Financing Decisions Capital Structure – CA Inter FM Question Bank | Financial Management and Strategic Management for CA Intermediate PDF Download (2024)

Financing Decisions Capital Structure – CA Inter FM Question Bank

Optimum Capital Structure

Optimum capital structure is crucial for a company as it aims to maximize the firm's value while keeping the cost of capital at a minimum. This leads to a higher market price per share and ultimately enhances the overall value of the firm. An optimal capital structure should possess the following key features:

• Maximization of profitability: By leveraging minimum cost effectively.
• Flexibility: The structure should allow the company to raise or reduce funds as needed.
• Control: It should mitigate the risk of dilution of control over the company.
• Solvency: Excessive debt levels can jeopardize the company's solvency.

It's important to note that taking on debt can initially increase the firm's value up to a certain threshold. Beyond that point, the firm's value may begin to decline. Failure to repay debts within the specified timeframe can also harm the company's reputation in the market. Therefore, selecting an appropriate capital structure is essential while considering all relevant factors.

Capital Structure vs. Financial Structure

Capital structure refers to the mix of debt and equity utilized by a company to finance its long-term operations. It represents the permanent financing of the company and includes owner's equity and long-term debts, excluding current liabilities. On the other hand, financial structure encompasses all long-term and short-term sources of capital present on the left-hand side of the balance sheet. Capital structure is a subset of the broader financial structure.

Capital Structure

• Definition: Capital structure pertains to the makeup of long-term funding sources in a company, encompassing debentures, long-term debt, preference share capital, ordinary share capital, reserves, and surplus (retained earnings).
• Composition: It comprises long-term debt, preferred stock, and net worth, indicating the blend of debt and equity in a company's overall capital.
• Planning: The capital structure should align with the interests of equity shareholders and the financial needs of the company.
• Optimal Structure: Optimal capital structure involves a suitable debt-equity mix that minimizes the firm's overall cost of capital and maximizes the market price per share or the total firm value.

Modigliani and Miller's Cost of Capital Theory

• Assumptions:
  • The Theory: Developed by Franco Modigliani and Meron H. Miller, this hypothesis extends the net operating income approach.
  • Independence: In the absence of corporate tax, the cost of capital and the market value of equity shares remain unaffected by changes in the capital structure or leverage level.

Modigliani-Miller Theory Summary

• Modigliani-Miller (M-M) Hypothesis Overview

  The Modigliani-Miller hypothesis comprises two key propositions:

  • The market value of a firm (V) and the cost of capital (ko) remain unaffected by its capital structure.
  • The firm's cost of equity rises in response to the utilization of cheaper debt capital. Essentially, the firm's employment of debt escalates its cost of equity as well.

• Assumptions Underlying the M-M Theory

  • Investors have the freedom to trade securities in a perfect market setting.
  • Investors share identical and hom*ogeneous expectations.
  • Firms can be categorized into hom*ogeneous classes.
  • The dividend payout ratio is 100%.
  • No corporate taxes are imposed.

• Relationship between Cost of Equity and Financial Leverage (MM Proposition II)

  According to Proposition II of the M-M theory, a firm's cost of equity increases to counterbalance the use of cheaper debt capital. In simpler terms, as a firm utilizes more debt, its cost of equity also rises. The overall cost of capital (ko) is a sum of a constant average cost of capital (ko) and a premium for financial risk.

  The risk premium is calculated as follows:

  See Also

  Financing Decisions Capital Structure – CA Inter FM Question Bank | Financial Management and Strategic Management for CA Intermediate PDF DownloadSimCorp future-proofs Swedbank Robur investment operationsAviva plc Q3 2023 Trading Update

  Risk premium = (ko - ke) * D/s, where:

  • ke = ko * (ko - ke) * D/s

  Proposition II assumes a linear relationship between the cost of equity and the debt-equity ratio (D/s).

  Graphical representation:

  • Investors can freely trade securities in a perfect market environment.
  • Firms can be grouped into hom*ogeneous classes.
  • No corporate taxes are applicable.

• Assumptions of Modigliani-Miller Theory

  The theory postulated by Franco Modigliani and Meron H. Miller is an extension of the net operating income approach. It states that in the absence of corporate taxes, the cost of capital and the market value of equity shares remain independent of changes in the capital structure or leverage levels.

Net Operating Income Approach and MM Hypothesis in Capital Structure

Net Operating Income Approach (NOI) Theory of Capital Structure

• The theory suggests that the market value of a firm is based on its net operating profit (EBIT) and Weighted Average Cost of Capital (WACC).
• Capital structure, according to this theory, does not impact the overall value of the firm.

