Capitalization- Over-capitalization and Under capitalization

Started by TechShristi, April 15, 2013, 01:10:41 pm

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Capitalization: It is where costs to acquire an asset are included in the price of the asset. For example, if a machine has a price of $1 million this value would be recorded in the assets, if there was also a $20,000 charge for shipping the machine then this cost would be capitalized and included in assets.   

Capitalization can be of two different types:
a)   Over Capitalization: Situation where a firm has more capital than it catered-for or needs.
   Investment in term of  FD is more than it required in term of Profit
   Profit is less than required in comparison of Investment
   Market value of equity is more that its book value of equity share

Reason for Over Capitalization:

a)   Establishment of company during Inflationary Period:
Purchase the assets at a high price may cause to over capitalization. This is because it will not increase the profitability as the inflation is temporary in nature.

b)   Acquisition of assets at higher Price: Acquisition of assets at a higher price also lead to over capitalization for example promoter transfer the land at a higher price.

c)   Higher Establishment Expenses: Remuneration paid to Promoter is consider as a Good will and in return good will do not give any return, so it would result in higher rate of expenses but not increase the profitability.

d)   Worth Assets: Worth assets also lead to over capitalization for example Old patent become worthless due to acquiring new paten.

e)   Wrong/Higher Depreciation:  Higher depreciation will reduce the profit and value of assets too. But the effect on profit would be greater than the effects on the assets. Thus, it will lead to over capitalization.

f)   Conservatism Policy: Less dividend lead to more amount of cash there by it lead to more investment and finally overall results in over capitalization


   Regular source of income would not be there
   Collateral securities will not be accepted and if accepted than it will be  at lower price
   Shareholder value is lowered
   Public at large:
a)   Unemployment
b)   Quality get hampered
c)   Liquidation cause wastage of resources of society

Remedies of Over-Capitalization:

   Reconstruction of Capital Structure: One of the important remedy for over capitalization is reconstruction of capital structure. For example:
a.   Preference share of higher rate of interest can be redeemed
b.   Issues debenture at a lower rate of interest at low maturing time period. This compel the public at large to opt for this options

   Increasing in efficiency: Motivate the employee and try to use the resource to the optimum to increase the efficiency and thereby profit of the company.

Under Capitalization: It is opposite of Over Capitalization that is situation where a firm has less capital than it catered-for or needs.

Note: The effects, reasons and remedies would be almost opposite of Over capitalization. So it is easy to do on your own. Further please note that above all points is written from the viewpoints of quick guide for the basic understanding at the foundation level.



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