(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obsolete (out of date) and some others remain idle, the earnings and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
(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.
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.
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.
XYZ CO. LTD.
BALANCE SHEET AS ON 31ST DECEMBER, 1981
Paid-up capital Rs.
8 percent preference Shares of Rs.10 each 2,00,000
50,000 Shares of Rs. 8 each 4,00,000
Debentures of Rs. 100 each 10,00,000
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:
------ = 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.