization is an unhealthy financial condition because it reduces profitability, lowers market
value of shares, and creates financial instability. It negatively affects shareholders, investors, and the
goodwill of the company. Therefore, management must maintain an optimum level of capitalization
according to the earning capacity of the business. ([Link])

Meaning

Over capitalization is a financial condition in which the actual value or earning capacity of a company
is lower than its total capitalized value. In simple words, the company has more capital than required
in comparison to its earnings. ([Link])

A company is said to be overcapitalized when it cannot earn sufficient profits to provide a fair return
on the capital invested in the business. As a result, dividends decline and the market value of shares
falls.

Over capitalization does not mean excess assets or excess cash. It mainly indicates low earning
capacity in relation to the amount of capital employed.

Definition of Over Capitalization

According to Gerstenberg,
“A corporation is overcapitalized when its earnings are not large enough to yield a fair return on the
amount of stocks and bonds that have been issued.”

Causes of Over Capitalization

1. Over-Issue of Capital

A company may raise excessive share capital or borrowed funds beyond its actual financial
requirements. As a result, the earnings become insufficient in comparison to the total capital
employed.

2. Overvaluation of Assets
Sometimes companies purchase assets at very high prices or show assets at inflated values in
financial statements. This increases total capitalization without increasing actual earning capacity.

3. Low Efficiency of Management

Inefficient management may fail to utilize resources properly. Poor planning, weak supervision, and
low productivity reduce profitability and lead to over capitalization.

4. High Operating Expenses

Excessive administrative expenses, production costs, and selling expenses reduce the net profits of
the company. Lower profits create imbalance between capital and earnings.

5. Decline in Demand

Reduction in market demand for products or services decreases sales and profits. When earnings
decline continuously, the company may become overcapitalized.

6. Heavy Depreciation and Interest Burden

High depreciation charges on fixed assets and heavy interest payments on loans reduce the earning
capacity of the business.

7. Unfavorable Market Conditions

Economic depression, inflation, intense competition, changes in government policies, and

technological changes may negatively affect profitability and create over capitalization.

8. Improper Financial Planning

Wrong estimation of capital requirements and poor financial decisions may result in excessive
capitalization.

9. Liberal Dividend Policy in Early Years

Some companies pay high dividends during initial years to attract investors. Later, when profits
decline, the company may not maintain the same returns, resulting in over capitalization.

10. Excessive Borrowing

Too much dependence on debt capital increases fixed financial obligations such as interest payments,
which reduce overall profitability.

Effects of Over Capitalization

1. Decline in Market Value of Shares

Due to low profitability and poor dividend payments, investors lose confidence in the company. As a
result, the market price of shares declines.

2. Low Dividend to Shareholders

The company is unable to generate adequate profits on the large amount of capital employed.
Therefore, shareholders receive lower dividends.

3. Loss of Goodwill
Continuous low earnings reduce the reputation and goodwill of the company in the market.

4. Difficulty in Raising Further Funds

Financial institutions and investors may hesitate to provide additional finance because of poor
financial performance and low investor confidence.

5. Financial Instability

Overcapitalized companies may face liquidity and solvency problems due to low profits and heavy
financial burden.

6. Dissatisfaction among Shareholders

Shareholders become dissatisfied because they do not receive satisfactory returns on their
investment.

7. Reduction in Efficiency

Management may lose motivation due to poor profitability, which reduces operational efficiency and
productivity.

8. Increase in Borrowing Burden

If the company has excessive debt capital, regular payment of interest increases financial pressure on
the business.

9. Adverse Effect on Employees

The company may reduce employee benefits, salaries, or workforce in order to control costs during
financial difficulties.

10. Possibility of Reconstruction

Severe over capitalization may force the company to undertake financial reconstruction or
reorganization.

Remedies of Over Capitalization

1. Reduction of Capital

The company may reduce its share capital or debt capital according to its earning capacity. This helps
maintain a proper balance between capital and profits.

2. Improvement in Management Efficiency

Efficient management practices should be adopted to improve productivity, reduce wastage, and
increase profitability.

3. Reduction in Operating Expenses

Unnecessary administrative, selling, and production expenses should be controlled to improve net
profits.

4. Better Utilization of Assets

Idle or unproductive assets should be properly utilized or sold to improve operational efficiency and
earnings.

5. Reconstruction of Company

The company may undertake financial reconstruction or reorganization to improve its capital
structure and financial position.

6. Increase in Sales and Profits

Management should focus on market expansion, product improvement, and effective marketing
strategies to increase sales and profitability.

7. Redemption of Debt

Excessive loans and debentures may be repaid to reduce interest burden and financial pressure.

