THEORIES OF

CAPITALIZATION

Dr. Mahesh Kumar.T

Introduction
⚫Capitalization is one of the most important constituents of
financial plan. The term “Capitalization” has been
derived from the word capital and in common practice it
refers to the total amount of capital employed in a
business. However, financial scholars are not unanimous
regarding the concept of capital.
⚫As a matter of fact, they have defined ‘Capitalization’ in a
number of ways. If the definitions are properly studied,
we can classify them into two ways, viz.; a broad
interpretation and a narrow interpretation.
Broad Interpretation of Capitalization
Many authors regard Capitalizations as synonymous
with financial planning. Broadly speaking, the term
‘Capitalization’ refers to the process of determining the
plan of financing. It includes not merely the determination
of the quantity of finance required for a company but also
the decision about the quality of financing. A financial plan
is a statement estimating the amount of capital and
determining its composition.
Used in this sense, capitalization includes:
(i) Estimating the total amount of capital to be raised;
(ii) Determining the type of securities to be issued; and
(iii) Determining the composition or proportion of the
various securities to be issued.
Narrow Interpretation of Capitalization
In its narrow sense, the term ‘Capitalization’ is used in its
quantitative sense and refers to the process of determining the
quantum of funds that a firm needs to run its business.
According to the scholars holding this view, the decisions
regarding the form or composition of capital fall under the
term “Capital Structure”.
Some of the important definitions of traditional experts,
in this regard, are given below:
⚫ According to Guthman and Dougall, “Capitalization is the sum of
the par value of stocks and bonds outstanding.”
⚫ The above definition considers and includes in capitalization only
the par value of share capital and debentures. It does not
include reserves and surpluses which, usually, form part of the
long-term funds of a firm.
⚫Bonneville and Deway refer to capitalization as,
“The balance sheet values of stocks and bonds
outstanding.”
⚫Arthur S. Dewing defines it as, “The sum total of the par
value of all shares.”
⚫According to Gerstenberg, “Capitalization comprises of a
company’s ownership capital which includes capital
stock and surplus in whatever form it may appear and
borrowed capital which consists of bonds or similar
evidences of long-term debt.”
Modern Concept of Capitalization
⚫ Though the narrower interpretation of capitalization is more
popular because of its being very specific in the meaning, the
modern thinkers consider that even short-term creditors should
be included in capitalization.
⚫ In the words of Walker and Baughn, “The use of
capitalization refers to only long-term debt and capital
stock; and short-term creditors do not constitute suppliers
of capital is erroneous. In reality total capital is furnished
by short-term creditors and long-term creditors.”
⚫ They further opine that the sum of capital stock and long-term
debt-refers to capital rather than the capitalization.
Thus, according to modern concept, capitalization
includes:
(i) Share Capital
(ii) Long-term Debt.
(iii) Reserves and Surplus.
(iv) Short-term Debt.
(v) Creditors.
Need of Capitalization
The need of capitalization arises not only at the time of
incorporation or promotion of a company but may also
arise as a going concern after promotion and during the life
time of a corporation.
Generally, the problem of capitalization arises in the
following circumstance:
i. At the time of promotion/incorporation of a company.
ii. At the time of expansion of an existing company.
iii. At the time of amalgamation and absorption of two or more
companies.
iv. At the time of re-organization of capital of a company.
 There are two important theories to determine the
amount of capitalization:
(i) The Cost Theory, and
(ii) The Earnings Theory.

(i) The Cost Theory of Capitalization:

