August 21, 2019

The theories of capitalisation: The Cost Theory and The Earnings Theory

The theories of capitalisation are:

  1. The cost theory
  2. The earnings theory

The Cost Theory

  • According to this theory, the amount of capitalisation 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.
  • This calculation of capitalisation is useful in case of newly formed companies as it enables the promoters to know exactly the amount of funds to be raised.
  • This theory is not totally satisfactory as it ignores the earning capacity of the business.
  • The amount of capitalisation 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

  • Recognises the fact that true value of an enterprise depends up on its earning capacity.
  • According to this theory, the capitalisation of a company depends upon its earnings and the expected fair rate of return on its capital invested. Thus the value of capitalisation is equal to the capitalised value of the estimated earnings.
  • For example, If a company is making a profit of Rs. 2,00,000/- per annum and the fair rate of return is 10%. The capitalisation of the company will be (2,00,000×10/100) = Rs. 20,00,000/-
  • This theory seems to be logical because it correlates the value of a firm or the amount of capitalisation directly with its earning capacity.
  • This theory can only be applied when the firm’s expected income and capitalisation rate can precisely be estimated.

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