Meaning of Capitalization

The term capitalization means the total amount of capital employed in a

business. However, like the broader concept of capital, there is no universally accepted definition of capitalization. Some authors have given a very broad interpretation to the term while others have taken a narrow view.

Broad Interpretation

According to this interpretation, the term capitalisation is synonymous with

the term financial planning and includes not merely the determination of the

quantity of finance required for a company but also the decision about the
quality of financing. Used in this sense, the term capitalisation includes : estimating the total amount of capital to be raised,

determining the types of securities to be issued for raising such capital,

and determining the relative proportion of various securities to be issued.

Narrow Interpretation

According to this interpretation, the term capitalisation refers to the process

of determining the quantum of funds required for a firm. As such, the decision regarding the type of securities and their relative proportion falls under the term 'capital structure not in Capitalization.

Definitions of Capitalization

According to Guthmann and Dougall, "Capitalisation is the sum of the par

value of stocks and bonds outstanding." According to this view, capitalisation includes only par value of shares and debentures but excludes surplus and

reserves

According to Gerstenberg, "Capitalisation comprises of a company's ownership

capital which includes capital stock and surplus in whatever form it may appear

and borrowed capital which consists of bonds or similar evidences of long-term

debt."

In the words of Lillian Doris, "Capitalisation of a corporation comprises the

ownership capital and the borrowed capital as represented by long-term
indebtedness. It may also mean the total accounting value of the capital stock, surplus in whatever form it may appear and the funded long-term debt."

Over-capitalisation

The term 'over capitalisation' is generally used to convey the sense of

overstatement of the value of properties held by the concern or a redundancy of capital.

According to Gerstenberg, "A corporation is over capitalised when its

earnings are not large enough to yield a fair return on the amount of stock and bonds that have been issued or when the amount of securities outstanding exceed the current value of the assets."

In the words of Gilbert Harold, "When a company has consistently been

unable to earn the prevailing rate of return on its outstanding securities, considering the earnings of similar companies in the same industry and the degree of risk involved, it is said to be over capitalised."

Test of Over-Capitalization

Actual Rate of Earnings is less than Current Rate of Earnings. Real Vale of Business is less than Book Value of the Business. Real Vale of the Shares is less than Book Value of the Shares.

Causes of Over-capitalization

1. High Cost of Promotion - If cost of promotion is high the balance sheet of

new company will show fictitious assets in larger amounts resulting into over-capitalization.

2. Excess Capital - If management of a company collects funds too much

without their need, it will be naturally over-capitalized. The management will not be able to pay suitable return on it.

3. Wrong Estimate of Earnings - If the projection of earnings is not correct;

they are estimated at a high level, the company after some time will be overcapitalized.

4. Capitalisation at a Lower Rate - If the normal rate of return is taken to be

low the capitalized value of earnings will be automatically high. It will make the company over-capitalized.

Effects of Over-capitalization Effects on the Company

Loss of goodwill Difficulty in obtaining capital Difficulty in obtaining loans Inflated profits

Weak internal position

Effects of Over-capitalization

Effects on Shareholders

Reduced Dividend Capital Loss Loss on Reorganization Unacceptable as Collateral Security

Loss on Liquidation

Meaning of Under Capitalization

An under-capitalized company is one whose earnings have been higher in

relation to the size of the invested capital. As such under capitalization is an indication of effective and proper utilization of funds employed in the business. In this condition the real value of a company is more than its book value.

Definition of Under Capitalization

In the words of Gerstenberg, "A company is under-capitalized when the

rate of profits it is making on the total capital is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry. Thus, the real value of an under-capitalized company is more than its book value. Its profits are higher than warranted by the book value of its assets. Hence, the rate of dividend on its equity shares goes up and company experiences the shortage of ready funds to exploit market opportunities. The market value of equity shares goes high and high encouraging speculators to buy them.

Test of Under-Capitalization

Actual Rate of Earnings is more than Current Rate of Earnings. Real Vale of Business is more than Book Value of the Business. Real Vale of the Shares is more than Book Value of the Shares.

Causes of Under-capitalization

Under estimation of Earnings - If at the time of promotion the expected

earnings are under estimated and afterwards there is an enormous increase in earnings, the company will be in a position to declare and pay bumper dividends.

Conservative Dividend Policy - A conservative dividend policy can also lead

under capitalization in the long-run. A sound reserves and surplus base encourages the management to pay higher dividends.

Trading on Equity - If company follows the policy of trading on equity for a

long time and the debt capital is available to the company on suitable terms and
conditions and comparatively at a lower rate, the company will be undercapitalized after some time.

Promotions during Depression Period If a company has been promoted

Effects of Under-capitalization on Company

Encouragement of competition Encouragement to management to manipulate share values Possibility of government interference Labour unrest Resistance by consumers

Effects of Under-capitalization on Share Holders

High dividend rate

Capital gains Ease in getting loans :

Optimum Capitalization

Over-capitalization and under-capitalization both are harmful. Hence, every

company desires to have a fair or optimum capitalization. Optimum

capitalization is that amount of capital at which the firm is in equilibrium,

i.e., if the capitalization is more than this amount, the firm will be overcapitalized and if it is less than this amount, it will be under-capitalized. The

amount of optimum capital is determined by the relationships of investment

and income. If the firm's income (after deducting operating expenses and interest on loan) is sufficient to give reasonable return on equity share capital, then firm's capitalization is said to be fair or optimum. In case the book value exceeds the real value, the company is said to be overcapitalized. In a reverse case, the company is undercapitalized.