Capital

and
Capitalisation
BY
Ms. Asha Agrawal
ASST. PROFESSOR
KES’ Shroff College
 UNIT: 3
C A P IT A L
AND
C A P I T A L IZ A T IO N
CAPITAL
 MEANING OF CAPITAL

• The term capital refers to the total

investment of the company in terms of
money, and assets.
• It is also called as total wealth of the
company.
• When the company is going to invest large
amount of finance into the business, it is
called as capital.
• Capital is the initial and integral part of new
and existing business concern.
Nature of Capital
• Capital is used to acquire the fixed assets and current
assets of the business concern.
• Capital meets the long-term as well as short-term
expenditure of the business concern.
• Capital is used to purchase raw material, payment of
wages to workers
• Capital helps in meeting the day-to-day expenses of
the business.
• Capital is used by companies to pay for the ongoing
production of goods and services to create profit.
• Capital can buy the latest technology and specialised
tools for production, which will help meet the
demand-supply gap.
Fixed Capital:
• Fixed capital is that amount of capital which
is incurred in procurement or buying the
fixed assets for a business or an
organization.
• The fixed assets of an organization are those
assets which remain with the business for
more than one year.
• For example: Plant and Machinery, land,
furniture and fixtures vehicles, etc.
Importance of Management of Fixed Capital

1.Long-term growth: Capital budgeting decisions have

long term effects on growth and profitability of the
business in the future.
2.Large amount of funds involved: Capital budgeting
decisions involving high amounts of funds block for a long
period of time.
3.Risk involved: Investment in fixed capital and the
related financial risks affect the overall business risk in
the long term.
4.Irreversible decisions: The investment decision
cannot be reversed without incurring heavy losses and
wasteful expenditure.
Working Capital:

• Working capital is that amount of capital

which is used in the day-to-day operations
of the business this may be in cash or cash
equivalents. The working capital is utilised
by the business within one year.
• For example: stocks and inventories,
debtors, bills receivables, etc.
 Importance of Management of Working Capital

1. Manage liquidity: Businesses need sufficient cash

(liquidity) for their day-to-day running.
2. Earn short-term profit: The excess funds can be
invested by the company to earn short-term profits.
3. Aids decision making: Working capital is important
for a business as it helps undertake sound decisions.
4. Value addition to business: An adequate working
capital improves the creditworthiness of the business
in the market.
CAPITALISATION
MEANING OF CAPITALISATION

 C apitalization means total amount capital

employed in business.

 C apitalization of company means the

combination of both owned and borrowed capital.

 Capitalization includes shares & debentures.

 Capitalization is also called as financial plans.

DEFINITION

 According to Gerstenberg-
“ Capitalization as the total accounting value of
all the capital employed regularly in the business”.

Thus, the capitalization includes;

1) O wnership capital which includes capital stock &

surplus.
2) Borrowed capital which consist of bonds or similar
long term debts.
SOURCES O F C A P I TA L I Z AT I O N

 Share capital
 Debentures
 Bonds
 Reserves and surplus
 Long term loans
 Short term loans
TYPES O F CAPITALIZATION

 Watered Capitalization
 Under Capitalization

 Over Capitalization

Net Profit Rs. 50,000

Rate of Return – 10%

Then capitalization should be – 5,00,000 (watered Capital)

If capital is less – under capitalized
If capital is more – over capitalized
UNDER-CAPITALIZATION
 Under -capitalization is used to denote the state of affairs just
converse of over-capitalization.
 When company succeeds in earning abnormally large income
consistently for long time, then the symptoms of under-
capitalization gradually develop in the company. (Consistently
high income)
 Under-capitalization is indicative of sound financial health and
good management of the company. (Good Management)
 Under-capitalization will happen when market value of shares
of the company becomes higher than its book value. (High
market value of shares)

 Under Estimation of the capacity

DEFINITION
 According to Bonneville and Dewey-
“Under-capitalization is not an economic problem
but a problem in adjusting the capital structure”.

 According to Gestenberg-
“A corporation may be under-capitalized when the
rate of profit, it is making on the total capital is
exceptionally high in relation to the return enjoyed by
similarly situated companies in the same industries or
when it has too little capital with which to conduct its
business”.
CAUSES OF UNDER-CAPITALIZATION

1. Under-estimation of initial earnings

2. Using low capitalization rate.

3. Deflationary condition.

4. Conservative dividend policy.

5. Maintaining high standards of efficiency

C O N S E Q U E N C E S O F UNDER-CAPITALIZATION
 To company-
- Competition increases
- Tax liability of under-capitalized concerns increases in
correspondence with increase in volume of profit (Tax
liability increases)
- Marketability of shares of under-capitalized firm tends
to be narrow because of exceptionally high market price
of these shares. (Low demand & marketability of shares
due to high price)
- Due to high profitability, workers may demand increase
in their wages rate. (Workers may demand higher
wages)
 To share- holders
- Under-capitalization is advantageous to share holders.

