Capitalisation: Meaning, Need and Theories

Capitalisation is an important constituent of the financial plan of a business. In common parlance, the term ‘capitalisation’ refers to the total amount of capital employed in a business.

In its broad sense, the term ‘capitalisation’ refers to the process of determining the quantum and patterns of financing. It includes the determination of not only the total quantity of capital but also about the quality financing as such. In other words, it includes decisions regarding the amount of capital and the modes of raising such capital.

In a narrow sense, the term ‘capitalisation’ means the amount of capital at which the company’s business can be valued. Most of the traditional authors have defined the term only in this sense. Though this definition restricts its meaning only to the quantitative aspect, it is more specific.

Contents

Introduction to Capitalisation
Meaning of Capitalisation
Definitions of Capitalisation
Theories of Capitalisation
Actual Capitalisation and Fair Capitalisation
Over Capitalisation
Undercapitalisation
Watered Capital
Watered Stock
Distinction Between Capital and Capitalisation
Watered Capital and Over-Capitalisation
Comparison of Watered Capital and Over Capitalisation
Comparison of Over Capitalisation and Under Capitalisation

What Is Capitalisation: Meaning, Definitions, Theories, Over Capitalisation, Under Capitalisation, Watered Capital, Distinction, Comparison and More…

What is Capitalisation – Introduction

Capital plays an important role in any business. At the time of incorporation of a business, it is the first problem before the promoters to decide how much capital is to be required and in what form. It is not an easy task.

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Hence a financial plan is to be prepared for the purpose, explaining the short term and long term needs of finance to the company. Several considerations would be kept in mind, such as the cost of raising capital fair return to the contributors of capital, risk involved, flexibility etc., while taking decisions in this regard.

What is Capitalisation – Meaning

Capitalisation is an important constituent of the financial plan of a business. In common parlance, the term ‘capitalisation’ refers to the total amount of capital employed in a business.

However, the financial scholars are not unanimous regarding the concept of capitalisation. As a matter of fact, there are as many definitions as there are writers on the subject. While some have given a very broad interpretation, some others have viewed it in a narrow sense.

Broader Interpretation of Capitalisation:

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In its broader sense, the term ‘capitalisation’ is synonymous with the term ‘financial planning’.

In this sense, it includes the following:

i) The determination about the total amount of capital required by a company;
ii) The decision regarding the types of securities to be issued for the purpose of raising the capital; and

iii) The relative proportion of the different securities and even the policies concerning the administration of the capital.

Thus, in its broad sense, the term ‘capitalisation’ refers to the process of determining the quantum and patterns of financing. It includes the determination of not only the total quantity of capital but also about the quality financing as such. In other words, it includes decisions regarding the amount of capital and the modes of raising such capital.

Narrow Interpretation of Capitalisation:

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It is in this sense that the term ‘capitalisation’ has been used here. In the narrow sense, therefore, ‘capitalisation refers to the amount of capital represented by the capital stock, surplus and funded or long-term debts’.

Definitions of Capitalisation

Guthmann and Dougall – “Capitalisation is the sum of the par value of stocks and bonds outstanding”.

According to this definition, the term ‘capitalisation’ includes only the par value of share capital and debentures. But it does not include reserves and surpluses.

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However, it should be noted that in actual practice both reserves and surpluses are frequently used by the companies to meet their long-term requirements. Therefore this definition appears to be inadequate and illogical.

Bonneville and Dewey – “Capitalisation refers to the balance sheet value of stocks and bonds outstanding”.

Gerstenberg – “Capitalisation comprises (i) ownership capital which includes capital stock and surpluses in whatever form it may appear and (ii) borrowed capital which consists of bonds or similar evidence of long-term debt”.

A good definition of capitalisation is given by E.E. Lincoln – “Capitalisation is a word ordinarily used to refer to the sum of the outstanding stocks and funded obligation which may represent wholly fictitious values”.

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Thus, according to the above definitions, the term ‘capitalisation’ includes share capital, reserves and surplus and long-term debt.

