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Modern Concept of Capitalization

According to modern concept, capitalization


includes:
(i) Share capital
(ii) Long – term debt
(iii) Reserves & surplus
(iv) Short – term debt
(v) Creditors
Need of Capitalization

1. At the time of promotion/incorporation of a


company
2. At the time of expansion of an existing company
3. At the time of amalgamation and absorption of two
or more company
4. At the time of re-organization of capital of a
company
 Over-Capitalization.

Over capitalization refers to that state of affairs where


earnings of a company do not justify the amount of capital
invested in its business. Over capitalization arises when the
existing capital of a firm is not effectively utilized with the
result that there is fall in the earning capacity of the
company. And this results into fall in rate of return on capital
and market value of shares of the company in long
run.
Effects of over-capitalization.

A. On company:

1. Loss of Goodwill
2. Poor creditworthiness
3. Decline in the efficiency
4. Difficulties in obtaining capital
5. Liquidation of company
Causes of Over-Capitalization.

1. Over issue of capital


2. Promotion, formation , extension during
inflation
3. Buying assets of lower value at higher prices
4. High promotion expenses
5. High investment in long term projects
6. Liberal dividend policy
7. Inadequate demand for products.
Effects of over-capitalization.

A. On company:

1. Loss of Goodwill
2. Poor creditworthiness
3. Decline in the efficiency
4. Difficulties in obtaining capital
5. Liquidation of company
B. Effects on shareholders.

1. Reduced dividends
2. Fall in the value of shares
3. Loss of faith/trust
4. Loss advantages as collateral security
 Under-capitalization
Under-capitalization refers to any situation where a business
cannot acquire the funds they need. An under-capitalized business may
be one that cannot afford current operational expenses due to a lack of
capital, which can trigger bankruptcy, may be one that is over-exposed
to risk, or may be one that is financially sound but does not have the
funds required to expand to meet market demand.

Under-capitalization is often a result of improper financial planning.


However, a viable business may have difficulty raising sufficient
capital during an economic downturn or in a country that imposes
artificial constraints on capital investment.
A company is said to be under-capitalized when it is earning
exceptionally higher profits as compared to other companies
or the value of its assets is significantly higher than the
capital raised. For instance, the capitalization of a company is
Rs. 20 lakhs and the average rate of return of the industry is
15%. But if the company is earning 30% on the capital
investment, it is a case of under-capitalization
Symptoms under capitalization.

(a) There is an unforeseen increase in earnings of the company.

(b) Future earnings of the company were under-estimated at the


time of promotion.

(c) Assets might have been acquired at very low prices


Causes of Under-capitalization

(a) Acquisition of Assets during Recession


(b) Under-estimation of Requirements
(c) Conservative Dividend Policy
(d) Efficient Management
(e) Creation of Secret Reserves
Effects of Under-capitalization on Company
(i) Because of higher profitability, the market value of company’s shares
would go up. This would also increase the reputation of the company.

(ii) The management may be tempted to build up secret reserves.

(iii) Higher rate of earnings will attract competition in the market.

(iv) The workers of the company may be tempted to demand higher


wages, bonus and other benefits.

(v) If a company is earning higher profits, the customers may feel that
they are being overcharged by the company.

(vi) The government may increase tax rates on companies earning


exceptional profits
Effects of Under-capitalization on Shareholders

(i) The profitability of the company may be very high. As a


result, the rate of earnings per share will go up.

(ii) The value of its equity share in the market will go up.

(iii) The financial reputation of the company will increase in the


market.

(iv) The shareholders can expect higher dividends regularly.