10 Major Causes of Over-Capitalisation – Discussed!

Some of the major causes of over-capitalisation are: 1. Over-issue of capital 2. Acquiring assets at inflated prices 3. Formation during the boom period 4. Over estimation of earnings 5. Inadequate depreciation 6. Liberal dividend policy 7. Lack of reserves 8. Heavy promotion and organisation expenses 9. Shortage of capital and 10. Taxation policy.

1. Over-issue of capital:

Defective financial planning may lead to excessive issue of shares or debentures. The issue would be superfluous and a constant burden on the earnings of the company.

2. Acquiring assets at inflated prices:

Assets may be 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 is below its book value and the earnings are very low.

3. Formation during the boom period:

If the establishment of a new company or the expansion of an existing concern takes place during the boom period, it may be a victim of over- capitalisation. The assets are acquired at fabulous prices. But when boom conditions cease prices of products decline resulting in lower earnings. The original value of assets remains in books while earning capacity dwindles due to depression. Such a state of affairs results in over- capitalisation.

4. Over estimation of earnings:

The promoters or 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 required. Consequently, the rate of earnings per share will be less.

5. Inadequate depreciation:

Absence of suitable depreciation policy would make the asset-values superfluous. If the depreciation or replacement provision is not adequately made, the productive worth of the assets is diminished which will definitely depress the earnings. Lowered earnings bring about fall in share values, which represents over-capitalisation.

6. Liberal dividend policy:

The company may follow a liberal dividend policy and may not retain sufficient funds for self- financing. It is not a prudent policy as it leads to over-capitalisation in the long run, when the book value of the shares falls below their real value.

7. Lack of reserves:

Certain companies do not believe in making adequate provision for various types of reserves and distribute the entire profit in the form of dividends. Such a policy reduces the real profit of the company and the book value of the shares lags much behind its real value. It represents over-capitalisation.

8. Heavy promotion and organisation expenses:

“A certain degree of over­capitalisation ,”says Beacham, “may be caused by heavy issue expenses”. If expenses incurred for promotion, issue and underwriting of shares, promoters’ remuneration etc., prove to be higher compared to the benefits they provide, the enterprise will find itself over-capitalised.

9. Shortage of capital:

If a company has small share capital it will be forced to raise loans at heavy rate of interest. This would reduce the net earnings available for dividends to shareholders. Lower earnings bring down the value of shares leading to over-capitalisation.

10. Taxation policy:

High rates of taxation may leave little in the hands of the company to provide for depreciation and replacement and dividends to shareholders. This may adversely affect its earning capacity and lead to over-capitalisation.

Submitted by : Dr. Cooper, Category : Finance, Tag : Over-Capitalisation