The term capitalisation has been defined by different writers in different ways in different contexts and one finds as many definitions as there are writers on this subject.
Authors like Husband and Dockeray give a broad interpretation to the term and regard the term ‘capitalisation’ and‘financial planning’ as one and the same thing. According to them the term ‘capitalisation’ is exhaustive in its scope and includes not only the determination of amount of capital (quantity aspect) but it also includes the decision regarding type of securities (quality aspect).
The narrow interpretation of the term includes only the quantitative aspect. Even in the narrow sense different authors have attempted to define it in different ways but now the meaning of the term capitalisation is generally understood that‘Capitalisation comprises of a corporation’s ownership and borrowings as represented by its long term indebtedness’.So, capitalisation may be said to be the sum of
- The face value of shares of different kinds.
- The face value of debentures and bonds not yet redeemed.
- Long term debts.
- Surpluses not meant for distribution—whether capital-surplus or revenue-surplus.
The term ‘Capitalisation’ is different from the term ‘share capital’ and ‘capital’ and it can be used only in relation to a joint stock company because it is only a joint stock company which can issue debentures and bonds. The term share capital means only the face value of paid up shares and the term ‘Capital’ includes all loans and surpluses but ‘Capitalisation’ includes only long term loans and surpluses not meant for distribution in addition to share capital.
To solve the problem of determining the amount of capitalisation is necessary both for a newly started enterprise as well as for an established concern. There are two theories of determining the amount of capitalisation, namely, the Cost Theory and the earnings Theory.
The Cost Theory :
In this theory the amount of capitalisation is determined from the summation of a number of capital expenditures required for putting the company as a going concern. In simple words, under the cost theory of capitalisation, a company’s value, worth, or capitalisation is worked out by aggregating the cost of fixed assets, the amount of regular working capital required to run the business, the cost of establishing the business and other costs such as promotion and organisation expenses and to cover possible initial losses.
For example, if investment in fixed assets, current assets, and other items is made to the tune of Rs. 20 lacs, Rs. 5 lacs and Rs. 2 lacs respectively, the total amount of capitalisation would be Rs. 27 lacs. Amount of capitalisation calculated under the cost theory facilitates the calculation of the amount to be raised. But this approach although simple to understand and calculate suffers from certain deficiencies,the main being that there is no provision for contingencies provided for future. Or if some assets lie idle, or are poorly employed, will result in low earning and the company will not be able to pay a fair return on capital invested. The result will be over-capitalisation.
In order to do away with these difficulties and arrive at a proper rate of capitalisation, earnings approach is used.
The Earnings Theory :
Under the earnings theory of capitalisation, two factors are generally taken into account to determine the capitalisation :
(a) What is the expected volume of earnings.
(b) The prevailing rate of return.
For example, if 10% be the rate of return and Rs. one thousand be the expected earnings of a business, the amount of capitalistion would come to Rs. ten thousand in terms of earnings theory. As the earnings theory is based upon two factors—the fair rate of return and the probable future earnings, any mistake in calculation in respect of these two factors would lead to the adoption of wrong amount of capitalisation.
Moreover, the earnings theory is based upon the ‘rate’ by which the earnings are to be capitalised. But this rate is difficult to estimate as it is determined by so many factors. But even then it provides a sound basis of capitalisatlon.