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Financial Management Unit 2 Sikkim Manipal University 15 Unit 2 Financial Planning Structure 2.1. Introduction 2.2. Steps in financial planning 2.3. Factors affecting financial plan 2.4. Estimation of financial requirements of a firm. 2.5. Capitalizations 2.1.1 Cost Theory 2.1.2 Earnings theory: 2.1.3 Overcapitalization 2.1.4 Undercapitalization 2.6 Summary Terminal Questions Answer to SAQs and TQs 2.1 Introduction  Liberalization and globalization policies initiated by the Government have changed the dimension of business environment. It has changed the dimension of competition that a firm faces today. Therefore for survival and growth a firm has to execute planned strategy systematically. To execute any strategic plan, resources are re quired. Resources may be manpower, plant and machinery, building, technology or any intangible asset. To acquire a ll these assets financial resources are essential ly required. Therefore, finance manager of a company mu st have both long-range an d short-range financial plans. Integration of both these plans is required for the effective utilization of all the resources of the firm. The long-range plan must consider (1) Funds required to execute the planned course of action. (2) Funds available at the disposal of th e company. (3) Determination of funds to b e procured from outside sources.
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Financial Management Unit 2

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Unit 2 Financial Planning

Structure 

2.1. Introduction

2.2. Steps in financial planning

2.3. Factors affecting financial plan

2.4. Estimation of financial requirements of a firm.

2.5. Capitalizations

2.1.1 Cost Theory

2.1.2 Earnings theory:

2.1.3 Overcapitalization

2.1.4 Undercapitalization

2.6 Summary

Terminal Questions

Answer to SAQs and TQs

2.1  Introduction 

Liberalization and globalization policies initiated by the Government have changed the dimension

of business environment. It has changed the dimension of competition that a firm faces today.

Therefore for survival and growth a firm has to execute planned strategy systematically.

To execute any strategic plan, resources are required. Resources may be manpower, plant and

machinery, building, technology or any intangible asset.

To acquire all these assets financial resources are essentially required. Therefore, finance

manager of a company must have both long-range and short-range financial plans. Integration of 

both these plans is required for the effective utilization of all the resources of the firm.

The long-range plan must consider (1) Funds required to execute the planned course of action.

(2) Funds available at the disposal of the company. (3) Determination of funds to be procured

from outside sources.

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Learning Objectives: 

After studying this unit you should

1. Explain the steps involved in financial planning.

2. Explain the factors affecting the financial planning.

3. List out the causes of over- capitation

4. Explain the effects of under capitation. 

Objectives of Financial Planning 

Financial Planning is a process by which funds required for each course of action is decided. It

must consider expected business Scenario and develop appropriate courses of action. A

financial plan has to consider Capital Structure, Capital expenditure and cash flow. In this

connection decisions on the composition of debt and equity must be taken.

Financial planning generates financial plan. Financial plan indicates:

1. The quantum of funds required to execute business plans.

2. Composition of debt and equity, keeping in view the risk profile of the existing business, new

business to be taken up and the dynamics of capital market conditions.

3. Formulation of policies for giving effect to the financial plans under consideration.

A financial plan is at the core of value creation process. A successful value creation process can

effectively meet the bench marks of investor’s expectations. 

Benefits that accrue to a firm out of the financial planning 

1. Effective utilization of funds: Shortage is managed by a plan that ensures flow of cash at the

least cost. Surplus is deployed through well planned treasury management. Ultimately the

productivity of assets is enhanced.

2. Flexibility in capital structure is given adequate consideration. Here flexibility means the firms

ability to change the composition of funds that constitute its capital structure in accordance

with the changing conditions of capital market. Flexibility refers to the ability of a firm to obtain

funds at the right time, in the right quantity and at the least cost as per requirements to

finance emerging opportunities.3. Formulation of policies and instituting procedures for elimination of all types of wastages in

the process of execution of strategic plans.

