Financial Management

CAPITALIZATION
Capitalization refers to the process of determination of the equality (amount) of finance
(which type of security is to issued and to what extent).Capitalization is also called as financial
planning. The term capitalization is used only its quantitative aspect and refers to the amount at
which a companys business can be valued.
Capitalization may be said to be composed of:
1. The value of shares of different kinds
2. The value of surplus, whether capital surplus or earned surplus
3. The value of bonds and debentures issued by a company still not redeemed
CAPITAL AND CAPITALIZATION:
The term capitalization is used only in relation to companies and not in respect of firms or sole
proprietor ships. Capitalization includes only long-term loan and retained profits besides the
capital.
Capital refers to the total investment of company in money, tangible assets and intangible assets.
It is in a way the total wealth of the company.
CAPITALIZATION THEORIES: There are two theories discuses about capitalization.
1. Cost Theory: According to this, the value of a company is arrived at by adding up the cost of
fixed assets. The capital regularly required for the continues operation of the company, the cost
of establishing business and expenses of promotion. These items become the basis for calculating
the capitalization of a company.
2. Earning Theory: The value of capitalization of a company is equal to the capitalized value of
its estimated earnings. To take an example, a company may estimate its a average profit in the
first few years at Rs.50, 000. Other companies of the same type are, let us assume, earning a

KECW::NRT

Financial Management
return of 10 percent on their capital. The capitalization of the company will then be
= 50,000 X100/10 =5, 00,000
MEANING AND DEFINITION OF OVER CAPITALIZATION:
Generally over-capitalization implies that the capital of the company exceeds its requirements. A
company is overcapitalized when its earning capacity does not justify the amount of
capitalization.
In other words, a company is said to be overcapitalized when its actual profits are not sufficient
to pay interest (on debentures and borrowings) and dividends (on share capital) at fair rates.
In the words of Beacham, "Overcapitalization occurs when securities in the company are issued
in excess of its capitalized earning power."
In the words of Hoagland, "Whenever the aggregate of the par value of its of stocks and bonds
outstanding exceeds the true value of its assets, the corporation company is said to be
overcapitalized.".
In the words of Charles W. Gerslenberg, "A corporation (company) is overcapitalized when its
earnings are not enough to yield a fair return on the amounts of stocks and bonds that have been
issued or when the amount of securities outstanding exceeds the current value of the assets."
REASONS: The main causes of over-capitalization are (i) Promotion of company with
overvalued assets, (ii) Purchase of assets during boom period, i.e., at higher prices; (iii) High
promotional expenses; (iv) Raising excessive capital, i.e., more capital than what it can
profitably use; (v) Borrowing money at high rates of interest; (vi) Overestimation of earnings:
(vii) Under provision of depreciation; (viii) High rate taxation; (ix) Lack of reserves; (x) Liberal
dividend policy etc.
MERITS/ADVANTAGES:
The main advantages or merits of overcapitalization are:

Increase in the competitive power of the company.

KECW::NRT

Financial Management

Easy expansion of the company's activities.

Morale of the management is raised.

Risk-taking capacity is increased.

No fear of shortage of capital.

Power to face depression period is increased.

DISADVANTAGES OF OVER-CAPITALIZATION:
DISADVANTAGE TO THE COMPANY:
i.

Set back in the Value of Shares and Goodwill Because of decrease of in the earning
capacity of the company, a large majority of investors lose their confidence in the
company. The market value of its shares comes down and the companys financial
stability is jeopardized. It also suffers a set back to its goodwill.

ii.

Set back Obtaining Capital -Because of fall in dividends the investors lose their
confidence in the company resulting in difficulty to obtain the requisite capital for
improvement and acquisition of new assets by issuing shares or debentures.

iii.

Set back in obtaining Loans The credit standing and goodwill of an over-capitalized
company suffers a setback due to falling earnings. Financial institutions hesitate in
providing loans to such a company for its development and expansion programmes.

iv.

Manipulation of Accounts An over Capitalization Company resorts to objectionable

practices including manipulation of accounts in order to cover up the deficiency of the
decreased earnings and to present a respectable figure of profits. It does not make
adequate provisions for depreciation, maintenance, renewal and replacement of asset. It
even declares and pays unearned dividends from capital to revive its decreasing credit
standing. This further aggravates the decreasing value of the company besides misleading
the investors.

KECW::NRT

Financial Management
v.

