OVER-CAPITALISATION

Over-capitalization refers to that state of affairs where earnings of a

company do not justify the amount of capital invested in its business.
According to Gerstenberg, “A company is over-capitalized when its
earnings are not large enough to yield a fair return on the amount of stock and
bonds that have been issued, or when the amount of securities outstanding
exceeds the current value of the assets”.
In the words of Bonneville, Dewey and Kelly, “When a business is
unable to earn fair rate on its outstanding securities, it is over-capitalized.”
Over-capitalization means more capital than actually required, and
therefore, in an over capitalized concern, the invested funds are not properly
used.
In terms of earnings, over-capitalization arises when the earnings of the
company are not sufficient to give a normal return on capital employed by it.
Let us take an example.
Suppose, a company earns Rs,5,00,000 and the normal rate of return
expected is 10% then capitalization at Rs. 50,00,000 would be (5,00,000 ×
100/10) = (Rs. 50,00,000) a fairly capitalized situation. But suppose, the capital
employed by this company is Rs. 60,00,000.
Then we will say that the company is over-capitalized to the extent of Rs.
10,00,000. The new rate of earnings in this company now would be
(5,00,000/60,00,000 × 100) = Rs. 8⅓%.Thus, we see that as a result of over-
capitalization, the rate of earnings has dropped from 10% to 8⅓%. Therefore,
we can say that the test of over—capitalization is the lower rate of return on
capital over a long-term.
On the other hand, over-capitalization may occur when the amount of
shares debentures, public deposits and loans exceed the current value of the
assets.
This may be due to:
(1) Acquiring of fictitious assets like goodwill at high prices.
(2) Acquiring assets during inflationary period.
(3) Showing assets at increased value due to lack of proper depreciation policy.
 Thus, the entire concept of over-capitalization can be summarized in the
words of Harold Gilbert as: “When a company has consistently been unable to
earn the prevailing rate of return on its outstanding securities (considering the
earnings of similar companies in the same industry and the degree of risk
involved) it is said to be over-capitalized.”
Causes of Over-Capitalization:
There are many factors which account for the situation of over-capitalization of
a company.
Following are some of the important causes of over-capitalization:
 Over-issue of capital: Sometimes, while floating a new company, the
promoters over-estimate the financial requirements, and as a result, they
raise more capital than what is actually needed, resulting in over-
capitalization.
 Promotion, formation or development during inflation: If a company
is to be floated during an inflationary period, or any development activity
is carried out in such a period, it will be a victim of over-capitalization
because it has to spend huge amounts.
 Buying assets of lower value at higher prices: It promoters buy assets
of lower values at higher prices, they are led to a situation of over-
capitalization because assets of lower value will be shown at higher value
in the Balance sheet.
 High Promotion expenses: Incurring high promotional expenses,
excessive preliminary expenses etc. may lead to over-capitalization.
 Inadequate depreciation: Providing inadequate depreciation results in
over-capitalization as it leaves insufficient provision for replacement of
assets.
 Liberal dividend policy: Many companies prefer to declare a higher rate
of dividend instead of retaining a part of the profits and ploughing them
back or reinvesting them. Such a practice should be discouraged as it
leads to over-capitalization, because liberal dividends are paid at the cost
of inadequate provision for depreciation.