Therefore, in its narrow sense, capitalisation includes:

i) The value of the shares of different classes issued;
ii) The value of the surpluses, whether capital surpluses (i.e. capital gains) or earned surpluses (i.e. undistributed profits in the form of reserves);

iii) The value of bonds and debentures issued by the company and still outstanding; and

iv) The value of long-term loans secured by the company other than bonds and securities.

It is thus evident that traditional authorities on finance include only long-term funds under capitalisation. Whereas the modern view is different and it includes both long-term and short-term loans under capitalisation.

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Walker and Baughn are of the view that “(i) the use of capitalisation to refer to only long-term debt, and (ii) capital stock and short-term creditors do not constitute suppliers of capital is erroneous”. “In reality, total capital is furnished by short-term creditors and long-term creditors.”

They further contend that the sum of long-term debt and capital stock refer to long-term capital rather than the capitalisation.

The modern concept of capitalisation is most logical that capitalisation should comprise all sources of capital – long-term and short-term sources which are employed to raise the desired amount of capital for the enterprise.

Thus, there are four sources of capitalisation:

a) Share Capital
b) Reserves and Surplus
c) Long-term Loans
d) Short-term Loans and Trade Credits.

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However, this modern view has not yet been recognised widely and hence, the traditional view or the narrow interpretation that capitalisation includes (a) value of share capital (b) reserves and surpluses and (c) long-term loans has been used in this book since it is more specific in its meaning.

It should be noted that the term ‘capitalisation’ is used only in relation to companies and not in respect of partnership firms or sole proprietorships. This narrow interpretation of the term ‘capitalisation’ is more popular since it is very specific in its meaning.

Capitalisation has been used in the narrow sense. The difference between capitalisation and capital structure should be noted. The term ‘capital structure’ refers to the form and proportion of various securities issued to raise the total amount.

Theories of Capitalisation – Cost Theory and Earnings Theory (With Example, Merits and Limitations)

There are two important theories to determine the amount of capitalisation:

1. Cost theory of capitalisation

According to this theory, the amount of capitalisation is equal to the total cost incurred in setting up of a firm as a going concern. Thus the estimation of capital requirements of a newly promoted firm is based on the total initial outlays for setting up of a firm.

The amount of capital is, under this theory, determined by aggregating:

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(i) Cost of fixed assets such as land and building, plant and machinery, furniture, etc.

(ii) The amount of regular working capital to carry on business operations.

(iii) The expenses of promotion, and

(iv) The cost of establishing business.

Example:

The cost theory of capitalisation is useful for those firms in which the amount of fixed capital is more and whose earnings are regular, such as construction and public utility concerns.

Merits:

(i) This theory is easy to understand.

(ii) It is useful to ascertain the capitalisation required for a new firm. It enables the promoters to know the amount of capital to be raised.

Limitations:

(i) The amount of capitalisation calculated under this theory is based on cost and not on earning capacity of a firm. The capitalisation will remain the same irrespective of the earning capacity of the firm.

(ii) Since some assets are idle or become obsolete, the earning capacity will be severely affected. But still the capitalisation will remain high as it is based on the cost of assets.

2. Earning theory of capitalisation

According to this theory, the amount of capitalisation of a firm is determined by its earning capacity. In other words, the worth of a firm is not measured by the capital raised but by the earnings made out of the productive harnessing of the capital.

To determine the amount of capitalisation, a new firm will have to estimate the average annual future earnings and the normal rate of earnings (also known as capitalisation rate) prevalent in the industry.

For example, suppose the estimated earnings of X Ltd. is Rs.12 lakh per annum and the fair rate of return expected is 12%.

The amount of capitalization of the firm is:

Merits:

(i) The amount of capitalisation found under this method represents the true worth of the firm.

(ii) The amount of capitalisation arrived at on the basis of earnings can be used as a standard for comparison.

Limitation:

Estimation of future earnings of a new firm is not easy. If the earnings are not estimated correctly, the amount of capitalisation would be misleading.