4. Maintaining the operating capability of the firm through the evolution of scientific replacement

schemes for plant and machinery and other fixed assets. This will help the firm in reducing its

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operating capital. Operating capital refers to the ratio of capital employed to sales generated.

A perusal of annual reports of Dell computers will throw light on how Dell strategically

minimized the operating capital required to support sales. Such companies are admired by

investing community.5. Integration of long range plans with the shortage plans. 

Guidelines for financial planning 

1. Never ignore the coordinal principle that fixed asset requirements be met from the long term

sources.

2. Make maximum use of spontaneous source of finance to achieve highest productivity of 

resources.

3. Maintain the operating capital intact by providing adequately out of the current periods

earnings. Due attention to be given to physical capital maintenance or operating capability.

4. Never ignore the need for financial capital maintenance in units of constant purchasing power.

5. Employ current cost principle wherever required.

6. Give due weightage to cost and risk in using debt and equity.

7. Keeping the need for finance for expansion of business, formulate plough back policy of 

earnings.

8. Exercise thorough control over overheads.

9. Seasonal peak requirements to be met from short term borrowings from banks. 

2.2 Steps In Financial Planning 

1. Establish Corporate Objectives: Corporate objectives could be grouped into qualitative and

quantitative. For example, a company’s mission statement may specify “create economic –

value added.” But this qualitative statement has to be stated in quantitative terms such as a

25 % ROE or a 12 % earnings growth rates. Since business enterprises operate in a dynamic

environment, there is a need to formulate both short run and long run objectives.

2. Next stage is formulation of strategies for attaining the objectives set. In this connection

corporates develop operating plans. Operating plans are framed with a time horizon. It could

be a five year plan or a ten year plan.

3. Once the plans are formulated, responsibility for achieving sales target, operating targets,

cost management bench marks, profit targets etc is fixed on respective executives.

4. Forecast the various financial variables such as sales, assets required, flow of funds, cost to

be incurred and then translate the same into financial statements. Such forecasts help the

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finance manager to monitor the deviations of actual from the forecasts and take effective

remedial measures to ensure that targets set are achieved without any time overrun and cost

overrun.

5. Develop a detailed plan for funds required for the plan period under various heads of expenditure.

6. From the funds required plan, develop a forecast of funds that can be obtained from internal

as well as external sources during the time horizon for which plans are developed. In this

connection legal constrains in obtaining funds on the basis of covenants of borrowings should

be given due weightage. There is also a need to collaborate the firm’s business risk with risk

implications of a particular source of funds.

7. Develop a control mechanism for allocation of funds and their effective use.

8. At the time of formulating the plans certain assumptions need to be made about the economic

environment. But when plans are implemented economic environment may change. To

manage such situations, there is a need to incorporate an inbuilt mechanism which would

scale up or scale down the operations accordingly. 

Forecast of Income Statement and Balance Sheet 

There are three methods of preparing income statement:

1. Percent of sales method or constant ratio method

2. Expense method

3. Combination of both these two 

Percent of Sales method: This approach is based on the assumptions that each element of cost

bears some constant relationship with the sales revenue.

For example, Raw material cost is 40 % of sales revenue of the year ended 31.03.2007. But this

method assumes that the ratio of raw material cost to sales will continue to be the same in 2008

also. Such an assumption may not hold good in most of the situations. For example, Raw

material cost increases by 10 % in 2008 but selling price of finished goods increases only by 5 %.

In this case raw material cost will be 44 / 105 of the sales revenue in 2008. This can be solved to

some extent by taking average for same representative years. However, inflation, change in Govt

policies, wage agreements, technological innovation totally invalidate this approach on a long run

basis.

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2. Budgeted Expense Method: Expenses for the planning period are budgeted on the basis of 

anticipated behaviour of various items of cost and revenue. This demands effective data

base for reasonable budgeting of expenses.

3. Combination of both these methods is used because some expenses can be budgeted by themanagement taking into account the expected business environment and some other 

expenses could be based on their relationship with the sales revenue expected to be earned.

