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Capitalisation
Unit- IV
Section -A
F.M.
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What is Capitalisation?
Capitalisation refers to the amount of capital
employed in a business.
It also refers the process of determining the plan
of financing.
In short Capitalisation includes:
Estimating the total amount of capital to be raised.
Determining the type of securities to be issued.
Determining the proportion of various securities.
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Definition.
Capitalisation comprises of a companys
ownership capital which include capital stock
and surplus and borrowed capital which
consists of Bonds or similar evidences of a
long term debts.
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Need of Capitalisation
It arises not only at the time of incorporation orpromotion of a company but may also arise as a
going concern after promotion and during life
time of a company.
Generally problem Capitalisation arises:
1. At the time of promotion/ incorporation of a
company.2. At the time of expansion of existing company.
3. At the time of mergers.
4. At the time of reorganization.
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Theories of Capitalisation:
The are two different theories of
Capitalisation :
Earning theory of Capitalisation
Cost theory o Capitalisation
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Earning Theory of Capitalisation
it recognises the fact that true value of an
enterprise depends upon its earning and the
expected fair rate of return on its capital
employed .
In short Capitalisation is equal to the capitalized
value of the estimated earnings.
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Earning Theory of Capitalisation
In real life it is very difficult to estimate correctly the
future earning as well as to determine the capitalisation
rate.
Future earning depends upon the number of factors such
as,
Demand for product
General price level.
Productivity of labour and so on.
These factors are beyond the control of management
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Earning Theory of Capitalisation
In the same manner, it is very difficult to
determine the capitalisation rate. As it depends
mainly on:
The expectations of investors
The degree of risk in particular firm.
In view of these difficulties, a newly establishedfirm prefers cost theory of capitalisation.
Where as earning theory of capitalisation is better
for the existing firms.
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For Example (Earning Theory of Capitalisation)
If a company is making a net profit of Rs.2,00,000 p.a.
and the fair rate of return is 10%.
The capitalization of the company will be
(2,00,000*100/10)= Rs.20,00,000
However this theory works only when the firms
expected income and capitalisation rate can precisely be
estimated.
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Cost theory ofCapitalisation
According to this theory Capitalisation is
arrived by adding up the cost of fixed assets
and working capital required for the
continuous operation of the company, the cost
of establishing the company and promotional
expenses.
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Over capitalisation
A company is said to be over capitalised when its
earnings are not sufficient to yield a fair return on
amount of shares or debentures.
In short, when a company is not in a position to
pay dividend or interest on its shares and
debentures at fair rates, is said to be over
capitalised.
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Misconception..
Over capitalisation implies a condition of excess
capital, actually speaking this notion is incorrect.
Over capitalisation does not always means anabundance of capital.
On the other hand, it is likely that an over
capitalised concern, there may be shortage of
capital.
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Over-capitalisation
Whenever the aggregates of the par value of
stocks and bonds outstanding, exceeds thetrue value of fixed assets the corporation is
said to be over capitalised.
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Fair Capitalisation Balance Sheet
Liability Amount Assets Amount
Share Capital
Debentures
Current liabilities
10,00,000
5,00,000
10,00,000
Fixed Assets
Current assets
15,00,000
10,00,000
25,00,000 25,00,000
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Over capitalised balance sheet
Liability Amount Assets Amount
Share Capital
Debentures
Current liabilities
10,00,000
5,00,000
10,00,000
Fixed Assets
Current assets
12,00,000
13,00,000
25,00,000 25,00,000
In the above balance sheet, the fixed liabilities are excess of
fixed assets by Rs.3,00,000 and hence firm is said to be over -
capitalised
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Causes of Over Capitalisation
Over issue of Capital.
Purchasing property of inflated price.
Production and development during inflation.
High promotion cost.
In adequate depreciation.
Liberal dividend policy
Taxation policy.
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Disadvantages of over - capitalisation
It may lead to watered stock
Difficulty in raising fresh capital
Tendency to raise the price or deteriorate the quality of
product.
It may lead to company failure.
Difficulty in payment of interest.
Decrease in the value of shares and goodwill.
Loss of workers
Loss to share holders
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Effects of Over Capitalisation:
On Business:
Loss of goodwill.
Difficulty in obtaining loan.
Decline in efficiency of a company.
Liquidation of company.
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Effects of Over Capitalisation:
On shareholders:
Reduced dividends
Fall in the market value of shares.
Unacceptable as collateral securities.
Loss on reorganization.
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Effects of Over Capitalisation:
On society:
Loss to consumer.
Loss to worker
Gambling in shares
Leads to recession.
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Remedies for over capitalisation
Redemption of debts.
Reduction of interest rate on debts.
Redemption of preference stock.
Reduction in the par value of shares.
Reduction of number of shares of common stock
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Under Capitalisation
The corporation may be under capitalise when the
rate of profit on the total capital is exceptionally high,
in relation to the return enjoyed by similarly situatedcompanies in the same industry.
In simple words, under capitalisation stands for a
state of affairs when the capital of company is less in
proportion to its total capital requirements.
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Under capitalisation is associate with: -
An effective utilization of resources.
A high rate of dividend.
Enhance the market value of share
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Under Capitalised Balance Sheet
Liability Amount Assets Amount
Share Capital
Debentures
Current liabilities
10,00,000
1,00,000
4,00,000
Fixed Assets
Current assets
12,00,000
3,00,000
15,00,000 15,00,000
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Causes of Under Capitalisation
Under estimation of capital requirement.
Under estimation of future earning.
Promotion during deflation.
Narrow dividend policy.
High efficiency.
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Disadvantages of under capitalisation
Limited marketability of shares.
Cut throat competition.
Rise in workers demand.
Dissatisfactions on the part of customers.
Dependence on outside sources of finance.
Danger of liquidation.
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Possible remedies for Under
Capitalisation
Splitting up of shares.
Increase in par value of shares.
Issue of bonus shares.
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Causes of watered stock
Valuing the services of promoters at unduly high
value and paying for their services in the form
stock. Acquiring assets of the company at too high price.
Acquisition of intangible assets such as patents,
goodwill at high value which latter proves
worthless.
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