Assumptions of NOI Approach:

• No taxes are considered in this model.
• The cost of capital remains constant regardless of the debt-equity mix.
• The market values the firm as a whole, making the debt-equity split insignificant.
• Increasing debt proportion raises shareholder risk perception, leading to higher cost of equity that offsets debt benefits.

Modigliani-Miller (MM) Hypothesis

The MM Hypothesis states that in perfect markets, the value of a firm is not impacted by its capital structure. It assumes no taxes, no transaction costs, and perfect information.

Example Calculation:

• Firms P and Q have identical earnings before interest and tax (EBIT) of ₹2,60,000 annually.
• Firm Q includes ₹8,00,000, 9% debentures in its capital structure, while P does not use any debt.
• Given a capitalization rate of 10% and a corporate tax rate of 30%, the MM Hypothesis calculates the value of both firms.

Value of Firm P (Unlevered):Vu = EBIT(1 - t) / Ke = ₹2,60,000(1 - 0.30) / 10% = ₹1,82,000 / 10% = ₹18,20,000

Capital Restructuring and MM Model Overview

• Market Value of Firm Q (Levered) is calculated as VE=Vu DT= ₹18,20,000 (8,00,000 × 0.30) = ₹18,20,000 + 2,40,000 = ₹20,60,000.

Question Analysis: RES Ltd. Capital Restructuring

• RES Ltd. is an all-equity financed company with a market value of ₹25,00,000 and a cost of equity, ke=21%.
• The company aims to repurchase equity shares worth ₹5,00,000 by issuing 15% perpetual debt of the same amount, considering a tax rate of 30%.

Calculation Details:

• Market Value of Equity = ₹25,00,000, Cost of Equity (Ke) = 21%.
• Net income for equity holders = ₹5,25,000.
• EBIT is computed as 5,25,000/0.7 = ₹7,50,000.

Financial Analysis:

• Present value of tax-shield benefits = ₹5,00,000 x 0.30 = ₹1,50,000.
• Value of Restructured firm = ₹25,00,000 + ₹1,50,000 = ₹26,50,000.

Financial Analysis Summary

• Cost of Equity (Ke)
  • Total Value = ₹26,50,000
  • Less: Value of Debt = ₹5,00,000
  • Value of Equity = ₹21,50,000
  • Ke = ₹4,72,500 / ₹21,50,000 = 0.219 = 22%
• Weighted Average Cost of Capital (WACC)
  • Cost of Debt (after tax) = 15% * (1 - 0.3) = 0.105 = 10.5%
  • Components of Costs
    • Equity: ₹21,50,000 * 0.22 = ₹0.178
    • Debt: ₹5,00,000 * 0.105 = ₹0.020
    • Total Weighted COC = 19.8%
• Company Restructuring Impact
  • After restructuring, Ke would increase to 21.98% while Ko would decrease to 19.81%.
  • Reduction in Ko and increase in Ke are beneficial for the company's financial health.
• Case Study Question
  • 'A' Ltd. vs. 'B' Ltd.: Capital Structure and Value Calculation
  • Given assumptions under the M-M model and specific financial data.
  • Calculation of firm values and Weighted Average Cost of Capital for both companies.
• Answer to Question
  • Calculation of Market Value for 'A Ltd.' and 'B Ltd.' based on MM Hypothesis.
  • Market Value of 'A Ltd.' (Unlevered) = ₹8,75,000.

Firm Valuation and Weighted Average Cost of Capital (WACC)

Firm Valuation according to Modigliani-Miller Hypothesis

• Unlevered Firm Value (Vu): This represents the value of a firm without any debt. It is calculated by dividing Earnings Before Tax (EBT) by the Equity Capitalization Rate (Ke). For example, if a firm's EBT is ₹5,00,000, and the equity capitalization rate is 20%, the Vu would be ₹17,50,000.
• Levered Firm Value (VE): This is the value of a firm that includes debt. It is computed by multiplying the Unlevered Firm Value by the Debt-to-Value ratio (DT). For instance, if the Unlevered Firm Value is ₹17,50,000 and there is debt of ₹20,00,000 at a rate of 30%, the Levered Firm Value would be ₹23,50,000.

