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Chapter 4 - CAPITALIZATION PDF

Financial planning involves estimating capital needs, determining security types and amounts, and setting financial policies. Capital refers to a company's total investment in money and assets and is needed for fixed assets like buildings and machinery (fixed capital) and day-to-day operations (working capital). Capitalization is the total capital employed and determines a firm's needs, consisting of stock and bond par values but not reserves. Types of capitalization include overcapitalization, undercapitalization, and watered capitalization.

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523 views

Chapter 4 - CAPITALIZATION PDF

Financial planning involves estimating capital needs, determining security types and amounts, and setting financial policies. Capital refers to a company's total investment in money and assets and is needed for fixed assets like buildings and machinery (fixed capital) and day-to-day operations (working capital). Capitalization is the total capital employed and determines a firm's needs, consisting of stock and bond par values but not reserves. Types of capitalization include overcapitalization, undercapitalization, and watered capitalization.

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ally jumanne
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INTRODUCTION

Financial planning and decision play a major role in the field of financial management
which consists of the major area of financial management such as, capitalization, financial
structure, capital structure, leverage and financial forecasting.
Financial planning includes the following important parts:
● Estimating the amount of capital to be raised.

● Determining the form and proportionate amount of securities.

● Formulating policies to manage the financial plan.

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.
The capital requirements of the business concern may be classified into two categories:
(a) Fixed capital
(b) Working capital.
Fixed Capital
Fixed capital is the capital, which is needed for meeting the permanent or long-term purpose
of the business concern. Fixed capital is required mainly for the purpose of meeting capital
expenditure of the business concern and it is used over a long period. It is the amount
invested in various fixed or permanent assets, which are necessary for a business concern.

Definition of Fixed Capital


According to the definition of Hoagland, “Fixed capital is comparatively easily defined to
include land, building, machinery and other assets having a relatively permanent existence”.
42 Financial Management

Character of Fixed Capital


● Fixed capital is used to acquire the fixed assets of the business concern.
● Fixed capital meets the capital expenditure of the business concern.
● Fixed capital normally consists of long period.
● Fixed capital expenditure is of nonrecurring nature.
● Fixed capital can be raised only with the help of long-term sources of finance.
Working Capital
Working capital is the capital which is needed to meet the day-to-day transaction of the
business concern. It may cross working capital and net working capital. Normally working
capital consists of various compositions of current assets such as inventories, bills, receivable,
debtors, cash, and bank balance and prepaid expenses.
According to the definition of Bonneville, “any acquisition of funds which increases
the current assets increase the Working Capital also for they are one and the same”.
Working capital is needed to meet the following purpose:
● Purchase of raw material

● Payment of wages to workers

● Payment of day-to-day expenses

● Maintenance expenditure etc.

Working Capital

Capital Fixed Capital

Fig. 4.1 Position of Capital

CAPITALIZATION
Capitalization is one of the most important parts of financial decision, which is related to the
total amount of capital employed in the business concern.
Understanding the concept of capitalization leads to solve many problems in the field
of financial management. Because there is a confusion among the capital, capitalization
and capital structure.
Meaning of Capitalization
Capitalization refers to the process of determining the quantum of funds that a firm needs
to run its business. Capitalization is only the par value of share capital and debenture and
it does not include reserve and surplus.
Capitalization 43

Definition of Capitalization
Capitalization can be defined by the various financial management experts. Some of the
definitions are mentioned below:
According to Guthman and Dougall, “capitalization is the sum of the par value of
stocks and bonds outstanding”.
“Capitalization is the balance sheet value of stocks and bonds outstands”.
— Bonneville and Dewey
According to Arhur. S. Dewing, “capitalization is the sum total of the par value of all
shares”.

