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CAPITALIZATION
MBA Finance IV Trimester
ITM University
Sajal Agrawal
Visiting Faculty
ITM School of Management
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Introduction
The capitalisation of a company is the sum total of all long-term
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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,
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Over Capitalization
Actual profits of the company are not sufficient to pay interest on
employed.
A part of the capital is either idle or invested in assets
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Causes of Over-Capitalisation
Acquisition of Assets at Higher Prices
Higher Promotional Expenses
Underutilisation
Insufficient Provision for Depreciation
Conservative Dividend Policy
Inefficient Management
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Effects of Over-capitalisation on
Company The shares of the company may not be easily marketable because
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Effects of Over-capitalisation on
Shareholders
Over-capitalisation results in reduced earnings for the
Effects of Over-capitalisation on
Society
The profits of an over-capitalised company would show a
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Under Capitalization
A company is said to be under-capitalised when it is earning
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Indicators Of Under-capitalisation
There is an unforeseen increase in earnings of the
company.
Future earnings of the company were underestimated at the time of promotion.
Assets might have been acquired at very low
prices.
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Causes of Under-capitalisation
Acquisition of Assets during Recession
Under-estimation of Requirements
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Effects of Under-capitalization on
Shareholders
The profitability of the company may be very high. As a
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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.
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Effects of Under-capitalization on
Society
Under-capitalisation may lead to higher profits and higher
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Theories of Capitalization
Newly Started Company In case of the new enterprise, the problem is more severe in so
Established Concern.
But the case is different with established concerns.They have to
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Cost Theory
The capitalisation of a company is determined by adding the
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Cost Theory
Very helpful for the new companies as it facilitates the
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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 overcapitalisation.
In order to do away with these difficulties and arrive at a correct
figure of capitalisation, earnings approach is used.
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Earning Theory
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
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Earning Theory
Having arrived at the estimated earnings figures, the financial
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Earning Theory
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
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