Capitalization and Theories of Capitalization¶
Introduction¶
The objective of every business is to maximize the value of the business. In this respect, the finance manager, as well as individual investors, want to know the value created by the business. The value of the business relates to the capitalization of the business.
The need for capitalization arises in all the phases of a firm’s business cycle. Virtually capitalization is one of the most important areas of financial management.
Concept of Capitalization¶
Capitalization refers to the valuation of the total business. It is the sum total of owned capital and borrowed capital. Thus it is nothing but the valuation of long-term funds invested in the business. It refers to the way in which its long-term obligations are distributed between different classes of both owners and creditors. In a broader sense it means the total fund invested in the business and includes owner’s funds, borrowed funds, long term loans, any other surplus earning, etc. Symbolically:
Meaning of Capitalization¶
Different authors have defined capitalization in different ways but the theme of those definitions remains almost the same. Some of the important definitions are presented below:
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According to Guthmami and Dougall, ‘capitalization is the sum of the par value of the outstanding stocks and the bonds’.
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In the words of Walker and Baughen, ‘capitalization refers only to long-term debt and capital stock, and short-term creditors do not constitute suppliers of capital, is erroneous. In reality, total capital is furnished by short-term creditors and long-term creditors’.
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Bonneville and Deway define capitalization as ‘the balance sheet values of stocks and bonds outstanding’.
Hence capitalization is the value of securities and may be defined as the par value of various obligations of a firm distributed over various classes of stocks, bonds, debenture, and creditors.
Theories of Capitalization¶
Several theories have been developed to explain and analyze capitalization in greater detail. These theories help in understanding how a company's capital structure and financial decisions impact its overall value. Some prominent theories of capitalization include:
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Net Income Approach: This theory suggests that the total capitalization of a company is determined by its net income and the rate of return required by investors. It emphasizes the relationship between earnings and capitalization.
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Net Operating Income Approach: According to this theory, the overall capitalization of a business is influenced by its net operating income, capitalization rate, and the risk associated with the investment.
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Traditional Approach: The traditional theory of capitalization is centered on the concept of the capitalization rate, which is calculated as the annual return expected by investors divided by the market price of the asset.
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Modigliani and Miller Theorem: This theorem asserts that, under certain assumptions, the value of a firm is not affected by its capital structure, including the mix of debt and equity. It suggests that capitalization is independent of the company's financing decisions.
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Trade-Off Theory: The trade-off theory posits that firms choose their capital structure by balancing the benefits of debt (interest tax shield) against the costs (financial distress and bankruptcy risk). The optimal capitalization is the result of this trade-off.
These theories offer valuable insights into how capitalization is determined and influenced by various financial factors. They provide a framework for financial managers and investors to make informed decisions about a company's capital structure and financing choices.
Understanding capitalization and these theories is essential for effective financial management and investment analysis, as they help stakeholders assess a company's value and its financial decisions' impact on that value.
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