capitalization

FINANCIAL MANAGEMENT
CHAPTER – 4

CAPITALIZATION

INTRODUCTION:

The word capitalization can be defined as the sum total of all the kinds of long term securities as well as the surpluses. It can also be interpreted as the total of the ownership capital, bonds and other long term debt and the accumulated profits. It is very important for the companies to determine beforehand the volume of finance required to carry on the business activities smoothly, the avenues from where it is to be collected and also about the retention required for near future.

According to the cost theory of capitalization, capitalization is regarded as the sum total of the costs to be actually incurred on fixed assets, current assets and promotional expenses in setting up of the business. All these items together give an idea of the magnitude of the capitalization of a company. On the basis of this estimation the company decides the amount of shares and debentures to be issued.

Capitalization can also be calculated on the basis of the flow of its expected earnings. However, the future earnings cannot be forecasted exactly and therefore, it is not practically possible to exactly arrive at the value of the capitalization.

Thus, we can conclude that capitalization comprises of share capital, debentures, loans, free reserves, etc. It represents permanent investment in companies excluding long-term loans. Capitalization can be distinguished from capital structure. Capital structure is a broad term and it deals with qualitative aspect of finance. While capitalization is a narrow term and it deals with the quantitative aspect.

If the capitalization of the company is just equal to its capital requirements, it is considered as proper or normal capitalization. If it is more than required profit per share falls and the capitalization is in appropriate. Similarly, capitalization less than required is not desirable.

FAIR OR PROPER CAPITALIZATION:

In case of fair capitalization the book value of the share and the real value of the share are equal. It is more of a theoretical concept or myth because it is practically not possible to accurately determine the amount of capitalization. Moreover, the extent of fair capitalization is not static and it keeps on fluctuating due to business cycle. In practice, the new companies should float their securities only after proper analysis of the required funds and the existing companies should make sure that their capitalization is proper if not they can redeem the borrowed funds or issue new securities depending n the situation just to bring the capitalization to its normal. It is also known as normal capitalization.

OVERCAPITALIZATION:

Overcapitalization is a situation in which actual profits of a company are not sufficient enough to pay interest on debentures, on loans and pay dividends on shares over a period of time. This situation arises when the company raises more capital than required. A part of capital always remains idle. With a result, the rate of return shows a declining trend. Main characteristics of over capitalization can be summarized as under:

1.      Real value of the assets is less than the book value

2.      Real value of the shares is less than the book value

3.      Rate of return is less than the reasonable rate of return

4.      Shares are quoted very low on the stock exchange.

CAUSES OF OVERCAPITALIZATION:

1.      High promotion cost- When a company goes for high promotional expenditure, i.e., making contracts, canvassing, underwriting commission, drafting of documents, etc. and the actual returns are not adequate in proportion to high expenses, the company is over-capitalized in such cases.

2.      Purchase of assets at higher prices- When a company purchases assets at an inflated rate, the result is that the book value of assets is more than the actual returns. This situation gives rise to over-capitalization of company.

3.      A company’s floatation in boom period- At times a company has to secure its solvency and thereby float in boom periods. That is the time when rate of returns are less as compared to capital employed. This results in actual earnings lowering down and earnings per share declining.

4.      Inadequate provision for depreciation- If the finance manager is unable to provide an adequate rate of depreciation, the result is that inadequate funds are available when the assets have to be replaced or when they become obsolete. New assets have to be purchased at high prices which prove to be expensive.

5.      Liberal dividend policy- When the directors of a company liberally divide the dividends into the shareholders, the result is inadequate retained profits which are very essential for high earnings of the company. The result is deficiency in company. To fill up the deficiency, fresh capital is raised which proves to be a costlier affair and leaves the company to be over- capitalized.

6.      Over-estimation of earnings- When the promoters of the company overestimate the earnings due to inadequate financial planning, the result is that company goes for borrowings which cannot be easily met and capital is not profitably invested. This results in consequent decrease in earnings per share.

EFFECTS OF OVERCAPITALIZATION:

A.    On Shareholders-  

1.      Since the profitability decreases, the rate of earning of shareholders also decreases.

2.      The market price of shares goes down because of low profitability.

3.      The profitability going down has an effect on the shareholders. Their earnings become uncertain.

4.      With the decline in goodwill of the company, share prices decline. As a result shares cannot be marketed in capital market.

B.     On Company-

1.      Because of low profitability, reputation of company is lowered.

2.      The company’s shares cannot be easily marketed.

3.      With the decline of earnings of company, goodwill of the company declines and the result is fresh borrowings are difficult to be made because of loss of credibility.

