MBA Finance IV Trimester

ITM University
CAPITALIZATION
1
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.
2
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.
3
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
4
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.
5
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.

6
Causes of Over-Capitalisation
Acquisition of Assets at Higher Prices

Higher Promotional Expenses

Underutilisation

Insufficient Provision for Depreciation

Conservative Dividend Policy

Inefficient Management
7
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.

8
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.

9
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.

10
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.

11
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.
12
Indicators Of Under-
capitalisation
There is an unforeseen increase in
earnings of the company.
Future earnings of the company were
under-estimated at the time of
promotion.
Assets might have been acquired at
very low prices.

13
Causes of Under-capitalisation
Acquisition of Assets during Recession

Under-estimation of Requirements

Liberal Dividend Policy

Efficient Management

Creation of Secret Reserves

14
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.

15
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.

16
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.

17
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.

18
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
19
Cost Theory
20
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.
Cost Theory
21
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

Drawbacks of Cost Theory
22
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 over-capitalisation.
In order to do away with these difficulties and arrive at
a correct figure of capitalisation, earnings approach
is used.

Earning Theory
23
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
Earning Theory
24
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.

Earning Theory
25
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.

Drawbacks of Earning Theory
26
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.