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Cost Theory: Theories of Capitalization: Cost Theory and Earnings Theory of Capitalization!

DRIVE SPRING 2019 PROGRAM MBA SEMESTER II SUBJECT CODE & NAME MBA205 & OPERATIONS RESEARCH BOOK ID B2068 CREDITS 4 MARKS 30(EACH SET)

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302 views2 pages

Cost Theory: Theories of Capitalization: Cost Theory and Earnings Theory of Capitalization!

DRIVE SPRING 2019 PROGRAM MBA SEMESTER II SUBJECT CODE & NAME MBA205 & OPERATIONS RESEARCH BOOK ID B2068 CREDITS 4 MARKS 30(EACH SET)

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Kritika
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© © All Rights Reserved
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DRIVE

SPRING 2019
PROGRAM MASTER OF BUSINESS ADMINISTRATION- MBA
SEMESTER SEMESTER II
SUBJECT CODE & NAME MBA 202 – FINANCIAL MANAGEMENT
BOOK ID B1628
CREDIT 4 CREDITS
MARKS 30 MARKS( EACH SET)

SET -1
Q1. Explain the theories of Capitalisation:

Cost Theory

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 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. In this article we will discuss
various aspects relating to capitalization.

Concept of Capitalization:
Capitalization refers to the valuation of the total business. It is the sum total of owned capital and bor-
rowed 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:

Capitalization = Share Capital + Debenture + Long term borrowing + Reserve + Surplus earnings.
Different authors have defined capitalization in different ways but the theme of those definitions
remains almost same. Some of the important definitions are presented below:
According to Guthmami and Dougall, ‘capitalization is the sum of the par value of the outstanding
stocks and the bonds’.
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’.

b) Earning Theory
Theories of Capitalization: Cost Theory and Earnings Theory of Capitalization!
The problems of determining the amount of capitalisation is necessary both for a newly started
company as well as for an established concern. In case of the new enterprise, the problem is more
severe in so far as it requires the reasonable provision for future as well as for current needs and
there arises the danger of either raising excessive or insufficient capital. But the case is different with
established concerns.

1. The cost theory of capitalisation:


Under this theory, the capitalisation of a company is determined by adding the initial actual expenses
to be incurred in setting up a business enterprise as a going concern. It is aggregate of the cost of
fixed assets (plant, machinery, building, furniture, goodwill, and the like), the amount of working
capital (investments, cash, inventories, receivables) required to run the business, and the cost of
promoting, organising and establishing the business.
2. The earnings theory of capitalisation:
This theory assumes that an enterprise is expected to make profit. According to it, its true value
depends upon the company’s earnings and/or earning capacity. Thus, the capitalisation of the
company or its value is equal to the capitalised value of its estimated earnings. To find out this value,
a company, while estimating its initial capital needs, has to prepare a projected profit and loss account
to complete the picture of earnings or to make a sales forecast.
2A. Explain Zero Coupon Bond.

In India, zero coupon bonds are alternatively known as Deep Discount Bonds (DDBs). These bonds
became very popular in India for over a decade because of issuance of such bonds at regular
intervals by IDBI and ICICI. Zero coupon bonds have no coupon rate, that is, there is no interest to be
paid out. Instead, these bonds are issued at a discount to their face value, and the face value is the
amount payable to the holder of the instrument on maturity. Thus, no interest or any other type of
payment is available to the holder before maturity. Since there is no intermediate payment between
the date of issue and the maturity date, these DDBs are also called zero coupon bonds. The valuation
of DDBs is similar to the ordinary bonds valuation. Since DDB at the time of maturity generates only
one future cash flow, the value of this may be taken as equal to the present value of this future cash
flow discounted at the required rate of return of the investor for the number of years of the life of
DDBs. The value of DDB is calculated as:

= Value of the DDB


FV= Face value of DDB payable at maturity

r= The required rate of return n= Life of the DDB

n= Life of the DDB

2b. Explain the concept of Yield to Maturity

What is Yield to Maturity (YTM)


Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures.
Yield to maturity is considered a long-term bond yield ut it is expressed as an annual rate. In other
words, it is the internal rate of return ( IRR) of an investment in a bond if the investor holds the bond
until maturity, with all payments made as scheduled and reinvested at the same rate.

BREAKING DOWN Yield to Maturity (YTM)


Yield to maturity is similar to current yield, which divides annual cash inflows from a bond by the
market price of that bond to determine how much money one would make by buying a bond and
holding it for one year. Yet, unlike current yield, YTM accounts for the present value of a bond's future
coupon payments. In other words, it factors in the time value of money, whereas a simple current
yield calculation does not. As such, it is often considered a more thorough means of calculating the
return from a bond.

The YTM of a discount bond that does not pay a coupon is a good starting place in order to
understand some of the more complex issues with coupon bonds. The formula to calculate YTM of a
discount bond is as follows

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