Demand for Liquidation An over-capitalized company is not able to pay the principle
amount of loan and interest there on. Therefore, the creditors may forcefully demand
liquidation of the company, unless drastic steps are taken to correct the situation.
Reorganization of the companys share capital, is one effective remedy leads to
considerable loss of its goodwill.

vi.

Absence of Competitive strength Due to its failure to produce goods at competitive

cost on accounts and inadequate provision for depreciation, repairs, maintenance and
replacement of assets an over-capitalized company loses its market to competitors. Such a
company is unable to provide facilities to their customers equal to its competitors.
Therefore, it fails to retain its customers and lose the market.

DISADVANTAGES TO SHAREHOLDERS:
i.

Low Dividend The shareholders of an over-capitalized company suffer a revenue loss

due to low return on their investment in the form of low dividends on account of low
earnings of the company.

ii.

Low Market value of Shares The shareholders suffer a capital loss on account of low
market value of shares. They have to sell their share below par, suffering a capital loss
through depreciation of their investments.

iii.

Loss on Re-organization or Liquidation If an over-capitalized company attempts to

overcome its ills by re-organization or liquidation, the shareholders are the worst
sufferers. Re-organization calls for reduction in capital for writing off past losses, leading
the reduction of par value of shares resulting in depreciation of the shareholders
investments. If an over-capitalized company is forced by its creditors to go into
liquidation, the shareholders are the recipients of the residual amount left after the
payments to creditors. Sometimes the shareholders have to forego the entire amount of
their investments in case of liquidation.

iv.

Low Value of Shares as Collateral Securities As the shares of an over-capitalized

company are not easily marketable due to low earnings and lower dividends of the

KECW::NRT

Financial Management
company, they have a lower value as collateral securities. Commercial banks and other
financial institutions are not willing to sanction loans against such securities. Even if they
agree to grant such loans, they insist upon strict terms and conditions hardly acceptable to
an ordinary borrower.
v.

Encouragement to Speculative Gambling As the low-priced shares of an overcapitalized company are subject to speculative gambling, the real investors have to suffer
on account of this manipulation.

DISADVANTAGES TO SOCIETY:
i.

Lower Quality and Higher Prices An over-capitalized company does everything to

increase its earnings. It reduces the quality and increases the price of products. The
ultimate consumers suffer in terms of both quality and price and have to pay high prices
for poor quality products.

ii.

Reduction in Wages and Labour Welfare Activities Over capitalization leads to

retrenchments and reduction in wages and salaries. An over-capitalized company tries to
cut the wages and welfare facilities of the workers creating soreness in industrial
relations. The interest of the workers suffers due to substantial cuts in wages and other
benefits. An over-capitalized company often resorts to retrenchment of the workers on
grounds of low earnings in the company.

iii.

Recession Due to low purchasing power of workers, demand for goods comes down.
As this process continues recessionary conditions are witnessed.

iv.

Unemployment Finding it difficult to survive in the competitive market overcapitalized companies is often forced to close down. The closure of a few overcapitalized companies tends to create panic in general. Industrial activity receives a
setback. The consumers are deprived of goods and services. The creditors lose their
credits. The workers lose their jobs. The society is confronted with a depressing effect in
general.

KECW::NRT

Financial Management
v.

Mis - utilization and Wastage of Resources An over-capitalized company is unable

to effectively utilize the societys resources. Thus over capitalization leads to the wastage
of national resources which could be used most effectively by those efficient companies
who are in need of funds.

vi.

Encouragement of Speculation The shares of an over-capitalized company are

invariably subject to speculative gambling.

vii.

Frustration Among Investors Over-capitalization leads to reduced efficiency and

possibility of failure of the business. Therefore, the investors are not willing to invest in
such a company. The industrial and economic development of the country is adversely
affected.

REMEDIES TO OVER-CAPITALIZATION:
Reduced Funded Debt To control the situation of over-capitalization, a company reduces the
amount of funded debts through outright re-organization. Debentures and bonds are immediately
redeemed out of accumulated earning or new issues. However, as the profits of an overcapitalized company are very low, it is very difficult for it to raise the necessary funds from the
market. If it issue its shares at a discount, it may do more damage to the company. Thus,
reduction in capital may be affected only by retiring the funded debts out of accumulated
earnings.
Reduced Interest Rate in Debentures An over-capitalized company tries to reduce its fixed
obligation with regard to payment of interest on debts. It persuades the existing debenture
holders to accept new debentures carrying lower rates of interest, on some premium for this
concession.
Redemption of Preference Shares The amount of capitalization may be reduced by
redemption of performance shares carrying high rate of dividend. This poses the same problem
as in case of redemption of debentures by issuing new shares at a reduced price. Raising of
necessary funds for redeeming the high dividend preference shares may further aggravate the
situation.

