Over-Capitalization: Causes, Consequences and Remedies

Over-capitalization is a situation where a company’s total capital is more than what it needs to carry on its business efficiently, so the earning capacity does not justify the capital invested. As a result, the rate of return on capital falls below the normal level in the industry, and the actual value of assets is lower than the book value of capital. It often arises from excess issue of shares or debentures, over-valuation of assets at promotion, or high promotion costs. Symptoms include falling dividends, declining share prices, and weak earnings per share. Dot-com era firms and some overexpanded infrastructure companies faced this problem.

What are the Causes of Over-Capitalization?

1. Overestimation of Earnings

The main cause of over-capitalization is overestimation of earnings. When promoters overestimate future profits, they fix capital at a high level. They expect high income but actual earnings turn out to be low. As a result, the company cannot pay fair dividend on the large capital. The rate of return falls. This creates over-capitalization. Overestimation may happen due to optimism, wrong market study, or lack of experience. Promoters should estimate earnings carefully based on past data and market conditions. Realistic estimation of earnings is essential to avoid over-capitalization in the company.

2. Issue of Shares at High Premium

Over-capitalization can occur when shares are issued at a very high premium. The company collects more money than the real value of its assets. This increases the total capital beyond its earning capacity. The excess funds may remain idle or be misused. The company has to pay dividend on the large capital, but profits are not enough. This reduces the rate of return. Issue at high premium is common during boom periods when investors are ready to pay high price. The company should issue shares at a fair price based on actual value and earning capacity.

3. Purchase of Assets at Inflated Prices

Over-capitalization arises when the company purchases assets at inflated prices. Promoters may buy land, building, or machinery at a price higher than its real value. This may happen due to fraud, lack of knowledge, or to benefit promoters. The book value of assets becomes higher than their real value. The total capital becomes more than the earning capacity of assets. The company cannot earn enough profit on such costly assets. This leads to over-capitalization. Assets should be purchased at market price after proper valuation and expert advice to avoid this problem.

4. Excessive Promotion and Formation Expenses

Over-capitalization can be caused by excessive promotion and formation expenses. At the time of formation, the company spends a lot on promotion, underwriting, brokerage, and legal expenses. These expenses are capitalized and added to the total capital. If these expenses are very high, the capital becomes more than the real value of the business. The company has to bear the burden of such high capital. It reduces profit. Promoters should control formation expenses and keep them at a reasonable level. Proper control of promotion cost helps in preventing over-capitalization.

5. Raising More Capital Than Needed

Over-capitalization occurs when the company raises more capital than needed for its business. During boom, companies raise large funds easily. They issue more shares and debentures than required. The surplus funds remain idle or are invested in low-return projects. The company cannot earn sufficient profit on the total capital. This reduces the rate of dividend. Raising excess capital increases the burden of interest and dividend. The company should raise capital only as per actual needs. Proper planning of capital requirements is essential to avoid over-capitalization.

6. Fall in Earnings Due to Recession

Over-capitalization may occur due to fall in earnings after capitalization. At the time of formation, earnings may be high, but later due to recession, competition, or change in technology, earnings fall. The capital remains the same, but profit decreases. The company cannot pay fair return on capital. This situation is called over-capitalization. It is not due to wrong planning but due to external factors. The company cannot control recession. However, it can maintain reserves during good times to face bad times. Proper financial planning helps in reducing the effect of falling earnings.

What are the Consequence of Over-Capitalization?

1. Low Rate of Dividend

The main consequence of over-capitalization is low rate of dividend. Since capital is more than the earning capacity, the profit is distributed over a large capital. The company cannot pay fair dividend to shareholders. Shareholders get low return on their investment. They become dissatisfied and may sell their shares. Low dividend reduces the goodwill of the company. It also makes it difficult to raise funds in future. The company loses investor confidence. Low dividend is a clear sign of over-capitalization. It shows that the capital is not being used efficiently for earning profit.

2. Fall in Market Value of Shares

Over-capitalization leads to fall in market value of shares. When dividend is low, investors lose interest in the company’s shares. Demand for shares falls and market price goes down. Shareholders suffer capital loss. The reputation of the company is damaged. It becomes difficult to issue new shares. The company’s creditworthiness also falls. Banks hesitate to give loans. Fall in market value is a serious consequence because it affects the wealth of shareholders. It also makes the company vulnerable to takeover by competitors at a low price.

3. Difficulty in Raising Further Capital

Over-capitalized companies face difficulty in raising further capital. Investors do not want to invest in a company which pays low dividend and has low market value. Banks also hesitate to give loans because the company’s financial position is weak. The company cannot issue new shares or debentures easily. This difficulty affects expansion plans. The company may have to borrow at high interest. It creates a vicious circle of financial problems. Difficulty in raising capital slows down growth and makes it difficult for the company to survive in a competitive market.

4. Misuse of Funds and Inefficiency

Over-capitalization leads to misuse of funds and inefficiency. Since the company has more funds than needed, managers may spend carelessly. Funds may be invested in unprofitable projects or used for personal benefits. Idle funds do not earn return. This inefficiency reduces profitability. Managers become careless because there is no shortage of funds. The company may also maintain excess stock and assets. Misuse of funds is a serious consequence. Proper control and audit are needed. Efficient use of funds is essential for the success of the company.

5. Loss of Goodwill and Confidence

Over-capitalization causes loss of goodwill and confidence. Shareholders, creditors, and customers lose trust in the company when it pays low dividend and its share price falls. The company’s reputation in the market is damaged. It becomes difficult to get trade credit from suppliers. Employees may also lose motivation. Loss of goodwill affects sales and profit. Rebuilding goodwill takes a long time. The company may have to take steps like reorganization to regain confidence. Loss of goodwill is a long-term damage caused by over-capitalization.

6. Possibility of Winding Up

In extreme cases, over-capitalization may lead to winding up of the company. Continuous low profit, fall in share price, and loss of confidence may make it impossible for the company to continue. The company may not be able to pay its debts and expenses. Creditors may demand repayment. The company may be forced to close down. Even if it does not wind up, it may have to undergo reorganization and reduce capital. This is a costly and painful process. Possibility of winding up shows how serious the consequences of over-capitalization can be for the business.

What are the Remedies of Over-Capitalization?