Capitalisation Bcom Notes
Capitalisation Bcom Notes:- In this post, you will get the notes of B.com 3rd year Financial Management, by reading this post you can score well in the exam, hope that this post has helped you with this post to all your friends and all groups right now I must share it so that every student can read this post and it can also be helped in this post. Capitalisation Bcom Notes Pdf
Broad Interpretation of Capitalisation: Many authors regard Capitalisations as synonymous with financial planning. Broadly speaking, the term ‘Capitalisation’ 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. In this sense, capitalisation includes:
(i) Estimating the total amount of capital to be raised;
(ii) Determining the type of rities to be issued; and
(iii) Determining the composition or proportion of the various securities to be issued.
Narrow Interpretation of Capitalisation: In its narrow sense, the term Capitalisation’ 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.
Capitalisation Bcom Notes Pdf
DEFINITION OF CAPITALISATION
- “Capitalisation means the total accounting value of all the capital regularly employed in the business”.
- “Capitalisation of a corporation comprises the ownership capital and the borrowed capital as represented by long-term indebtedness.”
NEED OF CAPITALISATION
Generally, the problem of capitalisation arises under the following conditions:
- At the time of promotion/incorporation of a company.
- At the time of expansion of an existing company.
- At the time of amalgamation and absorption of two or more companies.
- At the time of re-organisation of capital of a company.
Theories of Capitalisation: There are following two important theories which act as guidelines for determining the amount of capitalisation:
- Cost Theory of Capitalisation: Cost theory of capitalisation considers the amount of capitalisation on the basis of cost of various assets required to set up the organisation.
- Earning Theory of Capitalisation: This theory is based on the fact that the amount of capitalisation is correlated with the amount of earnings. Earnings theory of capitalisation considers the amount of capitalisation on the basis of expected future earnings of the company, by capitalising the future earnings at the appropriate capitalisation rate.
Amount of Capitalisation = [Expected Income x 100 / Current Rate of Capitalisation]
For example, the expected earnings of A Ltd. is 50,000 and current rate of Capitalisation is 10%, then the amount of Capitalisation would be [50,000 x 100 / 100] = 5,00,000.
Capitalisation Bcom Notes Pdf
STAGES OF CAPITALISATION
(A) Over-Capitalisation: When a company has consistently been unable to earn the prevailing rate of return on its capital employed, the situation is termed as over-capitalisation. In simple words, over capitalisation means existence of excess capital as compared to the level of activity and requirements. Some important definitions of over-capitalisation are as follows:
“When a business is unable to earn a fair rate of return on its outstanding securities, it is over capitalised.” -Bonneville and Dewey “Whenever the aggregate of the par-values of stocks and bonds outstanding exceeds the true value of fixed assets, the corporation was said to be over-capitalised.”
TEST OF OVER-CAPITALISATION
One can gain knowledge about over-capitalisation by using any one of the following parameters:
(i) Actual Rate of Earnings < Current Rate of Earnings.
(ii) Real value of the Business < Book value of the Business
(iii) Real value of the Shares < Book value of the Shares
In other words, any of the above relationship shall be prima facie the indicator of over-capitalisation.
Explanation of terms Used:
- Actual Rate of Earnings = [Actual Profit / Capital Employed] × 100
- Current Rate of Earnings = Rate of earnings of companies engaged in the same line of business activity. It is also called normal rate of return.
- Book Value of the Business = Total Assets – Outside Liabilities
- Real Value of the Business = [Average Profit / Current Rate of Return] × 100
- Book Value per share = [Book Value of the Business / No. of Equity Shares]
- Real Value per share = [Real Value of the Business / No. of Equity Shares]
Causes of Over-Capitalisation: 1. Wrong Estimate of Earnings, 2. Under-estimation of the Capitalisation Rate, 3. Over-issue of Capital, 4. High Promotion Expenses, 5. Liberal Dividend Policy, 6. Inadequate Depreciation, 7. Formation of the Company during Inflationary Period, 8. Taxation Policy.
EFFECTS OR EVILS OF OVER-CAPITALISATION
Over-capitalisation affects not only the company and its shareholders but also the society as a whole. The evil effects of over-capitalisation are discussed below:
(A) Effects on the Company: 1. Poor Creditworthiness, 2. Difficulties in Obtaining Capital, 3. Loss of Goodwill, 4. Loss of Market, 5. Liquidation of Company.
(B) Effects on Shareholders: 1. Reduced Dividends, 2. Fall in the Value of Shares, 3. Loss on Re-organisation.