TYPES OF CAPITALIZATION
Capitalization may be classified into the following three important types based on its nature:
• Over Capitalization
• Under Capitalization
• Water Capitalization
Over Capitalization
Over capitalization refers to the company which possesses an excess of capital in relation
to its activity level and requirements. In simple means, over capitalization is more capital
than actually required and the funds are not properly used.
According to Bonneville, Dewey and Kelly, over capitalization means, “when a
business is unable to earn fair rate on its outstanding securities”.
Example
A company is earning a sum of Rs. 50,000 and the rate of return expected is 10%. This
company will be said to be properly capitalized. Suppose the capital investment of the
company is Rs. 60,000, it will be over capitalization to the extent of Rs. 1,00,000. The new
rate of earning would be:
50,000/60,000×100=8.33%
When the company has over capitalization, the rate of earnings will be reduced from
10% to 8.33%.
Causes of Over Capitalization
Over capitalization arise due to the following important causes:
• Over issue of capital by the company.
• Borrowing large amount of capital at a higher rate of interest.
• Providing inadequate depreciation to the fixed assets.
44 Financial Management

• Excessive payment for acquisition of goodwill.


• High rate of taxation.
• Under estimation of capitalization rate.
Effects of Over Capitalization
Over capitalization leads to the following important effects:
• Reduce the rate of earning capacity of the shares.
• Difficulties in obtaining necessary capital to the business concern.
• It leads to fall in the market price of the shares.
• It creates problems on re-organization.
• It leads under or misutilisation of available resources.
Remedies for Over Capitalization
Over capitalization can be reduced with the help of effective management and systematic
design of the capital structure. The following are the major steps to reduce over capitalization.
• Efficient management can reduce over capitalization.
• Redemption of preference share capital which consists of high rate of dividend.
• Reorganization of equity share capital.
• Reduction of debt capital.
Under Capitalization
Under capitalization is the opposite concept of over capitalization and it will occur when
the company’s actual capitalization is lower than the capitalization as warranted by its
earning capacity. Under capitalization is not the so called inadequate capital.
Under capitalization can be defined by Gerstenberg, “a corporation may be under
capitalized when the rate of profit is exceptionally high in the same industry”.
Hoagland defined under capitalization as “an excess of true assets value over the
aggregate of stocks and bonds outstanding”.
Causes of Under Capitalization
Under capitalization arises due to the following important causes:
• Under estimation of capital requirements.
• Under estimation of initial and future earnings.
• Maintaining high standards of efficiency.
• Conservative dividend policy.
• Desire of control and trading on equity.
Effects of Under Capitalization
Under Capitalization leads certain effects in the company and its shareholders.
• It leads to manipulate the market value of shares.
• It increases the marketability of the shares.
Capitalization 45

• It may lead to more government control and higher taxation.


• Consumers feel that they are exploited by the company.
• It leads to high competition.
Remedies of Under Capitalization
Under Capitalization may be corrected by taking the following remedial measures:
1. Under capitalization can be compensated with the help of fresh issue of shares.
2. Increasing the par value of share may help to reduce under capitalization.
3. Under capitalization may be corrected by the issue of bonus shares to the existing
shareholders.
4. Reducing the dividend per share by way of splitting up of shares.
Watered Capitalization
If the stock or capital of the company is not mentioned by assets of equivalent value, it is
called as watered stock. In simple words, watered capital means that the realizable value of
assets of the company is less than its book value.
According to Hoagland’s definition, “A stock is said to be watered when its true value
is less than its book value.”
Causes of Watered Capital
Generally watered capital arises at the time of incorporation of a company but it also arises
during the life time of the business. The following are the main causes of watered capital:
1. Acquiring the assets of the company at high price.
2. Adopting ineffective depreciation policy.
3. Worthless intangible assets are purchased at higher price.

MODEL QUESTIONS

1. What is capital and define the capital?


2. Explain the types of capital.
3. What is capitalization?
4. What are the kinds of capitalization?
5. Explain the effects of under capitalization.
6. Discuss the causes of over capitalization.

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