Consequences and Remedies of Over-Capitalization
The phrase ‘over-capitalisation’ has been misunderstood with abundance of capital. In actual practice, overcapitalized concerns have been found short of funds. Truly speaking, over- capitalisation is a relative term used to denote that the firm in question is not earning reasonable income on its funds.
Causes of Over-Capitalisation:
There are various factors responsible for over-capitalized state of a company; important among them being as under:
(1) Promotion of a Company with Inflated Assets:
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. Such a situation arises particularly when corporate form of organisation is adopted by converting a partnership firm or when private limited company is converted into public limited firm because in that process assets may be transferred at price higher than their real value with the result that the book value of the corporation will be higher than its real value.
(2) Company Promoted with High Promotion Expenses:
Over-capitalisation may sometimes result because high expenses were incurred in promoting an enterprise and promoters were fabulously paid high price for their promotional services, particularly when the earnings of the company do not subsequently justify the capital employed.
(3) Over-estimating Earnings at the Time of Promotion:
A mistake in initial estimate of earnings may subsequently land a corporation into over-capitalisation since capitalisation based on such an estimate is not justified by income which the firm actually earns. For example, a company’s initial earning was estimated at Rs. 10,000 and industry’s average rate of return was fixed at 12 percent.
Accordingly, company’s capitalisation was decided at Rs. 83,333 (10,000 × 25/3). Subsequently, it was found that company actually earned Rs. 8,000. Evidently in such a case company’s capitalisation should have been fixed at Rs. 66,000. Thus, the company will be said to be over-capitalized by Rs. 16,667.
(4) Applying High Capitalisation Rate to Capitalize Earnings:
Despite correct estimate of earnings a company may plunge in state of over-capitalisation if higher capitalisation rate was applied to determine its total capitalisation. For example, a company’s earning was estimated at Rs. 10,000 and the industry average rate of return was fixed at 8 percent.
Hence capitalisation rate applied was 12.5 percent. 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.
(5) Company Formed or Expanded During Inflationary Period:
Generally, companies started in the days of inflationary conditions turn into over-capitalized concerns afterward when the inflationary conditions subside because assets were acquired at inflated prices which do not bear any relation with their earning capacity. Alongside this, in anticipation of high earnings during boom period there is strong tendency to fix the capitalisation at high figure.
With slackening of boom conditions followed by declining trends in earning level, companies gradually turn into over-capitalized ones. Even the existing ventures expand the scale of their business to exploit the earning opportunities which will necessitate the raising of further capital. These firms find themselves overcapitalized after the boom period is over.
(6) Shortage of Capital:
Sometimes, over-capitalisation may be the result of shortage of capital. Because of under-estimation of financial requirements a firm may be capitalized at low level. This may cause serious problem to the firm subsequently when it experiences shortage of funds to meet emergent requirements compelling the firm to procure necessary funds at unreasonably high rate of interest.
Consequently, lion share of firm’s income may be swallowed by the lenders who come to the firm’s rescue in eventuality, leaving little income available for the shareholders. This will naturally bring down the real value of the firm.
(7) Defective Depreciation Policy:
Many companies become over-capitalized because they did not make adequate provision for depreciation, replacement or obsolescence of assets. Inadequate depreciation causes inefficiency in the company which, in turn, results in its reduced earning capacity.
(8) Liberal Dividend Policy:
Liberal dividend policy may also contribute to over-capitalization of a company. Companies following too liberal dividend policy continuously for long period of time shall be definitely deprived of the benefits of retained earnings. Thus, in the first instance such companies fail to build up sufficient funds to replace old and worn-out assets and consequently, their operating efficiency suffers.
Secondly, these companies may, in times of necessity, be compelled to take recourse to costlier borrowing which, in turn adversely affects their earning position. The combined effects of these may land these companies in state of over-capitalisation.
(9) Fiscal Policy:
Taxation policy of the Government may also be responsible for company’s over-capitalisation. Due to negative taxation policy firms tax liability increases and is left with small residual income for dividend distribution and retention purposes. Further, such policy also restricts the benefits to tax deduct-ability on account of depreciation provision. Consequently, operating efficiency of companies suffers drastically and state of over-capitalisation develops in companies.
Consequences of Over-Capitalisation:
Over-capitalisation is a state that affects not only the company and its owners but also the society as a whole.
Shareholders suffer doubly the brunt of over-capitalisation. Not only does their dividend income fall but also its receipt becomes uncertain. They also suffer because capital invested by them in these companies depreciates due to fall in market value of their shares. Value of their holdings as collateral securities declines simultaneously.
Shareholders find it difficult to borrow money against the security of their shares. Banks and other financial institutions for similar reasons hesitate to lend money against such securities. Even if they agree to grant loan, they insist upon the stricter terms and conditions hardly acceptable to an ordinary borrower.