Forecast of Balance Sheet

1. Items of certain assets and liabilities which have a close relationship with the sales revenue

could be computed based on the forecast of sales and the historical data base of their 

relationship with the sales.

2. Determine the equity and debt mix on the basis of funds requirements and the company’s

policy on Capital structure.

Example : The following details have been extracted from the books of X Ltd

Income Statement (Rs. In millions) 

2006 2007 

Sales less returns 1000 1300

Gross Profit 300 520

Selling Expenses 100 120

Administration 40 45Deprecation 60 75

Operating Profit 100 280

Non operating income 20 40

EBIT (Earnings before interest & Tax 120 320

Interest 15 18

Profit before tax 105 302

Tax 30 100

Profit after tax 75 202

Dividend 38 100

Retained earnings 37 102 

Balance Sheet (Rs. In million)

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Liabilities 2006 2007 Assets 2006 2007

Share holders fund Fixed Assets 400 510 

Share Capital Less: Depreciation 100 120

Equity 120 120 300 390

Preference 50 50 Investments 50 50

Reserves & Surplus 122 224

Secured Loans 100 120 Current Assets, loans

& Advances 

Unsecured loans 50 60 Cash at Bank 10 12

Receivables 80 128 

Current Liabilities Inventories 200 300

Trade Crs 210 250 Loans & Advances 50 80 

Provisions Miscellaneous

expenditure10 24

Tax 10 60

Proposed Dividend 38 100

760 984 700 984

Forecast the income statement and balance sheet for the year 2008 based on the following

assumptions.

1. Sales for the year 2008 will increase by 30% over the sales value for 2007.

2. Use percent of sales method to forecast the values for various items of income statement

using the percentage for the year 2007.

3. Depreciation is to charged at 25 % of fixed assets.

4. Fixed assets will increase by Rs.100 million.

5. Investments will increase by Rs.100 million.

6. Current assets and Current liabilities are to be decided based on their relationship to sales in

the year 2007.7. Miscellaneous expenditure will increase by Rs.19 million.

8. Secured loans in 2008 will be based on its relationship to sales in the year 2007.

9. Additional funds required, if any, will be met by bank borrowings.

10. Tax rates will be 30 %.

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11. Dividends will be 50 % of profit after tax.

12. Non operating income will increase by 10%.

13. There will be no change in the total amount of administration expenses to be spent in the year 

200814. There is no change in equity and preference capital in 2008.

15. Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007.

Income Statement for the Year 2008 (Rs. In million)

(Forecast) 

Particulars Basis Working Amount (Rs.) 

a. Sales Increase by 30 % 1300 x 1.3 1690

b. Cost of Sales Increase by 30 % 780 x 1.3 1014

c. Gross profit Sales–Cost of sales 1690 - 1014 676

d. Selling expenses 30 % increase 120 x 1.3 156

e. Administration No change 45

f. Depreciation % given 390 + 100

4

123 (Rounded off)

g. Operating Profit C - (D + E + F) 352

h. Non operating Income Increase by 10 % 1.1 x 40 44

i. Earnings Before

Interest & Taxes (EBIT)

396

  j. Interest 18 of sales

1300

18 x 1690

1300

23 (Decimal ignored)

k. Profit before tax 373

l. Tax 112

m. Profit after tax 261

n. Dividends 130

o. Retained earnings 131 

Balance Sheet for the year 2008 (Rs. In million)

(Forecast)

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Particulars Basis Working Amount (Rs.)

