When a company follows a liberal dividend policy; it does not have many earnings left for reinvestment purposes. This hampers growth of the company; leading to a gradual but permanent decline in its earning capacity and producing over-capitalisation. Higher taxation rates may consume a large portion of earnings and, in this way, deprive shareholders of a dividend at a fair rate.
But when the boom conditions subside and recessionary conditions set in, the real value of the company’s assets fall whereas the book value of its assets remain at a, higher level. In finance, capitalization in finance is the sum of a company’s debt and equity. It represents the capital invested in the company, including bonds and stocks. Market capitalization is the value of a company’s outstanding shares of stock. Overcapitalization occurs when a company has issued more in debt and equity than its assets are worth.
Types of Capitalization: Over and Under Capitalization | Financial Management
In such a situation, a large part of the company’s income will be used to write off these expenses, as a result of which the company will not be able to pay dividend on its shares at a reasonable rate. Such a company will be said to be overcapitalized because due to recession its income earning capacity will decrease but the assets and capital will be shown in the books at their old values only. If a company has been promoted by purchasing assets at a higher price. So such a company will become a victim of over-capitalization. This is because such values of assets have no relation to their profit earning power.
- To find out whether the company is earning a reasonable rate of return or not.
- According to some scholars, when par value of shares of company is higher than the market value, the company would be in state of over-capitalisation.
- Thus, an enterprise is said to be over-capitalised when its earnings are not large enough to yield a fair return on its capital employed, i.e., on the amounts of shares and bonds.
Besides, limited the causes of over capitalisation are of the society are not utilised properly since, under conditions of over-capitalisation, the company is unable to make the best use of capital. When a company sells its shares at less than their nominal value, i.e., less than at par, it suffers from poor credit-worthiness. Naturally, it becomes very difficult for the company to raise funds by further issue of shares as and when necessary. If a company is floated under the conditions of inflation, it requires a large fund for acquiring its necessary assets.
In common practice, capitalization refers to the total amount of capital employed in a business. Broadly speaking, capitalisation refers to the act of deciding in advance the quantum of fund requirements of a firm, its patterns and administration of capital in the interest of the firm. Now, in the company, earnings are done only with Rs. 15, 00,000; whereas the earnings of the company have to be distributed over a capitalisation of Rs. 25, 00,000. Naturally, there is a considerable decline in the rate of equity dividend after having paid interest on debentures, income- tax and preference dividend. To ascertain whether a company is earning reasonable rate of return or not, a comparison of the company’s rate of earnings should be made with earning rate of the like concerns.
If the company’s rate of return is less than the average rate of return, it is indicative of the fact that the company is not able to earn fair rate of return on its capital. Insufficient provision for depreciation consumes unnecessary profits and reduces the overall earning capacity of the company. There can be several factors that may cause a company to become overcapitalized. Some of the key factors include poor accounting records, miscalculation of capital needs, abuse by management of shareholders’ funds, and poor financial analysis. Overcapitalization may result in a decline in the earnings capacity of the company which may consequently lead to fewer profits & lesser dividends.
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The total amount of equity share capital of the company is Rs. 18 lakhs and total assets amount to Rs. 30 lakhs. Investors expect 12% return on their investment in shares. Since profit of over-capitalized concerns might be extremely low, it would be necessary for them to go to stock market for sale of their securities. Overcapitalization happens when a company’s debt and equity values are higher than those of its total assets. This means that its market value is less than its capitalized value. Companies that are overcapitalized may have trouble getting more financing or may be subject to higher interest rates.
Definitions of Over – Capitalisation
If a company borrows large amount of capital at higher rate of interest than the rate of its earnings to meet its emergent needs, the company would be ultimately over-capitalised. Since a major part of its earnings is taken away by the creditors as interest, the rate of dividend would naturally fall, and the market value of shares would decline. Thus, lower market price of shares than the book value would make the company over-capitalised. Because of a fall on dividends, the shareholders/owners lose heavily.
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Liberal payment of dividend as well as higher rates of taxation may lead to overcapitalisation. They should be capitalised and they will also be a part of cost bearing capital. It will bring down the dividend at a reasonable level. Customers are under impression that they are being overcharged and so they compel the company to reduce the prices of the goods.
Because of under-estimation of financial requirements a firm may be capitalized at low level. This may cause serious problem to the firm subsequently when it experiences shortage of funds to meet emergent requirements compelling the firm to procure necessary funds at unreasonably high rate of interest. Here’s a hypothetical example to show how overcapitalization works. Assume that construction firm Company ABC earns $200,000 and has a required rate of return of 20%. The fairly capitalized capital is $1,000,000 or $200,000 ÷ 20%.
Difference between Overcapitalization and OverTrading
The excess issue of capital cannot be protitably employed in the business. An unsatisfactory rate of return on the equity leads to a poor market value of the company’s shares. There is thus, considerable loss of goodwill to the company.
Market value of company’s share falls, and company loses investors confidence. Company may collapse at any time because of anemic financial conditions – it will affect its employees, society, consumers and its shareholders. Liberal dividend policy may also contribute to over-capitalization of a company. Companies following too liberal dividend policy continuously for long period of time shall be definitely deprived of the benefits of retained earnings. Thus, in the first instance such companies fail to build up sufficient funds to replace old and worn-out assets and consequently, their operating efficiency suffers.
Obviously, there is over-capitalisation in the company to the extent of Rs. 25,000. The phrase ‘over-capitalisation’ has been misunderstood with abundance of capital. In actual practice, overcapitalized concerns have been found short of funds. Truly speaking, over- capitalisation is a relative term used to denote that the firm in question is not earning reasonable income on its funds. Over-capitalisation has nothing to do with redundance of capital in an enterprise. On the other hand, there is a greater possibility that the over-capitalised concern will be short of capital.
The par value and/or number of equity shares may be reduced. The profits of an over-capitalised company would show a declining trend. Such a company may resort to tactics like increase in product price or lowering of product quality.
However, this might also not prove more meaningful because large amount of funds would be needed to redeem the preferred stock, raising of which would increase the amount of capitalisation instead of reducing it. Taxation policy of the Government may also be responsible for company’s over-capitalisation. Due to negative taxation policy firms tax liability increases and is left with small residual income for dividend distribution and retention purposes.
Further, the owners are not in a position to dispose of their shares at profitable prices due to fall in the market value of their shares. Thus, the owners are the biggest losers in case of over-capitalisation of an enterprise. In order to decrease the rate of earnings per share, the directors of the company take the decision regarding splitting up of shares.
Banks and other https://1investing.in/ 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. Providing inadequate depreciation results in over-capitalisation as it leaves insufficient provision for replacement of assets. In terms of earnings, over-capitalisation arises when the earnings of the company are not sufficient to give a normal return on capital employed by it.
Consequently, the working efficiency of the company will be decreased, and the prices of its shares will fall. Even if the earnings are correctly estimated but the rate of capitalisation is under-estimated, the company would be over-capitalised. Under estimation of the rate of capitalisation results in raising excessive capital than what the company could utilise profitably. Consequently, the company is unable to distribute dividends at prevailing rates. The leads to decline the market value of its shares which a symptom of over-capitalisation. This situation will normally arise when a company raises more capital than what is justified by its actual earnings.
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-capitalisation because it has to spend huge amounts. Showing assets at increased value due to lack of proper depreciation policy. As a result of over-trading, creditors will not be paid timely and the company will effect its creditworthiness adversely. Effects of over-capitalisation are so grave that the management should take immediate measures to remedy the situation of over-capitalisation as soon as the symptoms of the over-capitalisation are observed.