Actual Capitalisation and Fair Capitalisation

Actual Capitalisation and Fair Capitalisation:

Actual capital of a company is arrived at by adding the paid up value of the company’s shares and debentures, reserves and other surpluses. While fair capitalisation of a company is arrived at, according to any of the two theories of capitalisation.

In case a company’s actual capitalisation is more than its fair capitalisation the company is said to be “Over capitalised”. In case the actual capitalisation of the company is less than its fair capitalisation, the company is said to be “Under capitalised”.

What is Capitalisation – Over Capitalisation: Meaning, Causes, Effects and Remedies

Meaning of Over Capitalisation:

In simple terms, over capitalisation means existence of excess capital as compared to the level of activity and requirements.

E.g. If a company is earning a profit of Rs. 50,000 and the normal rate of return applicable for the same industry is 10%, it means that the amount of shares and debentures should be Rs. 5,00,000. If the amount of shares and debentures issued by the company is more than Rs. 500,000, then the company will be said to be overcapitalised.

The term over capitalisation should not be taken to mean excess funds. There can be a situation of over capitalisation, still the company may not be having sufficient funds. Similarly, the company may be having more funds and still may be having a low earning capacity thus resulting in over capitalisation.

Causes of Overcapitalisation:

The situation of overcapitalisation may arise due to various reasons as stated below:

(1) The assets might have been purchased during the inflationary situations. As such the real value of the assets is less than the book value of the assets.

(2) Adequate provision might not have been made for depreciation on the assets. As such, the real value of the assets is less than the book value of the assets.

(3) The company might have spent huge amounts during its formation stage or might have spent huge amounts for the purchase of intangible assets like goodwill, patents, trade-marks, copy-rights and designs etc. As a result, the earning capacity of the company may be adversely affected.

(4) The requirement of funds might not have been properly planned by the company. As a result, the company may realise shortage of capital and to overcome the situation of shortage of capital, the company may borrow the funds at unremunerative rates of interest, which in turn will reduce the earnings of the company.

(5) The company might have followed the lenient dividend policy without bothering much about building up the reserves. As a result, the retained profits of the company may be adversely affected.

(6) If there is a very high rate of taxation for companies, the company may not be having sufficient funds left with it for modernisation or renovation programmes. As such, the real value and the earning capacity of the assets will be lower.

(7) There may be many instances, where the management of the company may raise large amounts by issuing securities, irrespective of the fact whether they are really required or not, in order to take advantage of favourable capital market conditions. As a result, only the liability of the company increases but not the earning capacity.

(8) According to the earnings theory of capitalisation, the capitalisation is the amount of earnings capitalised at a representative rate of return. As such, if the capitalisation rate is wrong, the amount of capitalisation will be wrong, in such a way that lower the rate of capitalisation, higher will be the amount of capitalisation.

Effects of Over Capitalisation:

(1) On Company:

The real value of the business and its earning capacity reduces with the adverse effect on market value of shares. Credit standing of the company in the market falls down and it is difficult to raise further capital. The temporary means like lower amount of depreciation and maintenance charges are followed to improve the earnings which aggravates the situation further.

(2) On Shareholders:

This is the worst affected class. The shares held by them are not having any backing of tangible assets. Due to the reduced market values, the shares become non-transferable or are required to be transferred at extremely low prices.

(3) On Consumers:

To overcome the situation of over capitalisation and to improve the earnings, the company may be tempted to increase the selling price, more particularly in monopoly conditions. Due to this, the quality of the products may also be affected.

(4) On Society at Large:

The increasing selling prices and reducing quality can’t be continued for a very long time due to the competition existing in the market. A situation like this means losing the backing of the shareholders as well as the consumers.

As a result, the company is dragged towards the winding up which ultimately affects the society at large in the adverse way in terms of lost industrial production, unemployment generated, unrest among the workers as a part of society etc.

Remedies Available:

In order to overcome the situation of over capitalisation, the company may resort to any of the following remedial measures.

(1) To reduce the debts by repaying them. But the debts should be repaid out of the own earnings of the company. There is no point in repaying the debts out of the fresh issue of shares or debentures, as it does not reduce the amount of capitalisation.

