Theories of Capitalization

Capitalization is the total amount of a company’s long-term financing. Such financing may include retained earnings, preferred and common stock and other forms of long-term debt (bonds and debentures). Capitalization can be distinguished from capital structure. Capital structure is a broad term and it deals with qualitative aspect of finance. While capitalization is a narrow term and it deals with the quantitative aspect.

The two main theories of capitalization which are used to determine the amount of capitalization are as follows:

1. Cost Theory of Capitalization

According to the cost theory of capitalization, the value of a company is arrived at by adding up the cost of fixed assets like plants, machinery patents, etc., the capital regularly required for the continuous operation of the company (working capital), the cost of establishing business and expenses of promotion. The original outlays on all these items become the basis for calculating the capitalization of company. Such calculation of capitalization is useful in so far as it enables the promoters to know the amount of capital to be raised. But it is not wholly satisfactory. On import objection to it is that it is based o a figure (i.e., cost of establishing and starting business) which will not change with variation in the earning capacity of the company. The true value of an enterprise is judged from its earning capacity rather than from the capital invested in it. If, for example, some assets become obsolete and some others remain idle, the earnings and the earning capacity of the concern will naturally fall. But such a fall will not reduce the value of the investment made in the company’s business.

2. Earnings Theory of Capitalization

The earnings theory of capitalization recognizes the fact that the true value (capitalization) of an enterprise depends upon its earnings and earning capacity. According to it, therefore, the value or capitalization of a company is equal to the capitalized value of its estimated earnings. For this purpose a new company has to prepare an estimated profit and loss account. For the first few year of its life, the sales are forecast ad the manager has to depend upon his experience for determining the probable cost. The earnings so estimated may be compared with the actual earnings of similar companies in the industry and the necessary adjustments should be made. Then the promoters will study the rate at which other companies in the same industry similarly situated are earnings. The rate is then applied to the estimated earnings of the company for finding out the capitalization.

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