- Share holder get high rate of dividend.

- Share holders get regular dividend.

 To society

- Increase employment.
- Encourages new entrepreneurs to set up new ventures.
- D evelopment of workers and employees with large
amount of profit.

- Effective utilization of natural resources

REMEDIAL MEASURES

 Capitalization of surplus of the company

 Fresh Issue of shares
 Increase in Par value
 Issue of Bonus shares-Reduce Dividend
Per share and earning per share
 Splitting up of shares-Reduce Dividend
Per share
F A I R C AP IT ALIZATION
Fair Capitalisation is a situation where the business
has employed the correct amount of Capital and its
earnings are same as the average rate of earnings.

Liabilities Amount Assets Amount

Share Capital 10,00,000 Fixed Assets 15,00,000
Debentures 5,00,000 Current Assets 10,00,000
Current Liab 10,00,000
Total 25,00,000 Total 25,00,000

Here fixed liabilities and fixed assets

are equal. Hence, this firm is fairly
capitalized
OVER-CAPITALIZATION

 Over capitalized concern have been found short of

funds due to over expectation.

 Over capitalization denotes that the firm is not

earning reasonable income on its funds.

 O ver capitalization means firm’s inability to earn

reasonable income on its funds or investment.
D E F IN IT IO N

 According to Bonneville, Dewey and Kelly-

“ When a business is unable to earn a fair rate of return
on its outstanding securities, it is over capitalized”.

 According to Gerstenberg-
“ a corporation is overcapitalized when its earnings are
not large enough to yield a fair return on the amount of stock &
bonds that have been issued”.
KEY FACTORS
 Over capitalization refers to that state of affairs where earnings of the
corporation do not justify the amount of capital invested in the business.
(Earning doesn’t justify)

 Over capitalizes company earns less than what it what it should have
earned at fair rate of return on its total capital. (Earns less than the
capacity)

 If the company’s rate of return is less than the average rate of return, it is
indicative of the fact that company is not able to earn fair rate of return on
its capital. i.e. over capitalization. (Indication of not earning fair rate of
return)
 When par value of shares of the company is higher than the market
value then company would be in state of over capitalization.

 When book value of shares is higher than the real share value then
its is overcapitalized.

 Par value – face value of shares.

 Market value – price at which shares are quoted in stock exchange.

 Book value= capital stock + surplus accounts/ No of sha res
outstanding

 Real value= ca pitalized value of company’s assets/outstanding

number of shares.
 CAUSES OF OVER CAPITALIZATION

1. Promotion of company with inflated assets (Trade mark, Goodwill,

payment to promoters)

2. Company promoted with high promotion expenses

3. Over estimating earnings at the time of promotion
4. Applying high capitalization rate to capitalize earnings
5. Company formed or expanded during inflationary period.
6. Shortage of capital
7. D efective depreciation policy
8. Liberal dividend policy
9. Raising excessive capital
10. Fall in the value of fixed assets
11. B orrowing at higher rate of interest
CONSEQUENCES O F O VER CAPITALIZATION

 To company

- company’s financial stability collapse

- Company loses investors confidence

- Due to poor profitability it can not internally finance its

projects

- Company fails to pay dividend

- Falls market value of shares

- Fails to make regular payments.

- Reputation of company lowers

 To share holders-
- Sh are holder do not get fair rate of return on their
investment

- Repayment of shares become uncertain

- Shares are not actively traded in stock exchange
- Low market value of shares
 To customer-
- Increased prices of goods and services
- Reduction in quality goods
 To society-
- Problem of unemployment
- Scare resources are poorly employed
REMEDIES OF OVER CAPITALIZATION

1. Reduction in bonded debts

2. Reduction in fixed charges on debt (Interest)

3. Redemption of high dividend preferred stock

4. Reducing par value of shares

5. Reducing number of shares

6. Utilizing idle money

Over Capitalization
Lower Earnings
Poor Management
Over Estimation of Resources
Promotion of Company with inflated
assets
Applying high capitalization rate
Formation during inflationary period Formation during deflationary
Defective depreciation policy
Liberal dividend policy
Raising excessive capital
Borrowing at high interest rate
Fall in the value of fixed assets
Low efficiency
Under Capitalization
High earnings
Good Management
Under estimation of resources
Promotion of company with deflated
assets
Applying low capitalization rate
period
Defective depreciation policy
Conservative dividend policy
Raising less capital
Borrowing at low interest rate
Increase in the value of fixed assets
High efficiency
 Comparison of Book Value (B.V.) and Real
Value (R.V.) of Shares
Under Capitalisation
= Actual Capitalisation < Fair Capitalisation i.e. B. V. < R. V.

Fair Capitalisation
= Actual Capitalisation = Fair Capitalisation i.e. B. V. = R. V.

Over Capitalisation
= Actual Capitalisation > Fair Capitalisation i.e. B. V. > R. V.