KECW::NRT

Financial Management
Reduced Par Value of Shares The existing shareholders are persuade to accept new shares
with reduced par value. This reduces the amount of capitalization and improves the earning
capacity of the company. However, this is possible only if the management is able to convince
the existing shareholders that reduction in par value of shares is in their interest.
Reduced Number of Shares A company sometimes reduces the number of shares to correct
the situation caused by over-capitalization. The shareholders may be given one share of the same
amount in exchange of several shares. Thus earning per share goes up without affecting the
amount of capitalization. This helps the company in raising the necessary funds for future
development.
Ploughing Back of Profits In the initial stage of over-capitalization, the company may resort
to the ploughing back of profits by suspending the distribution of dividends for a few years. This
increases the amount of its real value without an extra burden on its resources. The management
should make all-out efforts to eliminate wasteful expenditure and to increase the efficiency of the
companys resources.
UNDER CAPITALIZATION:
MEANING OF UNDER CAPITALIZATION:
Under capitalization is the reverse of over-capitalization. A company is under-capitalized when
its earnings are high in relation to other similar firms in the industry, or when it has very little
capital to conduct its business, or when the real value of asset are more than the book value.
Under-capitalization is associated with an effective utilization of investments, an exceptionally
high rate of dividend and prices of shares. It is a condition where the real value of the companys
assets is more than the book value.
DEFINITIONS OF UNDER CAPITALIZATION:
A Corporation is under-capitalized when the rate of profit it is making on the total capital, is
exceedingly high in relation to the return enjoyed by similarly situated companies in the same
industry, or when it has too little capital with which to conduct its business.-C.W. Gerstenberg

KECW::NRT

Financial Management
When a corporation earns exceedingly high income on its capital, it is said to undercapitalized.-Bonnevile and Dewy
When a company is earning considerably more than the prevailing rate on its outstanding
securities, considering the same factors, it is said to be under-capitalized.-G. Harold

Following are the Symptoms of under-capitalization

1. Higher rate of Earning The rate of earning is exceedingly higher than prevailing is
similarly situated companies in the same industry.
2. Higher rate of dividend This is as compared to the rate declared by other similar
companies.
3. Higher Value of Shares The real and market value of shares is higher than their book
value.
4. Higher value of Assets The real value of the companys assets is higher than their book
value.
CAUSES OF UNDER CAPITALIZATION
1. Under Estimation of Earning The amount of capitalization is less than what a
company can utilize effectively, if the promoters under-estimate the future earnings of the
company while formulating the financial plan. The company becomes under-capitalized
as the earnings in subsequent years prove to be higher.
2. Under-estimation of capital requirements If the promoters under-estimate the capital
requirements of the company, the amount of capitalization if low. Thus, the company
becomes under-capitalized due to inadequacy of capital.

KECW::NRT

Financial Management
3. Promotion during Recession If a company is promoted during the period of recession,
it may acquire the assets at cheaper prices. The real value of the assets automatically goes
up with the end of recession. Thus, during boom period its earnings increase
proportionately higher than the increase in the amount of capital employed, resulting in
high profits to the company and exceptionally higher rate of dividends as well as higher
market price of its shares making the company under-capitalized.
4. Unforeseen Increase in Earnings Due to government liberal policy towards a
particular industry, or increases in sale price of the product due to sudden increase in its
demand, the earning of a company may increase abnormal making in under capitalized.

5. Conservative Dividend Policy If a company follows a sound and conservative

dividend policy leading to the creation sufficient reserves for depreciation, repairs and
renewals, and the ploughing back of profits, its earnings increases tremendously, and real
value of its assets exceeds their book value indicating under-capitalization.
6. Promoters Desire to Control If the promoters of a company seek to retain its control
within the hands of a few persons, they issue lesser number of shares, and raise a large
portion of its capital by issuing securities bearing low rate of interest. The amount of
divisible profits available to the shareholders is exceptionally high and the company
becomes under-capitalized.
7.

High Standard of Efficiency If a company follows the policy of rationalization and

modernization entailing the use of latest production technique and efficient management
of resources, its profits invariably increase exceedingly. It may also increase it earnings
by creating large secret reserves, ploughing back of profits, maximizing productivity,
minimizing wasteful use of resources, etc. As a result the real value of its assets becomes
much higher than their book value, and the company becomes under-capitalized.