(2) To redeem the preference shares if they carry too high rate of dividend.

(3) The persons holding the debentures may be persuaded to accept new debentures which carry a lower rate of interest.

(4) The par value of the equity shares may be reduced but this also will have to be done only after taking the shareholders into confidence.

(5) The number of equity shares may be reduced but this also will have to be done only after taking the shareholders into confidence.

What is Capitalisation – Under Capitalisation: Meaning, Causes, Effects and Remedies

Under capitalisation implies a situation where the profits earned are exceptionally high but the capital employed is relatively small.

A firm is said to be under capitalised when:

(a) Profits earned are exceptionally high.

(b) The value of long term assets is higher than capital raised.

According to Gerstenberg “A corporation may be under capitalized when the rate of profits it is making on total capital is exceptionally high in relation to the return enjoyed by similar situated companies in the same industry or when it has too little capital with which it conducts its business”.

For example, if a firm earns a profit of Rs. 1 lakh and expected rate of earnings is 10%, the maximum amount of capitalisation is Rs.10 lakh. In case the firm raises only Rs.8 lakh, the actual average earnings shall be 12.5% more than the expected rate. Such a situation is called under capitalisation.

In short, under capitalisation is a situation where the profitability of a firm is much higher as compared to the capital employed.

Causes of Under Capitalisation

Following are some of the reasons of under capitalisation:

(i) Under estimation of earnings:

Capitalisation is based on the earnings estimated. If the estimated earnings are lower, the capitalisation figure is also lower. Sometimes, the earnings prove to be much higher and the capitalisation figure previously calculated is lower.

(ii) Floatation of a firm during depression:

When a firm acquires assets or is promoted during the recovery period, its earnings during the boom period may increase disproportionately to the capital employed.

(iii) Conservative dividend policy:

If a firm follows a conservative dividend policy i.e. payout ratio is maintained at low level in the initial stages, profits are retained in the business and reserves are created or reinvested in the business. This results in higher earnings on the capital employed and hence under capitalisation.

(iv) High efficiency:

If assets are used and maintained properly and costs are reduced because of improved technology, higher levels of vigilance and efficiency lead to improvement in productivity and profitability which is reflected by high earnings on capital employed.

Effects of Under Capitalisation

Under capitalisation has its effects on firms, its shareholders as well as society.

These effects are summarized as under:

(i) Effects on firm:

Under capitalisation affects a firm in the following ways:

(a) Under capitalisation increases the credit worthiness of the firm due to higher rate of earnings.

(b) The higher rate of earnings may encourage outsiders to enter the field and increase competition.

(ii) Effects on shareholders:

Under capitalisation is always beneficial to the existing shareholders of the firm in the following ways:

(a) Due to higher earnings of the firm, the shareholders regularly receive higher dividends on their investments.

(b) The shareholders also avail capital gains because the market value of firm’s shares increases very rapidly.

(c) Since the shares have great value as collateral security, the shareholders are at ease in getting loans against the security of shares of an under capitalized firm.

(ii) Effects on society:

Under capitalisation affects society as follows:

(a) Under capitalisation leads to unhealthy speculation on the stock exchanges, which affects investment climate adversely.

(b) Consumers feel exploited since profits of the firms are high.

(c) It may also lead to labour unrest and strike, if the demand for higher wages and increase in benefits are not accepted by the firm.

Remedies for Under Capitalisation

The following remedial steps may be taken to convert an under capitalised firm into a properly capitalised firm:

(a) Under capitalization may be remedied by increasing the par value and/or number of equity shares by revising upward the value of assets. This will decrease the rate of earnings per share.

(b) Management may capitalise the retained earnings by issuing bonus shares to the equity shareholders. This will also reduce the rate of earnings per share without reducing the total earnings of the firm.

(c) Where under capitalisation is due to insufficiency of capital, more shares and debentures may be issued to the public.

What is Capitalisation – Watered Capital

When the amount of share capital of a company is not represented by the same value of assets, rather that value is only shown in books, it is called watered capital. In such a situation, the realisable value of the assets is less than their book value. Generally, at the time of promotion of a company, the promoters are issued an excessive number of shares for their services.

