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4 views

FM Assignment

Uploaded by

muthyala.reddy
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Capitalization and its significance

The provision of capital for a company, or the conversion of income or assets into capital is
called as capitalization. Capitalization is the total amount of money a company has to run its
business, which comes from two main sources: debt (money borrowed that needs to be paid
back) and equity (money invested by the owners or shareholders). It shows how a company
finances its operations and can affect its ability to grow, its costs, and its overall financial
health.

Significance of Capitalization:
Cost of Capital: Capitalization affects the cost of capital, which is the rate of return required
by investors. A well-structured capitalization can lower the cost of capital, making it easier
for a company to finance growth.

Investment Decisions: Understanding capitalization helps management make informed


decisions about investments, acquisitions and expansions.

Risk Assessment: The level of debt versus equity in a company’s capitalization structure can
indicate its risk profile.

4).Valuation: Capitalization is key factor in determining a company’s market value and can
influence stock prices and investor perceptions.

Theories of Capitalization:

Earnings Theory of Capitalization: The earnings theory recognizes the fact that the true
value 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.

Merits:
Flexibility : The companies can adjust their capital structure(the mix of debt and equity) to
optimize their cost of capital, potentially lowering it.

Focus and profitability: It emphasizes the importance of generating the income, which is
crucial for long-term sustainability and growth.
Leverage benefits: It recognizes that using debt can enhance returns on equity when managed
properly.
Demerits:
Risk of over-leverage : Encouraging high levels of debt can lead to financial distress if the
company’s income does not meet expectations.
Market sensitivity : The theory may not hold in volatile markets where income can fluctuate
significantly, making it less reliable in uncertain economic conditions.
Short-term focus : It may lead to decisions that prioritize short-term income over long-term
stability.

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.

Merits:
Focus on cost efficiency: The theory encourages firms to minimize their cost of capital,
which can lead to more efficient use of resources and improved profitability.
Investment decision guidance: t provides a framework r evaluating investment opportunities.
Projects that offer return greater than the cost of capital are considerable viable, while those
that do not are typically rejected.
Capital structure optimization: This theory helps firms analyse their capital structure to find
the optimal balance that minimizes he overall cost of capital.

Demerits:
Oversimplification: The theory may oversimplify complex financial situations by focusing
primarily on cost, ignoring other factors such as market conditions, competitive landscape,
and operational efficiency.

Static Nature: It assumes that the cost of capital remains constant over time, which may not
be true in dynamic. Markets where interest rates and investor expectations can change
rapidly.

Neglect of Non-Financial Factors: The theory primarily focuses on financial metrics and may
overlook qualitative factors such as management quality, brand strength, and market
positioning that can also impact a firm’s value.

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