KECW::NRT

Financial Management
8. Low Promotion Expenses The company will become under-capitalized if the
promoters do not charge excessive amounts for their promotional services and the overall promotional cost is kept very low.
9. Liberal Policy Due to low tax burden, sufficient amount is left with the company for
higher dividend distribution, a symptom of under-capitalization. Liberal tax policy
enables the company to increase its working efficiency by maintaining adequate reserves
of financing the renewals and replacement of worn-out assets.
10. Capital Gains If a companys assets are sold by the management at higher price than
their book value, the resultant capital gains lead the company to under-capitalization.

ADVANTAGES OF UNDER CAPITALISATION

ADVANTAGES TO SHAREHOLDERS
1. Higher Dividends The shareholders of an under-capitalized company regularly receive
higher dividends on their investments, due to higher earnings of the company.
2. More Capital Gains The shareholders of an under - capitalized company also avail
more capital gains, because the market value of the companys shares increase very
rapidly.
3. Easier Loans As the shares of an under-capitalized company have great value as
collateral security, the shareholders get easier loans against the security of shares of an
under-capitalized company.
ADVANTAGES TO SOCIETY
KECW::NRT

10

Financial Management
1. General welfare The entire society is benefited with the higher earnings of an undercapitalized company
2. Employees advantage The employees get higher wages, bonus and better amenities.
3. Increased Production Under-capitalization encourages the establishment of new
companies resulting in increased industrial production and ensuring regular supply of
quality goods to the consumers at cheap prices.
4. Increased employment Establishment of new companies and expansion of the
established ones creates increased employment.
DISADVANTAGES OF UNDER-CAPITALIZATION
DISADVANTAGES TO THE COMPANY:
i.

More Speculation A high dividend rate on the shares of an under-capitalized company

leads to high market quotations of these shares. The management may manipulate share
values and enter into speculation of these shares.

ii.

Limited Marketability of Shares As the existing shareholders do not generally want

to dispose off such shares, the marketability of an undercapitalized companys share is
considerably reduced.

iii.

Cut throat competition As higher earnings of the existing under-capitalized

companies attract new competitors to enter the business, cutthroat competition among
rival companies tends to grip the business and reduce its profitability.

iv.

Industrial Unrest Industrial relations in under-capitalized companies tend to be

strained on account of the fact that employees begin to ask for higher wages, bonus,
reduced working hours, increased welfare facilities etc., out of he increased prosperity of
the company in the form of higher earnings. This leads to industrial unrest which
adversely affects the efficiency of the corporation leading to decline in its profits.

v.

Consumers Opposition Due to high earnings, the consumers of an under-capitalized

company feel that they are being cheated by overcharging the prices for its products. This
may lead to the consumer agitations for a reduction in prices of the products offered by
an undercapitalized company. They may demand state intervention to control the prices

KECW::NRT

11

Financial Management
of the products of such a company. This would result in reduction in the profits of the
company.
vi.

Interference by Government Declaring a high rate of dividend, an Under-capitalized

company attract the government interference to cut down the prices of its products, to
profit ceiling, to charge high profit taxes or file a suit against such a company under antitrust laws of the country.

vii.

Inadequacy of Capital Suffering from shortage of capital an under-capitalized

company always depends on borrowed funds. Sometimes, it is compelled to borrow funds
at a high rate of interest resulting in reduction of its earnings and control by its creditors,
who may even demand for its liquidation in case of non-payment of interest and the
principal amount of loan.

viii.

Over-capitalization Under-capitalization also leads a company to over-capitalization in

the long-run due to huge retained earnings and long-term debt financing.

REMEDIES TO UNDER-CAPITALIZATION:
Splitting up of Shares The shares of an under-capitalized company may be splitted into
shares of small denomination bringing down the amount of divided per share without affecting
the total earnings and the amount of capital of the company.
Increase in Par Value of Shares In exchange for the old shares a company may issue shares of
higher par value to its existing shareholders. While establishing parity between the par value and
the market value of the companys shares this brings down the rate of dividend without affecting
the amount of dividend per share.
Issue of Bonus Shares The most prevalent remedy to under-capitalization is to capitalize the
retained earnings of the company by issuing bonus shares increasing the share capital as well as
the number of shares of the company. That, the rate of dividend per share comes down.

KECW::NRT

12

Financial Management
Issue of Shares and Debentures Under capitalized due to the inadequacy of capital,
company may raise more capital by issuing shares and debentures. This increases the share
capital and number of shares of the company resulting in decline in the rate of dividend.

KECW::NRT

13