Q. Define Under Capitalisation. Explain its causes and remedies.
Ans. Under-capitalisation: The term ‘under-capitalisation’ does not mean shortage or inadequacy of capital. The term is just reverse to over-capitalisation. In the words of Grestenberg :
“A corporation may be under-capitalised when the rate of profits, it is making on total capital, is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry, or when it has too little capital with which to conduct its business.”
In simple words, under-capitalisation is a state of affairs when the capital or the resources of the company are being utilised more efficiently. As a result, the company succeeds in continuously earning abnormally high rate of return on the capital employed in it. Such company declares a high rate of dividend in comparison to the prevailing rate and the market value of its shares exceeds their book value. Thus, under-capitalisation refers to the sound financial position and good management of the company.
Causes of Under-Capitalisation: The following are the important causes of under-capitalisation :
(1) Under-Estmation of Capital Requirements: At the time of promotion, the promoters may under-estimate the capital requirements of the company. This results in a situation of under-capitalisation at later stages when more capital is required.
(2) Under-Estimation of Earnings: Sometimes at the time of promotion, the future earnings of the company are under-estimated and the company is capitalised accordingly. If, afterwards it is found that the actual earnings are far in excess of the estimates, the company company may find itself in a situation of under-capitalisation.
(3) Over-Estimation of Rate of Return at the Time of Promotion: Sometimes a concern estimate its income correctly but it over-estimates its rate of return (i.e. capitalisation rate)
(4) Promotion of Company During Deflation: Companies which are floated under recessionary conditions often experience under-capitalisation after recession is over. This is because of two reasons. Firstly, during the recession assets are purchased at a price which is much lower in comparison to their earning capacity. Secondly, companies established during recession are capitalised at a low figure anticipating low earnings but when recession is over the earnings increase and the company becomes under-capitalised.
(5) Conservative Dividend Policy: Certain companies follow a policy of declaring low dividends and ploughing back a major part of their earnings. They build up large funds for replacement, renovation and expansion. The result of such a policy is reflected in high earnings which is a situation of under-capitalisation.
(6) High Level of Efficiency: In a company where the management is very efficient, the company may operate on a high level of efficiency even with a meagre amount of capital. Over a period, earning position of the company will improve and it will become under-capitalised.
(7) Desire to Retain Control: In many companies, the promoters desire to retain full control over the management of the company. For this purpose, they issue lesser number of shares to monopolise them. This may lead to under-capitalisation.
(8) Difficulty in Raising Capital: Sometimes the promoters find it difficult to raise the required amount of capital. Even then they start the company and run it mostly with the help of short-term loans. This is a situation of under-capitalisation.
Remedies of Under-Capitalisation: Under-capitalisation can be corrected by adopting the following remedial measures:
(i) Issue of Bonus Shares: If company has adequate balance of reserves and surplus, the company can capitalise it by distributing bonus shares. This is the most widely used and effective remedy for under-capitalisation because by distributing bonus shares, the number of shares will increase which will reduce both dividend per share and earning per share.
(ii) Issue of Fresh Shares: If under-capitalisation is due to the shortage of capital, it can be remedied by issuing new shares.
(iii) Splitting of Shares: Another effective method of correcting under-capitalisation is to split up the existing shares into large number of shares by reducing the par value of shares. Supposing, the share capital of a company is divided into 10,000 shares of ₹20 each and its earning is ₹80,000 which comes to ₹8 per share. If the management decides to reduce the par value of shares by 50% and increase the number of shares in the same proportions, the new shares after the split will be 20,000 shares of ₹10 each. As a result of split the earning per share will come down to ₹4 per share (i.e.,
₹80,00020,000). Due to this, the market price of shares will decrease and this will have a psychological effect on the investors. Shareholders do not object to this procedure because they would continue to receive the same amount of income even after split.
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