Overcapitalization Definition, Examples Advantages & Disadvantages

(ii) Investors’ confidence in the company is lost; as to them, the future of the company seems to be gloomy and uncertain. Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting. In extreme conditions, the company may choose to merge or be acquired. All official expenses should be minimized and a conservative dividend declaration should be planned. Debt restructuring with banks and other lenders to reduce the interest obligation is another possible remedy.

Overcapitalization Vs Undercapitalization

It can result from factors like overvalued assets, excessive borrowing, or overly optimistic growth expectations. Overcapitalisation is a financial state in which a company’s capitalisation, consisting of equity and debt, exceeds its actual operational needs and the value of its underlying assets. When a corporation raises more funds than necessary, leading to an imbalance between capital investment and productive utilisation.

Effects of overcapitalisation

Accordingly, company’s capitalisation was decided at Rs. 83,333 (10,000 × 25/3). Subsequently, it was found that company actually earned Rs. 8,000. Evidently in such a case company’s capitalisation should have been fixed at Rs. 66,000. Thus, the company will be said to be over-capitalized by Rs. 16,667.

Over and under capitalisation are both harmful for a company’s financial health. Read further to know how.

One reason and an indicator of a business facing such a scenario is to pursue a large and liberal dividend policy. These businesses do not retain sufficient cash and issue large dividends instead. For a business having overcapitalization, its market value would fall against its capital value. The business would need to make more payments for dividends as well as interest payments on debt. Overcapitalization occurs when a business acquires more capital investment than needed.

• Sometimes, while floating a new company, the promoters over-estimate the financial requirements, and as a result, they raise more capital than what is actually needed, resulting in over-capitalisation.
• The actual rate of return in this case will go down to 10%.
• These buybacks are part of Infosys’ broader capital management strategy to strike a balance between financial stability and shareholder value creation.
• In the present day times, the corporate taxes are quite high.
• (ii) Market value of shares will go down because of lower profitability.
• In contrast, the book value of its assets stays at a greater level as the boom circumstances fade and recessionary circumstances take hold.

( Defective Depreciation Policy:

Moreover, a firm is said to be overcapitalised if it cannot pay the interest on its long-term debt and debentures and the fair dividend rates on its shares. If a company does  make adequate provision for depreciation and replacement of assets, it will be able to distribute higher dividends to its shareholders for years. However, with the a few passage of time the working efficiency of fixed assets will decrease resulting in  a fall in the earning capacity company.

As a result, the company is unable to pay a fair rate of return on the equity. Overcapitalization cannot be identified equally for businesses of all sizes. For instance, an established business with large accumulated cash reserves will employ lower capital investment.

• However, inaccurate forecasting and other reasons may lead a business to excessive capital.
• High rates of taxation may leave little in the hands of the management to provide for depreciation, replacements and dividends.
• (i) An unsatisfactory rate of return on the equity leads to a poor market value of the company’s shares.
• Par value of shares refers to face value of shares which is stated in memorandum of association of the company.
• Furthermore, shares of such companies are quoted at low prices in stock markets.

These inflated profits lead to payments of dividends out of capital. Sometimes, while floating a new company, the promoters over-estimate the financial requirements, and as a result, they raise more capital than what is actually needed, resulting in over-capitalisation. Simply stated, over-capitalisation means more capital than actually required, and therefore, in a over capitalised concern, the invested funds are not properly used. It is, therefore, quite clear that over-capitalisation may be explained in terms of earnings as well as cost of assets. Furthermore, shares of such companies are quoted at low prices in stock markets.

More so, the payment of dividend becomes uncertain and irregular. In an over-capitalised company, there is a reduced earning capacity resulting in the fall of market price of its shares and thereby shaking up the investor’s confidence. A company whose shares sell below the face value may find it difficult to improve its goodwill in the market.

In this case, a large amount of capital remains either idle or ineffectively utilised. Consequently, the   company’s earnings decline which lead to fall in market value of its shares. Overcapitalization is when a firm has raised capital over a particular limit, which is inherently unhealthy for the company. As a result, its market value is less than its capitalized worth.

Overcapitalization in working capital is often a result of increased short-term borrowings. It means the interest cost for the company increases significantly. Reduction in face value of shares is one of the solutions to overcapitalization.

Excessive Capital Funding

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. For that matter, existing bond holders will have to be made to agree to accept new bonds carrying lower interest rate in lieu of their old ones. The bondholders might agree to accept the new bonds provided these are issued to them at premium. Over-capitalisation may prove to be a menace to society as a whole. Over-capitalized concerns, in their endeavour to maintain their credit, take every possible measure to prevent declining tendency of income.

In actual practice, over­capitalized concerns have been found short of funds. Truly speaking, over- capitalisation is a relative term used to denote that the firm in question is not earning reasonable income on its funds. The promoters or the directors of the company may over-estimate the earnings of the company and raise capital accordingly.

If the company is not in a position to invest these funds profitably, the company will have more capital than required. An overcapitalized company has a market value less than its total capitalized value or current value, and may end up paying more in interest and dividend payments than it can sustain in the long term. Overcapitalization is when a company’s capital is worth more than its total assets.

New debentures may be issued at lower rate of interest with some premium, of course. The situation created by over-capitalisation may be al­leviated though not eliminated. Inflationary economy prevailing at the time company promo­tion.

However, market value, in fact, is consequence of cumulative effects through internal and external factors. In view of this, it would not be justified to rely on market value of shares to judge the state of capitalisation of a company. Contrary to this, real value of shares is calculated after capitalizing company’s earnings. Accordingly, it would be meaningful and justified too to depend on real value and contrast it with the book value to test the state of capitalisation. The company may follow a liberal dividend policy and may not retain sufficient funds for self- financing. It is not a prudent policy as it leads to over-capitalisation in the long run, when causes of over capitalisation the book value of the shares falls below their real value.

Essentially, the company cannot raise capital to fund itself, its daily operations, or any expansion projects. Undercapitalization most commonly occurs in companies with high startup costs, too much debt, and insufficient cash flow. 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. When a corporation is overcapitalised, it has extra cash or capital on its balance sheet that it can deposit in the bank and earn a nominal return on, improving its liquidity situation.