Over-Capitalisation and Under-Capitalisation

## Over-Capitalisation vs Under-Capitalisation

### Over-Capitalisation

A firm is over-capitalised when it has more capital than it can profitably employ — assets are worth less than issued capital, and earnings are insufficient to pay dividends and interest.

#### Causes

1. Raising more money than can be profitably invested

2. Borrowing at a higher rate than the firm can earn

3. Excessive payment for fictitious assets (e.g., overvalued goodwill)

4. Inadequate depreciation / overpaying dividends from capital

5. Wrong estimation of future earnings at the time of capitalisation

#### Consequences

• Reduced dividend and interest payment rate
• Fall in market price of shares
• 'Window dressing' (manipulating books to hide poor performance)
• May lead to reorganisation or liquidation

#### Remedies

• Reorganisation/restructuring of the company
• Buyback of shares (reduces excess capital)
• Reduction in claims of debenture holders and creditors
• Reduce share par value to free funds for asset replacement

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### Under-Capitalisation

The exact reverse — actual capitalisation is lower than what the firm's earning capacity warrants.

Typically happens when a firm has:

• Insufficient capital on record, but
• Large secret reserves (e.g., appreciated asset values not recorded in books)

#### Consequences

• Dividend rate is higher than comparable firms
• Market value of shares is higher than similar firms
• Real value of shares exceeds book value

#### Effects

• Encourages new competitors (high profitability attracts entry)
• Workers demand higher wages (seeing high profits)
• Public perception of exploitation
• Management may manipulate share prices
• Invites government scrutiny and higher taxation

#### Remedies

• Split shares → reduces dividend per share (EPS unchanged)
• Issue Bonus Shares → reduces effective dividend and earnings rate
• Revise par value upward (exchange existing shares for higher par value shares)

### Quick Comparison