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In other words, under the situation of over-capitalization the par value of shares and debentures of the company is more than the true value of its fixed assets. The most important area of financial planning is to determine the right proportion of debt and equity. The objective of a firm is to create value which can be performed through proper mobilization and use of funds. So the right amount of capitalization is the basic objective of a finance manager. Fair capitalization is that situation where the business has employed the correct amount of capital and its earnings are same as the average rate of earnings. A concern is said to be over-capitalized if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures that have been issued.<\/p>\n<\/p>\n
Even they will get a lower amount of dividend due to over-capitalization. The term capitalisation, or the valuation of the capital, includes the capital stock and debt. According to another view it is a word ordinarily used to refer to the sum of the outstanding stocks and funded obligations which may represent wholly fictitious values. Under capitalization is the state of affairs of a business, notably in terms of equity capitalization, where there is an excess surplus of assets over the legal requirement of assets. A situation of over-trading by the company may arise as a result of under-capitalisation, where the company does excessive business than what its finances can allow.<\/p>\n<\/p>\n
The company operates for six years during which it has earned the av\u00aderage profits of Rs. 16,000. If the earnings are capitalised at the rate of 5%, the capitalised value of earnings will be Rs. 3,20,000. It means that the company will be having watered capital but it will not be overcapitalised. Such net capital includes profits or gains earned from the use of capital and not distributed to the shareholders and excludes losses incurred in the business from the use of such capital.<\/p>\n<\/p>\n
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It means excessive dividend payments can also lead to the overcapitalization of a company in the long run. Many businesses acquire excessive equity and debt capital fundings than necessary. It may be due to overestimation of capital project costs or overambitious planning.<\/p>\n<\/p>\n
High rates of taxation may leave little in the hands of the management to provide for depreciation, replacements and dividends. This will adversely affect earnings capacity and thus leads to over-capitalisation. It is also suggested that with a view to improving their earning position over-capitalized concerns should slash down the burden of fixed charges on debt.<\/p>\n<\/p>\n
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Thus, over-capitalisation refers to that state of affairs where earnings of the corporation do not justify the amount of capital invested in the business. In other words, an over-capitalized company earns less than what it should have earned at fair rate of return on its total capital. From the earnings point of view the earnings of an under-capitalized over capitalisation and under capitalisation<\/a> firm is higher than its expected earnings. Equity component of an under\u00adcapitalized firm is less than debt in the capital structure. In an under-capitalized firm a part of fixed assets is financed through short-term funds. From the earnings point of view the earning of an over-capitalized firm must be lower than its expected earnings.<\/p>\n<\/p>\n (v) Because of low earnings, reputation of the company would be lowered. The company might incur heavy preliminary expenses such as purchase of goodwill, patents, etc.; printing of prospectus, underwriting commission, brokerage, etc. Spotify’s operating expenses plunged 16% year over year in the second quarter, reflecting recent layoffs. It announced a 17% staff reduction late last year, a necessary move to bring costs down. Debentures, public deposits and loans taken at higher rates of interest should be prepaid out of accumulated profits or out of fresh borrowings at lower rates of interest, if there are no accumulated profits. An over-capitalised company goes into liquidation unless drastic steps are taken to re-organise the whole capital structure, and re-organisation would itself lead to a lot of problems.<\/p>\n<\/p>\n For example, a company\u2019s earning was estimated at Rs. 10,000 and the industry average rate of return was fixed at 8 percent. 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.<\/p>\n<\/p>\n (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. (a) Under capitalisation leads to unhealthy speculation on the stock exchanges, which affects investment climate adversely. In simple terms, over capitalisation means existence of excess capital as compared to the level of activity and requirements. (ii) The amount of capitalisation arrived at on the basis of earnings can be used as a standard for comparison. Lincoln \u2013 \u201cCapitalisation is a word ordinarily used to refer to the sum of the outstanding stocks and funded obligation which may represent wholly fictitious values\u201d. 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.<\/p>\n<\/p>\n\n