In general sense capitalization means the amount of capital invested or employed in the business.

The term capitalization confines itself only to long term source of finance. It includes only ownership capital (Share capital + Equity + ) and long term borrowings. In financial management capitalisation has two concepts. These are as broad sense and narrow sense. Narrow sense: Only the quantity of finance required by the companyBroad sense: Determination of the amount of capital to be raised and the security through which the capital can be raised and the relative proportion of various types of security and the administration of the capital i.e. the different administration like raising, allocation and management of capital. Usually narrow sense is taken to financial management. There are controversies in narrow sense. According to Gerstenberg capitalization comprises ownership capital which includes capital states and surplus, in whatever form it may appear and borrowed capital which consists of bonds or similar evidence of long term debt . According to Bonneville and Dewey capitalization refers to the balance sheet values of stock and bonus outstanding . According to Walker and Baughan capitalization includes long term funds and short term funds . According to this definition the term capitalization includes ownership capital and borrowed capital, short term funds (short term borrowings and trade credit). The term capitalization means ownership capital and borrowed capital as majority of authors describe in this way. Estimation of capitalization: It means determination of capitalization or the value of the company. Determination of the value of the company is helpful to know the amount of capital that has to be raised by the company by the issue of shares and debentures. Theories of capitalization: 1. Cost theory/ cost approach/ historical cost theory: Under this approach capitalization of the company is based on cost of acquisition of fixed assets, cost of establishment, regular working capital. The various cost of establishment includes preliminary expenses, printing and stationary, underwriting commissions etc. all expenses of issue of shares. For example; working capital required throughout the year for carrying out the business like stock of raw material, partly finished goods, finished goods, salaries, wages etc. Criticism against this theory: a) Capitalization shall be based on and total value of assets. b) Savings of company decline when assets become obsolete, remain idle and underemployed but it will not be covered under this method. c) It is suitable for capitalization of new company and not suitable for old company having irregular earnings. 2. Earnings theory approach: Capitalization is determined on the basis of its earnings and the expected fair rate of return on its capital investment. Capitalization =av annual earnings/fair rate of return Over-Capitalization: According to Gestenberg a company is overcapitalized when its earnings are not large enough to yield a fair rate on the amount of stock and bonds that have been issued. A concern is said to be over-capitalized if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures that have been issued. It is said to be over capitalized when total of owned and borrowed capital exceeds its fixed and current assets i.e. when it shows accumulated losses on the assets side of the balance sheet. An over capitalized company can be like a very fat person who cannot carry his weight properly. Such a person is prone to many diseases and is certainly not likely to be sufficiently active. Unless the condition of overcapitalization is corrected, the company may find itself in great difficulties. Causes of Over Capitalization:Some of the important reasons of over-capitalization are: 1. Idle funds: The Company may have such an amount of funds that it cannot use them properly. Money may be living idle in banks or in the form of low yield investments. 2. Over-valuation: The fixed assets, especially good will, may have been acquired at a cost much higher than that warranted by the services which that asset could render. 3. Fall in value: Fixed assets may have been acquired at a time when prices were high. with the passage of time prices may have been fallen so that the real value of the asset may also have come down substantially even though in the balance sheet the assets are being shown at book value less depreciation written off. Then the book values will be much more than the economic value. 4. Inadequate depreciation provision: Adequate provision may not have been provided on the fixed assets with the result the profits shown by books may have been distributed as dividend, leaving no funds with which to replace the assets at the proper time. 5. A company s floatation n boom period- At times