If the payment made to promoters is not according to its earning capacity, the capital of the company will be watered. Similarly, when the assets are transferred by promoters and other sellers to the company at abnormally high prices or the company has some worthless assets, the capital of the company will be watered.

When the utility of goodwill, patents, copyrights, etc. existing at the time of promotion of a company starts decreasing, it will have watered capital. Thus, various companies are started with watered capital.

When share capital is not represented by the assets of equal value, the situation may mean introduction of water in the capital or watered capital.

This situation may arise due to following reasons:

(1) The services of the promoters are valued highly and they are paid usually in the form of shares of the company. As such, share capital is increased but no assets are created.

(2) Sometimes, the company pays a higher price to the vendors of the assets transferred i.e. the price which is more than the worth of the assets.

As such, the possibility of the existence of the watered stock or watered capital can be traced with the intention of the promoters who sell the shares. If the promoters deliberately acquire the assets at inflated prices, the situation of watered capital may exist.

What is Capitalisation – Watered Stock

When stock is not represented by assets of equivalent value, it is designated as watered stock signifying dilution of water in the capital of the enterprise. More often than not, services of promoters are valued highly and are accordingly paid usually in the form of stocks.

Under these circumstances, the existence of water in the stock cannot be ignored nevertheless the earning capacity of the enterprise may justify the payment at exorbitant price. Similarly, when an enterprise pays a higher price to the vendors for the assets transferred, the enterprise will be in the state of watered stock.

So as to test the existence of water in stock, the analyst should study the intent of the promoters who float the enterprise and sell the stock. If the promoters deliberately acquire the assets needed by the enterprise at inflated price, state of watered stock is said to have existed.

Difference Between Capital and Capitalisation

The distinction between capital and capitalisation should be clearly understood. Capital represents total investment of a company in money, tangible assets and intangible assets. In this sense, it refers to the total wealth of the company. Again in the sense of net capital, it refers to the excess of assets over liabilities.

Such net capital includes profits or gains earned from the use of capital and not distributed to the shareholders and excludes losses incurred in the business from the use of such capital. But capitalisation represents the sum total of all kinds of ownership and creditorship securities as well as capital gains and earned surpluses which are not meant for distribution as dividend to shareholders.

Secondly, capital includes all the loans (short-term and long-term loans) and reserves of the enterprise whereas capitalisation includes only long-term loans and retained profits in addition to share capital. Further, the term ‘share-capital’ refers only to the paid-up value of shares but it does not include bonds and debentures.

What is Capitalisation – Watered Capital and Over-Capitalisation

Sometimes, the terms watered capital and over-capitalisation are confused for each other, but it is not true. The concept of watered capital is confined to the time of promotion of the company.

Thus, at the time of promotion, the company is expected to acquire the assets at a price which justifies its real worth. If the assets prove to be worthless or are bought at an inflated price, the situation of watered capital may exist.

On the other hand, if the company has worked for several years and during these years has failed to earn sufficient earnings to justify the amount of its capital, the company will be in the state of over capitalisation.

Thus, the existence of watered capital may be one of the causes of overcapitalisation, but it is not inevitably the cause of over-capitalisation as the subsequent earnings may justify the amount of capitalisation though the capital may remain watered.

The following illustration may make the relationship between watered capital and over-capitalisation more clear:

Suppose that a company issues and subscribes for 1000 equity shares of Rs. 100 each (i.e total equity share capital is Rs. 1,00,000). This amount has been used to purchase the fixed assets of the company, the real value of which is only Rs. 75,000. It means that the company is watered to the tune of Rs. 25,000.

The company operates for six years during which it has earned the average profits of Rs. 16,000. If the earnings are capitalised at the rate of 5%, the capitalised value of earnings will be Rs. 3,20,000. It means that the company will be having watered capital but it will not be overcapitalised.

Now suppose, that the original amount of Rs. 1,00,000 is used by the company to purchase fixed assets, the real worth of which is really Rs. 1,00,000. It means that there is no watered capital.