Weighted Average Cost of Capital (WACC) Calculation

• WACC for Unlevered Firm: The WACC is typically equivalent to the Equity Capitalization Rate when there is no debt in the capital structure.
• WACC for Levered Firm: The WACC calculation involves considering the cost of debt and equity in the capital structure. It is crucial for determining the average rate of return required by both debt and equity investors.

Case Study: PNR Limited and PXR Limited

• Differences in Capital Structure: PNR Limited operates without debt, while PXR Limited includes 12% Debentures amounting to ₹20,00,000 in its capital structure.
• Given Information: Key data provided includes the Income Tax Rate of 30%, EBIT of ₹5,00,000, and the equity capitalization rate of PNR Limited at 20%.

Calculations to Determine Firm Values and WACC

• Value of Both Companies: To ascertain the value of PNR Limited and PXR Limited, various factors such as EBIT, tax rates, and capitalization rates need to be considered.
• Weighted Average Cost of Capital: Calculating the WACC involves understanding the cost of capital for each company based on their specific capital structures and financial metrics.

Application of Modigliani-Miller Approach

• MM Hypothesis: This theory provides insights into the relationship between capital structure and firm value, emphasizing the impact of debt on a company's overall worth.
• Assumptions: The Modigliani-Miller Approach operates under specific assumptions, ensuring that market imperfections do not skew the valuation process.

Financial Analysis Summary

• EBIT(-) Interest (12%): 5,00,000(2,40,000)
• EBT(-) Tax @ 30%: 2,60,000(78,000)
• PAT: 1,82,000
• Value of Firm(-) Value of Debt: 23,50,000(20,00,000)
• Value of Equity: 3,50,000

Calculating Ke (Return on Equity)

• Ke = PAT / Value of Equity = 1,82,000 / 3,50,000 = 52%

Weighted Average Cost of Capital (WACC)

• Equity: 3,50,000 | Weight: 0.1489 | Cost: 7.75% | W x C
• Debt: 20,00,000 | Weight: 0.8511 | Cost: 8.40% | W x C
• WACC: 15%

Question 13: A Limited and B Limited Analysis

• A Ltd. - 60% debt, 40% equity | B Ltd. - 20% debt, 80% equity
• (a) (i) Calculate X's return with given data
• (a) (ii) Determine the implied required rate of return on equity for A Ltd.
• (b) Calculate the implied required equity return of B Ltd.
• (b) Analyze the differences between A Ltd. and B Ltd.

Question 14: Valuation of Companies P and Q

• Company P - 10% debentures of ₹18 lakhs | Company Q - Unlevered
• Both companies earn 20% before interest and taxes on total assets of ₹30 lakhs
• Calculate the value of companies using Net Income Approach
• Calculate the value of companies using Net Operating Income Approach

Major Considerations in Capital Structure Planning

• Risk
• Cost of capital
• Control

Risk: Risk in capital structure planning refers to the uncertainty associated with the actual returns compared to the expected returns. Companies aim to minimize risk by designing an optimal capital structure.

Example: When a company diversifies its sources of funding to include both debt and equity, it aims to balance risk to ensure stable returns.

Cost of Capital: The cost of capital represents the minimum rate of return a company needs to generate on its investments to satisfy investors. It is a critical factor in capital structure planning.

Example: If a company's cost of capital is high, it might choose a capital structure with lower-cost financing options to enhance profitability.

Control: Capital structure decisions are made while considering the impact on control within the company. Issuing equity shares, for instance, can dilute ownership control.

Example: When a company decides to issue new shares, existing shareholders may see a reduction in their ownership percentage, potentially affecting decision-making power.

Fundamental Principles Governing Capital Structure

• Cost Principle: An ideal capital structure minimizes costs and maximizes earnings per share (EPS).
• Risk Principle: Emphasizes more on common equity over excessive debt to prevent erosion of shareholders' value.
• Control Principle: Capital structure should maintain existing management control and ownership.
• Flexibility Principle: Management should choose financing sources that are easily adjustable to future fund requirements.
• Other Considerations: Factors such as industry nature, timing of issue, and competition should also be considered.

Akash Limited Information Analysis

• Akash Limited has reserves and surplus of ₹7,00,000 and needs ₹4,00,000 for modernization.
• Debt ratio above 40% reduces PIE ratio to 8 and increases interest rate on additional debts to 12%.

• If additional capital is raised as debt, the share price will be influenced by the increased debt burden and interest rates.
• If the amount is raised by issuing equity shares at market price, the share price will be influenced by market valuation and dilution effects.

Working Notes

Calculation of existing Return on Capital Employed (ROCE)

• ROCE calculation involves assessing the return generated from the capital employed in the business.

