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Capitalization refers to the amount and composition of capital in a business. It determines how much capital is needed and what form it takes, such as shares, debt, or retained earnings. There are two main theories of capitalization - the cost theory, which values a company based on its assets and costs, and the earnings theory, which values it based on estimated future earnings. A company can be fairly capitalized, overcapitalized, or undercapitalized. Overcapitalization means more capital than needed, while undercapitalization means too little. Both have effects on shareholders, the company, and society. Capitalization can also be assessed by comparing the book and real value of shares.
Capitalization refers to the amount and composition of capital in a business. It determines how much capital is needed and what form it takes, such as shares, debt, or retained earnings. There are two main theories of capitalization - the cost theory, which values a company based on its assets and costs, and the earnings theory, which values it based on estimated future earnings. A company can be fairly capitalized, overcapitalized, or undercapitalized. Overcapitalization means more capital than needed, while undercapitalization means too little. Both have effects on shareholders, the company, and society. Capitalization can also be assessed by comparing the book and real value of shares.
Capitalization refers to the amount and composition of capital in a business. It determines how much capital is needed and what form it takes, such as shares, debt, or retained earnings. There are two main theories of capitalization - the cost theory, which values a company based on its assets and costs, and the earnings theory, which values it based on estimated future earnings. A company can be fairly capitalized, overcapitalized, or undercapitalized. Overcapitalization means more capital than needed, while undercapitalization means too little. Both have effects on shareholders, the company, and society. Capitalization can also be assessed by comparing the book and real value of shares.
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.