These slides are about the capital market.

2. CAPITALISATION & CAPITAL STRUCTURE
TWO ISSUES
CAPITAL EMPLOYED
PROPORTION OF DIFFERENT FORMS OF CAPITAL
CAPITALISATION → MAGNITUDE OF CAPITAL EMPLOYED BOTH LONG / SHORT
TERM.
OPTIMAL CAPITALISATION – BASIS
TWO APPROACHES – COST THEORY & EXPECTED EARNINGS
COST THEORY - CAPITAL EMPLOYED = VALUE OF IT’S ASSETS INCLUDING
FIXED, CURRENT & INTANGIBLES i.e. GOODWILL, PATENTS etc.
THEORY INADEQUATE WHEN EARNINGS FLUCTUATE CAUSING SHARE PRICE
FLUCTUATIONS LEADING TO DISCREPANCY INVALUE OF FIRM’S ASSETS/VALUE
OF SHARES.

3. EARNINGS THEORY
EARNINGS THEORY – SUGGESTS FIRM SHOULD BE CAPITALISED ON THE BASIS OF EXPECTED
EARNINGS.
NET ANNUAL EARNINGS Rs. 5, 000, MINIMUM ACCEPTABLE RETURN 10% CAPITAL (Rs.5,000/0.10) =
Rs.50,000
ESTIMATES OF FUTURE ANNUAL INCOME BASED ON HISTORICAL PROFIT (NORMAL – NOT BASED ON
BOOM OR BUST TIME, ELIMINATING NON-RECURRENT GAINS/LOSSES i.e ONLY OPERATIONAL PROFIT)
CAPITALISATION RATE (CR) → MINIMUM ACCEPTABLE RATE OF RETURN. THIS CAN BE ESTIMATED BY
COMPILING A LARGE SAMPLE OF SIMILAR FIRMS.
PRICE EARNING RATIO → MARKET PRICE OF THE SHARE/EPS. CAPITALISATION RATE IS THE OBVERSE
EPS / MARKET PRICE.
EXAMPLE - SHARE MARKET PRICE Rs. 50, EPS Rs. 5.00, CR 5/50=10%, PE= 50/5 =10
ANNUAL FUTURE EARNINGS → SAY Rs.5,000 WILL ENTAIL CAPITALISATION OF Rs. 5,000/0.10 = Rs. 50,000
EARNINGS THEORY→PREFERABLE AS IT IS ALIGNED TO FIRM’S EARNING CAPACITY. IT IS ADOPTED
BY GOING CONCERNS, WHERE ESTIMATES OF FUTURE INCOME CAN BE MADE RELIABLY. IN NEW FIRMS
HAVING NO RECORD OF HISTORICAL PROFIT, COST THEORY IS USED.

4. OVER CAPITALISATION
IS A HANDICAP TO A FIRM TO ARRIVE AT & MAINTAIN MARKET BASED RATE OF RETURNS;
OPTIMAL CAPITALISATION OVER CAPITALISATION
CAPITALISATION
CAPITALISATION 200,000 250,000
RETURN
RETURN RATE OF RETURN 20,000 20,000
RATE OF RETURN 10% 8%
CLEARLY THE EXCESS CAPITALISTATION (Rs.50,000) IS IDLE & HENCE WASTEFUL
OVER CAPITALISATION – CAUSES
ASSET COST INFLATED – WHEN FIRM IS TRANSFERRING FROM PARTNERSHIP TO SAY PRIVATE
COMPANY OR DURING INFLATIONARY PERIOD.
HIGHER EARNINGS EXPECTATION SETTING UP MORE CAPACITY THAN CAN BE ACTUALLY
ACHIEVED; ESPECIALLY DURING EARLY STAGE OF OPERATIONS
LOW EARNINGS DUE TO HIGHER PRODUCTION COSTS, INTEREST RATE, TAXATION AS WELL AS
DEFECTIVE POLICIES LIKE DIVIDEND, DEPRECIATION ETC.
EFFECTS OF OVER CAPITALISATION
MARKET SHARE PRICES FALL AT TIMES BELOW THEIR BOOK VALUE (CAPITAL STOCK + SURPLUS
/ OUTSTANDING SHARES) & / OR REAL VALUE (CAPITALISTATION VALUE OF FIRM’S ASSETS /
NUMBER OF OS SHARES)
OPERATIONAL EFFICIENCY SUFFERS
CREDIT WORTHINESS SUFFERS JEOPARDISING LIQUIDITY
SHARE HOLDERS INTERESTS COMPROMISED DUE TO MARKET SHARE PRICES REDUCTION &
FALL IN THEIR COLLATERAL VALUE.
PRODUCT QUALITY SUFFERS AFFECTING SOCIETY.

5. CAUSES OF UNDER CAPITALISTATION
REAL VALUE OF FIRM’S SHARES IS ABOVE THEIR BOOK
VALUE & MARKET SHARE PRICE > PAR VALUE
A FIRM INCORPORATED DURING RECESSION WITH LOW
CAPITAL ASSETS COSTS TENDS TO FETCH RAPID
INCREASE IN RATE OF RETURN.
CONSERVATIVE DIVIDEND POLICY → PLOUGH BACK OF
RETAINED EARNINGS REDUCING INTEREST COST.
UNDER CAPITALISTAION – IMPACT
ADVANTAGEOUS TO SHARE HOLDERS – MARKET PRICE &
COLLATERAL VALUE GOES UP.
ENHANCES FIRM’S CREDIT WORTHINESS
SOCIETY BENEFITS - CHEAPER HI-QUALITY PRODUCTS
HIGH MARKET SHARE PRICE MAY LEAD TO HIGH
SPECULATION

6. RE-ORGANISATION OF CAPITAL
MEASURES
REDEMPTION OF HI INTEREST DEBT / HI DIVIDEND PREF; SHARES – CONVERT
TO LOW COST SHARES
CHANGE IN PAR VALUE
CHANGES IN NO. OF SHARES
EFFECTS
EARNINGS NO.OF SHARES PAR VALUE CAPITALISATION EPS RETURN ON
EQUITY SHARES
EXISTING 10,000 5,000 20.00 100,000 2.00 10.00%
OVER 10,000 5,000 10.00 50,000 2.00 20.00%
CAPITALISATION
UNDER 10,000 10,000 10.00 100,000 1.00 10%
CAPITALISATION
OVER CAPITALISATION: PAR VALUE REDUCTION (FROM Rs. 20.00
TO RS. 10.00), & THE SAME AMOUNT TRANSFERRED TO A SURPLUS
ACCOUNT, THEREBY REDUCING CAPITALISATION & DOUBLING
RETURN ON EQUITY SHARES.
UNDER CAPITALISATION: SHARE STOCK SPLIT (FROM 5,000TO
10,000 SHARES) WITH CORRESPONDING REDUCTION IN PAR VALUE
(Rs.20.00 TO Rs.10.00): NO CHANGE IN CAPITALISATION WHILE EPS
REDUCES FROM Rs.2.00 TO Rs. 1.00
SHARE HOLDERS SHOULD BE O.K AS THEY HAVE TWO SHARES
INSTEAD OF ONE – TOTAL EARNINGS SAFE GUARDED.

7. MAINTAINING DESIRED EARNINGS
INCREASE IN NO.OF SHARES CAN BE
DONE BY ISSUING BONUS SHARES.
OVER CAPTILISATION :
INCREASE PROFIT MARGIN, ASSETS
TURNOVER.
UNDER CAPITALISATION:
EXPANSION SCHEMES, LABOUR WELFARE
SCHEMES.