Paraphrasing and elaborating on the provided information, it is crucial to consider the financial principles governing capital structure for effective financial management. By understanding and applying these principles, companies can optimize their capital mix to enhance profitability and shareholder value. Additionally, analyzing Akash Limited's financial situation highlights the importance of balancing debt and equity in capital raising decisions to maintain financial stability and shareholder wealth.

Understanding Capital Structure and Debt-Equity Ratios

• 10,000 shares are issued in Plan-II, totaling the shares to 40,000 after the issue.

Debt/Equity Ratio with Debt of ₹4,00,000

• With ₹4,00,000 raised as debt, the debt/equity ratio amounts to 44.44%.
• This high ratio necessitates lowering the PIE ratio to 8 in Plan-I.

Debt-Equity or EBIT-EPS Indifference Point

The concept of Debt-Equity or EBIT-EPS Indifference Point is crucial in determining a company's capital structure. This point aims to find the optimal level of debt within the capital structure, balancing return and risk effectively.

EBIT-EPS analysis is instrumental in this regard, enabling a comparison of financing methods to identify indifference points. These points represent EBIT levels where EPS remains constant regardless of the debt-equity mix.

For instance, the indifference point for the capital mix can be calculated as: (EBIT-I1)(1-T)E1 = (EBIT-I2)(1-T)E2

Question for Discussion

Discuss the importance of Debt-Equity or EBIT-EPS Indifference Point in determining a company's capital structure. (May 2009, 2 marks)

Answer: The Debt-Equity or EBIT-EPS Indifference Point is pivotal in guiding a company towards an optimal capital structure. It ensures a balance between return on investment and risk management, crucial for sustainable growth and financial stability.

Financial Management Concepts

• Financial Planning Proposals:
  • Cost of debt is 10%
  • Cost of preference shares is 10%
  • Tax rate is 50%
  • Equity shares with face value of ₹10 each to be issued at a premium of ₹10 per share
  • Total investment to be raised is ₹40,00,000
  • Expected earnings before interest and tax are ₹18,00,000
• Advice Sought by Z Company Ltd. Management:
  • Compute Earning per share
  • Determine Financial Break-even-point
  • Calculate the EBIT range among the plans for indifference
  • Identify if any of the plans dominate
• Computation of Financial Break-even Points:
  • Proposal 'P' has a break-even point of 0
  • Proposal 'Q' incurs an interest charge of ₹2,00,000
  • Proposal 'R' requires earnings of ₹4,00,000 for paying preference share dividends

Financial Analysis Concepts

• Computation of Indifference Point between Proposals:
  • Indifference point is the point where the Earnings before Interest and Tax (EBIT) are equal for two proposals.
  • The formula for calculating the indifference point between Proposal P and Proposal Q is: (EBIT-P)(1-T)E1 = (EBIT-Q)(1-T)E2.
  • Here, EBIT stands for Earnings before Interest and Tax, 11 represents Fixed Charges (Interest) under Proposal P, 12 represents Fixed Charges under Proposal Q, T is the Tax Rate, E1 is the number of equity shares in Proposal P, and E2 is the number of equity shares in Proposal Q.
• Combination of Proposals:
  • Indifference point where EBIT of Proposal P and Proposal Q is equal:
  • Example: If (EBIT-1)(1-0.5)2,00,000 = (EBIT-2,00,000)(1-0.5)1,00,000, then EBIT = ₹4,00,000.
  • Indifference point where EBIT of Proposal P and Proposal R is equal:
  • Example: If (EBIT-1)(1-T)E1 = (EBIT-2)(1-T)E2 - Preference Share dividend, and EBIT = ₹8,00,000.
  • Indifference point where EBIT of Proposal Q and Proposal R are equal:
  • Example: If (EBIT-2,00,000)(1-0.5)1,00,000 = (EBIT-0)(1-0.5)2,00,0001,00,000, then EBIT = ₹2,00,000.

Indifference Points in Financial Analysis

• Financial analysis often involves comparing different proposals to determine indifference points.
• Indifference point refers to the point at which two alternative financial proposals yield equal results.
• It helps in decision-making by highlighting where one option becomes more favorable than the other.

Example of Financial Proposal Comparison

• Consider Proposal Q and Proposal R:
• Proposal Q has a financial break-even point of ₹2,00,000 while Proposal R's break-even point is ₹4,00,000.
• This implies that Proposal Q is more advantageous as it reaches the break-even point at a lower value.

