What is Overcapitalization?
Overcapitalization is when a firm has raised capital over a particular limit, which is inherently unhealthy for the company. As a result, its market value is less than its capitalized worth. In this case, the company ends up paying more interest and dividends, which is impossible to sustain in the long term. It simply signifies that the company is not using the fund efficiently and has poor capital management.
We note from the above overcapitalization example of Boeing wherein its annual debt to equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. significantly jumped to 40.39x in 2018-2019.
Table of contents
- Overcapitalization is when a corporation raises capital above a certain threshold, which is intrinsically bad for the business. I
- Its market value is, therefore, lower than its capitalized value. In this situation, the business must pay out more in dividends and interest, which it cannot afford to do in the long run.
- It simply means that the corporation is not managing its capital well and is not employing the funds effectively.
Components of Overcapitalization
- Debt: The company issues debt capital to raise money and fund capital expenditure, but when a company raises debt capital over what is required, it does not meet its target capital structure and makes inefficient use of the raised funds.
- Equity Securities: The company raises money in the form of equity from capital markets through IPOIPOAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange. or FPO, which results in too much capital in the company’s hands. The company, in this case, has excess cash on its balance sheet and the opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven. of its funds is high. In this case, the company reports lower earnings than expected, and the shareholders lose trust in the company’s management.
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XYZ company is engaged in the construction business in the Middle East and earns a sum of $80,000 with a required rate of return, of 20%.
This implies that their fairly capitalized capital will be $80,000 / 20% = $400,000.
Now if we assume that instead of $400,000, XYZ company is using $500,000 as its capital, then their rate of earnings will be $80,000 / $500,000 = 16%.
Thus, their rate of return reduces from 20% to 16% due to overcapitalization.
- The company has excess capital or cash on the balance sheet, which they can put in the bank and earn a nominal rate of returnNominal Rate Of ReturnA nominal rate of return is nothing but the total amount of money earned from a particular investing activity before taking various expenses like insurance, management fees, inflation, taxes, legal fees, staff salaries, office rent, and depreciation of plants and machinery the due consideration., strengthening their liquidity position.
- It results in a higher valuation of the company, which means that the company, in case of an acquisition or a merger, can get a higher price for itself as it can take excess capital and cash on its balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company..
- Overcapitalization can fuel and fund the CapexCapexCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. plans of the company.
- The rate of return on capital goes down as the company raises more and more capital from the market, making the company’s capital structure look bad and inadequate.
- The shareholder’s confidence in the company gets lost because of the underutilization of funds, resulting in a fall in the share price.
- It creates problems with re-organization.
- It leads to the underutilization of available resources.
- It also leads to a higher rate of taxation on the company’s income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements..
- The company cannot easily market its shares. Thus, it can lead to malpractices, often associated with manipulating its earnings period or the earnings amount.
- It also leads to a superior valuation of assets than its real value or intrinsic value.
A company is over-capitalized when its earnings are insufficient to justify a fair return on the amount of capital raised through equity and debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.. Hence, both overcapitalization and undercapitalizationUndercapitalizationUndercapitalization in business means a scenario where a company faces a shortage of funds or capital requirements to continue its day-to-day operations. The company in these moments also faces a lack of ability to procure any new source of funding or capital. are not accepted in any of the economic principles or the smoothing functioning of the company as it affects the company’s financial stability and revenue leakage. Therefore, a good analyst should look at the company’s financial statements of compressive income to determine the capital structure of the company and should also make a peer comparison of the optimal capital structure prevailing in the industry before deciding to make an investment decision.
Frequently Asked Questions (FAQs)
Capitalization of interest results in lower interest expenditure, somewhat higher depreciation, higher operating cash flow, and a higher interest coverage ratio. Financial statements are frequently changed by analysts to eliminate the consequences of capitalized interest.
Undercapitalization occurs when the amount of share capital that the company owns is significantly less than the amount of borrowed capital, as opposed to overcapitalization, which occurs when earnings are insufficient to justify the fair return on the amount of share capital that the company has issued.
When the profits are divided across many shares, overcapitalization causes a drop in the rate of dividends on equity shares. 2) Declining Market Value of Shares: The dividend rate reduction also has an impact on the declining market value of shares.
This article has been a guide to what overcapitalization is and its definition. Here we discuss the examples of overcapitalization along with its advantages and disadvantages. You can learn more about financing from the following articles –