Assets 

Fixed Assets Given 510

Add: Addition 100

610

Depreciation 120 + 123 243

1. Net fixed assets 367

2. Investments 150

3. Current Assets & Loans

& advances

Cash at bank 12

1300

12 x 1690

130016 (Rounded off)

Receivables 128

1300

128 x 1690

1300166

Inventories 300

1300

300 x 1690

1300390

Loans & Advances 80

1300

80 x 1690

1300104

4. Miscellaneous

ExpenditureGiven 24 + 19 43 

Total 1236

Liabilities 

1. Share Capital 

Equity 120

Preference 50

2. Reserves & Surplus Increase by current

year’s retained

earnings

355

3. Secured Loan 60

1300

60 x 1690

130078

Bank borrowings 40 (Difference –

Balancing figure)

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4. Unsecured Loan 60 60

5. Current Liabilities &

Provision 

Trade creditors 250

1300

250 x 1690

1300325

Provision for tax 60

1300

60 x 1690

130078

Proposed Dividend Current year given 130 

Total Liabilities 1236

Computerised Financial Planning Systems 

All corporate forecasts use Computerised forecasting models.

Additional funds required to finance the increase in sales could be ascertained using a

mathematical relationship based on the following:

Additional funds = Required increase -- Spontaneous -- Increase in

Required in assets increase in retained

liabilities earnings

(This formula has been recommended by Engene.F.Brighaom and Michael C Ehrharte in their 

book financial management – Theory and Practice, 10th

edition.

Prof. Prasanna Chandra, in his book Financial Management, has given a comprehensive formula

for ascertaining the external financing requirements:

EFR = A (Ds) – L (Ds) – ms (1-d) – (D1m + SR)

S S

Here

A = Expected increase in assets, both fixed and current required for the

S expected increase in sales in the next year.

L = Expected Spontaneous financing available for the expected increase in

S sales

MS1 (1-d) = It is the product of 

Profit margin x Expected sales for the next year x Retention Ratio 

X Ds

X Ds

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Here, retention ratio is 1 – payout ratio. Payout ratio refers to the ratio of dividend paid to

earnings per share 

D1m = Expected change in the level of investments and miscellaneous expenditure

SR = It is the firm’s repayment liability on term loans and debenture for the next year.

This formula has certain features:-

1. Ratios of assets and spontaneous liabilities to sales remain constant over the planning period.

2. Dividend payout and profit margin for the next year can be reasonably planned in advance.

3. Since external funds requirements involve borrowings from financial institution, the formula

rightly incorporates the management’s liability on repayments.

Example

A Ltd has given the following forecasts:

“Sales in 2008 will increase to Rs.2000 from Rs.1000 in 2007”

The balance sheet of the company as on December 31, 2007 gives the following details:  

Liabilities Rs Assets Rs 

Share Capital Net Fixed Assets 500

Equity (Shares of Rs.10 each) 100 Inventories 200

Reserves & Surplus 250 Cash 100

Long term loan 400 Bills Receivable 200

Crs for expenses outstanding 50

Trade creditors 50

Bills Payable 150 

1000 1000 

Ascertain the external funds requirements for the year 2008, taking into account the following

information:

1. The Company’s utilization of fixed assets in 2007 was 50 % of capacity but its current assets

were at their proper levels.

2. Current assets increase at the same rate as sales.

3. Company’s after-tax profit margin is expected to be 5%, and its payout ratio will be 60 %.

4. Creditors for expenses are closely related to sales ( Adapted from IGNOU MBA) 

Answers 

Preliminary workings

A = Current assets = Cash + Bills Receivables + Inventories

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= 100 + 200 +200 = 500

A = 500 = Rs.500

S 1000

L = Trade creditors + Bills payable + Expenses outstanding= 50 + 150 + 50 = Rs.250

L = 250 = Rs.250

S 1000

M (Profit Margin)= 5 / 100 = 0.05

S1 = Rs.200

1-d = 1 – 0.6 = 0.4 or 40 % 

D1m = NIL

SR = NIL

Therefore: 

)1()1()(

1  SRmd mS S  xS 

 L

 s A EFR +D---D-

D=

= 500 – 250 – (0.05 x 200 x 0.4) – (0 + 0)

= 500 – 250 – 40 - (0 + 0)

= Rs.210

Therefore, external funds requirements (additional funds required) for 2008 will be Rs.210.

This additional funds requirements will be procured by the firm based on its policy on capital

structure. 

