Over-Capitalisation and Under-Capitalisation of a Company | Essay

After reading this essay you will learn about the phenomenon of over and under capitalisation of a company.

Phenomenon of Over-Capitalisation:

This is a business phenomenon where is the company raises more capital than is wanted by the figure of capitalisation of its earning power and as a result of which actual profits are not sufficient enough to pay interests and dividends at proper rates. Suppose a company earns Rs. 1,00,000 with general expectation at 10 per cent, then capitalisation at Rs. 1,00,000 would be normal.

But, if this company raises capital to the extent of say Rs. 15,00,000 then this is over- capitalisation. However, over capitalisation doesn’t quite mean excess of capital but it means ineffective utilization of existing capital resulting in poor efficiency.

This condition occurs when:

(i) Amount of capital invested in business exceeds real value of assets;

(ii) “Rate-of-return” on capital is lower than normal or prevailing rate-of-return in market; and

(iii) business has more net assets then it requires.

In the words of H. Gilbut “When a company has consistently been unable to earn the prevailing rate of return on its outstanding securities (considering the earning of similar companies in same industry and degree of risk involved) it is said to be over-capitalised.”

Causes of Over-Capitalisation:

(i) Raising of more capital than required:

A company may issue more shares and debentures than it can profitably and efficiently utilise. This may be intentional or unintentional in nature.

(ii) Purchase in Boom Period:

If company is floated and hence assets etc. are purchased in boom period, the price paid is naturally high. The assets in such period are bought at inflated prices but these extra prices can’t increase its earnings accordingly and hence company becomes over-capitalised.

(iii) Lack of Capital:

If a company borrows a large sum of money and hence has to pay a rate of interest higher than its rate of earning, a major part of earnings may be given away to creditors’ as interests etc. leaving little for shareholders. The rate of dividend is thus, lowered and the market value of shares also declines.

(iv) Dividend Policy:

If dividend policy is very liberal and higher rates of interests are given to debenture holder, there may be a situation where due to these stipulated payments, there is fall in profits and hence, the company becomes over capitalised.

(v) High Promotional Costs:

It may be that at time of floatation, high prices are paid for patents, goodwill and preliminary expenses as promoters, fees, brokerage etc. These expenses may be unproductive and hence hardly increase company’s earning capacity. Thus, the earnings do not justify capitalisation.

(vi) Inadequate Provisions of Depreciation:

If provisions are not maintained, and book value of assets is high while real value is very low, the efficiency of company is adversely affected and its earnings go down thus bringing down market value of shares. This is yet another case of over-capitalisation.

(vii) High Rates of Taxation:

This may leave little in hands of company to provide for depreciation and replacements and dividends to shareholders. This may adversely effect its earning capacity and lead to over capitalisation.

Evils of Over-Capitalisation:

It has evil consequences from point of view of company, society and the shareholders.

Let’s discuss them one by one:

(A) From company, point of view:

(i) The rate of dividend on the equity shares issued declines.

(ii) The reduction in dividend leads to fall in market value of shares as investors lose faith in the company.

(iii) Since earnings are decreasing, company cuts down expenditure on maintenance, etc.

(iv) Companies in order to share normal profits may resort to window dressing and other manipulations.

(v) The reputation of company is adversely affected.

(vi) It becomes difficult for such companies to raise loans.

(vii) It becomes hard to find required personnel due to the tarnished reputation.

(viii) Many times such organisations have to go into liquidation unless drastic steps are taken to re-consolidate the position of company in market.

(B) From shareholders, point of view:

(i) The dividends received by them reduce.

(ii) Market value of their investments fall.

(iii) Many times even dividends or their income become uncertain and irregular.

(iv) If company is liquidated, they may lose their entire investment.

(v) The shares of such companies have relatively small value as security for loans which shareholder may like to raise.

(vi)The low priced shares are subject to speculative gambling. This reduces the interest of real investors.

