Capitalisation

Meaning and Definition of

Capitalisation
Broad Interpretation of Capitalisation:
capitalisation is synonymous with financial planning.
Besides the amount of capital required in a business,
it decides about the determination of the form and the
relative proportions of the various classes of
securities to be issued and administration of policies
concerning capital.
Narrow Interpretation of Capitalisation:
Capitalization comprises of share capital,
debentures, loans, free reserves,etc.
Capitalization represents permanent investment
in companies excluding long-term loans.

Capitalization can be distinguished from capital
structure. Capital structure is a broad term and it
deals with qualitative aspect of finance. While
capitalization is a narrow term and it deals with
the quantitative aspect.
Theories of Capitalization
The Cost Theory of Capitalization:
In this theory the value of the company is decided by adding certain factors
such as:-

(i) Cost of fixed assets i.e. Machinery, mechanical items

(ii) Working capital i.e. the capital which is required for continuous operation of
the company

(iii) Cost of establishment of business promotion i.e. Expenses in doing the
advertisements
These factors allow the promotion team to know the amount of capital which
has to be raised to fulfill the promotion job. The true income of the company is
been found out by its earning not by its investment in other states. For
example if some assets becomes out of date and some idle then the earnings
will fall but that fall of capital won't affect the investment made by the company
in other company's business.



2) Earnings Theory: In this theory true value of an enterprise depends on its
earnings capacity.

The value of the company capitalization will be same as the estimated earning
of the company.

To find out this a company has to prepare a profit and loss account and then
check regularly to see the effect of their sales over the years to find out how
correct there estimations are.

The earnings will be compared to the actual earning and the adjustment will be
made according to that. The promotion team will then see the up and down of
the earnings and then overall decision will be taken on management and how
to simulate the earning to increase the revenue of the company.

For example if there is a company which has an estimated average profit of
Rs. 25,000 in first few years and earning a return of 5% on their capital. The
capitalization will be: (25,000*100)/5 = Rs. 5, 00,000

Capitalization is generally found to be of following
types-
Fair
Over
Under

Fair Capitalization
It is The desire of every company to have fairly
capitalised situation i.e. neither over capitalized
nor under capitalized.
Overcapitalization
Over capitalization refers to that state of affair ehere
earnings of a company do not justify the amountof
capital invested in its business.

It means more capital than actually required, and
therefore in a over capitalized concern , the invested
funds are not properly used.
It can be expressed in terms of earnings as well as
cost.
Suppose a company earns Rs. 5,000,00 and normal
Rate of return expected is 10% so capitalization at
earning would be-
5,000,00x100/10= Rs. 50,00,000
A fairly capitalised situation.

Suppose Capital employed is Rs. 60,000,00, then
over capitalization of 10,000,00, the new rate of
earning would be

5,000,00/60,000,00x100=8.03%
High promotion cost
Purchase of assets at higher Prices
A companys floatation n boom period
Inadequate provision for depreciation
Liberal dividend policy
Over-estimation of earnings-
Effects of Overcapitalization
On Shareholders
On Company
On Society


Undercapitalization
An undercapitalized company is one which incurs
exceptionally high profits as compared to industry. An
undercapitalized company situation arises when the
estimated earnings are very low as compared to
actual profits. This gives rise to additional funds,
additional profits, high goodwill, high earnings and
thus the return on capital shows an increasing trend.
The causes can be-
Low promotion costs
Purchase of assets at deflated rates
Conservative dividend policy
Floatation of company in depression stage
High efficiency of directors
Adequate provision of depreciation
Large secret reserves are maintained.

Efffects of Under Capitalization

On Shareholders
Companys profitability increases. As a result, rate of
earnings go up.
Market value of share rises.
Financial reputation also increases.
Shareholders can expect a high dividend.

On company
With greater earnings, reputation becomes strong.
Higher rate of earnings attract competition in
market.
Demand of workers may rise because of high
profits.
The high profitability situation affects consumer
interest as they think that the company is
overcharging on products.

On Society
With high earnings, high profitability, high market price of
shares, there can be unhealthy speculation in stock
market.
Restlessness in general public is developed as they link
high profits with high prices of product.
Secret reserves are maintained by the company which
can result in paying lower taxes to government.
The general public inculcates high expectations of these
companies as these companies can import innovations,
high technology and thereby best quality of product.

Comparison of BOOK Value and
REAL Value of Shares:
The Over and Under Capitalization Situations of a
company can also be ascertained by Comparing
the book value and real value of equity shares of
the company.
The book value is calculated on the basis of net
assets available for equity Share Holders
Book Value= Net Assets/No. of equity Shares
Real Value : Real value of equity shares can be
determined on the basis of capitalised value of
earnings.
Capitalised Value of Earning
= Earnings/ Normal Rate of Return

Real Value of an Equity share=Capitalised value
Earning /No. of Equity Shares.
Watered Stock or Capital:
Stock that is issued with a value much greater
than the value of the issuing company's assets.
Watered stock can be caused by excessive stock
dividends, overvalued assets and/or large
operating losses.
Stock price x Shares outstanding > Net assets (or
in some cases, capital invested) For example, if
the founders of Company XYZ invested $10
million in the company and then decided to take
the company public by selling 50
million shares priced at $3 (a $150 million market
capitalization),analysts might say that Company
XYZ is issuing watered stock.

Over Trading v/s Under Trading
Over Trading: A company which is under-capitalized will try to do too
much with the limited amount of capital which it has. For example it may
not maintain proper stock of stock. Also it may not extend much credit to
customers and may insist only on cash basis sales. It may also not pay
the creditors on time.
A situation in which a company is growing its sales faster than it can
finance them. This usually leads to enormous accounts payable or
accounts receivable and a lack of working capital to finance operations.

Under-trading is the reverse of over-trading. It means keeping funds
idle and not using them properly. This is due to the under employment of
assets of the business, leading to the fall of sales and results in financial
crises. This makes the business unable to meet its commitments and
ultimately leads to forced liquidation.