Overcapitalization

Updated on March 22, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

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.

Overcapitalization

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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. read more significantly jumped to 40.39x in 2018-2019.

Key Takeaways

  1. Overcapitalization is when a corporation raises capital above a certain threshold, which is intrinsically bad for the business. I
  2. 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. 
  3. It simply means that the corporation is not managing its capital well and is not employing the funds effectively.

Components of Overcapitalization

Overcapitalization (Components)

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Overcapitalization Examples

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.

Advantages

Disadvantages

Conclusion

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.read more. 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.read more 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)

What effect does capitalization have?

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.

Why are companies undercapitalized or overcapitalized?

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.

What benefit does over capitalization have?

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.

Recommended Articles

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 –

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