The company will pay more on its debts than it would earn otherwise. Thus, through simple process of accounting, condition of over-capitalisation can be converted into that of undercapitalization. But it would be difficult to convince the shareholders in this respect. They may believe it to be management trick to dupe them by giving them lower par value stock in exchange for higher value stock though in fact real value of shares is in no way affected. To reduce the burden of fixed charges on the over-capitalized company it is suggested to reduce preferred stock bearing high dividend rate. Shareholders find it difficult to borrow money against the security of their shares.

Now, if the company reduces the par value of shares by 50% and transfers the same to surplus account, it would result in increase in return on capital by 100%. A company right from its incorporation falls prey to overcapitalization if it has been established with assets acquired at higher prices which do not bear any relation to their earning capacity. Market value of shares is the price at which shares of a company are quoted in stock exchange.

Value of their holdings as collateral securities declines simultaneously. By applying this rate the company’s capitalisation was worked out at Rs. 1, 25,000. Subsequently, it was found that industry average rate of return was 10 percent and hence company’s fair amount of capitalisation would be Rs. 1,00,000 . Obviously, there is over-capitalisation in the company to the extent of Rs. 25,000.

• In conclusion, overcapitalisation can have significant consequences for a company and its stakeholders.
• Something significant is being ruined by its financial stability.
• Such a practice should be discouraged as it leads to over-capitalisation, because liberal dividends are paid at the cost of inadequate provision for depreciation.
• The employees and labourers suffer since they cannot receive adequate salaries and wages owing to lower profit.

Capital Budgeting and Time Value of Money

Another clear indicator of a business in such a situation is a troubled working capital. Often, a business overestimates its working capital requirements and arranges excessive capital investment. Intensive capital investment is a clear indicator of a business with overcapitalization. Businesses look for expansion with optimistic plans and acquire additional resources. If they causes of over capitalisation acquire more resources than their net assets, that can soon turn into overcapitalization. Stressed working capital due to excessive borrowings and increased interest costs would mean lower profits for the company.

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

• Quite often, the enterprises resort to window dressing with questionable practices.
• Owing to fall in purchasing power of the labour class their demand tends to decline.
• Thus, we see that as a result of over-capitalisation, the rate of earnings has dropped from 10% to 8⅓%.
• Taxation policy of the Government may also be responsible for company’s over-capitalisation.
• No consideration is given to the demands of the workers and some of them even lose their jobs because of lay offs and retrenchment and closure of such units.
• Inadequate provisions for depreciation and replacement of fixed assets.

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. In this case, the company ends up paying more interest and dividends, which is impossible to sustain in the long term. It simply signifies that the company is not using the fund efficiently and has poor capital management.

Acquiring assets at inflated prices:

Over-capitalisation arises when the existing capital of a firm is not effectively utilised with the result that there is a fall in the earning capacity of the company. Thus, the main sign of over-capitalisation is fall in the rate of dividend and market value of shares of the company in the long-run. Suppose, Cachar Paper Mill, Panchgram (Assam) earned an annual profit of Rs. 50,000 on its total capital investment of Rs. 5, 00,000. If the expectation for return is 10%, this mill will be called properly capitalised. Since the capital is not utilised properly, i.e., the company cannot effectively use its capital employed the rate of return must be low and, consequently, the value of shares in the market may go down.

( Company Formed or Expanded During Inflationary Period:

You can easily calculate this figure by multiplying the price of one share by the total number of shares outstanding. Instead of $1,000,000, Company ABC decides to use $1,200,000 as its capital. The rate of earnings in this case becomes 17%, or $200,000 ÷ $1,200,000 × 100. Due to overcapitalization, the rate of return has dropped from 20% to 17%. Essentially, the company cannot raise capital to fund itself, its daily operations, or any expansion projects.

If the company is not in a position to invest these funds profitably, the company will have more capital than required. Consequently, the rate of earnings per share will be less. Preference shares carrying high rate of dividend should be redeemed out of retained earnings in order to raise the share of equity shareholders. Many companies prefer to declare a higher rate of dividend instead of retaining a part of the profits and ploughing them back or reinvesting them. Such a practice should be discouraged as it leads to over-capitalisation, because liberal dividends are paid at the cost of inadequate provision for depreciation.

On Enterprise:

In other words, they are in a fix as to whether they should sell the shares or retain it. If they want to sell, they will have to suffer heavily because of the lower price and, again, if they retain them, they will get a very poor rate of return by way of dividend. Cash flow and working capital management are essential for the success of any business.

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 the book value of the shares falls below their real value. It is a financial situation where a company has more than enough total capital as compared to the needs of its business operations. In case of overcapitalization, the total equity (owner’s capital + debt) of a company exceeds the actual worth of its assets.

Insufficient provision for depreciation consumes unnecessary profits and reduces the overall earning capacity of the company. In order to regain the confidence of its investors, over-capitalised companies generally resort to manipulation of accounts and over-statement of their profits. These inflated profits lead to payments of dividends out of capital. In terms of earnings, over-capitalisation arises when the earnings of the company are not sufficient to give a normal return on capital employed by it. Market capitalization refers to the total dollar value of a company’s outstanding shares.

It should be noted that overcapitalisation does not always imply an excess of capital. Because capital is not being used properly, which results in a consistent fall in profitability, the company may be overcapitalised. Overcapitalization happens when a company’s debt and equity values are higher than those of its total assets. This means that its market value is less than its capitalized value. Companies that are overcapitalized may have trouble getting more financing or may be subject to higher interest rates.

The temptation to raise product pricing to boost profits is too great for a corporation to deny, and there is a good chance that the product’s overall quality will suffer as a result. As, shareholders are the real owners of a company, they suffer most on account of over-capitalisation. Procurement of funds at high rate of interest will adversely affect the company resulting in over-capitalisation. It promoters buy assets of lower values at higher prices, they are led to a situation of over-capitalisation because assets of lower value will be shown at higher value in the Balance sheet. The excess capital also means that the company has a higher valuation and can claim a higher price in the event of an acquisition or merger.