Capitalisation
- 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.