Self Assessment Questions 1 

1. Corporate objectives could be group into ________ and ________.

2. Control mechanism is developed for _____________ and their effective use.

3. Seasonal peak requirements to be met from ___________________ from banks.

4. Exercise through _________ over overheads. 

2.3 Factors Affecting Financial Plan 

1. Nature of the industry: Here, we must consider whether it is a capital intensive or labour 

intensive industry. This will have a major impact on the total assets that the firm owns.

2. Size of the Company: The size of the company greatly influences the availability of funds

from different sources. A small company normally finds it difficult to raise funds from long 

X Ds X 1000

X Ds X 1000

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term sources at competitive terms. On the other hand, large companies like Reliance enjoy

the privilege of obtaining funds both short term and long term at attractive rates.

3. Status of the company in the industry: A well established company enjoying a good

market share, for its products normally commands investors’ confidence. Such a companycan tap the capital market for raising funds in competitive terms for implementing new projects

to exploit the new opportunities emerging from changing business environment.

4. Sources of finance available: Sources of finance could be grouped into debt and equity.

Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital

structure that would achieve the least cost capital structure. A large firm with a diversified

product mix may manage higher quantum of debt because the firm may manage higher 

financial risk with a lower business risk. Selection of sources of finance is closely linked to the

firm’s capacity to manage the risk exposure.

5. The Capital structure of a company is influenced by the desire of the existing management

(promoters) of the company to retain control over the affairs of the company. The promoters

who do not like to lose their grip over the affairs of the company normally obtain extra funds

for growth by issuing preference shares and debentures to outsiders.

6. Matching the sources with utilization: The prudent policy of any good financial plan is to

match the term of the source with the term of investment. To finance fluctuating working

capital needs the firm resorts to short terms finance. All fixed assets financed investments are

to be financial by long term sources. It is a cardinal principle of financial planning.

7. Flexibility: The financial plan of a company should possess flexibility so as to effect changesin the composition of capital structure when ever need arises. If the capital structure of a

company is flexible, it will not face any difficulty in changing the sources of funds. This factor 

has become a significant one today because of the globalization of capital market.

8. Government Policy: SEBI guidelines, finance ministry circulars, various clauses of Standard

Listing Agreement and regulatory mechanism imposed by FEMA and Department of 

corporate affairs (Govt of India) influence the financial plans of corporates today.

Management of public issues of shares demands the compliances with many statues in India.

They are to be complied with a time constraint.  

Self Assessment Questions 2: 

1. ___________ has a major impact on the total assets that the firm owns.

2. Sources of finance could be grouped into __ and _______________.

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3. ___________ of any good financial plan is to match the term of the source with the term of 

the source with the term of the investment.

4. ________________ refers the ability to ______________________ whenever need arises. 

2.4 Estimation Of Financial Requirements Of a Firm.

The estimation of capital requirements of a firm involves a complex process. Even with expertise,

managements of successful firms could not arrive at the optimum capital composition in terms of 

the quantum and the sources. Capital requirements of a firm could be grouped into fixed capital

and working capital. The long term requirements such as investment in fixed assets will have to

be met out of funds obtained on long term basis. Variable working capital requirements which

fluctuate from season to season will have to be financed only by short term sources. Any

departure from this well accepted norm causes negative impacts on firm’s finances.  

Self Assessment Question 3: 

1. Capital requirement of a firm could be grouped into ________ and __________.

2. Variable working capital will have to be financed only by _______________. 

2.5 Capitalizations

Meaning: Capitalization of a firm refers the composition of its long-term funds. It refers to the

capital structure of the firm. It has two components viz debt and equity.

After estimating the financial requirements of a firm, then the next decision that the management

has to take is to arrive at the value at which the company has to be capitalized.

