Consequences and Remedies of Under Capitalization
The phrase ‘Under-capitalisation’ should never be misconstrued with inadequacy of capital. Truly speaking, this term is used to denote the state of affairs just converse of over-capitalisation.
When a company succeeds in earning abnormally large income consistently for a pretty long time, symptoms of under-capitalisation gradually develop in the company; the most important one being that market value of shares of the company exceeds their book value. Under-capitalisation is an index of effective and proper utilisation of funds employed in the enterprise.
It should be noted in this regard that if a company under exceptionally good conditions makes substantially large earnings in a year or so, it should not be considered that the company is under-capitalized. Over-capitalised concerns have always earning superiority over average concerns engaged in the same line of activity.
Thus, under-capitalisation is indicative of sound financial health and good management of the company. Bonneville and Dewey rightly observed that “Under-capitalisation is not an economic problem but a problem in adjusting the capital structure”.
Causes of Under-Capitalisation:
(1) Deflationary Condition:
Companies set up in recessionary condition generally become under-capitalized after recession is over. There are two factors contributing to this tendency. In the first instance, during recession assets are purchased at exceptionally low prices which bear no relation with their income producing capacity. As period of recession abates, earning position of the companies tends to improve.
This would result in increase in real value of assets while book value of assets remains as before and the consequence would be under-capitalisation. Secondly, companies set up in period of recession are capitalized at low figure anticipating low level of business income. But as the period of recession is over, company’s earning capacity improves and the result is undercapitalization.
(2) Conservative Dividend Policy:
Company following conservative dividend policy builds up substantially large funds available for replacement and renovation of obsolete assets and for financing developmental and expansion purposes. This thus goes a long way in improving earning position of the company.
(3) Maintaining High Standards of Efficiency:
By employing new techniques of production and rationalization of production activities, operating efficiency of a company can be improved.
(4) Under-Estimation of Initial Earnings
If earnings of new venture were under-estimated and the enterprise was capitalized accordingly, it may find itself in condition of under-capitalisation afterwards when it’s actual earning was much more than what was anticipated.
(5) Using Low Capitalisation Rate:
If low capitalisation rate was employed to determine capitalisation of a company, it might plunge in state of under-capitalisation subsequently when it would be found that actual capitalisation rate was much higher than the employed one.
Consequences of Under-capitalisation:
Although under-capitalisation does not threaten financial stability and solvency of the enterprise, management should not be complacent towards this situation because the company may suffer in the following ways:
Under-capitalisation does not pose any economic problem to the society. On the contrary, it may prove boon to it. It encourages new entrepreneurs to set-up new ventures and encourages the existing ones to expand. This as a result, boosts industrial production. Consumers get variety of products at relatively cheaper rate.
Establishment of more and more firms and expansion of existing ones helps to mitigate sufferings of unemployed persons. Purchasing power of newly employed people increases resulting in a rise in demand which, in turn leads to increase in investment and production. Through demand-investment and employment spiral the economy marches ahead to reach the pinnacle of prosperity.
However, society may plunge in state of turmoil when psychic feeling develops among consumers and workers that they are being plundered by capitalists. This feeling may sow seeds of dissension among consumers at large and labour-management relation is disrupted.
The whole society is mired in plight of discontentment and agitation forcing government to intervene immediately and to clamp, for that matter, numerous types of controls such as price control, dividend ceiling and dividend freeze.
Under-capitalisation is advantageous to shareholders in as much as they get high dividend income regularly. Because of soaring rise in share price of under-capitalized concerns, shareholders’ investment in these companies appreciates phenomenally which they may encash at any time.
In another way also, under-capitalisation benefits the shareholders. They can, in periods of necessity, get loans on soft-terms against the security of their shares because of high credit standing of the under-capitalized concerns in the market.
Remedies for Under-Capitalisation:
To correct condition of under-capitalisation it is inevitable on the part of the company to reorganize its capital structure in such a way that number of shares increases and earning per share is reduced.
(1) Splitting Stock:
Another effective way of reorganizing capitalisation of a company to reduce the effects of under-capitalisation is to split up the stock into a large number of shares and reduce the value of each share in accordance with the rate of split up. The effect of this split is that the earnings would be spread over a greater number of shares, Supposing a company is capitalized with Rs. 1,00,000 divided into 1000, its earning per share would come to Rs. 10.
Management may reduce earning per share if it so likes by taking recourse to stock split. If, for example, the management decides to reduce par value of shares by 50 percent and increase the number of shares in the same proportion, number of shares in the company would after splitting double to reach 20,000 shares and earning per share would be halved to Rs. 5.
The shareholders will have no objection to this procedure because they are not going to lose anything. Thus, by this simple device the management can neutralize the effects of under-capitalisation and save the company from any eventuality.
It is evident from the foregoing discussions that both the strategy under-capitalisation and over-capitalisation are undesirable and should be discouraged as far as possible. Over-capitalisation means a great strain on the financial structure of a company, an evil for shareholders and a menace to economic prosperity, and stability of society.
On the other hand, under-capitalisation encourages competition on the part of business rivals, sows seeds of dissension among labourers and creates psychic feeling of being exploited among consumers. On comparison, state of over-capitalisation relatively is more harmful. However, the management should avoid emergence of both these situations and its ideal should be of fair capitalisation.
(2) Capitalisation of Surplus of the Company:
If a company has adequate surplus in hand the whole or a part of it can be capitalized by issue of bonus shares. This will, in no way, affect the quantum of capitalisation. Of course, make-up of capitalisation will undergo marked change. Thus, with issue of bonus shares, share capital will increase and so also the number of shares but surplus of the company will lie reduced by the amount of bonus shares.
In consequence, earnings per share automatically are reduced. Take for example, a company has total capitalisation of Rs. 2,00,000 comprising share capital of Rs. 1,50,000 (divide in 3,000 shares of Rs. 50 per share) and surplus of Rs. 50,000. The company’s present earning is Rs. 60,000.
Thus earning per share in this case comes to Rs. 20 per share. Management may save this company against the effects of under-capitalisation by issuing bonus shares. If, for example, it is decided that the company will issue 5,000 bonus shares of Rs. 10 each, share capital in the company will increase from Rs. 1,50,000 to Rs. 2,00,000 and number of shares from 3,000 to 8,000 though of course amount of total capitalisation remains unchanged.
As a result of this, earning per share which was earlier Rs. 20 would, after capitalisation, decline to Rs. 7.50. However, owner’s income is no longer affected. They would continue to receive the same amount of income even after recapitalization. This would keep the management free from workers’ threats; consumers do not feel being exploited by capitalists.