8. Modernization and Technological Improvement

Adoption of modern technology and efficient production methods helps improve productivity and
reduce operating costs.

9. Proper Financial Planning

The company should estimate its capital requirements carefully and avoid raising unnecessary funds
in the future.

10. Revision of Dividend Policy

The company should adopt a balanced dividend policy according to its actual earning capacity and
financial position.

Under Capitalization

Every business requires adequate capital for carrying out production, expansion, modernization, and
other operational activities. The amount of capital raised by a company should be properly balanced
with its earning capacity. Sometimes, a company earns very high profits compared to the amount of
capital employed in the business. This condition is known as under capitalization.

Under capitalization is considered the opposite of over capitalization. In this condition, the earning
capacity and market value of the company become much higher than its actual capital. Although
under capitalization may indicate efficiency and profitability, excessive under capitalization may
create pressure on management, increase competition, and lead to overworking of business
resources. ([Link])

Meaning

Under capitalization is a financial condition in which the value or earning capacity of a company is
higher than its total capitalized value. In simple words, the company has insufficient capital
compared to the profits earned by the business. ([Link])

A company is said to be undercapitalized when it earns exceptionally high profits in comparison to its
capital employed. As a result, the market value of shares and dividend rates increase significantly.
Under capitalization generally indicates high efficiency, better management, and strong earning
capacity of the business.

Definition of Under Capitalization

According to Gerstenberg,
“A corporation may be undercapitalized when the rate of profit it is making on total capital is
exceptionally high in relation to the earnings of similar companies in the same industry.”

Causes of Under Capitalization

1. Underestimation of Capital Requirements

Sometimes companies estimate their capital requirements at a lower level during formation. As a
result, the capital employed becomes insufficient compared to the profits earned later.

2. High Efficiency of Management

Efficient management and proper utilization of resources increase productivity and profitability,
leading to under capitalization.

3. Conservative Dividend Policy

When companies retain large amounts of profits instead of distributing them as dividends, reserves
increase and earning capacity improves rapidly.

4. Increase in Demand and Sales

Sudden increase in market demand and sales may increase profits significantly without
corresponding increase in capital.

5. Undervaluation of Assets

Assets may be recorded at lower values in financial statements, while actual earning capacity
remains high.

6. Use of Modern Technology

Adoption of advanced technology and efficient production methods increases productivity and
profitability of the company.

7. Increase in Profits without Additional Capital

If profits increase continuously while capital remains unchanged, the company may become
undercapitalized.

8. Efficient Utilization of Resources

Proper use of labour, machinery, materials, and finance helps generate higher earnings from limited
capital.

9. Low Cost of Borrowing

Companies obtaining loans at lower interest rates may earn higher profits, resulting in under
capitalization.
10. Favourable Economic Conditions

Economic growth, rising market demand, and favorable government policies may increase company
profits rapidly.

Effects of Under Capitalization

1. Increase in Market Value of Shares

Due to high profitability and higher dividends, investor confidence increases and the market price of
shares rises significantly.

2. Higher Dividend to Shareholders

The company earns large profits with limited capital, allowing it to distribute higher dividends to
shareholders.

3. Increase in Goodwill

High earnings and financial strength improve the reputation and goodwill of the company in the
market.

4. Attraction of Competitors

High profits attract new competitors into the industry, increasing market competition for the
company.

5. Pressure on Management and Resources

Limited capital may create pressure on machinery, labour, and management because of expanding
business activities.

6. Possibility of Overworking Assets

Continuous use of existing resources without sufficient expansion may reduce efficiency and increase
wear and tear of assets.

7. Difficulty in Expansion

Insufficient capital may create problems in financing future expansion and modernization activities.

8. Government Control and Taxation

Very high profits may attract government regulations, higher taxation, or public criticism against the
company.

9. Dissatisfaction among Consumers

Consumers may feel exploited if the company earns excessive profits by charging high prices.

10. Risk of Financial Imbalance

Excessive under capitalization may disturb the balance between capital employed and earning
capacity of the company.
Remedies of Under Capitalization

1. Increase in Share Capital

The company may issue additional equity shares or preference shares to increase its capital base
according to business requirements.

2. Capitalization of Reserves and Profits

Accumulated reserves and retained earnings may be converted into share capital through bonus
shares.

3. Expansion of Business Operations

The company may expand production capacity, purchase new machinery, and increase infrastructure
to balance profits with capital employed.

4. Proper Utilization of Profits

Profits should be properly utilized for modernization, expansion, and development activities instead
of excessive dividend distribution.

5. Improvement in Financial Planning

Management should estimate capital requirements properly and maintain adequate finance for
future growth and expansion.

6. Borrowing Additional Funds

The company may raise long-term loans or debentures for expansion and modernization purposes.