There are two theories of Capitalization for new companies:

1. Cost theory and 2. Earnings theory 

2.5.1 Cost Theory:

Under this approach, the total amount of capitalization for a new company is the sum of the

following:

1. Cost of fixed assets.

2. Cost of establishing the business.

3. Amount of working capital required

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Merits of cost approach:

1. It helps promoters to estimate the amount of capital required for incorporation of company

conducting market surveys, preparing detailed project report, procuring funds, procuring

assets both fixed and current, trial production run and successfully producing, positioning andmarketing of its products or rendering of services.

2. If done systematically it will lay foundation for successful initiation of the working of the firm. 

Demerits 

1. If the firm establishes its production facilities at inflated prices, productivity of the firm will be

less than that of the industry.

2. Net worth of a company is decided by the investors by the earnings of a company. Earnings

capacity based net worth helps a firm to arrive at the total capital in terms of industry specified

yardstick ( i,e, operating capital based on bench marks in that industry) cost theory fails in

this respect. 

2.5.2 Earnings Theory:

Earnings are forecast and capitalized at a rate of return which is representative of the industry. It

involves two steps.

1. Estimation of the average annual future earnings.

2. Normal earning rate of the industry to which the company belongs. 

Merits 1. It is superior to cost theory because there are, the least chances of neither under not over 

capitalization.

2. Comparison of earnings approach with that of cost approach will make the management to be

cautious in negotiating the technology and cost of procuring and establishing the new

business. 

Demerits 

1. The major challenge that a new firm faces is in deciding on capitalization and its division

thereof into various procurement sources.

2. Arriving at capitalization rate is equally a formidable task because the investors’ perception of 

established companies cannot be really representative of what investors perceive of the

earning power of new company.

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Because of the problem, most of the new companies are forced to adopt the cost theory of 

capitalization.

Ideally every company should have normal capitalization. But it is an utopian way of thinking.

Changing business environment, role of international forces and dynamics of capital marketconditions force us to think in terms of what is optimal today need not be so tomorrow. Even with

these constraints, management of every firm should continuously monitor the firms capital

structure to ensure to avoid the bad consequences of over and under capitalization. 

2.5.3 Overcapitalization 

A company is said to be overcapitalized, when its total capital (both equity and debt) exceeds the

true value of its assets. It is wrong to identify overcapitalization with excess of capital because

most of the overcapitalized firms suffer from the problems of liquidity. The correct indicator of 

overcapitalization is the earnings capacity of the firm. If the earnings of the firm are less then that

of the market expectation, it will not be in a position to pay dividends to its shareholders as per 

their expectations. It is a sign of overcapitalization. It is also possible that a company has more

funds than its requirements based on current operation levels, and yet have low earnings.

Overcapitalization may be on account of any of the following:

1. Acquiring assets at inflated rates

2. Acquiring unproductive assets.

3. High initial cost of establishing the firm

4. Companies which establish their new business during boom condition are forced to pay morefor acquiring assets, causing a situation of overcapitalization once the boom conditions

subside.

5. Total funds requirements have been over estimated.

6. Unpredictable circumstances (like change in import –export policy, change in market rates of 

interest, changes in international economic and political environment) reduce substantially the

earning capacity of the firm. For example, rupee appreciation against U.S.dollar has affected

earning capacity of firms engaged mainly in export business because they invoice their sales

in US dollar.

7. Inadequate provision for depreciation adversely affects the earning capacity of a company ,

leading to overcapitalization of the firm.

8. Existence of idle funds.

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Effects of over capitalization 

1. Decline in the earnings of the company.

2. Fall in dividend rates.

3. Market value of company’s share falls, and company loses investors confidence.4. Company may collapse at any time because of anemic financial conditions – it will affect its

employees, society, consumers and its shareholders. Employees will lose jobs. If the

company is engaged in the production and marketing of certain essential goods and services

to the society, the collapse of the company will cause social damage.  

Remedies for Overcapitalization:

Restructuring the firm is to be executed to avoid the situation of company becoming sick.

It involves

1. Reduction of debt burden.

2. Negotiation with term lending institutions for reduction in interest obligation.

3. Redemption of preference shares through a scheme of capital reduction.

4. Reducing the face value and paid-up value of equity shares.

5. Initiating merger with well managed profit making companies interested in taking over ailing

company. 