company has to secure it s solvency and thereby float in boom periods. That is the time when rate of returns are less as compared to capital employed. This results in actual earnings lowering down and earnings per share declining. 6. Over-estimation of earnings- When the promoters of the company overestimate the earnings due to inadequate financial planning, the result is that company goes for borrowings which cannot be easily met and capital is not profitably invested. This results in consequent decrease in earnings per share. 7. Acquisition of intangible assets which are not providing its advantage like patent, copyright etc. 8. Liberal dividend policy also causes overcapitalization. 9. High corporate tax discourages renewals and it will result in reduction in earning capacity. Effects of overcapitalization: On Shareholders- The over capitalized companies have following disadvantages to shareholders: a. Since the profitability decreases, the rate of earning of shareholders also decreases. B. The market price of shares goes down because of low profitability. C. The profitability going down has an effect on the shareholders. Their earnings become uncertain. D. With the decline in goodwill of the company, share prices decline. As a result shares cannot be marketed in capital market. On Company- a. Because of low profitability, reputation of company is lowered. B. The company s shares cannot be easily marketed. C. With the decline of earnings of company, goodwill of the company declines and the result is fresh borrowings are difficult to be made because of loss of credibility. D. In order to retain the company s image, the company indulges in malpractices like manipulation of accounts to show high earnings. E. The company cuts down it s expenditure on maintainance, replacement of assets, adequate depreciation, etc. On Public- An overcapitalized company has got many adverse effects on the public: a. In order to cover up their earning capacity, the management indulges in tactics like increase in prices or decrease in quality. B. Return on capital employed is low. This gives an impression to the public that their financial resources are not utilized properly. C. A low earnings of the company affects the credibility of the company as the company is not able to pay its creditors on time. D. It also has an effect on working conditions and payment of wages and salaries also lessen. Remedies for overcapitalization: Restructuring the firm is to be executed avoid the situation of company becoming sick. It involves 1. Reduction of debt burden 2. Negotiation with term lending institutions for reduction in interest obligation. 3. Redemption of preference share through a scheme of capital reduction. 4. Reducing the face value and paid-up value of equity shares. 5. Initiating merger with well managed profit making companies interested in talking over ailing company. 6. Reduction in the number of equity shares. This can again be tried with the consent of the shareholders. 7. Reduction of interest on bounds, if the existing debenture-holders are given new debentures carrying lower rates of interest, it will alleviate the situation created by over-capitalisation. However, this can be done by offering some premium to the debenture-holders. If the said premium is more than the economy in interest payments, the measure will lose its pint. Overcapitalization and excess capital: Overcapitalization arises when the existing capital of company is not efficiently utilized. It is indicated by a fall in saving capacity of company. For example a company has raised rupees 20 lakhs and the company is utilizing that amount of 20 lakh fully. The company s requirement is only 15 lakh, but it is doing business of 15 lakh in 20 lakh, this will be the case of overcapitalization and if the company is doing business with only 15 lakh but keeping 5lakh idle, out of 20lakh raised then it will be the case of excess capital. Undercapitalization: An undercapitalized company is one which incurs exceptionally high profits as compared to industry. An undercapitalized company situation arises when the estimated earnings are very low as compared to actual profits. This gives rise to additional funds, additional profits, high goodwill, high earnings and thus the return on capital shows an increasing trend. Causes of undercapitalization 1. Low promotion costs 2. Purchase of assets at deflated rates 3. Conservative dividend policy 4. Floatation of company in depression stage 5. High efficiency of directors 6. Adequate provision of depreciation 7. Large secret reserves are maintained. Effects of Under Capitalization: On Shareholders: 1. Company s profitability increases. As a result, rate of earnings go up. 2. Market value of share rises. 3. Financial reputation also increases. 4. Shareholders can expect a high dividend. On company: 1. With greater earnings, reputation becomes

strong. 2. Higher rate of earnings attract competition in market. 3. Demand of workers may rise because of high profits. 4. The high profitability situation affects consumer interest as they think that the company is overcharging on products. On Society: 1. With high earnings, high profitability, high market price of shares, there can be unhealthy speculation in stock market. 2. Restlessness in general public is developed as they link high profits with high prices of product.3. Secret reserves are maintained by the company which can result in paying lower taxes to government. 4. The general public inculcates high expectations of these companies as these companies can import innovations, high technology and thereby best quality of product. Remedies of undercapitalization 1. Splitting up at the shares This will reduce the dividend per share 2. Issue of bonus share: this will reduce both the dividend per share and earning per share. 3. Both over-capitalization and under capitalization are detrimental to the interests of the society. Evils/ Demerits/ Disadvantages of Under-capitalization:The evils of under capitalization are- 1. Wide fluctuation in the prices of shares etc., 2. Increase in competition, 3. Increase in speculative activities, 4. Increase in opportunities for manipulation by management, 5. Industrial relations tend to be strained, 6. Dissatisfaction amongst consumers, they feel they are being exploited by the company,7. Increase in the tax burden of the company, 8. Increased Government interference etc. Comparison of overcapitalization and undercapitalization: 1. Overcapitalization is a state where earnings are not sufficient to justify the fair return on the amount of share capital which has been issued by the company whereas undercapitalization is a state where the capital which is owned by the business is much less than the borrowed capital. 2. Overcapitalization happens when the actual profits of a company are not enough or sufficient to pay interest to the creditors whereas undercapitalization happens due to overtrading and when the company earn high profits as compared to other industry. 3. Overcapitalization shows the rate of return as declining entity whereas undercapitalization shows the rate of return as increasing entity.