Japan Stock Market: 5 Charts Show How Nikkei Surged to New Record High

If a cost is incorrectly expensed, net income in the current period will be lower than it otherwise should be. The company will also pay lower taxes in the current period. If a cost is incorrectly capitalized, net income in the current period will be higher than it otherwise should be. In addition, assets on the balance sheet will be overstated.

But in fact, there is a reserve fund amounting to Rs. 3,00,000. Company suffering from the problem of under-capitalization may issue stock divi­dend instead of cash dividend. This would not affect par value of share but would increase the capitalization and the number of shares.

1. At the time of incorporation of a business, it is the first problem before the promoters to decide how much capital is to be required and in what form.
2. If a cost is incorrectly expensed, net income in the current period will be lower than it otherwise should be.
3. Consequently, the company may be forced to incur unwieldy debts and bear the heavy loss of its goodwill In a subsequent reorganization.
4. When a small company starts, it must create a capitalization strategy that outlines how the company will use its scarce resources to start operations.
5. When a company is overcapitalized, its market value is less than its total capitalized value or its current value.

Undercapitalization is just the reverse of over-capitalization. The state of under-capitalization is where the value of assets is much more than it appears in the books of the company. In well-established companies, there is a large appreciation in assets, but such appreciation is not shown in the books. Assets may be acquired at inflated prices or at a time when the prices were at their peak.

What is undercapitalization?

If a company’s products register a constant decline, it will bring down the profitability of the concern and as a result, returns on capital employed will be reduced which represents over-capitalisation. 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. 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.

Real value is a study of the working of company in the light of the earning capacity in the particular line of business. It takes into account not only the previous earnings or earning capacity of a concern but relates the earnings to the general earning capacity of other units of the same nature. It is calculated by dividing the aggregate of the proprietary items – like share capital, surplus and proprietary reserves – by the number of outstanding shares. Originally, it was used in the sense of ‘valuation’ and ‘amount’ but qualitative connotation now usually accompanies the quantitative expression. The term capitalisation is now taken as being synonymous with capital structure or financial plan.

Merits of Theory of Capitalization

Companies can only raise capital through a few methods; the long-term goal of a company is to be overcapitalized as it can return funds to investors, invest for growth, and still earn a profit. Companies with a high market capitalization are referred to as large caps. Over-capitalisation involves a great-strain on the financial resources of a company whereas under-capitalisation implies high rate of earnings on its shares. High rate of earnings of the under-capitalized firm may allure competitor firms to enter into the market. A company becomes under-capitalized when the future earning is under-estimated at the time of promotion.

An over-capitalised company goes into liquidation unless drastic steps are taken to re-organise the whole capital structure, and re-organisation would itself lead to a lot of problems. To cover for one loss, other losses are incurred by the company and in the process overall efficiency of the company declines. Such a company usually does not make adequate provisions for depreciation, repairs and renewals, etc., leading to further decline in its efficiency. If a company is to be floated during an inflationary period, or any development activity is carried out in such a period, it will be a victim of over-capitalisation because it has to spend huge amounts. (1) Acquiring of fictitious assets like goodwill at high prices.

FAQs About the Overcapitalization and Undercapitalization

(i) Cost of fixed assets such as land and building, plant and machinery, furniture, etc. Lincoln – “Capitalisation is a word ordinarily used to refer to the sum of the outstanding stocks and funded obligation which may represent wholly fictitious values”. However, it should be noted that in actual practice both reserves and surpluses are frequently used by the companies to meet their long-term requirements. Therefore this definition appears to be inadequate and illogical.

High Promotion Cost

Over-capitalisation of an enterprise may also be caused due to excessive taxation by the Government and also their basis of calculation may leave the corporations with meagre funds. At the time of promotion, many firms incur heavy preliminary expenses such as promoter fees, brokerage and underwriting commission, and purchase of patents/goodwill. (ii) The total par value of all the securities outstanding at a given time plus the valuation of all other long-term obligations. (iii) Determining the composition or proportion of the various securities to be issued. (b) The value of long term assets is higher than capital raised.

Companies that are overcapitalized may have trouble getting more financing or may be subject to higher interest rates. They may also have to pay more in dividends than they can sustain over the long run. Undercapitalization occurs when a company has neither sufficient cash flow nor access to the credit it requires to finance its operations. The company may not be able to issue stock on the public markets because the company does not meet the requirements or because the filing expenses are too high. (4) The company may follow a conservative dividend policy (i.e., moderate rate of dividend) thereby leading to enough funds for business expansion, machinery replacement etc.

Overcapitalization occurs when earnings are not enough to cover the cost of capital, such as interest payments to bondholders or dividend payments to shareholders. Undercapitalization occurs when there’s no need for outside capital because profits are high and earnings were underestimated. If the future capital requirements are under­estimated by the promoters, the inadequacy of capital is experienced at a later stage.

Thus, we see that as a result of over-capitalisation, the rate of earnings has dropped from 10% to 8⅓%. Therefore, we can say that the test of over—capitalisation is the lower rate of return on capital over a long-term. Financial statements can be manipulated when a cost is wrongly capitalized or expensed.

Guthmann and Dougall – “Capitalisation is the sum of the par value of stocks and bonds outstanding”. However, when the amount of capitalization is the same as warranted by the amount of earnings, it is a case of ‘Fair Capitalisation’. According to this theory a projected Balance Sheet is prepared. The sum of amounts of all items to be shown on the assets side of the projected Balance Sheet is taken as the amount of capitalisation. S. Dewing, “capitalization is the sum total of the par value of all shares”. The excess capital also means the company has a higher valuation and can claim a higher price in the event of an acquisition or merger.

This can be achieved by debt and equity components in the capitalisation. Under-capitalisation is just the reverse of over-capitalisation but it should never be taken https://1investing.in/ to indicate deficiency or inadequacy of capital. The stage of under-capitalisation arises when the concern starts earning at a rate higher than current rate.

Overcapitalization occurs when the supply of policies exceeds demand for policies, creating a soft market and causing insurance premiums to decline until the market stabilizes. Policies purchased in times of low premium levels can reduce an insurance company’s profitability. Capitalization has two meanings in accounting and finance. In accounting, capitalization is an accounting rule used to recognize a cash outlay as an asset on the balance sheet, rather than an expense on the income statement. In finance, capitalization is a quantitative assessment of a firm’s capital structure. The term under-capitalisation should never be considered synonymous with inadequate capital.

If the par value of shares is increased by exchanging the old shares with new increased par value shares the rate of earnings will be reduced. The company may divide the denomination of stock into small value to increase the number of shares. An under-capitalized firm may have to depend frequently on short-term over capitalisation and under capitalisation funds. If the company has preferred stock in their capital structure that is to be redeemed or the rate of dividend is to be reduced. This can be done by converting the pre­ferred stock into equity. The company can try to retire its debt capital to reduce the burden of paying fixed interest.