Get an answer for ‘Overcapitalization and Undercapitalization are both unhealthy signs for Distinguish between the marketing concept and the selling concept. This article will help you to differentiate between Over-Capitalisation and Under- Capitalisation. 1. Over-capitalisation involves a great-strain on the financial. Overcapitalization A company is said to be overcapitalized, when its total capital ( both equity and debt) exceeds the true value of its assets.
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The most important dofference of financial planning is to determine the right proportion of debt and equity. The objective of a firm is to create value which can be performed through proper mobilization and use of funds.
So the right amount of capitalization is the basic objective of a finance manager. Fair capitalization is that situation where the business has employed the correct amount of capital and its earnings are same as the average rate of earnings. The sources of funds and their amount should be carefully selected betwee attain the value maximization objective of a firm.
Fair capitalization helps a firm achieve this objective. Under fair capitalization every rupee of the fund mobilized is used profitably.
Neither is there any shortage of funds nor is any fund left unutilized. This can be done by balancing the debt and equity component in capitalization. It is an imbalanced condition between par value of capital and true value of fixed assets of a concern. Generally this situation is indicated by earnings of the company and not by the excess of capital.
In other words, lower rate of earnings compared to the expected return is explained as over-capitalization. If the rate of earnings of the company is less than the average of the industry it belongs to, then the company is considered over-capitalized.
The situation of over-capitalization arises when the capital becomes redundant. In other words, under the situation of over-capitalization the par value of shares and debentures of the company is more than the true value of its fixed assets.
From the earnings point of view the earning of an over-capitalized firm must be lower than its expected earnings. An over-capitalized firm has more equity component than debt in its capital structure and its long-term fund is not optimally deployed on fixed assets.
Difference between Over-Capitalization and Under Capitalization
Moreover, a part of current assets of such type of firm is financed through long-term funds. Often due to inadequate financial planning, the capital of the company is not estimated correctly and it undercwpitalization shortage of capital. Hence it raises additional capital at a non- remunerative rate differrence interest, which leads to excessive fixed charges. Sometimes companies distribute large amounts of dividend from the profit and do not keep aside retained earnings or reserves.
Difference between Over Capitalization and Under Capitalization of Company
This weakens their liquidity position and puts the company in the state of over-capitalization. This also leads to over-capitalization. At the time of promotion companies may spend heavy preliminary expenses such as payment of commission, fees to underwriters, brokers, etc. Faulty depreciation policy may also lead to over-capitalization. If the provision for depreciation or obsolescence is inadequate it will reduce the profit earning capacity of the company.
Over-capitalization is not desirable as the company may face various problems including the inability to pay interest on bonds. It has severe adverse effects on various stakeholders as discussed below:.
This may make it difficult for the company to raise new capital. Due to fall in price of stock the shareholders will be the biggest losers. Even they will get a lower amount of dividend due to over-capitalization. To combat over-capitalization the company may increase prices of their products or it may compromise with the quality of the product.
So the customers will be the ultimate sufferers. A company is also a social organization. If the company continues with over-capitalization there may be chance of its liquidation.
In such situation the society will face an irreparable damage.
Over-capitalization puts the company in difficulty. It may induce a failure.
So every firm suffering from the problem of over-capitalization must search ways to overcome this problem. Mentioned below are some measures that can be taken to rectify the problem of over-capitalization: The company can try to retire its debt capital to reduce the burden of paying fixed interest. However, this is voercapitalization an easy task as large amounts of funds are required to pay the debt off; this can be done by issuing new shares.
By a thorough reorganization, a company may reduce the rate of interest on bonds. This is also a difficult task as the bondholders may not agree and could force the company to pay the debt off thereby creating a shortage of funds in the company.
If the company has preferred stock in their capital structure that is to be redeemed or the rate of dividend is to be reduced. This is also a difficult method to bwtween as the common stockholders may be reluctant to receive one share in place of several shares. This is also an imbalanced condition between par value of capital and the true value of fixed assets of an organization.
Under-capitalization does not mean shortage of funds—rather it is indicated by the higher rate of earnings compared to the expected returns. In other words, under this situation ajd real worth of overcwpitalization exceeds their book value. Betdeen is the reverse of over-capitalization. When the rate of earnings of a company is more than the fair or normal rate of earnings of that industry then the beween is considered as under-capitalized.
The par value of shares and debentures of an under-capitalized company is less than the true value of its fixed assets.
From the earnings point of view the earnings of an under-capitalized firm is higher than its expected earnings. In an under-capitalized firm a part of fixed assets is financed through short-term funds. A company becomes under-capitalized when the future earning is under-estimated at the time of promotion. As a result the actual earnings is much higher than the expected earnings.
Due to conservative dividend policy a company may have higher accumulated profits as retained earnings. This may lead to the situation of under-capitalization. Change in any macroeconomic factors may bring windfall gains to the company. This may also lead to under-capitalization of a firm. Often companies indulge in rivalries through under-capitalization. The effects of under-capitalization may be seen in many ways like increase in market value of shares or entry of competitors in the market.
Consumers may feel exploited because of high rate of profit. They may think that there could be a chance to reduce prices or improve quality of product—which the company is not adopting.
An under-capitalized firm may have to depend frequently on short-term funds. This may threaten the liquidity position of the company.
Over-Capitalisation and Under-Capitalisation (Differences)
The market price of shares goes up as the earnings are high. This may tempt the company to issue new shares. High rate of earnings of the under-capitalized firm may allure competitor firms to enter into the market.
This may affect the profitability of the firm adversely. Looking at the high rate of profit the labour force may demand higher wages which may lead to labour unrest. Moreover, the dissatisfaction of the labour force may reduce its efficiency and productivity. Under-capitalization is not as dangerous as the over-capitalization, yet it creates certain difficulties for the firm.
So companies suffering from the problem of under-capitalization must try to remove the state of under-capitalization. The company may divide the denomination of stock into small value to increase the number of shares.
This will reduce the earnings per share. If the par value of shares is increased by exchanging the old shares with new increased par value shares the rate of earnings will be reduced.
This would not affect par value of share but would increase the capitalization and the number of shares. Consequently the rate of earnings and earnings per share will come down. Designing an Optimum Capital Structure.
Concept and Features of Optimal Capital Structure.