(C) From society’s point of view:

(i) It results in misapplication and under-utilization of society’s valuable resources.

(ii) An over-capitalised concern is compelled to raise the prices of its products whereas the quality keeps on deteriorating due to low efficiency.

(iii) Such concerns may be shut down leading to large-scale unemployment.

(iv) Such concerns may try to raise its profits by effecting cuts on wages of workers which may affect industrial relations.

Phenomenon of Under Capitalisation:

Under-capitalisation is just the reverse of over-capitalisation. Sometimes a company may have insufficient capital but may have large secret reserves. Many times value of a few assets such as buildings, plants etc. are appreciated but their appreciated values are not brought into the books.

Nevertheless, these assets do bring profits. Therefore, the profits in such a company would appear to be much larger than are warranted by the book figures of the capital.

In such a case, dividends will be higher than the par value of shares of other similar companies. It is in this case that an under-capitalised company pays high rates of dividend and value of the shares is higher than the par values. A company is under capitalised when its actual capitalisation is lower than its proper capitalisation as warranted by its earning capacity.

Suppose a company has capitalisation of Rs. 10,00,000 and prevailing rate of return in industry is say 10 per cent. Thus, its profits must be 1,00,000 but if it earns 150,000, than the company is said to be under-capitalised.

This occurs when:

(i) Rate of return on capital is artificially changed or is more than the market rate.

(ii) The future earnings are underestimated.

(iii) Unforeseen increase in earnings later on.

This however doesn’t mean that capital is inadequate but the earnings are out-of-time with market or the reverse of over-capitalisation occurs.

Causes of Under-Capitalisation:

1. Conservative Dividend Policy:

The company might not distribute profits as dividends among its owners but may plough back profits by creation of various secret reserves, This results in higher earning on capital employed and hence under-capitalisation.

2. Purchase in Depression Period:

If company is floated in depression period, the prices paid for the purchase of various assets are naturally low due to the fact that the prices are deflated due to market conditions. These decreased prices do not decrease earnings and hence the company becomes under-capitalised.

3. Low Promotional Costs:

At the time of floatation, it may be that low price is paid through bargain for goodwill and preliminary expenses which hardly bring down company’s efficiency. Thus the earnings exceed the capitalisation’s justification and hence company becomes under-capitalised.

4. Underestimation of Earnings:

Capitalisation is based on earnings estimated. If the estimation is lower than the actual earnings, this may lead to a capitalisation figure which is lower than the profits or earnings later on. This is nothing but stage of under-capitalisation.

5. High Efficiency:

If the company and its hired personnel are very efficient in their work i.e., produce maximum with minimum resources, wastage of resources is nil or very low which may be even due to improved technology and higher level of vigilance, experimentation and innovation, the productivity and hence profitability is high leading to under-capitalisation.

Effects of Under-Capitalisation:

(A) On Company:

(i) Secret reserves are built up.

(ii) The employees may demand for higher salaries and wages leading to dissatisfaction and labour tensions.

(iii) Market value of shares rises.

(iv) Government may try and interfere in internal affairs in form of higher taxes.

(v) The high rate of earnings may encourage outsiders to enter the field and increase competition.

(B) On Society:

(i) Higher prices of shares may lead to more speculative activities and investment is endangered.

(ii) Since profits are high, consumers may feel exploited.

(iii) The top level management may manipulate with share prices leading to insecurity of investments.

Under-capitalisation is not a permanent phenomenon but is very short-lived and temporary in nature, which ends up automatically. Higher earnings attracts Government intervention and competition leading to downfall in profits.

Over­-capitalisation on the other hand is a very serious problem which highlights the inefficiency of company and of society valuable resources. The only thing which can be suggested to end over-capitalisation is reorganisation of capitalisation.

Though both under-and over-capitalisation have drastic evils, but the evils are more in over-capitalisation. Thus, goal of every company should be “proper” or “fair” capitalisation i.e., capitalisation related to normal earning capacity in an industry for firms of certain size.