The equity holders are the main losers when the company is over capitalized. It demoralizes them. There are many causes for it and it can be avoided in your company.
Over capitalization is “When securities in the company are issued in excess of its capitalized earning power.” This demoralizes equity share holders who have invested their savings. They do not earn dividends since the company does not earn enough profits to be declared as dividends.
This state may also imply shortage of capital. It is a shortage of capital because the aggregate of par value of stocks and bonds outstanding exceeds the value of fixed assets. The market value of equity shares eventually declines.
Nine Causes of Over Capitalization.
1. Over Issues of Shares
Due to poor planning,
a company issues more shares and debentures than it should. This results to low earnings.
2. Acquiring Assets at Inflated Prices
If assets are bought at inflated prices, then it results to low book value. The real value of assets is low thus resulting to low earnings per share.
3. Boom Period
When a company is formed during boom period, then it experiences low earnings after the boom period is over.
4. Over Estimated Earnings
During the promotion stage, the promoters and directors may over estimate its earnings thus raising more capital than required. This excess capital leads to lower earnings.
5. Adoption of Liberal Dividend Policy
If this is adopted, it causes low earnings in the long run. It results to low book value compared to real value.
6. Lack of Reserves
When a company is not making enough provisions for reserves, it results to over capitalization. This happens especially if it distributes whole profits as dividends to share holders.
7. Heavy Promotion and Organization Expenses
When the expenses incurred for promotion of the company such as, issuing and underwriting shares, promoter’s remuneration are very high compared to their benefits to the company, then this results to over capitalization.
8. Shortage of Capital
If a company has insufficient capital, it’s forced to raise additional capital through loans at high interest rates which results to low earnings.
9. Taxation Policy
Overcapitalization occurs when the policy adopted by the government is not fair. A small amount of profits is left to cater for depreciation and dividends. Its earning capacity is reduced as a result of high taxes.
Seven Ways of Overcoming Over Capitalization
1. The efficiency and productivity of human power and other company’s resources should be increased. Their wastages should be avoided. This results to increased earnings.
2. The company should plough back its profits. This stabilizes the company’s earnings during difficult moments.
3. There should be a reduction in the funded debts by redeeming debentures and bonds in order to equalize the book value and the real value.
4. The interest rates of bonds should be reduced to ensure sufficient earnings of the company.
5. If preferred stocks are of high dividend, then they should be redeemed.
6. There should be a reduction in the par value of shares.
7. The number of equity shares should be reduces.
