Over capitalisation arises in those cases where the company’s earnings are too low to give a fair return on shares and debentures issued by the company, i.e. the company is not earning adequate return on the assets employed. It is so because the assets employed exceed the actual requirements of the business. For example, if the actual amount of assets needed is Rs. 2,00,000, the rate is10%. But if company raises Rs. 2,40,000. The concern will be over capitalised to the extent of Rs.40,000. If the earnings are Rs. 20,000, the rate of return available to equity shareholders will be 8-1/3%. So the company would be said to be overcapitalised because the rate of return is less than the required rate of return. Overcapitalisation should not be taken as excess of capital. In fact, there may be overcapitalised companies having shortage of funds.
The overcapitalisation appears from the overvaluation of assets in relation to the amount of shares and debentures issued by a company. That is the amount of securities exceeds the value of the assets. Such overvaluation may be caused by a number of factors like:
(i) The enterprise may raise money by issue of shares and debentures than it can probably use.
(ii) If the company borrows a large sum of money and has to pay a rate of interest higher than its earnings.
(iii) When higher amount of goodwill has been paid to the vendor from whom the asset has been purchased.
(iv) The company might have acquired the assets in the boom period when the price of the assets were at the peak. But now they may have fallen to a considerable extent.
(v) The company might have not provided for adequate amount of depreciation and thus having high earnings, so distributing high rate of dividend in the initial period but after some time the company may find it difficult to pay adequate amount of dividend as the actual value of the asset may have been much lower than as shown in the books.
(vi) High rates of taxation may leave little in the hands of the company to pay adequate rate of return to the shareholders.
Due to this over-capitalisation, the company may find itself in certain difficulties like:
(i) The price of its shares in the stock market decline due to lower rate of dividend and higher rate of interest in the market.
(ii) The company may lose its credit-worthiness and hence the company may be required to pay a higher rate of interest to the suppliers of funds.
(iii) Moreover, it will be difficult for the company to raise capital in the market.
(iv) The lower rate of return may induce the company to raise the price of its product if it is operating on monopoly terms in order to have higher margin of profit to pay adequate rate of return.
Remedies for Over Capitalisation
The problem of over capitalisation poses certain problems for a company as well as to the shareholders whose wealth in terms of share market value has gone down. To overcome these problems and difficulties certain measures and steps are to be taken, some of which may be listed as follows :
(i) Reduction of interest on debentures which increases the earnings available to shareholders and thus raising the rate of return.
(ii) Reduction in the number of preference shares.
(iii) Reduction of par value of shares.
(iv) Reduction in the number of equity shares so that the dividend per share may be increased.
(v) Complete reorganisation of the concern in terms of financial needs, sources and allied matters.
So, overcapitalisation is very harmful for the company as well as for the shareholders and for removing this difficulty, the whole thing has to be reorganised.
Under-capitalisation is the reverse of overcapitalisation. It may refer to either the situation where the market value of assets is in excess of the book value of the assets shown in the books of accounts of the company or the company might be earning more rate of return as compared to other norms and paying a higher rate of dividend to its shareholders. In a large well cstablished concern there may be a very large appreciation in the value of assets especially of plant, goodwill and the buildings. This appreciation may not be brought in the books. So under-estimating the value of assets in the books whereas the actual market value is much more than this. In such cases the dividends will be much higher and the market quotation for shares will also be higher than warranted by the book value of the assets.
So, a company is said to be under-capitalised when its actual capitalisation is less than its proper capitalisation as warranted by its earning capacity.
The different causes of under capitalisation are just reverse to those responsible for over- capitalisation, namely:
(i) Under-estimation of earnings.
(ii) Capitalising earnings at a higher rate.
(iii) Conservative dividend policy.
(iv) Maintenance of high efficiency.
(v) Increase in price level and so on.
But this under-capitalisation although good for shareholders is detrimental to the company in the long run. The main consequences of under-capitalisation may be as follows:
- Competition is encouraged by the higher earnings of such companies.
- High dividend rates give an opportunity for workers to ask for increase in wages.
- It may give the consumers a feeling that they are being exploited by the company.
- It may limit the marketability of the shares and thus narrow the market of the shares of the company.
These consequences in the long run will reduce the profit margin of the company and make it equivalent to the earnings of the other similar companies. But to remove this problem, following steps may be taken :
- Splitting-up of shares.
- Increase in par value of shares.
- Issue of Bonus Shares.
- Re-appraisal of assets upward.
One thing should be noted here that sometimes over-capitalisation and under-capitalisation are misunderstood in terms of abundance of capital and shortage of capital, respectively. But in fact this is not so.