(ii) The earnings are not justified by the amount of capitalization. This means that the rate of earnings of the company is less than the fair or normal rate of earnings. This is more likely when corporate and personal assets are commingled when the corporation’s owners defraud creditors, and when adequate records are not kept.
However, this theory can only be applied when the firm’s expected income and capitalisation rate can precisely be estimated. If the payment made to promoters is not according to its earning capacity, the capital of the company will be watered. Similarly, when the assets are transferred by promoters and other sellers to the company at abnormally high prices or the company has some worthless assets, the capital of the company will be watered.
The ordinary meaning of capitalisation in the computation appraisal or estimation of present value. This ‘valuation’ concept underlies the definitions of capitalisation and the emphasis is placed upon the amount of capital. But the term capitalisation has on thrown its previous concept. Companies may also find themselves at risk of becoming overcapitalized when they either mismanage or underutilize the capital they have at their disposal. A company may have large secret reserves due to which its profitability is higher.
(ii) The total par value of all the securities outstanding at a given time plus the valuation of all other long-term obligations. (iii) Determining the composition or proportion of the various securities to be issued. (2) Sometimes, the company pays a higher price to the vendors of the assets transferred i.e. the price which is more than the worth of the assets. Lincoln – “Capitalisation is a word ordinarily used to refer to the sum of the outstanding stocks and funded obligation which may represent wholly fictitious values”. However, it should be noted that in actual practice both reserves and surpluses are frequently used by the companies to meet their long-term requirements.
- The distinction between capital and capitalisation should be clearly understood.
- (5) The company might have followed the lenient dividend policy without bothering much about building up the reserves.
- This means that the rate of earnings of the company is less than the fair or normal rate of earnings.
- For example, if a firm earns a profit of Rs.1 lakh and the expected rate of earnings is 10% the maximum limit of capitalization is Rs .10 lakh (i.e.1 lakh /10%).
- It means that the company will be having watered capital but it will not be overcapitalised.
In real life, it is very difficult to estimate correctly the future earnings as well as to determine the capitalisation rate. According to this theory, the capitalisation of a company depends upon its earnings and the expected fair rate of return on its capital invested. Thus, the value of capitalisation is equal to the capitalised value of the estimated earnings. E.g. If a company is earning a profit of Rs. 50,000 and the normal rate of return applicable for the same industry is 10%, it means that the amount of shares and debentures should be Rs. 5,00,000. If the amount of shares and debentures issued by the company is more than Rs. 500,000, then the company will be said to be overcapitalised.
The sum of amounts of all items to be shown on the assets side of the projected Balance Sheet is taken as the amount of capitalisation. Once the concept of capitalization is explained and made clear, a natural question arises as how to ascertain the required capital for a newly-promoted concern (this is called the amount of Capitalisation). “Capitalization is the balance sheet value of stocks and bonds out stands”. The remedial procedure of over-capitalisation is more difficult and expensive as compared to the remedial procedure of under-capitalisation. (ii) The management may be tempted to build up secret reserves.
Monetary Policy: Definition, Objectives, Features, Limitations
(iv) Loss on speculation, the prices of the shares of an over-capitalised company remain unstable because of speculative dealings in such shares. This malpractice further adds to the losses of the shareholders. It promoters buy assets of lower values at higher prices, they are led to a situation of over-capitalisation because assets of lower value will be shown at higher value in the Balance sheet.
Over-capitalisation affects the company, the shareholders and the society as a whole. The confidence of Investors in an over-capitalised company is injured on account of its reduced earning capacity and the market price of the shares which falls consequently. The real value of the business and its earning capacity reduces with the adverse effect on market value of shares. https://1investing.in/ Credit standing of the company in the market falls down and it is difficult to raise further capital. The temporary means like lower amount of depreciation and maintenance charges are followed to improve the earnings which aggravates the situation further. Low rate of earnings and reduced dividends cause fall in the market value of shares of the over-capitalised company.
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This raising of funds at a lower rate of interest than the earnings of the company eventually leads to under-capitalisation. (4) The company may follow a conservative dividend policy (i.e., moderate rate of dividend) thereby leading to enough funds for business expansion, machinery replacement etc. This will lead to higher rates of earnings and hence under-capitalisation. Over-capitalisation arises when the existing capital of a firm is not effectively utilised with the result that there is a fall in the earning capacity of the company.
Even they will get a lower amount of dividend due to over-capitalization. At the time of promotion companies may spend heavy preliminary expenses such as payment of commission, fees to underwriters, brokers, etc. This exorbitant promotional expense may be a cause of over-capitalization.
Overcapitalization and Undercapitalization: Definition, Theories, Causes, Effects, Remedies
Due to conservative dividend policy a company may have higher accumulated profits as retained earnings. Undercapitalization occurs when a company does not have sufficient capital to conduct normal business operations and pay creditors. This can occur when the company is not generating enough cash flow or is unable to access forms of financing such as debt or equity. A firm should raise long-term funds in a way that it is able to pay interest on borrowed funds and also a fir dividend on equity capital. If a firm is unable to pay interest on borrowed funds and a fir rate of dividend on equity shares out of profit, it is said to be over-capitalized. Under these circumstances, the book value of the corporation will be more than its real value.
Capitalization is a term used in corporate finance to describe the total amount of debt and equity held by a company. As such, it defines the total amount of money that is invested in the company itself. Companies can be either undercapitalized or overcapitalized.
(4) The requirement of funds might not have been properly planned by the company. Actual capital of a company is arrived at by adding the paid up value of the company’s shares and debentures, reserves and other surpluses. While fair capitalisation of a company is arrived at, according to any of the two theories of capitalisation. To determine the amount of capitalisation, a new firm will have to estimate the average annual future over capitalisation and under capitalisation earnings and the normal rate of earnings (also known as capitalisation rate) prevalent in the industry. The cost theory of capitalisation is useful for those firms in which the amount of fixed capital is more and whose earnings are regular, such as construction and public utility concerns. Hence a financial plan is to be prepared for the purpose, explaining the short term and long term needs of finance to the company.
(iv) The workers of the company may be tempted to demand higher wages, bonus and other benefits. (i) All avoidable costs should be avoided e.g., purchase of new vehicles, air-conditioners, sophisticated office furniture etc. (3) Customers may feel that they are being exploited by the company.
Just like overcapitalization, being undercapitalized is not where any company wants to be. When used in this context, the supply of available policies exceeds consumer demand. This situation creates a soft market and causes insurance premiums to decline until the market stabilizes. Policies purchased when premiums are low can reduce an insurance company’s profitability. Assets may be acquired at inflated prices or at a time when the prices were at their peak. In both cases, the real value of the company is below its book value and the earnings are very low.
Understanding Overcapitalization
These assets do not give commensurate returns or contribute to the earning capacity of the firm. For example, if a firm earns a profit of Rs.1 lakh and the expected rate of earnings is 10% the maximum limit of capitalization is Rs .10 lakh (i.e.1 lakh /10%). In case the firm raises Rs.20 lakh, the average earnings shall be 5% i.e., below the expected rate.
However, the financial scholars are not unanimous regarding the concept of capitalisation. As a matter of fact, there are as many definitions as there are writers on the subject. While some have given a very broad interpretation, some others have viewed it in a narrow sense. According to this theory a projected Balance Sheet is prepared.
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