 Taxation Policy: High rates of taxation may leave little in the hands of
the management to provide for depreciation, replacements and dividends.
This will adversely affect earnings capacity and thus leads to over-
capitalization.
  Inadequate demand for products: If a company’s products register a
constant decline, it will bring down the profitability of the concern and as
a result, returns on capital employed will be reduced which represents
over-capitalization.
 Payment of high rate of interest: Procurement of funds at high rate of
interest will adversely affect the company resulting in over-capitalization.
 Under-estimation of the capitalization rate: If the rate of capitalization
is under-estimated, it will lead to a situation of over-capitalization.
Effects of Over-Capitalization:
Over-capitalization affects not only the company and its owners
(shareholders) but also the society as a whole. The evil effects of over-
capitalization are discussed below:
Effects on the Company:
Loss of goodwill: In an over-capitalized company, there is a reduced earning
capacity resulting in the fall of market price of its shares and thereby shaking up
the investor’s confidence. A company whose shares sell below the face value
may find it difficult to improve its goodwill in the market.
Poor creditworthiness: Reduced earnings of an over-capitalized concern affect
its creditworthiness and as a result, it becomes difficult for it to get loans or
credit at cheaper rates of interest.
Difficulties in obtaining capital: For a company faced with a situation of over-
capitalization, it is very difficult to obtain further capital for its growth and
expansion programmes. It is so because the investors have already lost
confidence in the company.
Decline in efficiency of the company: To cover for one loss, other losses are
incurred by the company and in the process overall efficiency of the company
declines. Such a company usually does not make adequate provisions for
depreciation, repairs and renewals, etc., leading to further decline in its
efficiency.
Loss of market: Over-Capitalized companies fail to produce goods at
competitive costs and, hence, often lose their market to competitors.

Inflated profit: In order to regain the confidence of its investors, over-

capitalized companies generally resort to manipulation of accounts and over-
statement of their profits. These inflated profits lead to payments of dividends
out of capital.
Liquidation of company: An over-capitalized company goes into liquidation
unless drastic steps are taken to re-organize the whole capital structure, and re-
organization would itself lead to a lot of problems.
Effects on Shareholders:

As, shareholders are the real owners of a company, they suffer most on account
of over-capitalization.
Reduced dividends: An over-capitalized company will not be able to pay a fair
rate of dividend to its shareholders because it is earning a low rate of return
(earnings) on its capital. The payment of dividend becomes uncertain and
irregular.
Fall in the value of share: Low rate of earnings and reduced dividends cause
fall in the market value of shares of the over-capitalized company. Thus,
shareholders have to suffer a loss in capital due to depreciation of their
investments.
Unacceptable as collateral security: The shares of an over-capitalized
company have small value as collateral security. Banks and other financial
institutions are reluctant to lend money against such securities. Hence, it is very
difficult for the shareholders to borrow money against the security of their
shares.
Loss on speculation: the prices of the shares of an over-capitalized company
remain unstable because of speculative dealings in such shares. This
malpractice further adds to the losses of the shareholders.
Loss on re-organization. An over-capitalized company has to often resort to
reorganization and reduction of its capital in order to write off the accumulated
losses. This results in the reduction of face value of shares and loss to its
owners.

Effects on Society:
Over-capitalization affects not only the company and its owners but also the
society as a whole.
Loss to Consumers:In order to prevent declining trend of income, an over-
capitalized concern resorts to increased prices and reduction in quality of its
products.. Hence, consumers have to suffer by paying more for the poorer
quality.

Loss to Workers:An over-capitalized company tends to reduce wages and

welfare facilities of the workers to reduce losses of the earnings. No
consideration is given to the demands of the workers and some of them even
lose their jobs because of layoffs and retrenchment and closure of such units.
Under or misutilization of Resources:An over-capitalized concern either
misutilises or under utilizes its resources. Hence, the scarce resources of society
are not properly utilized.
Gambling in Shares:Another social evil of over-capitalization is promotion of
gambling habits by providing scope for gambling in shares of such a company.
Recession:Over-capitalization leads to increased losses, poor quality of
products, retrenchment or unemployment of workers, decline in wage rates and
purchasing power of labour. This tendency gradually affects the entire industry
and the society, and may lead to recession of economy.

Remedies for Over-Capitalization:

The evil effects of over-capitalization are so grave that the management must
take remedial measures to rectify the situation as soon as the first symptoms of
over-capitalization are observed by the firm. An over-capitalized company has
been rightly compared with a very fat person who is likely to suffer from
various diseases unless he takes steps to immediately reduce his weight.