However after operating for six years the company is able to earn the average profits of only Rs. 3,000. If the earnings are capitalised at the rate of 5%, the capitalised value of the earnings will be Rs. 60,000. It means that the company has no water in capital but it is overcapitalised.

Comparison of Watered Capital and Over Capitalisation

Difference # Watered Capitalisation:

It is observed at the time of promotion of the company.
It is a cause of over-capitalisation.

iii. It occurs when securities are raised without corresponding increase in assets.

There may be watered stock but no over-capitalisation

Difference # Over Capitalisation:

It is observed after five years of the company’s working.
It is a cause of watered capital.

iii. It occurs due to under-utilization of the existing assets and therefore, the company’s earnings go down.

There may be over-capitalisation without the stock being watered.

Comparison of Over Capitalisation and Under Capitalisation

Having examined the various disadvantages of overcapitalisation and Undercapitalisation, it is clear that there is little to choose between them. At the most, one may like to know which of the two is the lesser evil. Over-capitalisation can prove more dangerous to the company, the shareholders and the society than Undercapitalisation.

The only solution in over-capitalisation is a thorough reorganisation which would mean considerable loss for the shareholders and the creditors. Under-capitalisation characterised by high share values and high rates of dividend may be avoided by capitalisation of reserves. This would distribute the earnings over a large number of shares.

Thus, under-capitalisation may be called the lesser evil though both are bad. The goal of every company should be ‘proper’ or ‘fair’ capitalisation, i.e., capitalisation related to the normal earning capacity in an industry for firms of a certain size.

Capitalisation: Meaning of Capitalisation, Modern Concept, Need, Theories and Fair Capitalisation

1. Meaning of Capitalisation:

Capitalisation is one of the most important constituents of financial plan. The term “Capitalisation” has been derived from the word capital and in common practice it refers to the total amount of capital employed in a business. However, financial scholars are not unanimous regarding the concept of capital.

As a matter of fact, they have defined ‘Capitalisation’ in a number of ways. If the definitions are properly studied, we can classify them into two ways, viz.; a broad interpretation and a narrow interpretation.

Broad Interpretation of Capitalisation:

Many authors regard Capitalisations as synonymous with financial planning. Broadly speaking, the term ‘Capitalisation’ refers to the process of determining the plan of financing. It includes not merely the determination of the quantity of finance required for a company but also the decision about the quality of financing. A financial plan is a statement estimating the amount of capital and determining its composition.

Used in this sense, capitalisation includes:

(i) Estimating the total amount of capital to be raised;

(ii) Determining the type of securities to be issued; and

(iii) Determining the composition or proportion of the various securities to be issued.

Narrow Interpretation of Capitalisation:

In its narrow sense, the term ‘Capitalisation’ is used in its quantitative sense and refers to the process of determining the quantum of funds that a firm needs to run its business. According to the scholars holding this view, the decisions regarding the form or composition of capital fall under the term “Capital Structure”.

Some of the important definitions of traditional experts, in this regard, are given below:

According to Guthman and Dougall, “Capitalisation is the sum of the par value of stocks and bonds outstanding.”

The above definition considers and includes in capitalisation only the par value of share capital and debentures. It does not include reserves and surpluses which, usually, form part of the long-term funds of a firm.

Bonneville and Deway refer to capitalisation as, “The balance sheet values of stocks and bonds outstanding.”

Arthur S. Dewing defines it as, “The sum total of the par value of all shares.”

According to Gerstenberg, “Capitalisation comprises of a company’s ownership capital which includes capital stock and surplus in whatever form it may appear and borrowed capital which consists of bonds or similar evidences of long-term debt.”

Gilbert Harold refers to capitalisation as any of the following concepts:

(i) The total par value of all the securities -shares and debentures outstanding at a given time.

(ii) The total par value of all the securities outstanding at a given time plus the valuation of all other long-term obligations.

(iii) The total amount of capital and liabilities of corporation, i.e. amount of capital stock plus bonds.

