What is capitalization? What are the kinds of capitalization?

What is capitalization? What are the kinds of capitalization?

Ans. Capitalization can be defined by the various financial management experts. Some of the definitions are mentioned below:

According to Guthman and Dougall, “capitalization is the sum of the par value of stocks and bonds outstanding”.

“Capitalization is the balance sheet value of stocks and bonds outstands”.

— Bonneville and Dewey

According to Arhur. S. Dewing, “capitalization is the sum total of the par value of all shares”.

TYPES OF CAPITALIZATION

Capitalization may be classified into the following three important types based on its nature:

•    Over Capitalization

•    Under Capitalization

•    Water Capitalization

Over Capitalization

A company is said to be over-capitalised when its total capital (both equity and debt) exceeds the true value of its assets. It is wrong to identify over-capitalisation with excess of capital because most of the over-capitalised firms suffer from the problems of liquidity. The correct indicator of overcapitalization is the earnings capacity of the firm.

If the earnings of the firm are less than that of the market expectation, it will not be in a position to pay dividends to its shareholders as per their expectations. This is a sign of over-capitalisation. It is also possible that a company has more funds than its requirements based on current operation levels and yet have low earnings.

Over-capitalisation may be considered on the account of:

 Acquiring assets at inflated rates

 Acquiring unproductive assets

 High initial cost of establishing the firm

 Companies which establish their new business during boom condition are forced to pay more for

 acquiring assets, causing a situation of over-capitalisation once the boom conditions subside

Total funds requirements have been over estimated

 Unpredictable circumstances (like change in import/export policy, change in market rates of interest, and changes in international economic and political environment) reduce substantially the earning capacity of the firm. For example, rupee appreciation against US dollar has affected the earning capacity of the firms engaged mainly in the export business because they invoice their sales in US dollar

 Inadequate provision of depreciation adversely affects the earning capacity of the company leading to over-capitalisation of the firm

 Existence of idle funds

Effects of over-capitalisation

 Decline in earnings of the company

 Fall in dividend rates

 Loss of goodwill

 Market value of the company’s share falls, and the company loses investors’ confidence.Company may collapse at any time because of anaemic financial conditions which affect its employees, society, consumers, and shareholders. Employees will lose jobs. If the company is engaged in the production and marketing of certain essential goods and services to the society, the collapse of the company will cause social damage

Remedies of over-capitalisation

Over-capitalisation often results in a company becoming sick. Restructuring the firm helps to avoid such a situation. Some of the other remedies of over-capitalisation are:

 Reduction of debt burden

 Negotiation with term lending institutions for reduction in interest obligation

 Redemption of preference shares through a scheme of capital reduction

 Reducing the face value and paid-up value of equity shares

 Initiating merger with well–managed, profit-making companies interested in taking over ailing company

 Under Capitalization

 Under-capitalisation is just the reverse of over-capitalisation. A company is considered to be under-capitalised when its actual capitalisation is lower than the proper capitalisation as warranted by the earning capacity.

Symptoms of under-capitalisation

The following points describe the symptoms of under-capitalisation:

 Actual capitalisation is less than the warranted earning capacity

 Rate of earnings is exceptionally high in relation to the return enjoyed by similar situated companies in the same industry

Causes of under-capitalisation

The following points describe the causes of under-capitalisation:

 Under estimation of the future earnings at the time of the promotion of the company

 Abnormal increase in earnings from the new economic and business environments

 Under estimation of total funds requirement

 Maintaining very high efficiency through improved means of production of goods or rendering of services

 Companies which are set up during the recession period will start making higher earning capacity as soon as the recession is over .

 Purchase of assets at exceptionally low prices during recession

Effects of under-capitalisation

The following points describe some of the effects of under-capitalisation:

 Under-capitalisation encourages competition by creating a feeling that the line of business is lucrative

 It encourages the management of the company to manipulate the company’s share prices

 High profits will attract higher amount of taxes

 High profits will make the workers demand higher wages. Such a feeling on the part of the employees leads to labour unrest

 High margin of profit may create an impression among the consumers that the company is charging high prices for its products

 High margin of profits and the consequent dissatisfaction among its employees and consumer may invite governmental enquiry into the pricing mechanism of the company

Remedies

The following points describe the remedies of under-capitalisation:

 Splitting up of the shares, which will reduce the dividend per share

 Issue of bonus shares, which will reduce both the dividend per share and the earnings per share

Watered Capitalization

If the stock or capital of the company is not mentioned by assets of equivalent value, it is called as watered stock. In simple words, watered capital means that the realizable value of assets of the company is less than its book value.

According to Hoagland’s definition, “A stock is said to be watered when its true value is less than its book value.”

Causes of Watered Capital

Generally watered capital arises at the time of incorporation of a company but it also arises during the life time of the business. The following are the main causes of watered capital:

1.  Acquiring the assets of the company at high price.

2.  Adopting ineffective depreciation policy.

3.  Worthless intangible assets are purchased at higher price.