CAPITALISATION :

MEANING OF CAPITALISATION :
Capitalization is one of the most important constituents of financial
plan. The term “capitalization “ has been derived from the word capital
and in common practice it refers to the total amount of capital
employed in a business.
Broad Interpretation of capitalization:
Broadly speaking , the term capitalization refers to the process of
determining the plan of financing . It includes not merely the
determination of quantity of finance required for a company but also
the decision about the quality of financing.
NARROW INTERPRETATION OF
CAPITALISATION
• In its narrow sense , the term ‘ capitalization ‘ is used in its
quantitative sense and refers to the process of determining the
quantum of funds that a firm needs to run its business .
Modern concept of capitalization :
• In the words of walker and Baughn , “ The use of capitalization refers
to only long term debt and capital stock ; and short term creditors do
not constitute suppliers of capital is erroneous . In reality total capital
is furnished by short term creditors and long term creditors .”

• They further opine that the sum of capital stock and long term debt
refers to capital rather than the capitalization .
• Thus , according to modern concept ,capitalization includes :
Share capital , long term debt , reserve and surplus ,short term debt ,
creditors
NEED OF CAPITALISATION :
The need of capitalization arise not only at the time of incorporation or
promotion of a company but may also arise as a going concern after
promotion and during the life time of a corporation . Generally , the
problem of capitalization arises in the circumstances :
• 1. At the time of incorporation /promotion of a company .
• 2. At the time of expansion of an existing company
• 3. At the time of amalgamation and absorption two or more
companies
• 4. At the time of re-organisation of capital of a company
Over-capitalization :
• In the words of Gerstenberg, “a corporation is over-capitalised
when its earnings are not large enough to yield a fair return on
the amount of stocks and bonds that have been issued or when
the amount of securities outstanding exceeds the current value
of the assets’.
• In other words, a company is over­capitalised when the amount
of shares issued is in excess of actual requirements or more than
the real assets. Over-capitalisation tends to make the dividend
rate to fall low and bring down the value of shares below the par
value.
• A company is over-capitalised when its earning power is lower
and it is not able to pay dividends and interest at proper rates.
Over-capitalisation does not always imply an abundance of
capital. On the other hand, it is likely that in an over- capitalised
concern there may be shortage of capital. In the words of
Hoagland, “Whenever the aggregate of the par values of stocks
and bonds outstanding exceeded the true value of the fixed
assets, the corporation was said to be over-capitalised.”
• In simple words, over-capitalisation takes place when a
company raises more money by the issue of shares and
debentures than can be profitably used. It results in a fall in the
earning capacity and consequently in the rate of dividend
payable to equity shareholders.
Causes of over-capitalization :
• Some of the major causes of over-capitalisation are:
• 1. Over-issue of capital 2. Acquiring assets at inflated prices
3. Formation during the boom period
4. Over estimation of earnings
5. Inadequate depreciation 6. Liberal dividend policy
7. Lack of reserves 8. Heavy promotion and organisation
expenses
9. Shortage of capital and
10. Taxation policy.
1. Over-issue of capital:

• Defective financial planning may lead to excessive issue of

shares or debentures. The issue would be superfluous and a
constant burden on the earnings of the company.
2. Acquiring assets at inflated prices:

• Assets may be acquired at inflated prices or at a time when the

prices were at their peak. In both the cases, the real value of the
company is below its book value and the earnings are very low.
3. Formation during the boom period:

• If the establishment of a new company or the expansion of an

existing concern takes place during the boom period, it may be a
victim of over- capitalisation. The assets are acquired at
fabulous prices. But when boom conditions cease prices of
products decline resulting in lower earnings. The original value
of assets remains in books while earning capacity dwindles due
to depression. Such a state of affairs results in over-
capitalisation.
4. Over estimation of earnings:

• The promoters or the directors of the company may over-

estimate the earnings of the company and raise capital
accordingly. If the company is not in a position to invest these
funds profitably, the company will have more capital than
required. Consequently, the rate of earnings per share will be
less.
5. Inadequate depreciation:

• Absence of suitable depreciation policy would make the asset-

values superfluous. If the depreciation or replacement provision
is not adequately made, the productive worth of the assets is
diminished which will definitely depress the earnings. Lowered
earnings bring about fall in share values, which represents over-
capitalisation.
6. Liberal dividend policy:

• The company may follow a liberal dividend policy and may not
retain sufficient funds for self- financing. It is not a prudent
policy as it leads to over-capitalisation in the long run, when the
book value of the shares falls below their real value.
7. Lack of reserves:

• Certain companies do not believe in making adequate provision

for various types of reserves and distribute the entire profit in
the form of dividends. Such a policy reduces the real profit of
the company and the book value of the shares lags much behind
its real value. It represents over-capitalisation.
8. Heavy promotion and organisation
expenses:

