Over Capitalization

If a company raises more capital (by the issue of shares and debentures and through long-term loans) than is warranted by the figure of capitalization of its earning power, the company will be said to be over-capitalized.


In other words, a company is over-capitalized when its actual profits are not sufficient to pay interest and dividends at proper rates. It follows that an over-capitalized company is unable to pay a fair return on its capital investment. Thus if a company earns Rs. 1,50,000 with the general expectation at 10 per cent, capitalization at Rs. 15,00,000 would b proper. But if the company, somehow, issues shares and debentures to the extent of Rs. 25,00,000, the rat of earning will be only 6 per cent because with surplus but idle funds profits will still remain Rs. 1,50,000. This company is over-capitalized. However, over-capitalization is not quite the same thing as excess of capital. A company is over-capitalized only because the existing capital is not effectively utilized with the result that there is a fall in the earning capacity, and consequently in the rate of dividend payable to equity shareholders. This usually leads to a decline in the market value of the shares. The chief sign of over-capitalizations is, therefore, a fall in the rate of dividend over a long-term period. This means that over-capitalization presents chronic conditions and is not based on the results of only a few years. To emphasize this point, it may be stated that “when a company has consistently (regularly) been unable to earn the prevailing rate of return on its outstanding securities (considering the earnings of similar companies in the same industry and the degree of risk involved) it is said to be over-capitalized”. Over capitalization results in the following ways:

(1) The enterprise may raise more money by issue of shares and debentures than it can profitably use. In other words, there may be large amounts of idle funds with the company. This may be done intentionally or unintentionally. Some companies, for instance, are tempted by a favorable sentiment in the market, and issue too large a number of shares.

(2) If a company borrows a large sum of money and has to pay a rate of interest higher than its rate of earning, the results will be over-capitalization. A major part of the earnings may be given away to the creditors as interest, leaving little for the shareholders. The rate of dividend is thus lowered and the market value of the shares also declines.

(3) Over-capitalization may often result when an excessive amount is paid for goodwill and for fixed assets acquired from the vendor company or from promoters or other people associated with the company, or when unduly high amounts are spent on establishment. In such cases, the price paid for the requisition of a going concern has no relation to its earning capacity.

(4) Sometimes a company acquires assets like plant, machinery and buildings during a boom period. The price paid is naturally high. If the boom disappears and a slump sets in, the real value of such assets will greatly decline and a large part of the company’s capital would be lost even though the books will still show the assets and the capital at their previous figures. Such a company is over-capitalized because its real earnings capacity will suffer a setback due to a fall in the value of assets, whereas the capital will stand at its original figures.

(5) If a company does not make sufficient provision for depreciation and replacement and distributes higher rates of profit amongst the shareholders, the company will find after some time that, while the book value of assets is high, the real, value is extremely low. The efficiency of the company is adversely affected and its earnings go down thus bringing down the market value of the shares. This is yet another case of over-capitalization.

(6) High rates of taxation may leave little in the hands of the company to provide for depreciation and replacement and dividend to shareholders. This may adversely affect its earnings capacity and lead to over-capitalization.

(7) When the promoters underestimate the capitalization rate, the capitalization may not support the expected rate of earnings and over-capitalization may result. Suppose a company’s regular profit of rs. 50,000 is capitalized at 5% (i.e., capitalization is Rs. 1, 00,000), the rate which the promoters consider sufficient to induce investors to buy the offered securities. If it is later on found that such companies cannot command capital at less than 10% the correct capitalization of the profit of 10,000 will work out at
                100
50,000 x ——, i.e., Rs. 5,00,000.
                 10

Over-capitalisation has evil consequences from the point of view of the company, the society and the shareholders.

From the point of view of the company

(a) over-capitalization will result in considerable reduction of the rate of dividend on the equity shares issued. This is because the profits which the company earns have to be distributed over an unnecessarily large number of shares.

(b) With the disappearance of reduction of dividends, the market value of the shares falls, and the investors lose confidence in the company. The credit of the company suffers a setback. Should a company require more funds for the purposes of bringing about any improvement or acquiring new assets, it will find it extremely difficult to raise the necessary fund from the market.

(c) Sometimes the company resorts to questionable practices including ‘window dressing’ in order to show a respectable figure of profits. Some people are downright dishonest and merely cook up an increase. Others avoid necessary expenditure so that the debit in the profit and loss account is reduced. In the latter case, the efficiency of the company will be still further undermined. For example, if maintenance of machinery and repairs to machinery are postponed, the damage to the machinery will be very heavy and the efficiency would be greatly reduced. This will further reduce profits.

(d) It is often found that an over-capitalized company has to go into liquidation, unless drastic steps are taken to re-organize the share capital. Re-organization would again mean considerable loss of goodwill.

From the point of view of society

(a) Over-capitalization is an indication of reduced efficiency. An over-capitalized concern is compelled to raise the prices of its products. With diminished efficiency it is usually not able to maintain the quality of its products. Thus, the public is a loser both as regards price an quality.

(b) An over-capitalized company may try to raise its profits by effecting cuts in wages of workers. This may affect industrial relations.

(c) Since an over-capitalized concern is unable to compete with other concerns, it may have to close down. The closure of a few companies in this manner may well become the cause of general panic and alarm. This would affect the interests of the creditors. The workers would also lose their jobs.

(d) Over-capitalization results in misapplication of society’s resources. The capital lying idle or being under-utilized by an over-capitalized concern can be better utilized by other concerns which are in need of funds.

The shares of an over-capitalized concern provide scope for gambling on the stock exchange. It is undesirable from the social point of view.

From the shareholders’ point of view

(a) Over-capitalization means depreciation of investment. The shares of an over-capitalized company sell below par in the market. Originally the shareholders may have paid much more for them.

(b) The shareholders have also to suffer due to a low return on their investment which, too, is not always certain and regular.

(c) The shares of an over-capitalized company have relatively have relatively small value as security for loans which a shareholder may like to raise.

(d) The low-priced shares of an over-capitalized concern are subject to speculative gambling. This harms the interests of the real investors.

(e) When an over-capitalized concern tries to set its house in order through reorganization, the shareholders are the worst suffers. Re-organization would usually take the form of reduction of capital for writing off past losses. Such a reeducation has to be borne by the shareholders. In the event of liquidation too, the shareholders have to content themselves with much less than their original investment.

Remedies of over-capitalizationAn over-capitalized concern is like a person who is extremely fat. Sooner or later, he will suffer from various diseases and will come to an untimely end, unless he takes steps to reduce his weight. An over-capitalized company must, likewise, mercilessly cut all its dead weight. An over-capitalized company must, likewise, mercilessly cut all its dead weight. Its dead weight. The following remedial steps may be adopted to this end:

(i) Redemption of bonds through outright re-organizations. If bonds are redeemed with cash received through the issue of more shares, it will only make matters worse. An over-capitalized company must, therefore, go if for complete re-organization and utilize its accumulated earnings for the purpose.

(ii) Reduction of interest on bounds, if the existing debenture-holders are given new debentures carrying lower rates of interest, it will alleviate the situation created by over-capitalization. However, this can be done by offering some premium to the debenture-holders. If the said premium is more than the economy in interest payments, the measure will lose its pint.

(iii) Reduction of preferred stock. If it carries high dividend rate, this can be tried in cases where the preferred stock is cumulative.

(iv) Reduction in the number of equity shares. This can again be tried with the consent of the shareholders.

All the measures indicated above involve re-organization. It may, therefore, be suggested in conclusion that the remedy for over-capitalization lies through re-organization

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