Effect of over-capitalisation on company is disastrous. Company’s financial stability is jeopardized. It loses investors’ confidence owing to irregularity in dividend declaration caused by reduced earning capacity. Consequently, it has to encounter enormous problems in raising capital from the capital market to cover its developmental and expansion requirements. Commercial banks too feel shy of lending short-term advances to such a company to meet its working capital requirements. As a result, production work hampers.
Over-capitalized concerns, more often than not, fail to make regular payments of interest and repay principal money on stipulated date. Under the situation creditors may demand liquidation of reorganization of company.
In its desperate bid to regain its lost confidence over-capitalized concerns have been found manipulating books of accounts to show inflated profits. Large dividends are distributed. As a matter of fact, such payments are made out of capital and to cover capital deficiency they take recourse to debt which would further aggravate the crisis.
Over-capitalized concerns gradually lose market to their competitors because in the first instance they fail to produce goods at competitive cost owing to lack of adequate provision for replacement of depleted or worn-out assets.
Secondly, these companies are also not capable of providing as much facility to their customers as their competitors could with the result that they fail to maintain their customers. Inventories lie in store for pretty long time and substantially large amount of capital is unnecessarily tied up in them. This may ultimately spell death knell upon the company.
Over-capitalisation may prove to be a menace to society as a whole. Over-capitalized concerns, in their endeavour to maintain their credit, take every possible measure to prevent declining tendency of income. They try to increase the prices and deteriorate the quality of products. But to take recourse to such practices becomes difficult under the perfect competition and the result is the liquidation of such concerns.
The failure of such over-capitalized concerns tends to precipitate panic. Industrial development languishes, and labourers lose employment. Wage rate also tends to decline. Owing to fall in purchasing power of the labour class their demand tends to decline. This tendency may gradually permeate over the whole society and recession may follow. Such a situation is most dangerous. Process of capital formation is hampered and development activity slackens and the economy is thrown out of gear.
Remedies of Over-Capitalisation:
Effects of over-capitalisation are so grave that the management should take immediate measures to remedy the situation of over-capitalisation as soon as the symptoms of the over-capitalisation are observed.
Various remedial measures such as reduction in bonded debt, reduction of rate of interest paid on debentures, redemption of high dividend preferred shares, reduction of par value of shares and reduction of number of shares are suggested. We shall now examine efficacy of each of these measures as curative to the problem of over-capitalisation.
(1) Redemption of High Dividend Preferred Stock:
To reduce the burden of fixed charges on the over-capitalized company it is suggested to reduce preferred stock bearing high dividend rate. However, this might also not prove more meaningful because large amount of funds would be needed to redeem the preferred stock, raising of which would increase the amount of capitalisation instead of reducing it.
(2) Reducing Par Value of Shares:
It is often suggested that an over-capitalized concern should reduce the amount of stock outstanding by reducing par value of shares. This is nothing but reorganization of share capital which helps the concern in obscuring the real state of affairs. Supposing a company is capitalized at Rs. 10,00,000 with 5,000 ordinary shares of Rs. 200 per share and the company’s average annual earning is Rs. 50,000.
Thus, the company’s earnings per share is Rs. 10 and return on total capital employed is Rs. 5. 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%.
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.
(3) Reducing Number of Shares:
By reducing number of outstanding shares, efforts are made to correct the outward symptoms of overcapitalization. For example, a company is capitalized with 10,000 shares of Rs. 10/- each. If the management decides to issue one new share in exchange of four old shares and shareholders agree to accept the decision, number of shares is reduced to 2,500.
As a result of this, earning per share tends to go up by the same proportion. This, in turn, may help the company to improve its credit position in the market and its share values consequently may soar.
(4) Reduction in Bonded Debt:
To cut the knot of over-capitalisation, over-capitalized concerns are suggested to reduce the amount of bonded indebtedness to prune the amount of capital in accordance with their earning position. This measure seems to be inexpedient. Redemption of debt needs additional funds which can be procured either from reinvested earnings, or from sale of additional stock.
Since profit of over-capitalized concerns might be extremely low, it would be necessary for them to go to stock market for sale of their securities. They would, however, find it difficult to raise required amount of share capital because public response to their issues might not be very encouraging in view of their reduced earning position and increased financial instability.
Furthermore, shares of such companies are quoted at low prices in stock markets. Consequently, they might be compelled to issue large stock to raise the money. This, instead of remedying the problem, might aggravate it.
(5) Reduction of Fixed Charges on Debt:
It is also suggested that with a view to improving their earning position over-capitalized concerns should slash down the burden of fixed charges on debt. For that matter, existing bond holders will have to be made to agree to accept new bonds carrying lower interest rate in lieu of their old ones. The bondholders might agree to accept the new bonds provided these are issued to them at premium. This again fails to remedy the situation.