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.
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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,
(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,
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