Chapter 7 Capitalisation

8/10/2019 Chapter 7 Capitalisation

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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 therelative proportions of the various classes ofsecurities to be issued and administration of policies

concerning capital.


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Narrow Interpretation of Capitalisation:

Capitalization comprises of share capital,

debentures, loans, free reserves,etc.Capitalization represents permanent investmentin companies excluding long-term loans.

Capitalization can be distinguished from capitalstructure. Capital structure is a broad term and itdeals with qualitative aspect of finance. Whilecapitalization is a narrow term and it deals withthe quantitative aspect.


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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 ofthe company

(iii) Cost of establishment of business promotion i.e. Expenses in doing theadvertisements

These factors allow the promotion team to know the amount of capital whichhas to be raised to fulfill the promotion job. The true income of the company isbeen found out by its earning not by its investment in other states. Forexample if some assets becomes out of date and some idle then the earningswill fall but that fall of capital won't affect the investment made by the companyin other company's business.


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

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

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

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

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


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Capitalization is generally found to be of followingtypes-

Fair

Over Under


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Fair Capitalization It is The desire of every company to have fairly

capitalised situation i.e. neither over capitalizednor under capitalized.


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Overcapitalization

Over capitalization refers to that state of affair ehere

earnings of a company do not justify the amountofcapital invested in its business.

It means more capital than actually required, and

therefore in a over capitalized concern , the investedfunds are not properly used.

It can be expressed in terms of earnings as well ascost.

Suppose a company earns Rs. 5,000,00 and normalRate of return expected is 10% so capitalization atearning would be-


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5,000,00x100/10= Rs. 50,00,000A fairly capitalised situation.

Suppose Capital employed is Rs. 60,000,00, thenover capitalization of 10,000,00, the new rate ofearning would be

5,000,00/60,000,00x100=8.03%


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High promotion cost Purchase of assets at higher Prices

A companysfloatation n boom period

Inadequate provision for depreciation Liberal dividend policy

Over-estimation of earnings-


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Effects of Overcapitalization

On Shareholders

On Company On Society


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Undercapitalization

An undercapitalized company is one which incursexceptionally high profits as compared to industry. Anundercapitalized company situation arises when theestimated earnings are very low as compared toactual profits. This gives rise to additional funds,additional profits, high goodwill, high earnings andthus 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.


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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.


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On company With greater earnings, reputation becomes strong.

Higher rate of earnings attract competition inmarket.

Demand of workers may rise because of highprofits.

The high profitability situation affects consumerinterest as they think that the company is

overcharging on products.


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On Society With high earnings, high profitability, high market price of

shares, there can be unhealthy speculation in stockmarket.

Restlessness in general public is developed as they linkhigh profits with high prices of product.

Secret reserves are maintained by the company whichcan 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.


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Comparison of BOOK Value andREAL Value of Shares:

The Over and Under Capitalization Situations of acompany can also be ascertained by Comparingthe book value and real value of equity shares ofthe company.

The book value is calculated on the basis of netassets available for equity Share Holders

Book Value= Net Assets/No. of equity Shares


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Real Value : Real value of equity shares can bedetermined on the basis of capitalised value ofearnings.

Capitalised Value of Earning

= Earnings/ Normal Rate of Return

Real Value of an Equity share=Capitalised value

Earning /No. of Equity Shares.


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Watered Stock or Capital:

Stock that is issued with a value much greaterthan the value of the issuing company's assets.Watered stock can be caused by excessive stockdividends, overvalued assets and/or largeoperating losses.

Stockprice xShares outstanding> Net assets(or

in some cases, capital invested) For example, ifthe founders of Company XYZ invested $10million in the company and then decided to takethe company public by selling 50

million sharespriced at $3 (a $150 million marketcapitalization),analysts might say that CompanyXYZ is issuing watered stock.
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Over Trading v/s Under Trading Over Trading: A company which is under-capitalizedwill try to do too

much with the limited amount of capital which it has. For example it maynot maintain proper stock of stock. Also it may not extend much credit tocustomers and may insist only on cash basis sales. It may also not paythe creditors on time.

A situation in which a company is growing its sales faster than it canfinance them. This usually leads to enormous accounts payable oraccounts receivable and a lack of working capital to finance operations.

Under-trading is the reverse of over-trading. It means keeping fundsidle 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 financialcrises. This makes the business unable to meet its commitments andultimately leads to forced liquidation.
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Chapter 7 Capitalisation