Calculation of Rate of Dividend

• To find the rate of dividend on preference shares, EPS (Earnings Per Share) is equated between alternative financing plans.
• An example calculation is done to showcase how the rate of preference dividend is derived.
• Understanding dividend rates is crucial in financial decision-making for companies.

Comparison of Financing Alternatives for Projects

• Companies often have to choose between various financing options for new projects.
• Comparing equity shares, debentures, and borrowing can help in determining the most cost-effective solution.
• Calculating the indifference point assists in identifying the point where both options are equally viable.

Choosing Financing Modes Wisely

• Deciding between equity shares, debentures, and borrowing hinges on factors like interest rates, tax implications, and company needs.
• Each financing mode has its advantages and disadvantages, requiring careful evaluation before making a decision.

Financial Leverage and Capital Structure Decisions

• Interest Payable on Loan and Debentures
  • Plan I: Interest Payable on Loan amounts to 2,40,000 calculated at 12% on 20,00,000.
  • Plan II: Interest Payable on Debentures totals 4,80,000 computed at 12% on 40,00,000.
• Point of Indifference Calculation
  • Point of indifference is reached when EBIT - Interest(I) multiplied by (1-tax rate) equals Earnings per Share (EPS) for Plan I and Plan II.
  • It is crucial to determine the EBIT level at which the two financing plans yield the same EPS.
  • For instance, when expected EBIT is lower than the indifference point, Plan I is preferable due to higher EPS from equity capital usage.
  • Conversely, if estimated EBIT surpasses the indifference point, Plan II is favored for its higher EPS, leveraging fixed costs and benefiting from the EPS perspective.
• Calculation Variations and Considerations
  • Alternate EBIT figures above and below 9,60,000 can be assumed to explore different scenarios.
  • Factors influencing capital structure decisions such as costs, risks, control, and principles should also be factored into the analysis.

Summary and Explanation:

Scenario Overview:

• India Limited needs ₹50,00,000 for a new Plant.
• The Plant is projected to generate earnings before interest and taxes of ₹10,00,000.
• The company aims to maximize earnings per share through financial planning.

Financing Alternatives:

• Raising debt options: ₹5,00,000, ₹20,00,000, or ₹30,00,000 with the rest from equity shares.
• Share price: Currently at ₹150, expected to decrease to ₹125 if borrowing exceeds ₹20,00,000.
• Interest rates: 9% up to ₹5,00,000, 14% from ₹5,00,000 to ₹20,00,000, and 19% over ₹20,00,000.
• Company tax rate: 40%.

Optimal Financing Choice:

• Option B (Debt of ₹20 lakhs and equity capital of ₹30 lakhs) maximizes earnings per share.

Working Notes (WN):

• Interest Calculation: Applying relevant interest rates on the total debt amount.
• Number of Equity Shares:
• Alternative A: 30,000 shares
• Alternative B: 20,000 shares
• Alternative C: 16,000 shares

Conclusion:

• By selecting financing Alternative B, India Limited can optimize its earnings per share.

Sun Ltd. Financing Plans

• Fund's Requirement

  The fund's requirement is ₹100 Lakhs.

• Financial Plans

  • Plan 1

    Sun Ltd.'s first financing plan involves...

  • Plan 2

    The second financing plan of Sun Ltd. includes...

Financial Planning and Decision Making in Corporate Finance

• Scenario Overview:

  • The company, Y Limited, is contemplating two financial plans to fund a new project requiring ₹50,00,000.

• Plan I:

  • Raise debt of ₹5,00,000 and equity of ₹45,00,000.
  • Expected earnings before interest and taxes (EBIT) from the project are ₹10,00,000.
  • Debt can be sourced at a rate of 12%.
  • The tax rate applicable is 25%.

• Plan II:

  • Raise debt of ₹20,00,000 and equity of ₹30,00,000.
  • Similar EBIT projections as Plan I.
  • Varying interest rates apply based on the debt amount.
  • Tax implications remain consistent at 25%.

• Decision Making:

  • The company aims to maximize earnings per share (EPS) through its financing choice.
  • Considerations include the impact of debt levels on share price and the cost of borrowing.
  • The choice between Plan I and Plan II hinges on EPS optimization amidst differing debt-equity structures.

Overview

• Calculation of Earnings Per Share (EPS) involves analyzing different financial plans to maximize shareholder earnings.

Key Points

• Financial Plan II, involving a rising debt of ₹20 lakhs and the issuance of equity share capital of ₹30 lakhs, maximizes EPS.

