20-09-2014

CAPITALIZATION
MBA Finance IV Trimester
ITM University
Sajal Agrawal
Visiting Faculty
ITM School of Management
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Introduction
The capitalisation of a company is the sum total of all long-term

funds available to it and also those reserves not meant for

distribution among the shareholders.
It comprises
Share Capital
Debenture Capital
Long-Term Borrowings
Free reserves of the company.

In other words, capitalisation represents the permanent

investments in a company. The short-term loans are excluded.

The amount of capitalisation which a company should have is
related to the earning capacity of the company.
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Possible Situations Of Capitalisation

Fair or normal capitalisation:
It means business has employed correct amount of capital and its earnings
are same as average rate of earnings of the industry.
Over-capitalisation:
It means business has employed more capital than required and its earnings
are less than the average rate of earnings of the industry.
Under-capitalisation:
It means business has employed Less capital than required and its earnings
are more than average rate of earnings of the industry.

Possible Situations Of Capitalisation

Considering average rate of earnings of an industry is 10% per

annum.
Case 1: A company is earning Rs. 1, 00,000 by investing Rs. 10,
00,000, it would be considered as normal capitalised company.
Case 2: If a company is earning Rs. 1, 00,000 by investing Rs. 12,

00,000 then this company will be considered as over-capitalised

Case 3: If a company is earning Rs. 1,00,000 by investing only Rs.

8,00,000, then it is considered as under-capitalised

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Over Capitalization
Actual profits of the company are not sufficient to pay interest on

debentures and borrowings and a fair rate of dividend to shareholders

over a period of time.

Suppose a company earns a profit of Rs. 3 lakhs.

Expected earnings of 15%
the capitalisation of the company should be Rs. 20 lakhs.
But if the actual capitalisation of the company is Rs. 30 lakhs, it will be

over-capitalised to the extent of Rs. 10 lakhs.

The actual rate of return in this case will go down to 10%.

Since the rate of interest on debentures is fixed, the equity

shareholders will get lower dividend in the long-run.

Indicators of Over Capitalization

The amount of capital invested in the companys business

is much more than the real value of its assets.

Earnings do not represent a fair return on capital

employed.
A part of the capital is either idle or invested in assets

which are not fully utilised.

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Causes of Over-Capitalisation
Acquisition of Assets at Higher Prices
Higher Promotional Expenses
Underutilisation
Insufficient Provision for Depreciation
Conservative Dividend Policy
Inefficient Management
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Effects of Over-capitalisation on
Company The shares of the company may not be easily marketable because

of reduced earnings per share.

The company may not be able to raise fresh capital from the
market.
Reduced earnings may force the management to follow unfair
practices. It may manipulate the accounts to show higher profits.
Management may cut down expenditure on maintenance and
replacement of assets. Proper amount of depreciation of assets
may not be provided for.
Because of low earnings, reputation of the company would be
lowered.

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Effects of Over-capitalisation on
Shareholders
Over-capitalisation results in reduced earnings for the

company.This means the shareholders will get lesser

dividend.
Market value of shares will go down because of lower
profitability.
There may be no certainty of income to the shareholders in
the future.
The reputation of the company will go down. Because of this,
the shares of the company may not be easily marketable.
In case of reorganisation, the face value of the equity share
might be brought down.

Effects of Over-capitalisation on
Society
The profits of an over-capitalised company would show a

declining trend. Such a company may resort to tactics like

increase in product price or lowering of product quality.
Return on capital employed is very low. This means that
financial resources of the public are not being utilised
properly.
An over-capitalised company may not be able to pay interest
to the creditors regularly.
The company may not be able to provide better working
conditions and adequate wages to the workers.
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Remedies for Over-capitalization

The earning capacity of the company should be increased by

raising the efficiency of human and non-human resources of

the company.
Long-term borrowings carrying higher rate of interest may
be redeemed out of existing resources.
The par value and/or number of equity shares may be
reduced.
Management should follow a conservative policy in declaring
dividend and should take all measures to cut down
unnecessary expenses on administration.
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Under Capitalization
A company is said to be under-capitalised when it is earning

exceptionally higher profits as compared to other companies

or the value of its assets is significantly higher than the capital
raised.
For instance, the capitalisation of a company is Rs. 20 lakhs

and the average rate of return of the industry is 15%. But if

the company is earning 30% on the capital investment, it is a
case of under-capitalisation.

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Indicators Of Under-capitalisation
There is an unforeseen increase in earnings of the

company.
Future earnings of the company were underestimated at the time of promotion.
Assets might have been acquired at very low
prices.

