Podcast
Questions and Answers
Which of the following best describes the relationship between capital, capitalization, and capital structure?
Which of the following best describes the relationship between capital, capitalization, and capital structure?
- Capital, capitalization, and capital structure are interchangeable terms with identical meanings in financial management.
- Capital refers to the total investment, capitalization is the process of determining funding needs, and capital structure is how these funds are organized. (correct)
- Capital structure is the broadest term encompassing capital and capitalization, with capital being a subset of capitalization.
- Capitalization is the total investment, capital refers to funding needs, and capital structure is an initial part of the business concern.
A company's earnings are consistently lower than the average for its industry, and its stock price remains stagnant despite overall market growth. Which type of capitalization is the most likely cause?
A company's earnings are consistently lower than the average for its industry, and its stock price remains stagnant despite overall market growth. Which type of capitalization is the most likely cause?
- Under Capitalization
- Over Capitalization (correct)
- Water Capitalization
- Proper Capitalization
A company issued a large amount of new stock, used debt financing with high-interest rates, and made large payments for intangible assets, and later discovered they had over estimated profits. Which of the following is the most likely consequence considering the causes of overcapitalization?
A company issued a large amount of new stock, used debt financing with high-interest rates, and made large payments for intangible assets, and later discovered they had over estimated profits. Which of the following is the most likely consequence considering the causes of overcapitalization?
- Higher stock valuation due to over estimation of profits.
- Increased market share due to the availability of more capital.
- Difficulty in meeting financial obligations and reduced profitability. (correct)
- Attracting more investors because of increased capital.
Which of the following strategies would be most effective for a company seeking to correct a situation of overcapitalization?
Which of the following strategies would be most effective for a company seeking to correct a situation of overcapitalization?
A company consistently reports higher-than-average profits compared to its competitors, its stock is in high demand, and it has a high rate of return. Which form of capitalization is this company experiencing?
A company consistently reports higher-than-average profits compared to its competitors, its stock is in high demand, and it has a high rate of return. Which form of capitalization is this company experiencing?
A company adopts a conservative dividend policy, reinvests most of its earnings, and maintains strict operational efficiency. What could these factors collectively lead to?
A company adopts a conservative dividend policy, reinvests most of its earnings, and maintains strict operational efficiency. What could these factors collectively lead to?
What is the most direct way for a company to remedy undercapitalization and bring its capital structure in line with its earning potential?
What is the most direct way for a company to remedy undercapitalization and bring its capital structure in line with its earning potential?
A company's balance sheet includes a significant amount of intangible assets that are carried at a high value, despite their limited real-world marketability or contribution to earnings. What situation does this scenario describe?
A company's balance sheet includes a significant amount of intangible assets that are carried at a high value, despite their limited real-world marketability or contribution to earnings. What situation does this scenario describe?
During a period of inflation a company acquired assets at inflated prices and used an inappropriate depreciation policy. Which of the following forms of capitalization is likely to emerge?
During a period of inflation a company acquired assets at inflated prices and used an inappropriate depreciation policy. Which of the following forms of capitalization is likely to emerge?
Early in a company's lifecycle, which actions are most likely to cause watered capital?
Early in a company's lifecycle, which actions are most likely to cause watered capital?
Flashcards
Capitalization
Capitalization
The total amount of capital employed in a business.
Meaning of Capitalization
Meaning of Capitalization
The process of determining the amount of funds needed to run a business, based on share capital and debentures.
Over Capitalization
Over Capitalization
When a company has more capital than needed for its activities, the funds are not properly used.
Under Capitalization
Under Capitalization
A company's actual capitalization is less than what its earning capacity warrants or not the adequate capital.
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Watered Capitalization
Watered Capitalization
Stock or capital not backed by equivalent asset value; realizable asset value is less than book value.
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Consequence of Over Capitalization
Consequence of Over Capitalization
Company's inability to earn a fair return rate on its outstanding securities, leading to a reduced earnings rate.
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Remedies for Under Capitalization
Remedies for Under Capitalization
Fresh share issues and/or increasing par value.
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Capitalization Basics
- Capitalization is a key financial decision relating to the total capital employed in a business.
- Understanding capitalization helps resolve issues in financial management, amidst potential confusion with capital and capital structure.
- Capital is the total company investment in money and assets, representing the company's total wealth.
- Investing a large amount of finance into a business is also called Capital.
- Capital is essential for both new and existing businesses.
- Capital requirements are classified into fixed and working capital.
Meaning of Capitalization
- Capitalization is determining the amount of funds needed to run a business.
- It includes the par value of share capital and debentures only, excluding reserves and surplus.
- Guthman and Dougall define capitalization as the sum of the par value of outstanding stocks and bonds.
- Bonneville and Dewey define it as the balance sheet value of outstanding stocks and bonds.
- Arthur S. Dewing defines it as the total par value of all shares.
Types of Capitalization
- Capitalization is classified into three types based on its nature: over, under, and watered capitalization.
Over Capitalization
- Over capitalization occurs when a company has excess capital relative to its activity level.
- It means having more capital than required, with funds not properly utilized.
- Bonneville, Dewey, and Kelly define it as a business's inability to earn a fair rate on its outstanding securities.
- Example: A company earning Rs. 50,000 with an expected 10% return is properly capitalized.
- If the capital investment is Rs. 60,000, over capitalization is to the extent of Rs. 1,00,000 and the new rate of earning would be 8.33%.
- When a company is over capitalized, the rate of earnings decreases.
Causes of Over Capitalization
- Over issue of capital by the company.
- Borrowing large amounts of capital at high interest rates.
- Providing inadequate depreciation to fixed assets.
- Excessive payments for acquiring goodwill.
- High rate of taxation.
- Underestimation of capitalization rate.
Effects of Over Capitalization
- Reduces the earning capacity of shares.
- Creates difficulties in obtaining necessary capital.
- Leads to a fall in the market price of shares.
- Creates problems in re-organization.
- Results in under or misutilization of resources.
Remedies for Over Capitalization
- Effective management and systematic design of the capital structure are needed.
- Efficient management can reduce over capitalization.
- Redemption of preference share capital with a high dividend rate help.
- Reorganization of equity share capital needed.
- Reduction of debt capital is necessary.
Under Capitalization
- Under capitalization occurs when a company's actual capitalization is lower than warranted by its earning capacity.
- It is not the same as inadequate capital.
- Gerstenberg defines it as when a corporation's profit rate is exceptionally high.
- Hoagland defines it as an excess of true asset value over outstanding stocks and bonds.
Causes of Under Capitalization
- Underestimation of capital requirements.
- Underestimation of initial and future earnings.
- Maintaining high efficiency standards.
- Conservative dividend policy.
- Desire for control and trading on equity.
Effects of Under Capitalization
- Leads to the manipulation of the market value of shares.
- Increases the marketability of shares.
- May lead to more government control and higher taxation.
- Causes consumers to feel exploited by the company.
- Leads to high competition.
Remedies of Under Capitalization
- Can be compensated with a fresh issue of shares.
- Increasing the par value of shares can help.
- Issue of bonus shares to existing shareholders can correct it.
- Reducing the dividend per share by splitting shares is a solution.
Watered Capitalization
- Watered stock occurs when a company's stock or capital is not backed by equivalent asset value.
- In simple terms, the realizable value of assets is less than the book value.
- Hoagland defines it as a stock with a true value less than its book value.
Causes of Watered Capital
- Watered capital generally arises at the time of incorporation or during the business's lifetime.
- Acquiring assets at a high price.
- Adopting an ineffective depreciation policy.
- Purchasing worthless intangible assets at a higher price.
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