4.      In order to retain the company’s image, the company indulges in malpractices like manipulation of accounts to show high earnings.

5.      The company cuts down its expenditure on maintenance, replacement of assets, adequate depreciation, etc.

C.    On Public- 

1.      In order to cover up their earning capacity, the management indulges in tactics like increase in prices or decrease in quality.

2.      Return on capital employed is low. This gives an impression to the public that their financial resources are not utilized properly.

3.      Low earning of the company affects the credibility of the company as the company is not able to pay its creditors on time.

4.      It also has an effect on working conditions and payment of wages and salaries also lessen.

REMEDIES TO CURE OVERCAPITALIZATION:

1.      If there is debt element in the capital structure then it should be redeemed so that the cost saving becomes possible. However, cash resources are required for the same.

2.      With the consent of the debenture holders the rate of interest payable can be negotiated and curtailed down so as to save interest cost.

3.      Redeemable preference shares can be repaid back to bring down the capital.

4.      Capital reduction can be done so as to bring down the face value of equity shares.

5.      Capitalization can also be reduced by reducing the number of equity shares.

UNDERCAPITALIZATION:

 An undercapitalized company is one which incurs exceptionally high profits as compared to industry. An undercapitalized company situation arises when the estimated earnings are very low as compared to actual profits. This gives rise to additional funds, additional profits, high goodwill and high earnings and thus the return on capital shows an increasing trend. The main characteristics of under capitalization are:

1.      Real value of assets is higher than book value

2.      Real value of share is higher than book value

3.      Rate of return on investment is higher than the expected rate of return

4.      Prices of the shares are quoted very high in the stock market

CAUSES OF UNDERCAPITALIZATION:

1.      Low promotion costs- When a company goes for low promotional expenditure, i.e., making contracts, canvassing, underwriting commission, drafting of documents, etc. and the actual returns are higher as compared to low expenses, the company is under-capitalized in such cases.  

2.      Purchase of assets at deflated rates- When a company purchases assets at a deflated rate, the result is that the book value of assets is less than the actual returns. This situation gives rise to under-capitalization of company.  

3.      Conservative dividend policy- Majority of the profits earned is retained in the business for further requirements, repairs or renovation. Consequently, earnings of the company as well as the market price of the shares move up.  

4.      Floatation of company in depression stage- During depression fixed assets is acquired at lower rate and during inflation earnings move up at faster rate.  

5.      High efficiency of directors- Undercapitalization can also be an outcome of very high level of efficiency of management and very high productivity of labour.  

6.      Adequate provision of depreciation- In order to conceal the actual profits earned by the company, management provides unnecessarily high amounts of depreciation reserves. In long run when reserves grow very huge they under capitalize the company.    

7.      Large secret reserves are maintained- sometimes management creates a secret reserve in the names of transfers to several reserves or creates unnecessary provisions to conceal the profits resulting into higher retained earnings.

 EFFECTS OF UNDER CAPITALIZATION:

A.    On Shareholders-

1.      Company’s profitability increases. As a result, rate of earnings go up.

2.      Market value of share rises.

3.      Financial reputation also increases.

4.      Shareholders can expect a high dividend.

B.     On company-

1.      With greater earnings, reputation becomes strong.

2.      Higher rate of earnings attract competition in market.

3.      Demand of workers may rise because of high profits.

4.      The high profitability situation affects consumer interest as they think that the company is overcharging on products.

C.    On Society-

1.      With high earnings, high profitability, high market price of shares, there can be unhealthy speculation in stock market.

2.      Restlessness in general public is developed as they link high profits with high prices of product.

3.      Secret reserves are maintained by the company which can result in paying lower taxes to government.

4.      The general public inculcates high expectations of these companies as these companies can import innovations, high technology and thereby best quality of product.

 THE REMEDIAL MEASURES TO CURE UNDERCAPITALIZATION:

1.      Bonus shares can be issued.

2.      Upward revaluation of the assets of the company can be done.

3.      New equity shares can be issued.

4.      The denomination of the equity shares can be increased.

5.      Higher dividends should be declared

WATERED CAPITAL:

That part of capital which is not utilized for acquisition or maintenance of fixed asset is watered capital. It can also be interpreted as a part of capital which is not represented by any assets. Practically where more number of shares is issued than required, watered stock arises. It denotes the unutilized funds lying idly in the business. It reduces the earnings per share as well as the market price of the share. It represents the situation of overcapitalization.

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