2.5.4 Undercapitalization 

Under-capitalization is just the reverse of over-capitalization. A company is considered to beunder-capitalized when its actual capitalization is lower than its proper capitalization as warranted

by its earning capacity. 

Symptoms of under-capitalization 

1. Actual capitalization is less than that warranted by its earning capacity.

2. Its rate of earnings is exceptionally high in relation to the return enjoyed by similar situated

companies in the same industry. 

Causes of under-capitalization 

1. Under estimation of future earnings at the time of promotion of the company.

2. Abnormal increase in earnings from new economic and business environment.

3. Under estimation of total funds requirements.

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4. Maintaining very high efficiency through improved means of production of goods or rendering

of services.

5. Companies which are set up during recession start making higher earning capacity as soon

as the recession is over.6. Use of low capitalization rate.

7. Companies which follow conservative dividend policy will achieve a process of gradually rising

profits.

8. Purchase of assets at exceptionally low prices during recession. 

Effects of under-capitalization 

1. Encouragement to competition: under-capitalization encourages competition by creating a

feeling that the line of business is lucrative.

2. It encourages the management of the company to manipulate the company’s share prices.

3. High profits will attract higher amount of taxes.

4. High profits will make the workers demand higher wages. Such a feeling on the part of 

employees leads to labour unrest.

5. High margin of profit may create among consumers an impression that the company is

charging high prices for its products.

6. High margin of profits and the consequent dissatisfaction among its employees and

consumer, may invite governmental enquiry into the pricing mechanism of the company. 

Remedies 

1. Splitting up of the shares – This will reduce the dividend per share.

2. Issue of bonus shares: This will reduce both the dividend per share and earnings per share.

Both over-capitalization and under-capitalization are detrimental to the interests of the society. 

Self Assessment Question 4 

1. ______________ of a firm refers to the composition of its long –term funds.

2. Two theories of capitalization for new companies are ________ and earnings theory.

3. A company is said to be ___________, when its total capital exceeds the true value of its

assets.

4. A company is considered to be ________________ when its actual capitalization is lower than

its proper capitalization as warranted by its earning capacity.

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2.6 Summary 

Financial planning deals with the planning, execution and monitoring of the procurement and

utilization of funds. Financial planning process gives birth to financial plan. It could be thought of 

a blueprint explaining the proposed strategy and its execution. There are many financial planning

models. All these models forecast the future operations and then translate them into income

statements and balance sheets. It will also help the finance managers to ascertain the funds to

be procured from outside sources. The essence of all these is to achieve a least cost capital

structure which would match with the risk exposure of the company. Failure to follow the principle

of financial planning may lead a new firm to over or under-capitalization when the economic

environment undergoes a change. Ideally every firm should aim at optimum capitalization. Other 

wise it may face a situation of over or under-capitalization. Both are detrimental to the interests of 

the society. There are two theories of capitalization viz cost theory and earnings theory. 

Terminal Questions 

1. Explain the steps involved in Financial Planning.

2. Explain the factors affecting Financial Plan

3. List out the causes of Over – Capitalization.

4. Explain the effects of Under – Capitalization. 

Answers To Self Assessment Questions

Self Assessment Questions 1 1. Qualitative, Quantitative.

2. Allocation of funds

3. Short term borrowings 

Self Assessment Question 2 

1. Nature of the industry

2. Debt, Equity

3. The product policy

4. Flexibility in capital structure, effect changes in the composites of capital structure 

Self Assessment Question 3

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1. Fixed capital, working capital.

2. Short term sources 

Self Assessment Question 4 1. Capitalization

2. Cost theory

3. Over Capitalized

4. Under capitalized 

Answer to Terminal Questions 

1. Refer to unit 2.2

2. Refer to unit 2.3

3. Refer to unit 2.5.3

4. Refer to unit 2.5.4


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