• “A certain degree of over­capitalisation ,”says Beacham, “may be

caused by heavy issue expenses”. If expenses incurred for
promotion, issue and underwriting of shares, promoters’
remuneration etc., prove to be higher compared to the benefits
they provide, the enterprise will find itself over-capitalised.
9. Shortage of capital:

• If a company has small share capital it will be forced to raise

loans at heavy rate of interest. This would reduce the net
earnings available for dividends to shareholders. Lower
earnings bring down the value of shares leading to over-
capitalisation.
10. Taxation policy:

• High rates of taxation may leave little in the hands of the

company to provide for depreciation and replacement and
dividends to shareholders. This may adversely affect its earning
scapacity and lead to over-capitalisation.
Effects of Over-capitalisation on
Company:

• An over-capitalised company may suffer from the

following ill consequences or disadvantages:
• (i) The shares of the company may not be easily marketable
because of reduced earnings per share.
• (ii) The company may not be able to raise fresh capital from the
market.
• (iii) Reduced earnings may force the management to follow
unfair practices. It may manipulate the accounts to show higher
profits.
• (iv) Management may cut down expenditure on maintenance
and replacement of assets. Proper amount of depreciation of
assets may not be provided for.
• (v) Because of low earnings, reputation of the company would
be lowered.
Effects of Over-capitalisation on
Shareholders:

• Over-capitalisation is disadvantageous to the shareholders

because of the following reasons:
• (i) Over-capitalisation results in reduced earnings for the
company. This means the shareholders will get lesser dividend.
• (ii) Market value of shares will go down because of lower
profitability.
• (iii) There may be no certainty of income to the shareholders in
the future.
• (iv) The reputation of the company will go down. Because of
this, the shares of the company may not be easily marketable.
• (v) In case of reorganisation, the face value of the equity share
might be brought down.
Effects of Over-capitalisation on Society:
• The effects of over-capitalisation on the society are as
follows:
• (i) The profits of an over-capitalised company would show a declining
trend. Such a company may resort to tactics like increase in product
price or lowering of product quality.
• (ii) Return on capital employed is very low. This means that financial
resources of the public are not being utilised properly.
• (iii) An over-capitalised company may not be able to pay interest to the
creditors regularly.
• (iv) The company may not be able to provide better working conditions
and adequate wages to the workers.
 Remedies for Over-capitalization:
• In order to correct the situation caused by over-
capitalisation, the following measures should be adopted:
• (i) The earning capacity of the company should be increased by raising
the efficiency of human and non-human resources of the company.
• (ii) Long-term borrowings carrying higher rate of interest may be
redeemed out of existing resources.
• (iii) The par value and/or number of equity shares may be reduced.
• (iv) Management should follow a conservative policy in declaring
dividend and should take all measures to cut down unnecessary
expenses on administration.
What Is Undercapitalization?

• Undercapitalization occurs when a company does not have

sufficient capital to conduct normal business operations and pay
creditors. This can occur when the company is not generating
enough cash flow or is unable to access forms of financing such as
debt or equity.
• Undercapitalized companies also tend to choose high-cost sources
of capital, such as short-term credit, over lower-cost forms such as
equity or long-term debt. Investors want to proceed with caution if a
company is undercapitalized because the chance of bankruptcy
increases when a company loses the ability to service its debts.
Definition:
• Under-capitalisation is just the reverse of over-capitalisation.
Properly speaking, an enterprise is said to be under-capitalised
when its actual capitalisation is lower than the proper
capitalisation. In case of under-capitalisation, the rate of
dividend and the market value of shares are fairly higher than
the market value of shares of similar enterprises. According to
Gerstenberg, “An enterprise may be under-capitalised when the
rate of profit is exceptionally high in relation to the return
enjoyed by similar situated enterprises in the same industry.
The assets may be worth more than the values reflected in the
books.”
Causes of Under-Capitalisation:
• The causes of under-capitalisation are:
• 1. Under-estimation of initial rate of earnings.
• 2. Utilization of high efficiency for exploiting every possibility
available.
• 3. Using lower rate of capitalisation.
• 4. Under-estimation of required funds.
• 5. Retaining profits because of conservative dividend policy followed by
the enterprise.
• 6. Setting up of an enterprise in recessionary conditions. After the
recession period is over, enterprises start earning profits at an unusually
high rate.
• 7. Because of excessive earnings, enterprises are exposed to a heavy
incidence / burden of taxation.
Effects of Under-Capitalisation:

• The effects of under-capitalisation are:

• 1. It encourages cut-throat competition in the market. High profit earning

capacities of under-capitalized enterprises lure new entrepreneurs to plunge
into the manufacturing.

• 2. High rate of dividend given to the shareholders propels to the workers to

demand for higher wages and salaries.