Working Notes

• Interest on Debt Calculation:
  • Plan I: ₹5,00,000 x 12% = ₹60,000
  • Plan II: (₹5,00,000 x 12%) + (₹15,00,000 x 10%) = ₹2,10,000
• Number of Equity Shares to be Issued:
  • Plan I: ₹45,00,000 / 300 = 15,000 Shares
  • Plan II: ₹30,00,000 / 300 = 10,000 Shares

Question for Discussion

• RM Steels Limited scenarios: Issuing ordinary shares, debentures, and preference shares for a new plant construction.
• Compute EPS under each scenario based on varying Earnings Before Interest and Taxes (EBIT).
• Recommendation: Plan II (Debt-equity mix) is preferable when EBIT is ₹80,000 or more due to higher EPS.

These financial analyses provide insights into how different financing strategies impact Earnings Per Share, guiding companies in making informed decisions regarding capital structure and maximizing shareholder value.

Finance and Capital Structure Concepts

Financing Plans Comparison

• Company J Ltd. is evaluating three financing options to raise a total of ₹4,00,000.
• Plans Overview:
• X Plan: 100% Equity
• Y Plan: 50% Equity, 50% Debt
• Z Plan: 50% Equity, 50% Preference Shares
• Costs and Rates:
• Cost of Debt: 10%
• Cost of Preference Shares: 10%
• Tax Rate: 50%
• Equity Issuance:
• Equity Shares: ₹10 face value + ₹10 premium per share
• Expected EBIT: ₹1,00,000
• Calculations for Each Plan:
• (i) Earnings per Share (EPS)
• (ii) Financial Break-even Point
• (iii) Indifference Point Analysis

Understanding Over Capitalization

• Definition:
• Over Capitalization occurs when a company consistently fails to generate the expected return on its invested capital.
• It signifies an excess of capital compared to the operational needs and scale of the business.
• Causes of Over Capitalization:
• Overestimation of Earnings
• Improper Asset Valuation
• Excessive Borrowings
• High Debt Servicing Costs
• Consequences of Over Capitalization:
• Reduced Profitability
• Lower Dividend Payments
• Decreased Market Value
• Risk of Bankruptcy

Causes of Over-Capitalisation:

• Underestimation of the Capitalisation Rate: When the capitalisation rate is underestimated, it can lead to over-capitalisation. For example, if the expected rate of return on investment is miscalculated, the company may end up with excess capital.
• Over-Issue of Capital: This occurs when promoters of a new company overestimate financial needs, leading to raising more capital than necessary. This results in over-capitalisation, where the company has more funds than it can effectively utilize.
• High Promotion Expenses: Excessive spending on promotional activities or preliminary expenses can contribute to over-capitalisation. For instance, if a company spends excessively on marketing without proportional returns, it may face over-capitalisation.
• Liberal Dividend Policy: A lenient dividend policy that prioritizes immediate payouts over building reserves can lead to over-capitalisation. When profits are distributed generously instead of being reinvested, the company may face a surplus of capital.
• Inadequate Depreciation Provision: Failing to account for depreciation properly can result in the real value of assets being less than their book value. This discrepancy can contribute to over-capitalisation as the company's assets are overvalued on paper.
• Formation of the Company during Inflationary Period: Starting a company during inflation may require a significant amount of capital to acquire assets. However, if asset prices decrease during a subsequent economic downturn, the company may end up over-capitalised.

Consequences of Over-Capitalisation:

• Poor Creditworthiness: A company suffering from over-capitalisation may experience reduced earnings, affecting its creditworthiness. This can make it challenging to secure loans or credit at favorable interest rates, as lenders may perceive the company as financially unstable.

Challenges of Over-Capitalization

• Difficulty in Acquiring Capital: When a company is over-capitalized, it becomes arduous to secure additional funds for its development and expansion initiatives. This arises from a loss of investor trust in the company's potential to grow.
• Diminished Goodwill: An over-capitalized company experiences a decline in its ability to generate earnings, leading to a decrease in the market value of its shares. Consequently, investor confidence is undermined. If a company's shares are trading below their face value, it can be challenging to enhance its reputation in the market.
• Market Loss: Over-capitalized firms often struggle to manufacture goods at competitive prices, resulting in the loss of their market share to rival companies.
• Company Liquidation: Unless significant measures are taken to restructure the entire capital framework, an over-capitalized company faces the risk of liquidation. However, the reorganization process itself can introduce a host of complications.