Thus, the essence of the above definitions is that capitalisation is the sum total of long-term securities issued by a company and the surplus not meant for distribution.

2. Modern Concept of Capitalisation:

Though the narrower interpretation of capitalisation is more popular because of its being very specific in the meaning, the modern thinkers consider that even short-term creditors should be included in capitalisation.

In the words of Walker and Baughn, “The use of capitalisation refers to only long-term debt and capital stock; and short-term creditors do not constitute suppliers of capital is erroneous. In reality total capital is furnished by short-term creditors and long-term creditors.”

They further opine that the sum of capital stock and long-term debt-refers to capital rather than the capitalisation.

Thus, according to modern concept, capitalisation includes:

(i) Share Capital

(ii) Long-term Debt.

(iii) Reserves and Surplus.

(iv) Short-term Debt.

(v) Creditors.

3. Need of Capitalisation:

The need of capitalisation arises not only at the time of incorporation or promotion of a company but may also arise as a going concern after promotion and during the life time of a corporation.

Generally, the problem of capitalisation arises in the following circumstance:

i. At the time of promotion/incorporation of a company.

ii. At the time of expansion of an existing company.

iii. At the time of amalgamation and absorption of two or more companies.

iv. At the time of re-organisation of capital of a company.

4. Theories of Capitalisation:

There are two important theories to determine the amount of capitalisation:

(i) The Cost Theory, and

(ii) The Earnings Theory.

(i) The Cost Theory of Capitalisation:

According to this theory, the amount of capitalisation is arrived at by adding up the cost of fixed assets (like plants, machinery, building, etc.); working capital required for the continuous operations of the company; the cost of establishing the company and the promotional expenses.

Such calculation of capitalisation is useful in case of newly-formed companies as it enables the promoters to know exactly the amount of funds to be raised. But, this theory is not totally satisfactory as it ignores the earning capacity of the business. The amount of capitalisation is based on a figure which will not change with changes in the earning capacity of the business.

For instance, if some of the fixed assets of a company become obsolete, some remain idle and the others are under-employed, the total earning capacity of the company will naturally fall, but such a fall in the earning capacity, would not reduce the value of the investment made in the company’s business.

(ii) The Earnings Theory of Capitalisation:

The earnings theory of capitalisation recognises the fact that true value of an enterprise depends upon its earning capacity.

According to this theory, the capitalisation of a company depends upon its earnings and the expected fair rate of return on its capital invested. Thus, the value of capitalisation is equal to the capitalised value of the estimated earnings.

For example, if a company is making net profit Rs.2.00,000 per annum and the fair rate of return is 10%. The capitalisation of the company will be (2,00,000 × 100/10) = Rs.20,00,000. A comparison of actual value of capitalisation with this value will show whether the company is fairly capitalised, over-capitalised, or under capitalised.

Earnings theory of capitalisation seems to be logical because it correlates the value of a firm or the amount of capitalisation directly with its earning capacity. However, this theory can only be applied when the firm’s expected income and capitalisation rate can precisely be estimated.

In real life, it is very difficult to estimate correctly the future earnings as well as to determine the capitalisation rate. The future earnings of a firm depend upon a number of factors such as demand for its products, general price level, efficiency of management and productivity of labour, etc., which are beyond the control of an organisation and may vary with the changed circumstances.

In the same manner, it is very difficult to determine the capitalisation rate which depends mainly on the expectations of the investors and the degree of risk in a particular enterprise. In view of these difficulties, newly established firms prefer cost theory of capitalisation. However, earnings theory may provide a better basis for capitalisation of an existing concern.

Illustration 1:

The estimated annual earnings of Sunny Enterprises Ltd. is Rs. 3,00,000. What will be the amount of capitalisation of the company if the fair rate of return earned by similar companies is (i) 12% and (ii) 15%.

Solution:

5. Fair Capitalisation:

It is the desire of every company to have a fairly capitalised situation, i. e neither over-capitalisation nor under-capitalisation. To understand this situation, it would be necessary for us to understand and analyse the situations of over and under-capitalisation of a company.