MEANING AND DEFINITION OF OVER-CAPITALISATION
A company is said to be over-capitalised when its earnings are consistently insufficient to yield a fair rate of return on the amount of capitalisation. In other words, when a company is not in a position to pay interest on debentures and long-term borrowings, and dividends shares at fair rates, it is said to be overcapitalised.
This situation will normally arise when a company raises more capital than what is justified by its actual earnings. It may be noted that over-capitalisation does not necessarily mean abundance or excess of capital. Company may be over-capitalised because its capital is not effectively utilised, thus causing a constant decline in earnings. This leads to the inability of the company to pay normal rate of dividend and interest on shares and debentures respectively, and the .consequent fall in the market value of its shares.
In essence, if a company has been unable to earn a fair or prevailing rate of return on its capital, and consequently the market value of its shares is lower than the book value over a fairly long period of time, the company will be said to be overcapitalised.
Some definitions of over-capitalisation are as follows:
"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), it is to be over-capitalised.
Harold Gilbert
"Whenever the aggregate of the par value of stock and bonds outstanding exceeds the true value of fixed assets, the corporation is said be over-capitalised."
Hoagland
Thus, there are three main symptoms of over-capitalisation:-
- Lower rate of earning than prevailing in similar companies in the same industry over a fairly long period of time.
- Lower rate of dividend over a long period of time.
- Lower market value of shares than the book value of shares over a long period of time.
REMEDIES OF OVER-CAPITALISATION
It is evident from the foregoing discussion that the effects of over-capitalisation are very serious. Various remedial measures to correct the situation caused by over-capitalisation are as under:-
Reduction in Funded Debt
In order to control the situation of over-capitalisation, the company should reduce the amount of funded debts through outright re-organisation. The debentures should be immediately redeemed out of accumulated earnings or new and bonds issues.
Reduction of Interest Rate on Debentures
In order to increase earnings, an over -capitalised company should try to reduce its fixed obligation with regard to payment of interest on debts. The company may persuade the existing debenture holders to accept new debentures carrying lower rates of interest. The debenture holders may be attracted by offering some premium in this regard.
Redemption of Preference Shares
The amount of capitalisation may also be reduced by redeeming the preference shares carrying high rate of dividend. But the raising of necessary funds for redeeming the high dividend preference shares may further aggravate the situation.
Reduction of Par Value of Shares
The situation of over-capitalisation may also be corrected by persuading the existing shareholders to agree to accept new shares with reduced par value. Obviously, this would reduce the amount of capitalisation and improve the earning capacity of the company. However, it is very difficult to shareholders in this regard as they take it as a convince the trick to deceive them. If the management is able to management convince the existing shareholders that reduction in par value of share is the situation of in their interest, then it is possible to correct over-capitalisation by following this measure.
Reduction in Number of Shares
With the consent of its existing shareholders, the company may also reduce the number of shares to correct the situation caused by over-capitalisation. This may be done through consolidationof shares or reverse share split. The shareholders may be given one share of the same amount in exchange of several shares. This will not affect the amount of capitalisation, but earnings per share will go up. It will help the company in raising the necessary funds for future developments. In fact, this is purely psychological approach.