⚫According to this theory, the amount of capitalization is
arrived at by adding up the cost of fixed assets (like plants,
machinery, building, etc.); working capital required for the
continuous operations of the company; the cost of establishing
the company and the promotional expenses.
⚫ Such calculation of capitalization is useful in case of newly-
formed companies as it enables the promoters to know exactly
the amount of funds to be raised. But, this theory is not totally
satisfactory as it ignores the earning capacity of the business.
The amount of capitalization is based on a figure which will
not change with changes in the earning capacity of the
business.
⚫ For instance, if some of the fixed assets of a company
become obsolete, some remain idle and the others are
under-employed, the total earning capacity of the company
will naturally fall, but such a fall in the earning capacity,
would not reduce the value of the investment made in the
company’s business.
The Earnings Theory of Capitalization:
⚫ The earnings theory of capitalization recognizes the fact that
true value of an enterprise depends upon its earning capacity.
⚫ According to this theory, the capitalization of a company
depends upon its earnings and the expected fair rate of
return on its capital invested. Thus, the value of
capitalization is equal to the capitalized value of the estimated
earnings.
⚫ For example, if a company is making net profit Rs.2,00,000
per annum and the fair rate of return is 10%. The
capitalization of the company will be (2,00,000 × 100/10) =
Rs.20,00,000. A comparison of actual value of capitalization
with this value will show whether the company is fairly
capitalized, over­capitalized, or under capitalized.
⚫ Earnings theory of capitalization seems to be logical because it
correlates the value of a firm or the amount of capitalization
directly with its earning capacity. However, this theory can only
be applied when the firm’s expected income and capitalization rate
can precisely be estimated.
⚫ In real life, it is very difficult to estimate correctly the future
earnings as well as to determine the capitalization rate. The future
earnings of a firm depend upon a number of factors such as
demand for its products, general price level, efficiency of
management and productivity of labor, etc., which are beyond
the control of an organization and may vary with the changed
circumstances.
⚫ In the same manner, it is very difficult to determine the
capitalization rate which depends mainly on the expectations of the
investors and the degree of risk in a particular enterprise. In view
of these difficulties, newly established firms prefer cost theory
of capitalization. However, earnings theory may provide a
better basis for capitalization of an existing concern.
Types of Capitalization
1. Over-Capitalization:
⚫When a company is consistently (regularly) unable to
earn the prevailing rate of return on its outstanding
securities (considering the earning of similar companies in
the same industry and the same degree of risks involved), it
is said to be overcapitalized.
Causes of Over-Capitalization:
⚫Promotion with inflated assets. Book value of company
more than its real value.
⚫High promotion expenses, high remuneration of promoters;
high price of patent, goodwill, etc.
⚫Floatation of companies in inflationary period and when
boom subsides earnings fall, leading to over-capitalization.
⚫ Inadequate owned capital, defective financial plan, chooser
of capital becomes beggar of capital, top heavy borrowing;
high interest charges, shareholders starved falling dividends,
falling market value of shares.
⚫Defective depreciation policy affecting adversely company’s
efficiency and leading to low profits Depreciated assets.
⚫Manipulation of accounts to inflate profits and declare liberal
dividends and no retained profits.
⚫High taxation policy.
Effects of Over-Capitalization
(A) Effects on the Company:
⚫ Low dividend rates,
⚫ Low market price of shares and loss of investors confidence.
⚫ Manipulation of accounts to show prosperity on paper.
⚫ Inadequate provision for depreciation, replacement and reserves.
(B) Effects on the Shareholders:
⚫ Depreciation in share value.
⚫ Low, uncertain and irregular income.
⚫ Low loan value of shares.
⚫ Unhealthy speculation and exploitation of real investors.
⚫ Reduction and re-organization of capital-burden on shareholders.
(C) Effects on Society:
⚫When a company is over-capitalized, it tries to increase the
prices and reduce the quality of products. But to adopt both
these practices, company has to face one great difficulty and
there is keen competition in the market. The result is that
sooner or later the concern may have to face liquidation.
⚫Panic may be created due to failure of such an over-
capitalized concern. Members lose on both fronts due to
lower dividends on lower share prices in the market. Not
only are the creditors of the company adversely affected
but the workers also lose their employment.
⚫A bad ethical atmosphere is created in the society and the
whole economy may suffer from depressing effect. An
over-capitalized company likes to effect economy by
wage cuts and it may have to face strikes and labor
unrest.
⚫Over-capitalization also leads to wastage and mis-
application of scarce financial resources of the society. The
cure for an over-capitalized company is reorganization
of capital structure, if necessary, with reduction of share
capital. Otherwise, sooner or later, the corporation may
have to face insolvency and liquidation.
Remedies for Over-Capitalization
1. Redemption of debentures or repayment of loans.
2. Reduction in the rate of interest on debentures or on
loans.
3. Reduction in the rate of dividends on preference shares.
4. Reduction of issued or paid-up share capital.

All these steps may be a part of re-organization of

capital to restore balance to its capital structure.
Under-Capitalization
⚫ A company is under-capitalized when its actual
capitalization (i.e. total long-term resources) is lower than
its proper capital as warranted by its earning capacity.
⚫ We have over-capitalization if
1. earnings are overestimated, or
2. rate of capitalization or return on investment is
underrated by the company promoters. Hence, we have
falling dividends and falling market values of shares.
⚫ We have under-capitalization if
1. earnings are underestimated, or
2. rate of capitalization or return on investment is overrated
by the company promoters.
Hence, we have rising dividends and rising market values of
shares.
⚫Over-capitalization - (over-valued assets in B/S.) Book
value of shares is more than the real value of shares (shares
sold at a discount).
⚫Balanced or proper capitalization - Book value of shares is
equal to the real value of shares (shares sold at par).
⚫Under-capitalization -(under-valued assets in B/S). Book
value of shares is less than the real value of share (shares
sold at a premium).
Causes of Under-Capitalization:
1. Underestimation of future earnings by accident.
2. Companies floated in recession find themselves under-
capitalized during prosperity because they have unexpected
increase in earnings.
3. Conservative dividend policy adopted by the management
providing liberal depreciation, liberal retained profits and
emphasis on self-financing for growth Appreciated assets.
4. Latest process of production and techniques, rationalization,
scientific management, finance out of past savings,
maximization of productivity and efficiency, increase in
profits.
5. Built-up secret reserves.
Effects of Under-capitalization:
1. Higher dividends on shares.
2. High prices of shares.
3. Cut-throat competition due to new rivals.
4. Liberal depreciation provision.
5. Demand for higher wage and bonus by employees.
6. Demand for lower prices by consumers.
Remedies of Under-capitalization:
1. Capitalization of reserves and issue of bonus shares.
2. Sub-division of share capital.
3. Increase of issued capital.