Undercapitalization: Definition and Explanation
Undercapitalization occurs when a company has insufficient capital but a large secret reserve.
Generally, the value of land and buildings, plant, machinery, and goodwill appreciate over time, but companies do not show this in their accounts. These assets may earn a substantial return, which results in a larger amount of profit compared to the initial capital investment.
In the case of undercapitalization, the full capacities of the enterprise cannot be exploited due to the shortage of funds. The rate of dividends and the value of shares are higher than the rate of dividends and the value of shares in similar companies.
Suppose that the normal rate of return in an industry is 15%. A company in this industry earns a profit of $3,000,000 and has an amount of employed capital totaling $10,000,000.
The proper capital of the company for this profit of $3,000,000 should be $20,000,000. The company has been earning the same profit with a capital of $10,000,000.
In this case, the company is undercapitalized to the extent of $10,000,000.
Undercapitalized companies earn profit at considerably higher rates compared to similar companies in the same industry. Undercapitalization can be compared to a lean, thin, and weak person who cannot run effectively due to this weakness.
Disadvantages of Undercapitalization
Undercapitalized companies suffer from the following disadvantages.
(i) Conflict between labor and management: A higher rate of earning may cause workers to demand a wage increase. If management does not meet these demands, a conflict between labor and management may arise.
(ii) Consumers may feel exploited: Declaring a dividend at a higher rate creates a feeling among consumers that they are being exploited. This is because, instead of decreasing the price, the company has increased the dividend.
(iii) Manipulation of share value: Managers may use undercapitalization to manipulate share value and, in this way, exploit shareholders.
(iv) Higher rates of taxation: Earnings at a higher rate attract the government’s attention, which results in higher rates of taxation.
Effects of Undercapitalization on Shareholders
1. Higher rate of returns: In the case of undercapitalization, the rate of return payable to shareholders is higher. Dividends are also paid at higher rates.
2. Higher share value: Due to the larger dividend that the company declares, the share price will increase.
3. Increased liquidity of investments: A higher share value increases their liquidity. These shares can be sold whenever required due to their increasing market price.
Solutions to Limit the Negative Impact of Undercapitalization
The following measures should be adopted as remedial measures to limit the negative impact of undercapitalization:
(i) Increase the number of shares: Under this scheme of reorganization, the number of shares is increased, which results in a reduction of the dividend per share.
(ii) Increase the par value of shares: Under this method, the par values of shares are increased so that the rate of dividend declines, but the dividend per share remains the same.
(iii) Issue bonus shares: Issue of bonus shares increases the number of shares, and so the dividend per share and the rate of dividend fall.
Undercapitalization has negative consequences, but these are not as fatal as those associated with overcapitalization. Even so, efforts should be made to reduce the pressure of undercapitalization.