Skip to content

Theories of Capitalization

In the context of capitalization, there are two popular theories: Cost Theory and Earning Theory.

Cost Theory

This theory focuses on the cost of acquiring assets as the basis for determining capitalization. Under the Cost Theory, the total value of capitalization is the sum total of the costs incurred in acquiring both fixed and current assets. This theory includes the costs associated with the issuance of shares and other securities in the capitalization calculation. Therefore, capitalization under the Cost Theory comprises the following components:

  • Land and building
  • Plant and machinery
  • Other fixed assets
  • Stock of raw materials
  • Debtors and other current assets
  • Preliminary expenses

The Cost Theory is particularly useful for new firms as it assists in determining the total capital required to establish the business. However, it has certain limitations:

  1. It emphasizes only the cost aspect of assets and does not consider their productive capacity.
  2. It does not account for the potential obsolescence of assets.
  3. For firms with fluctuating earnings, the theory may lose relevance.

Earning Theory

The Earning Theory, on the other hand, considers the earning capacity of the business as the foundation for capitalization. According to this theory, the capitalized value of a firm's earnings determines its capitalization. The rate of capitalization is typically derived from the industry's representative rate of return.

The formula for calculating capitalization under the Earning Theory is as follows:

Capitalization = (Average Annual Future Earnings / Capitalization Rate) x 100

While the Earning Theory provides a different perspective on capitalization, it also has its limitations:

A. Estimating future earnings, especially for a new company, can be challenging and uncertain. B. The rate used for capitalization may not accurately represent the unique characteristics of the firm. C. Errors made during the estimation of future earnings can lead to inaccurate capitalization values.

These theories offer different approaches to determining capitalization, each with its own set of advantages and drawbacks. The choice between Cost Theory and Earning Theory may depend on the specific circumstances and goals of a business.

🎶
Hide