Under-capitalization

Under-capitalization

Under-capitalisation is just the reverse of over-capitalisation. Sometimes a company, on the face of it, may have an insufficient capital but it may have large secret reserves.

Thus, in case of well-established companies, there is a very large appreciation in the value of assets specially of buildings, plant and goodwill. Such appreciation is generally not brought into the books. Nevertheless these assets do bring profits and, therefore, the profits in such a company would appear to be much larger than are warranted by the book figures of the capital. In such a case, the dividends will be high and the market quotations of the shares of such companies will be higher than the par value of the shares of other similar companies. It is in this sense that an under-capitalized company pays high rates of dividend and the value of the shares is higher than the par value. A company is under-capitalized when its actual capitalisation(i.e., total long-term resources) is lower than its proper capitalisation as warranted by its earning capacity. Such a company will earn considerable more than the prevailing rate on its outstanding securities.

Disadvantages of under-capitalisation

Under-capitalisation, too, has its own disadvantages

(i) competition is encouraged and made acute by the higher earnings of such companies

(ii) the high dividend rates given an opportunity to workers to ask for increase in wages

(iii) it may give the consumers a feeling that they are being exploited by the company

(iv) it may tempt the management to manipulate share values

(v) it may limit the marketability of shares due to which the shares may not enjoy so high a market value as is justified by the earnings

(vi) it may attract governmental control and higher taxation. All or some of these factors may act together to reduce the margin of profit earned by the company. In course of time, then, the earnings of the company may come down to the level of other companies’ earnings. Under-capitalisation of this type may thus be temporary in character and often gets remedied automatically.

Remedies of under-capitalisation

If it is desired to remedy under-capitalization, it can be done relatively more easily than in the case of over-capitalization.

The possible corrections for under-capitalisation may be outlined as under:

(i) Spliting-up of shares. The effect of this measure will be more apparent than real because the overall rate of earnings in this case will remain the same though the dividend per share will now b e a smaller amount.

(ii) Increase in par value of shares. The values of assets, under this scheme, may be revised upwards and the existing shareholders may be given new shares carrying higher par (face) value. In this way, the rate of earnings will decline though the amount of dividend per share may not be affected. As a further step, the com pay may offer the shareholders a share split-up and an increase in par-value.

(iii) Issue of bonus shares. The most widely used and effective remedy for under capitalisation is the conversion of reserves into shares. This will affect both dividend per share and the over-all rate of earnings.

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