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Causes of Under-capitalisation
Acquisition of Assets during Recession
Under-estimation of Requirements

Liberal Dividend Policy

Efficient Management
Creation of Secret Reserves
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Effects of Under-capitalization on
Shareholders
The profitability of the company may be very high. As a

result, the rate of earnings per share will go up.

The value of its equity share in the market will go up.
The financial reputation of the company will increase in the
market.
The shareholders can expect higher dividends regularly.

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Effects of Under-capitalization on
Company
Because of higher profitability, the market value of companys

shares would go up. This would also increase the reputation of the
company.
The management may be tempted to build up secret reserves.
Higher rate of earnings will attract competition in the market.
The workers of the company may be tempted to demand higher
wages, bonus and other benefits.
If a company is earning higher profits, the customers may feel that
they are being overcharged by the company.
The government may increase tax rates on companies earning
exceptional profits.

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Effects of Under-capitalization on
Society
Under-capitalisation may lead to higher profits and higher

prices of shares on the stock exchange. This may encourage

unhealthy speculation in its shares.
Because of higher profits, the consumers feel exploited. They
link higher profits with higher prices of the products.
The management of the company may build up secret
reserves and pay lower taxes to the Government.

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Remedies for Under-capitalization

Under-capitalisation may be remedied by increasing the par

value and/or number of equity shares by revising upward the

value of assets. This will lead to decrease in the rate of
earnings per share.
Management may capitalise the 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 company.
Where under-capitalisation is due to insufficiency of capital,
more shares and debentures may be issued to the public.
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Theories of Capitalization
Newly Started Company In case of the new enterprise, the problem is more severe in so

far as it requires the reasonable provision for future as well as

for current needs and there arises the danger of either raising
excessive or insufficient capital.

Established Concern.
But the case is different with established concerns.They have to

revise or modify their financial plan either by issuing of fresh

securities or by reducing the capital and making it in conformity
with the needs of the enterprises.
Cost Theory
Earnings Theory

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Cost Theory
The capitalisation of a company is determined by adding the

initial actual expenses to be incurred in setting up a business

enterprise as a going concern.
It is aggregate of Cost of fixed assets (plant, machinery, building, furniture,

goodwill, and the like)

The amount of working capital (investments, cash, inventories,
receivables) required to run the business
Cost of promoting, organising and establishing the business
If the funds raised are sufficient to meet the initial
costs and day to day expenses, the company is said to be
adequately capitalised.
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Cost Theory
Very helpful for the new companies as it facilitates the

calculation of the amount of funds to be raised initially.

It gives a concrete idea to determine the magnitude of
capitalisation, but it fails to provide the basis for assessing the
net worth of the business in real terms.
The capitalisation determined under this theory does not
change with earnings

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Drawbacks of Cost Theory

It does not take into account the future needs of the business.
This theory is not applicable to the existing concerns because it

does not suggest whether the capital invested justifies the earnings
or not.
The cost estimates are made at a particular period of time.
They do not take into account the price level changes. For
example, if some of the assets may be purchased at inflated prices,
and some assets may remain idle or may not be fully utilised,
earnings will be low and the company will not be able to pay a fair
return on the capital invested. The result will be overcapitalisation.
In order to do away with these difficulties and arrive at a correct
figure of capitalisation, earnings approach is used.
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Earning Theory
This theory assumes that an enterprise is expected to make

profit.
True Capitalization value depends upon the companys
earnings and/or earning capacity.
Thus, the capitalisation of the company or its value is equal to
the capitalised value of its estimated earnings.
To find out this value, a company, while estimating its initial
capital needs, has to prepare a projected profit and loss
account to complete the picture of earnings or to make a
sales forecast
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Earning Theory
Having arrived at the estimated earnings figures, the financial

manager will compare with the actual earnings of other

companies of similar size and business with necessary
adjustments.
After this the rate at which other companies in the same
industry, similarly situated are making earnings on their
capital will be studied. This rate is then applied to the
companys estimated earnings for determining its
capitalisation.

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Earning Theory
Two factors are generally taken into account to determine

capitalisation
(i) how much the business is capable of earning
(ii) What is the fair rate of return for capital invested in the

enterprise.
This rate of return is also known as multiplier which is 100

per cent divided by the appropriate rate of return.

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Drawbacks of Earning Theory

More appropriate for going concerns, it is difficult to

calculate the amount of capitalisation under this theory. It is

based upon a rate by which earnings are capitalised. This
rate is difficult to estimate in so far as it is determined by a
number of factors not capable of being calculated
quantitatively.
These factors include nature of industry/ financial risks,
competition prevailing in the industry and so on.
New companies cannot depend upon this theory as it is
difficult to estimate the expected returns in their case.
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