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%. Profits are high in such companies and a part of the profits are plowed back into the business directly or indirectly. The value of assets is shown at a lower price than their real value. It means that there are secret reserves in under-capitalized companies.
- To determine the amount of capitalization, a new firm will have to estimate the average annual future earnings and the normal rate of earnings (also known as capitalization rate) prevalent in the industry.
- An over-capitalised 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.
- It is the desire of every company to have a fairly capitalised situation, i.
- Procurement of funds at high rate of interest will adversely affect the company resulting in over-capitalisation.
- In other words, lower rate of earnings compared to the expected return is explained as over-capitalization.
They link higher profits with higher prices of the products. (v) If a company is earning higher profits, the customers may feel that they are being overcharged by the company. (iv) The shareholders can expect higher dividends regularly. (a) There is an unforeseen increase in earnings of the company. Higher profits earned by the companies give a psychological feeling to the customers that they are being over-charged and hence they develop grouse towards that company.
Effects on Society
The real value of an under-capitalised company is more than its book value. The profits are higher than warranted by the book value of its assets. Such a company can pay a higher rate of dividend and the market value of its shares is much higher than its face value. If future earning is over-estimated, the market value of shares will fall below the purchase price because shareholders will not https://1investing.in/ get what they had been promised by the company. (i) More shares and/or debentures might have been issued, resulting in availability of surplus funds that cannot be profitably employed, but dividend shall have to be paid on such excess capital also. Preference shares carrying high rate of dividend should be redeemed out of retained earnings in order to raise the share of equity shareholders.
What Causes a Company to Become Overcapitalized?
But when boom conditions cease prices of products decline resulting in lower earnings. The original value of assets remains in books while earning capacity dwindles due to depression. Such calculation of capitalisation is useful in case of newly-formed companies as it enables the promoters to know exactly the amount of funds to be raised.
An over-capitalized firm has more equity component than debt in its capital structure and its long-term fund is not optimally deployed on fixed assets. Moreover, a part of current assets of such type of firm is financed through long-term funds. It is an imbalanced condition between par value of capital and true value of fixed assets of a concern. Generally this situation is indicated by earnings of the company and not by the excess of capital. In other words, lower rate of earnings compared to the expected return is explained as over-capitalization.
Stages of Capitalisation
(1) Acquiring of fictitious assets like goodwill at high prices. The company may obtain high degree of efficiency by utilizing its assets optimally and exploring all the opportunities. Employees demand high share in the increased prosperity of the company. Reorganisation of the company by selling shares at a high rate of discount.
As a result, the retained profits of the company may be adversely affected. According to this theory, the amount of capitalisation is equal to the total cost incurred in setting up of a firm as a going concern. Thus the estimation of capital requirements of a newly promoted firm is based on the total initial outlays for setting up of a firm. Over capitalization is a situation when the company raises more capital than required for its level of business activity and requirements. Business activity here represents the routine operations of the business.
Inadequate Provision of Depreciation
Thus, various companies are started with watered capital. (c) Where under capitalisation is due to insufficiency of capital, more shares and debentures may be issued to the public. (c) Since the shares have great value as collateral security, the shareholders are at ease in getting loans against the security of shares of an under capitalized firm. (b) The shareholders also avail capital gains because the market value of firm’s shares increases very rapidly.
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-capitalisation, because liberal dividends are paid at the cost of inadequate provision for depreciation. 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-capitalisation. Thus, we see that as a result of over-capitalisation, the rate of earnings has dropped from 10% to 8⅓%.
In case the actual capitalisation of the company is less than its fair capitalisation, the company is said to be “Under capitalised”. If the earnings are not estimated correctly, the amount of capitalisation would be misleading. (ii) Since some assets are idle or become obsolete, the earning capacity will be severely affected. But still the capitalisation will remain high as it is based on the cost of assets.
This would distribute the earnings over a large number of shares. Thus, at the time of promotion, the company is expected to acquire the assets at a price over capitalisation and under capitalisation which justifies its real worth. If the assets prove to be worthless or are bought at an inflated price, the situation of watered capital may exist.
Boom is a significant factor for making the business enterprises over-capitalised. The newly started concern during the boom period is likely to be capitalised at a high figure because of the rise in general price level and payment of high prices for the property assembled. These newly floated concerns as well as the reorganised and expanded ones find themselves over-capitalised after the boom conditions subside. When a company raises capital well above certain limits, it may become overcapitalized. Again, this isn’t good for the company as its capitalized value is higher than its market worth. The earnings theory of capitalisation recognises the fact that true value of an enterprise depends upon its earning capacity.
Likewise, an over-capitalised company must cut its dead weight before it becomes deep rooted and almost impossible to get rid of. 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. If the earnings are lower than the expected returns, it is overcapitalised.
The amount of Capitalisation is computed by both cost theory and capitalized value of earning theory. However capitalized value of earning theory is considered to be more scientific and modern. One can highlight upon the justification of the amount of capitalization by considering the earning of the concern.