When a company is overcapitalized, its market value is less than its total capitalized value or its current value. An overcapitalized company may end up paying more in interest and dividend payments than it can sustain in the long term. Being overcapitalized means that a company’s capital management strategies are running inefficiently, placing it in a poor financial position.
( Redemption of High Dividend Preferred Stock:
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. Market value of shares is the price at which shares of a company are quoted in stock exchange. By doing so, Infosys aims to return excess capital to shareholders, enhance earnings per share (EPS), and maintain a more efficient capital structure. These buybacks are part of Infosys’ broader capital management strategy to strike a balance between financial stability and shareholder value creation.
In this scenario, creditors demand that the corporation be reorganised. For similar reasons, banks and other financial organisations are reluctant to provide loans. When a company’s earnings are continuously insufficient to generate a reasonable rate of return on the amount of capitalization, it is said to be over-capitalized.
The term Capitalisation means total amount of long term funds available to the company. Something significant is being ruined by its financial stability. Investors lose faith in the company due to irregular dividend payments brought on by a decline in earning potential. As a result, it has a tough time obtaining the necessary funding from the capital market to meet its needs for growth and development. Commercial banks are also hesitant to provide such a company with short-term advances to cover its working capital needs, which will impede output. Overcapitalised businesses occasionally risk missing deadlines for principal repayment and interest payments.
- Thus, we see that as a result of over-capitalisation, the rate of earnings has dropped from 10% to 8⅓%.
- Consequently, the rate of earnings per shares will be less.
- Certain companies do not believe in making adequate provision for various types of reserves and distribute the entire profit in the form of dividends.
- Overcapitalization in working capital can lead to distressing working capital management for any business.
It means excessive dividend payments can also lead to the overcapitalization of a company in the long run. Cash flow and working capital management are essential for the success of any business. Overcapitalization can lead to compromised cash flow of a business as more of it would go to interest or dividend payments than for the retained earnings. Overcapitalization refers to a situation where a company issues more debt and equity capital than its net assets. It means a business has funded more capital than it acquired assets that result in overcapitalization.
The actual rate of return in this case will go down to 10%. Since the rate of interest on debentures is fixed, the equity shareholders will get lower dividend in the long-run. It is the capitalization under which the actual profits of the company are not sufficient to pay interest on debentures and borrowings and a fair rate of dividend to shareholders over a period of time.
Excessive Capital Funding
Hence, the scarce resources of society are not properly utilised. 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. (3) Showing assets at increased value due to lack of proper depreciation policy. (1) Acquiring of fictitious assets like goodwill at high prices.
Thus, if a business can keep its cashflows and working capital smooth, it can avoid the problems of capitalization. Overcapitalization can have negative impacts on the working capital management of a business. It also affects the profitability and sustainability of the business in the long term.
The company would be overcapitalised even if the earnings estimates were accurate, but the capitalization rate was underestimated. Underestimating the capitalization rate causes the company to raise more money than it might profitably use. As a result, the corporation cannot pay dividends at market prices, resulting in a declining market value of its shares, which signifies overcapitalisation. 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.
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. 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. 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. High rates of taxation may leave little in the hands of the company to provide for depreciation and replacement and dividends to shareholders.
Working Capital Management
In the common sense, it may seem that abundance causes of over capitalisation of capital is over-capitalisation. But over-capitalisation is that state of capitalisation in which a company has capital in excess of what it cans fruitfully utilize. Abundance Of capital, it is not unlikely, does not mean further capital for various reasons. (ii) Closure of an over-capitalised company hits the society adversely; in terms of loss of production, generation of unemployment, etc.
Increased Capital Investment
If the return on equity is persistently low, it results in a decline in investor trust. Businesses aim to produce earnings at a targeted level in the future. They can fund projects with debt and equity capital in anticipation of future earnings. In some cases, overestimation of earnings would also result in excessive capital investment and overcapitalization. Low rate of earnings and reduced dividends cause fall in the market value of shares of the over-capitalised company.
- Assume that construction firm Company ABC earns $200,000 and has a required rate of return of 20%.
- This situation creates a soft market and causes insurance premiums to decline until the market stabilizes.
- This situation will normally arise when a company raises more capital than what is justified by its actual earnings.
Causes of Overcapitalisation
Different societal groups fight overcapitalised companies in a variety of ways. They cannot remain competitive, and they are edging closer to a point where liquidation is required even though the existence of these worries cannot be substantiated. As a result of falling wages, workers’ purchasing power decreases. The entire society may exhibit this propensity, and a recession may result. Undercapitalization refers to a situation where a business does not have sufficient capital investment as compared to its needs.
Taxation policy:
Repayment of long-term debts to reduce the interest payments may help an overcapitalized firm to relieve the problem. Overcapitalization may occur when the return on investment earned by a company is exceptionally lower with respect to other similar companies in the same industry. Depreciation may be charged at a lower rate than warranted by the life and use of the assets, and the company may not make sufficient provisions for replacement of assets. Assets might have been acquired at inflated prices or at a time when the prices were at their peak. In both the cases, the real value of the company would be below its book value and the earnings very low.