Capitalization in Finance

What is Capitalization

Capitalization includes share capital, debentures, loans, free reserves, etc. Capitalization represents permanent investment in firms excluding semipermanent loans. Capitalization is often distinguished from the capital structure. The capital structure could be a broad term and it deals with qualitative side of finance. whereas capitalization could be a slender term and it deals with the quantitative side.

Capitalization is mostly found to be of following types-

1. Normal
2. Over
3. Under

Overcapitalization

Overcapitalization could be a state of affairs within which actual profits of an organization aren't adequate enough to pay interest on debentures, on loans and pay dividends on shares over an amount of your time. this example arises once the corporate raises additional capital than needed. a section of capital continually remains idle. As a result, the speed of come back shows a declining trend. The causes will be-

• High promotion cost- once an organization goes for top promotional expenditure, i.e., creating contracts, canvassing, underwriting commission, drafting of documents, etc. and therefore the actual returns aren't adequate in proportion to high expenses, the corporate is over-capitalized in such cases.
• Purchase of assets at higher prices- once an organization purchases assets at associate inflated rate, the result's that the value of assets is over the particular returns. this example offers rise to the over-capitalization of the company.
• A company’s floatation n boom period- sometimes the company has got to secure it’s economic condition and thereby float in boom periods. that's the time once the rate of returns area unit less as compared to capital utilized. This leads to actual earnings lowering down and earnings per share declining.
• Inadequate provision for depreciation- If the finance manager is unable to supply associate adequate rate of depreciation, the result's that inadequate funds area unit accessible once the assets have to be compelled to get replaced or after they become obsolete. New assets have to be compelled to be purchased at high costs that encourage be overpriced.
• Liberal dividend policy- once the administrators of an organization munificently divide the dividends into the shareholders, the result's inadequate maintained profits that area unit terribly essential for top earnings of the corporate. The result's deficiency in the company. To replenish the deficiency, contemporary capital is raised that proves to be a costlier affair and leaves the corporate to be overcapitalized.
• Over-estimation of earnings- once the promoters of the corporate overestimate the earnings because of inadequate money designing, the result's that company goes for borrowings that can not be simply met and capital isn't fruitfully endowed. This leads to a subsequent decrease in earnings per share.

Effects of capitalization

On Shareholders-
The overcapitalized firms have following disadvantages to shareholders:

1. Since the gain decreases, the speed of earning of shareholders additionally decreases.
2. The value of shares goes down attributable to low gain.
3. The gain taking place has a control on the shareholders. Their earnings become unsure.
4. With the decline in goodwill of the corporate, share costs decline. As a result, shares can not be marketed in the capital market.

On Company-

1. Because of the low gain, the name of the company is lowered .
2. The company’s shares can not be simply marketed.
3. With the decline of earnings of the company, goodwill of the corporate declines and therefore the result's contemporary borrowings area unit troublesome to be created attributable to loss of believability.
4. In order to retain the company’s image, the corporate indulges in malpractices like manipulation of accounts to indicate high earnings.
5. The company reduces or can cut down it’s expenditure on maintenance, replacement of assets, adequate depreciation, etc.

On Public- 

associate overcapitalized company has many adverse effects on the public:

1. In order to cover up their earning capability, the management indulges in ways that like increase in prices or decrease in quality.
2. Return on capital utilized is low. this offers a control to the general public that their money resources aren't utilised properly.
3. Low earnings of the corporate affects the believability of the corporate because the company isn't ready to pay it’s creditors on time.
4. It additionally has a control on operating conditions and payment of wages and salaries additionally reduce.

Undercapitalization

An undercapitalized company is one that incurs exceptionally high profits as compared to trade. associate undercapitalized company state of affairs arises once the calculable earnings area unit terribly low as compared to actual profits. this offers rise to extra funds, extra profits, high goodwill, high earnings associated therefore the come back on capital shows an increasing trend. The causes will be-

• Low promotion prices
• Purchase of assets at deflated rates
• Conservative dividend policy
• Floatation of the company in the depression stage
• High potency of administrators
• Adequate provision of depreciation
• Large secret reserves area unit maintained.
• Efffects of underneath Capitalization

On Shareholders

1. The company’s gain will increase. As a result, rate of earnings go up.
2. Market value of share rises.
3. Financial name additionally will increase.
4. Shareholders will expect a high dividend.

On the company

1. With larger earnings, the name becomes sturdy.
2. Higher rate of earnings attract competition in market.
3. The demand of employees could rise attributable to high profits.
4. The high gain state of affairs affects client interest as they assume that the corporate is overcharging on merchandise.

On Society

1. With high earnings, high gain, high value of shares, there are often unhealthy speculation available market.
2. ‘Restlessness generally public is developed as they link high profits with high costs of product.
3. Secret reserves area unit maintained by the corporate which may lead to paying lower taxes to government.
4. The general public inculcates high expectations of those firms as these firms will import innovations, technology and thereby the highest quality of a product.