Capitalisation: Meaning, Need and Theories

After reading this article you will learn about Capitalisation:- 1. Meaning of Capitalisation 2. Modern Concept of Capitalisation 3. Need 4. Theories 5. Fair.

Contents:

  1. Meaning of Capitalisation
  2. Modern Concept of Capitalisation
  3. Need of Capitalisation
  4. Theories of Capitalisation
  5. 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:

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.


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