Likewise, an over-capitalized company must cut its dead weight before it

becomes deep rooted and almost impossible to get rid of. In this regard, various
remedial measures such as increasing the efficiency of management, reduction
of high interest bearing funded debt, redemption of preference shares, reduction
in face value and number of shares, etc., have been suggested.
To have Efficient Management:Management should try to become more
efficient and try to curb excess expenditure. Earning capacity should be
improved and care must be taken to spend every single rupee in the most
profitable and economic manner.
Redemption of Preference Shares:Preference shares carrying high rate of
dividend should be redeemed out of retained earnings in order to raise the share
of equity shareholders.
Reduction of Funded Debts:Debentures, public deposits and loans taken at
higher rates of interest should be prepaid out of accumulated profits or out of
fresh borrowings at lower rates of interest, if there are no accumulated profits.
Reorganization of Equity Share Capital:The face value or the number of
equity shares may be reduced in order to rectify over-capitalization. Sometimes,
shareholders may oppose to this proposal but actually their proportionate
interest in the equity is not reduced. The amount available due to reorganization
of share capital is utilized for writing off the fictitious assets and other over-
valued assets.
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What do you mean by the term Over-capitalization?/Under-capitalisation

What are causes of over-capitalization?/under-capitalisation
Define Over-capitalization/under-capitalisation. Discuss the effects and
remedies for over-capitalization./under-capitalisation.

UNDERCAPITALIZATION
 Under-capitalization is just the reverse of over-capitalization. A company
is considered to be under-capitalized when its actual capitalization is lower than
its proper capitalization as warranted by its earning capacity.
Generally under-capitalization denotes the inadequacy of capital; i.e., the
shortage of capital. It is a condition when the real value of the company based
on its earnings is more than the book value. A company is said to be under-
capitalized when its actual capitalization is lower than its proper capitalization
as warranted by its earning capacity.
In the words of Hoagland, “Under-capitalization is an excess of true
asset values over the aggregate -of stocks and bonds outstanding.
In the words of Charles W. Gerstenberg, “A corporation may be
undercapitalized when the rate of profits it is making on the total capital is
exceptionally high in relation to the return enjoyed by similarly situated
companies in the same industry, or when it has too little capital with which to
conduct its business.”
In short, under-capitalization is a state of affairs when the actual capital is
short of the requirements of the company.

Causes of under- capitalization:

 Under estimation of future earnings of the time of promotion of the
company.
 Abnormal increase in earnings from new economic and business
environment.
 Under estimation of total funds requirements.
 Maintaining very high efficiency through improved means of production
of goods or rendering of services.
 Companies which are set up during recession start making higher earning
capacity as soon as the recession is over.
 Use of low capitalized rate.
 Companies which follow conservative dividend policy will achieve a
process of gradually rising profits.
 Purchase of assets at exceptionally low prices during recession.

Merits of Under-capitalization:
The main advantages/ merits of under-capitalization are
  Creation of secret reserves;
 Higher rate of dividend;
 Rapid increase in the prices of shares in the stock exchange;
 Symptom of economic prosperity of the company;
 Increase in the rate of profits of the company; and
 Shares can be sold easily.

Demerits of Under-capitalization:
The evils of under capitalization are-
 Wide fluctuation in the prices of shares etc.,
 Increase in competition,
 Increase in speculative activities,
 Increase in opportunities for manipulation by management,
 Industrial relations tend to be strained,
 Dissatisfaction amongst consumers, they feel they are being exploited by
the company,
 Increase in the tax burden of the company,
 Increased Government interference etc.

Remedies of undercapitalization:
 Splitting up of the shares – This will reduce the dividend per share
 Issue of bonus share: this will reduce both the dividend per share and
earning per share.
 Both over-capitalization and under – capitalization are detrimental to the
interests of the society.

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