• 3. Under-capitalization enables management to manipulate the value of shares

of enterprises.
• 4. The Government charges higher taxation.
Remedies for Under-Capitalisation:

• Under-capitalisation may be rectified by taking the

following remedial measures:
• 1. To split up the shares of the enterprise.

• 2. To issue bonus shares.

• 3. To increase the par value of shares/stock.

• 4. To declare dividend payable in stock, if large surplus is available.

• Now, it is clear that both over-capitalization and under-
capitalization are not desirable as both bear evil effects.
Notwithstanding, over-capitalization is more dangerous. Under-
capitalization is easily corrected but over-capitalization not so
easily.
• Furthermore, under-capitalization is indicative of sound
financial position and efficient management of the enterprises.
That is why under-capitalization is not considered as an
economic problem but a problem of adjusting the capital
structure of an enterprise. Every enterprise should try to have a
proper or fair capitalization.
What Is Venture Capital (VC)?

• Venture capital (VC) is a form of private equity and a type of

financing that investors provide to startup companies and small
businesses that are believed to have long-term growth potential.
Venture capital generally comes from well-off investors, investment
banks, and any other financial institutions. However, it does not
always take a monetary form; it can also be provided in the form of
technical or managerial expertise. Venture capital is typically
allocated to small companies with exceptional growth potential, or
to companies that have grown quickly and appear poised to
continue to expand.v
• Though it can be risky for investors who put up funds, the potential
for above-average returns is an attractive payoff. For new companies
or ventures that have a limited operating history (under two years),
venture capital is increasingly becoming a popular—even essential—
source for raising money, especially if they lack access to
capital markets, bank loans, or other debt instruments. The main
downside is that the investors usually get equity in the company,
and, thus, a say in company decisions.
History of Venture Capital:

• Venture capital is a subset of private equity (PE). While the roots of

PE can be traced back to the 19th century, venture capital only
developed as an industry after the Second World War.
• Harvard Business School professor Georges Doriot is generally
considered the "Father of Venture Capital." He started the American
Research and Development Corporation (ARD) in 1946 and raised a
$3.5 million fund to invest in companies that commercialized
technologies developed during WWII. ARDC's first investment was in
a company that had ambitions to use x-ray technology for cancer
treatment. The $200,000 that Doriot invested turned into $1.8
million when the company went public in 1955.1
Hit From the 2008 Financial Crisis

• The 2008 financial crisis was a hit to the venture capital industry
because institutional investors, who had become an important
source of funds, tightened their purse strings. The emergence of
unicorns, or startups that are valued at more than a billion dollars,
has attracted a diverse set of players to the industry. Sovereign
funds and notable private equity firms have joined the hordes of
investors seeking return multiples in a low-interest-rate
environment and participated in large ticket deals. Their entry has
resulted in changes to the venture capital ecosystem.
• India is becoming the world's fastest-growing startup ecosystem
with 99 Unicorn Startups, as of 2022. In today's world, unicorn
startups are not as uncommon as before; however, building a unicorn
startup is not easy. It takes a lot of hard work, commitment, and
perseverance throughout the startup's journey to climb the ladder of
unicorns, and the ones that have bagged the title of unicorns are
discussed in this article.
• Unicorn Startup consists of two words, "Unicorn" and
"Startup". Unicorn is a business term used to define a startup with a
valuation of over $1 Billion. The term was coined by a venture
capitalist and a seed investor, Aileen Lee. On the other
hand, Startups are privately owned companies typically at the early
stages of their development. On this note, know in detail -
What Makes A Unicorn Startup & How To Build One.
• The country has been declared as the 3rd top country hosting
unicorn companies for the year 2021. With 33 Indian startups
joining the unicorn club, it has displaced the UK from the 3rd
position, which managed to witness only 15 unicorns in the same
year. The leading countries - the US added 254
unicorns whereas China saw 74 unicorns in 2021, taking their tally
to 487 and 301 startups that achieved over $1 bn valuations.
• The Indian startups have reportedly raised around $42 Bn in funding
across 1,584 deals in 2021. The startup ecosystem of India where
around 60,000 new startups have been established since 2016, across
56 different sectors in the country, has also managed to create over 6
lakh job opportunities in the country. This has even got a special
mention from President Ram Nath Kovind in his Presidential address
on 31 January 2022, where he emphasized the new opportunities that
the startups of India are ushering in.
• With the start of 2022, India has been starting to see unicorns already
with Mamaearth being the first of the unicorns of 2022, followed by
Fractal Analytics, LEAD School, Darwinbox, DealShare, ElasticRun,
Livspace, Xpressbees, Uniphore, Hasura, CredAvenue, Amagi,
CommerceIQ, and Oxyzo. Know more about these Indian Unicorn
Startups in the article ahead.