Concept of capitalisation and theories of capitalisation
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The problems of determining the amount of capitalisation is necessary both for a newly started company as well as for an established concern. 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. But the case is different with established concerns.
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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. However, to estimate the amount of capitalisation two theories have been pronounced.
1. The cost theory of capitalisation:
Under this 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 the 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, and the cost of promoting, organising and establishing the business.
In other works, the original total outlay incurred on various items becomes the basis for determining the capitalisation of a company. If the funds raised are sufficient to meet the initial costs and day to day expenses, the company is said to be adequately capitalised. This theory is very helpful for the new companies as it facilitates the calculation of the amount of funds to be raised initially.
Cost theory, no doubt, 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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Moreover, 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. Moreover, 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.
2. The earnings theory of capitalisation:
This theory assumes that an enterprise is expected to make profit. According to it, its true value depends upon the company’s 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.
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 company’s estimated earnings for determining its capitalisation.
ADVERTISEMENTS:
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. However, to estimate the amount of capitalisation two theories have been pronounced.
1. The cost theory of capitalisation:
Under this 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 the 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, and the cost of promoting, organising and establishing the business.
In other works, the original total outlay incurred on various items becomes the basis for determining the capitalisation of a company. If the funds raised are sufficient to meet the initial costs and day to day expenses, the company is said to be adequately capitalised. This theory is very helpful for the new companies as it facilitates the calculation of the amount of funds to be raised initially.
Cost theory, no doubt, 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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Moreover, 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. Moreover, 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.
2. The earnings theory of capitalisation:
This theory assumes that an enterprise is expected to make profit. According to it, its true value depends upon the company’s 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.
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 company’s estimated earnings for determining its capitalisation.
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