Remedies of Over-Capitalisation: (1) Ploughing Back of Profits, (2) Redemption of High Dividend Preference Shares, (3) Reduction in the Rate of Interest of Debentures, (4) Reduction in Par Value of Shares, (5) Reduction in the number of Shares.
The real value of an under-capitalised company is more than its book value. The profits are higher than warranted by the book value of its assets. Such a company can pay a higher rate of dividend and the market value of its shares is much higher than its face value.
In the words of Gerstenberg, “A company may be under- capitalised when the rate of profits it is making on the total capital is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry, or when it has too little capital with which to conduct its business.”
When the situation of under-capitalisation continues for a longer period, it promotes over-capitalisation.
Test of Under-Capitalisation: The following parameters are used to identify whether there is stage of under-capitalisation or not:
Actual Rate of Earning Current Rate of Earnings
Real Value of the Business Book Value of the Business
Real Value of Shares> Book Value of Shares In other words, any of the above relationship shall be prime facie the indicator of under-capitalisation.
CAUSES OF UNDER-CAPITALISATION
The situation of under-capitalisation may arise due to various reasons as stated below:
- Under-Estimation of Earnings and use of High Rate of Capitalisation
- Promotion During Depression
- Desire of Control and Trading on Equity
- Conservative Dividend Policy
- High Standard of Efficiency
- Under-Estimation of Capital Requirements
Remedy for Under-Capitalisation: (1) Spliting-up of Shares, (2) Issue of Bonus Shares, and (3) Fresh Issue of Shares.
OVER-CAPITALISATION VS. UNDER-CAPITALISATION
Both are harmful for the concern but state of over capitalisation is more injurious and fatal. On the contrary, under capitalisation is some what less injurious and fatal. In other words, both are bad but under-capitalisation is some what less bad. Gerstenberg has said, “As between over and under capitalisation, the later is the lesser evil of the two, but still both should be discouraged and the ideal should be fair capitalisation.” Moreover, fair capitalisation is only ideal, rarely it is found in the practice.
Capitalisation Bcom Notes Pdf
FAIR OR OPTIMUM CAPITALISATION
Every company desires to have a fairly capitalised situation, i.e., neither over-capitalisation nor under-capitalisation. When the amount of capitalisation is the same as warranted by the amount of earnings, it is a case of ‘Fair or Optimum Capitalisation’. Let us explain this fact by taking an example: Suppose the expected earnings of a company is 20,000. In similar companies, 10% is the rate of return on capital employed. In such a case the amount of capitalisation as per expected earnings should be [20,000 × 100 / 10] = ₹ 2,00,000. Only on this amount of capital, the expected earnings can be earned at 10%.
Watered Capital: It is also known as Value-less Capital, liquid capital and Stock Watering. When the amount of share capital of a company is not represented by the same value of assets, rather that value is only shown in books, it is called watered capital. In such situation, the realisable value of the assets is less than their book value. Hoagland says, “A stock is said to be be watered when its true value is less than its book value.”
Illustration 1: (i) The estimated annual income of a limited company is ₹10,00,000 and in the same business, rate of return on capital employed is 10%, find out the amount of capitalisation.
Amount of Capitalisation = [100x Estimated Annual Income / Rate of Return]
= [100 × 10,00,000 / 10] = ₹ 1,00,000,00
(ii) If the market value of shares of a company is 50 and book value of the same shares is 35, what is the stage of capitalisation in the said company?
Since the market value of shares > Book value of the same shares, hence the company is in the stage of under capitalisation.
(iii) If current rate of earning is 12% and annual profits of a company is ₹1,00,000 and its equity share capital is ₹10,00,000 what is the stage of capitalisation in the said company?
Current Rate of Earning = 12%
Actual Rate of Earning = [1,00,000 / 1,0,00,000] x 100 = 10%
Because the current rate of earning 12% > Actual rate of earning 10%, hence the company is in the stage of over capitalisation.
(iv) Annual Earnings ₹60,000, capitalisation Rate = 12.5%, out the amount of capitalisation.
Amount of Capitalisation = [Annual Earning / Capitalisation Rate] x 100
= [60,000 / 12.5] × 100 = ₹ 4,80,000
(v) Average Profit 15,950, Tax Rate 30%, Capitalisation Rate 10%. Find out the amount of capitalisation.
Average Profit after tax = 15,950-(15,950 x 30%) = ₹11,165
Amount of Capitalisation = 11,165 /10 = ₹1,11,650
Capitalisation Bcom Notes Pdf