## Under-Capitalization

### Meaning

Under-capitalization occurs when a company's actual capitalization is lower than the proper capitalization warranted by its earning capacity. It is often seen in companies with insufficient capital but large secret reserves (due to unrecorded appreciation of fixed assets).

### Consequences

1. Higher dividend rate compared with similar companies.

2. Higher share price due to higher earnings.

3. Real (intrinsic) value of shares exceeds their book value.

### Effects

1. Encourages acute competition, as high profits attract new businesses.

2. High dividend rate may trigger higher wage demands from workers' unions.

3. Consumers may feel exploited.

4. Management may manipulate share values.

5. May invite more government control, regulation, and higher taxes.

### Remedies

1. Share split — reduces dividend per share, but EPS remains the same.

2. Issue of bonus shares — lowers both dividend per share and the average earnings rate.

3. Increase the par value of shares in exchange for existing shares.

⚠️ Common exam mistakes

Thinking under-capitalization means the company is doing badly — in fact it reflects high earnings relative to capital (real value > book value).
A share split changes dividend per share but NOT EPS — students often claim EPS falls.
Confusing the remedies for under-capitalization (share split, bonus shares, raising par value) with those for over-capitalization (buyback, reducing claims).

Reference:

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