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Define capitalisation and its type in financial management.
Capitalisation is combination of owner’s capital and borrowed capital. That means, it tells about total fund invested in a company. Share capitals, debentures, loans etc.
Capitalisation is generally classified as follows −
- Normal capitalisation.
- Over capitalisation.
- Under capitalisation.
In this, profits are not enough to pay interest on debentures and dividends to shareholders over a period of time. That means, amount generated is used to raise capital than required capital, which results decline in rate of returns.
Some of the causes for over capitalisation are as follows −
- High promotion cost.
- Purchase of assets at higher price.
- Liberal dividend policy.
- Over estimation.
- Inadequate provision for depreciation.
Some of the effects of over capitalisation are as follows −
- Company market price will go down.
- Company goodwill also effects.
- Company reputation is also lowered.
- Company shares will not market easily.
- Low earnings.
- Return on capital is low.
Company will earn high profit than estimated, which gives additional funds to the company for expansion in form of profits. Goodwill of the company increases and return of capital increases.
Some of the causes for under capitalisation are mentioned below −
- Low promotion cost.
- Purchase of assets at low cost.
- Conservative dividend policy.
- Maintenance of secret reserves.
- Floatation of company in depression stage.
- Adequate provisions of depreciation.
Some of the effects of under capitalisation are mentioned below −
- Increase in company profits.
- Company market value increases
- Goodwill increases.
- Company reputation increases.
- Unhealthy speculation in stock.
- Shareholders will get high dividends.
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