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What is over capitalization? What are its causes?

Avatar 37a3bd7bc7328f0ead2c0f6f635dddf60615e676e6b4ddf964144012e529de45 asked

Hi I am Kiran. I am preparing for CA exam. Can I know, What is over capitalization? What are its causes?

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Avatar 37a3bd7bc7328f0ead2c0f6f635dddf60615e676e6b4ddf964144012e529de45 answered

**Meaning of Over-capitalization:** It is the capitalization under which the actual profits of the company are not sufficient to pay interest on debentures and borrowings and a fair rate of dividend to shareholders over a period of time. In other words, a company is said to be over-capitalised when it is not able to pay interest on debentures and loans and ensure a fair return to the shareholders. We can illustrate over-capitalisation with the help of an example. Suppose a company earns a profit of Rs. 3 lakhs. With the expected earnings of 15%, the capitalisation of the company should be Rs. 20 lakhs. But if the actual capitalisation of the company is Rs. 30 lakhs, it will be over-capitalised to the extent of Rs. 10 lakhs. The actual rate of return in this case will go down to 10%. Since the rate of interest on debentures is fixed, the equity shareholders will get lower dividend in the long-run. **Causes of Over-Capitalisation:** Over-capitalisation may be the result of the following factors: (i) Acquisition of Assets at Higher Prices: Assets might have been acquired at inflated prices or at a time when the prices were at their peak. In both the cases, the real value of the company would be below its book value and the earnings very low. (ii) Higher Promotional Expenses: The company might incur heavy preliminary expenses such as purchase of goodwill, patents, etc.; printing of prospectus, underwriting commission, brokerage, etc. These expenses are not productive but are shown as assets. (iii) Underutilisation: The directors of the company may over-estimate the earnings of the company and raise capital accordingly. If the company is not in a position to invest these funds profitably, the company will have more capital than is required. Consequently, the rate of earnings per shares will be less. (iv) Insufficient Provision for Depreciation: Depreciation may be charged at a lower rate than warranted by the life and use of the assets, and the company may not make sufficient provisions for replacement of assets. This will reduce the earning capacity of the company. (v) Liberal Dividend Policy: The company may follow a liberal dividend policy and may not retain sufficient funds for self-financing. This may lead to over-capitalisation in the long-run. (vi) Inefficient Management: Inefficient management and extravagant organisation may also lead to over-capitalisation of the company. The earnings of the company will be low.

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