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Theories of Capitalization
There are two recognized bases for capitalizing new companies


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(i) Cost Theory: According to the cost theory of capitalization, the value of a company is arrived at by adding up the cos of fixed assets like plants, machinery patents, etc., the capital regularly required for the continuous operation of the company (working capital), the cost of establishing business and expenses of promotion. The original outlays on all these items become the basis for calculating the capitalization of company. Such calculation of capitalisation is useful in so far as it enables the promoters to kn ow the amount of capital to be raised. But it is not wholly satisfactory. On import objection to it is that it is based o a figure (i.e., cost of establishing and starting business) which will not change with variation in the earning capacity of the company. The true value of an enterprise is judged from its earning capacity rather than from the capital invested in it. If, for example, some assets become obsolete (out of date) and some others remain idle, the earnings and the earning capacity of the concern will naturally fall. But such a fall will not reduce the value of the investment made in the company's business.

(ii) Earnings Theory: The earnings theory of Capitalization recognizes the fact that the true value (capitalization) of an enterprise depends upon its earnings and earning capacity. According to it, therefore, the value or Capitalization of a company is equal to the capitalized value of its estimated earnings. For this purpose a new company has to prepare an estimated profit and loss account. For the first few year of its life, the sales are forecast ad the manager has to depend upon his experience for determining the probable cost. The earnings so estimated may be compared with the actual earnings of similar companies in the industry and the necessary adjustments should be made. Then the promoters will study the rate at which other companies in the same industry similarly situated are earnings. The rate is then applied to the estimated earnings of the company for finding out the capitalization. To take an example a company ma estimate its average profit in the first few years at Rs. 50,000. Other companies of the same type are, let us assume, earnings a return of 10 per cent on their capital. The Capitalization of the company will then be
50,000 x 100
---------------- = Rs. 5,00,000.
It will be noted that the
earnings basis for Capitalization has the merit of valuing (capitalizing) a company at an amount which is directly related to its earning capacity. A company is worth what it is able to earn. But it cannot, at the same time be denied that new companies will find it difficult, and even risky, to depend merely on estimate of their earnings as the generally expected return is an industry. In case of new companies, therefore, the cost theory provides a better basis for capitalisation than the earning theory.

In established concerns too, the Capitalization can be arrived at either (i) on the basis of the cost of business, or (ii) the average or regular earnings and the rate of return expected in an industry If cost is adopted as the basis, the Capitalization may fall to reveal the true worth of a company. The assets of a company stand at their original values while its earnings may have declined considerably. In such a situation, it will be risky to believe that the Capitalization of the company is high. Earnings, therefore, provide a better basis of Capitalization in established concerns The figure will be arrived at in the same manner as above.

Actual and Proper Capitalization. The capitalisation of a company as arrived at by totaling up the value of the shares, debentures and non-divisible retained earnings of the company may be called the actual Capitalization of the company. Let us take the relevant items in a company balance sheet for illustration. The actual Capitalization as per balance sheet given below will be Rs. 16,00,000.





Paid-up capital Rs.

20,000 8 percent preference Shares of Rs.10 each 2,00,000

50,000 Shares of Rs. 8 each                                   4,00,000

10,000 Debentures of Rs. 100 each                      10,00,000

                     Rs.          SundryAssets



As against the actual Capitalization the proper, normal or standard Capitalization for a company can be found out by capitalizing the average annual profits at the normal rate of return earned by comparable companies in the same line of business. Thus if a company gets an annual return of Rs. 1,50,000 and the normal rate of return in the industry is 0 per cent, the proper Capitalization will be arrived at as under:
1,50,000 x ------ = Rs. 15,00,000

A comparison between the actual and the proper on normal Capitalization will show whether the company is properly capitalized, over-capitalized or under-capitalized.

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