7. Reduction in Excessive Dividend Rate

Very high dividends may reduce internal funds available for growth. Therefore, a balanced dividend
policy should be adopted.

8. Revaluation of Assets

Assets may be revalued according to their actual market value to maintain proper balance between
capital and assets.

9. Adoption of Modern Technology

Investment in modern technology and advanced production methods helps support increasing
business operations efficiently.

10. Strengthening Working Capital

Adequate working capital should be maintained for smooth day-to-day operations and business
expansion.

Conclusion

Under capitalization can be controlled through proper financial planning, increase in capital, business
expansion, and effective utilization of profits. Timely corrective measures help maintain financial
balance, support future growth, and reduce operational pressure on the business. Therefore,
companies should maintain adequate capitalization according to their earning capacity and long-
term objectives.
Introduction to Basics of Dividend Policy

Dividend policy is one of the most important financial decisions of a company because it determines
how profits will be distributed among shareholders and how much profit will be retained for future
growth. Every company earns profits through its business operations, but management must decide
whether the profits should be paid as dividends or reinvested in the business.

A proper dividend policy helps maintain investor confidence, increases market value of shares, and
supports long-term financial stability. It also helps balance the interests of shareholders who expect
regular returns and the company’s need for funds for expansion and development. Therefore,
dividend policy plays an important role in financial management and corporate decision-making.

Meaning of Dividend Policy

Dividend policy refers to the policy followed by a company regarding the proportion of profits to be
distributed as dividends to shareholders and the proportion to be retained in the business for future
needs and expansion.

In simple words, dividend policy determines how much profit will be paid to shareholders and how
much will remain in the company as retained earnings.

Objectives of Dividend Policy

1. Maximization of Shareholders’ Wealth

The main objective of dividend policy is to maximize shareholders’ wealth by providing regular and
satisfactory returns on investment.

2. Maintaining Stability of Dividends

Companies try to maintain stable dividend payments to build confidence and trust among investors.
Stable dividends improve the goodwill of the company in the market.

3. Ensuring Adequate Retained Earnings

A part of profits is retained in the business for future expansion, modernization, and development
activities.

4. Maintaining Financial Stability

A balanced dividend policy helps maintain liquidity and financial strength of the company.

5. Increasing Market Value of Shares

Regular and stable dividends improve investor confidence and increase the market price of shares.

Factors Affecting Dividend Policy

1. Profitability of the Company

Dividend payments mainly depend upon the profitability and earning capacity of the company.
Higher profits generally allow higher dividend payments.
2. Liquidity Position

Even profitable companies require sufficient cash availability for paying dividends to shareholders.

3. Growth and Expansion Plans

Companies planning expansion usually retain a larger portion of profits for future investment.

4. Stability of Earnings

Companies with stable and regular earnings can maintain a stable dividend policy more easily.

5. Legal Requirements

Dividend policy should follow legal provisions, company regulations, and government rules regarding
distribution of profits.

6. Shareholders’ Expectations

Many investors prefer regular income through dividends, so shareholder expectations influence
dividend decisions.

Types of Dividend Policy

1. Stable Dividend Policy

Under this policy, the company pays a fixed or stable dividend regularly, regardless of fluctuations in
profits.

2. Regular Dividend Policy

The company pays dividends every year from current profits and maintains regularity in payments.

3. Irregular Dividend Policy

Under this policy, dividends are not paid regularly and depend upon the availability of profits and
financial position of the company.

4. Residual Dividend Policy

Dividends are paid only after meeting all investment and expansion requirements of the business.

Importance of Dividend Policy

1. Builds Investor Confidence

Regular dividend payments increase confidence and trust among shareholders.

2. Helps in Financial Planning

Dividend policy helps management plan profit distribution and retention effectively.

3. Improves Market Reputation

A stable dividend policy improves goodwill and reputation of the company in the capital market.
4. Supports Business Growth

Retained earnings provide internal funds for expansion, modernization, and future growth of the
company.

Conclusion

Dividend policy is an important financial decision that determines the proportion of profits
distributed to shareholders and retained for future growth. A balanced dividend policy helps
maximize shareholders’ wealth, maintain financial stability, improve investor confidence, and support
long-term business growth. Therefore, management should carefully design dividend policy
according to the profitability, liquidity, and future requirements of the company.

Conclusion of Unit 3 – Capital Structure

Capital structure is an important part of financial management because it helps determine the
proper mix of debt and equity in a business. Proper capital structure, balanced leverage, suitable
capitalization, and effective dividend policy help increase profitability, maintain financial stability, and
maximize shareholders’ wealth. Therefore, companies should make financial decisions carefully
according to their earning capacity and future growth needs.