Definition and Explanation
Over-capitalization is that aspect of a business enterprise, wherein long term funds (share capital, debentures and loans) exceed the amount of optimum capitalization. The company earns reasonably fair return on its investment in case of proper capitalization.
In case of over-capitalization, the rate of return in lesser than the rate of return of competitive firms. Declining rate of return and dividend presents a case of over-capitalization. In case of over-capitalization, the supply of long term funds exceeds the required amount of funds, or the economic activities of the enterprise get slower.
Over-capitalisation, in other words, means under-utilization of funds. In other words, a company is said to be over-capitalized when its actual profits are not sufficient to pay interest and dividend at proper rates. In case of over-capitalization total profit may increase but the rate of earning will decline.
Hoagland defines over-capitalization as: “Whenever the aggregate of the par-values of stocks and bonds outstanding exceeded the true value of the fixed assets, the corporation is said to be over-capitalized.”
Causes/Factors leading to Over-capitalization
The following causes are responsible for the over-capitalization of a business enterprise:
1. Idle Funds. It is just possible that the promoters of the company may issue more than the required number of shares and debentures. The funds raised may remain idle. The unutilized funds will not earn any return, whereas those investing these funds will be expecting a high return. The result will be the declaration of the rate of return at lower rates.
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2. Under-utilisation of funds. The return of the company will be comparatively lower if the funds are not properly utilized. Under-utilization of funds will yield low earning and result in the decline of return per share.
3. Acquisition of goodwill at excessive price. In case of purchasing an enterprise, the company may pay for goodwill more than its net worth. Goodwill is a fictitious asset, which has got no real worth. If excessive funds have been wasted in acquiring goodwill lesser funds will be available for utilization. It will consequently result in the fall of rate of returns.
4. Acquisition of fixed asset at a time when prices are higher. The enterprises may acquire assets at a time when it was very costly but due to the passage of time, the price of the fixed assets purchased earlier at a higher price has decreased. The fall in the real value of assets will cause earning at lower rates.
5. Inadequate provision for depreciation. It is just possible that depreciation has been charged at lower rates, whereas actual depreciation was more. The result will be fall in the real value as compared to its book value. The fall in the real value of assets will lead to low earning and the over-capitalization.
6. Excess of rate on loans over the rate of return on funds. Sometimes it may happen that the rate of interest on the loans borrowed exceeds the rate of earnings on the investment. In this case, the company will have to pay more than what it has earned. The situation will result in the decline of return and it be a case for over-capitalization.
7. Higher rate of taxation. Higher rate of taxation may eat up large amount of earnings and thus deprive shareholders from receiving a dividend at fair rate. The situation will lead to the over-capitalization of the company.
Evil/Adverse effects Over-Capitalization on Company, Society and Shareholders.
The economic consequences of over-capitalization are fatal to a company, society and shareholders.
(a) Effect-upon company
The company suffers from over-capitalization in the following ways
1. Decline in the rate of dividend. Declining rate of dividend due to over-capitalization adversely effects and reputation and future prospects of the company.
2. Fall in the market value of shares. Decline in the rate of dividend reduces the market value of shares. It is very difficult for the company to raise funds in this situation.
3. Indulgence in malpractices. The company in order to show respectable profit indulges in manipulation, window dressing and malpractices. Certain companies do not show expenditures, others show an increase in the value of assets, although there is a decrease in the value of assets.
4. Considerable loss of goodwill. In order to correct the evil effects of over-capitalization, the company reorganizes itself. In case of reorganization, par value of shares are reduced, rate of dividend on preference shares are reduced, interest rates on debentures are also reduced. All these result in the loss of goodwill.
(b) Effect upon Society
The society is also the victim of over-capitalization and suffers in the following ways:
1. Increased price of the commodity. In order to increase the rate of dividend, the company increases, the price of the commodity and consequently the consumers suffer.
2. Loss of the quality of good. In order to earn more profit the company tries to reduce the cost of production, for which the company starts supplying interior quality of good. The sufferers, in this case, are consumers again.
3. Decrease in wage rates. The company in order to reduce the cost of production, reduces wage rates and in this way workers, the important element of the society suffer.
4. Misuse of society’ s resources. Important resources of the society invested in the over-capitalized companies are not effectively utilized and consequently, resources are misused.
5. Gambling in the stock exchange. There are fluctuations in the value of shares of the over-capitalized company. It provides scope for gambling in the shares of the company.
(c) Effect upon shareholders
Over-capitalization affects shareholders’ adversely in the following ways:
1. Loss of the value of shares. Shareholders are the worst losers in case of over-capitalization. Lower rate of earning and dividend reduces the value of their shares.
2. Low return on investment. Shareholders do not get a fair and competitive return on their investment, because the over-capitalized company earns profit at a very low rate.
3. Speculative gambling in shares. Fluctuation in the value of shares provides an opportunity for gambling in shares.
4. Loss due to reorganization. The general remedy of over-capitalization is reorganization i.e. the reduction in the par value of shares and in this way shareholders are the worst sufferers.
Remedial Measures to Eradicate evils of Over-capitalization.
An over-capitalized company is just like an extremely fat man, who cannot move smoothly due to its excessive weight. The deadly weight of the man will make him the victim of various diseases and result in his untimely death unless effective measures are adopted to reduce weight. In the same way an over-capitalized company suffers from various evils and will face dissolution unless remedial measures are adopted. In order to eradicate the evils of over-capitalization, the company may adopt the following measures.
(i) Reduction in the par value of shares. It is the common practice of relieving the company from the pressure of over-capitalization. For example, shares of $100 each of the company may be reduced to 1,00,000 shares of $50 each. In this way, the subscribed capital of the company will reduce from $1,00,00,000 to $50,00,000.
(ii) Reduction in the number of shares. In this case number of shares are reduced. In the previous example reduction of 1,00,000 shares to 50,000 shares of $100 will reduce the subscribed capital to $50,00,000.
(iii) Reduction in the rate of dividend on preferred shock. In case of commutative preference shares, the company may reduce the rate of dividend on preference shares in consultation with preference shareholders.
In case of over-capitalization, reorganization of the company is the best remedy.