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    Capitalization

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    severinmsangi
    Capitalization refers to the total amount of capital (funds) a company uses to operate its business. There can be over-capitalization, under-capitalization, or watered capitalization. Over-capitalization means a company has more capital than needed, reducing earnings. Under-capitalization is the opposite - not enough capital. Watered capitalization means the real value of assets is less than their book value. Managing capitalization effectively is important for company performance and financial health.

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    Capitalization

    Uploaded by

    severinmsangi
    8 views4 pages
    Capitalization refers to the total amount of capital (funds) a company uses to operate its business. There can be over-capitalization, under-capitalization, or watered capitalization. Over-capitalization means a company has more capital than needed, reducing earnings. Under-capitalization is the opposite - not enough capital. Watered capitalization means the real value of assets is less than their book value. Managing capitalization effectively is important for company performance and financial health.

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    Capitalization refers to the total amount of capital (funds) a company uses to operate its business. There can be over-capitalization, under-capitalization, or watered capitalization. Over-capitalization means a company has more capital than needed, reducing earnings. Under-capitalization is the opposite - not enough capital. Watered capitalization means the real value of assets is less than their book value. Managing capitalization effectively is important for company performance and financial health.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    8 views4 pages

    Capitalization

    Uploaded by

    severinmsangi
    Capitalization refers to the total amount of capital (funds) a company uses to operate its business. There can be over-capitalization, under-capitalization, or watered capitalization. Over-capitalization means a company has more capital than needed, reducing earnings. Under-capitalization is the opposite - not enough capital. Watered capitalization means the real value of assets is less than their book value. Managing capitalization effectively is important for company performance and financial health.

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    of 4

    CAPITALIZATION

    Capitalization is one of the most important parts of financial decision, which is related to the total
    amount of capital employed in the business concern.
    Understanding the concept of capitalization leads to solve many problems in the field of financial
    management. Because there is a confusion among the capital, capitalization and capital structure.
    The term capital refers to the total investment of the company in terms of money, and assets. It is
    also called as total wealth of the company. When the company is going to invest large amount of
    finance into the business, it is called as capital. Capital is the initial and integral part of new and
    existing business concern. The capital requirements of the business concern may be classified into
    two categories: (a) Fixed capital (b) Working capital.

    Meaning of Capitalization
    Capitalization refers to the process of determining the quantum of funds that a firm needs to run
    its business. Capitalization is only the par value of share capital and debenture and it does not
    include reserve and surplus.
    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
    Over capitalization refers to the company which possesses an excess of capital in relation to its
    activity level and requirements. In simple means, over capitalization is more capital than actually
    required and the funds are not properly used.
    According to Bonneville, Dewey and Kelly, over capitalization means, “when a business is unable
    to earn fair rate on its outstanding securities”.
    Example A company is earning a sum of Rs. 50,000 and the rate of return expected is 10%. This
    company will be said to be properly capitalized. Suppose the capital investment of the company is
    Rs. 60,000, it will be over capitalization to the extent of Rs. 1,00,000. The new rate of earning
    would be: 50,000/60,000×100=8.33% When the company has over capitalization, the rate of
    earnings will be reduced from 10% to 8.33%.

    Causes of Over Capitalization


    Over capitalization arise due to the following important causes:
    • Over issue of capital by the company.
    • Borrowing large amount of capital at a higher rate of interest.
    • Providing inadequate depreciation to the fixed assets.
    • Excessive payment for acquisition of goodwill.
    • High rate of taxation.
    • Under estimation of capitalization rate.

    Effects of Over Capitalization


    Over capitalization leads to the following important effects:
    • Reduce the rate of earning capacity of the shares.
    • Difficulties in obtaining necessary capital to the business concern.
    • It leads to fall in the market price of the shares.
    • It creates problems on re-organization.
    • It leads under or misutilization of available resources.

    Remedies for Over Capitalization


    Over capitalization can be reduced with the help of effective management and systematic design
    of the capital structure. The following are the major steps to reduce over capitalization.
    • Efficient management can reduce over capitalization.
    • Redemption of preference share capital which consists of high rate of dividend.
    • Reorganization of equity share capital.
    • Reduction of debt capital.

    Under Capitalization
    Under capitalization is the opposite concept of over capitalization and it will occur when the
    company’s actual capitalization is lower than the capitalization as warranted by its earning
    capacity. Under capitalization is not the so called inadequate capital.
    Under capitalization can be defined by Gerstenberg, “a corporation may be undercapitalized when
    the rate of profit is exceptionally high in the same industry”.
    Hoagland defined under capitalization as “an excess of true assets value over the aggregate of
    stocks and bonds outstanding”.

    Causes of Under Capitalization


    Under capitalization arises due to the following important causes:
    • Under estimation of capital requirements.
    • Under estimation of initial and future earnings.
    • Maintaining high standards of efficiency.
    • Conservative dividend policy.
    • Desire of control and trading on equity.

    Effects of Under Capitalization


    Under Capitalization leads certain effects in the company and its shareholders.
    • It leads to manipulate the market value of shares.
    • It increases the marketability of the shares.
    • It may lead to more government control and higher taxation.
    • Consumers feel that they are exploited by the company.
    • It leads to high competition.

    Remedies of Under Capitalization


    Under Capitalization may be corrected by taking the following remedial measures:
    1. Under capitalization can be compensated with the help of fresh issue of shares.
    2. Increasing the par value of share may help to reduce under capitalization.
    3. Under capitalization may be corrected by the issue of bonus shares to the existing shareholders.
    4. Reducing the dividend per share by way of splitting up of shares.

    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.

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