INTRODUCTION

The term capitalisation, or the valuation of the capital, includes the capital stock and
debt. According to another view it is a word ordinarily used to refer to the sum of the
outstanding stocks and funded obligations which may represent wholly fictitious values. The
ordinary meaning of capitalisation in the computation appraisal or estimation of present
value. This valuation concept underlies the definitions of capitalisation and the emphasis is
placed upon the amount of capital. But the term capitalisation has on thrown its previous
concept. Originally, it was used in the sense of valuation and amount but qualitative
connotation now usually accompanies the quantitative expression. The term capitalisation is
now taken as being synonymous with capital structure or financial plan.

The study of capitalisation involves an analysis of three aspects:

i) amount of capital

ii) composition or form of capital

iii) changes in capitalisation.

Capitalisation may be of 3 types. They are over capitalisation, under capitalisation and
fair capitalisation. Among these three over capitalisation is likely to be of frequent occurrence
and practical interest.

Over Capitalisation:

Many have confused the term over-capitalisation with abundance of capital and
under-capitalisation with shortage of capital. It becomes necessary to discuss these terms in
detail. An enterprise becomes over-capitalised when its earning capacity does not justify the
amount of capitalisation. Over-capitalisation has nothing to do with redundance of capital in
an enterprise. On the other hand, there is a greater possibility that the over-capitalised
concern will be short of capital. The abstract reasoning can be explained by applying certain
objective tests. These tests require the comparison between the different values of the equity
shares in a corporation. When we speak in terms of over-capitalisation we always have the
interest of equity holders in mind.
Effects of over capitalisation

Over-capitalisation affects the company, the shareholders and the society as a whole.
The confidence of Investors in an over-capitalised company is injured on account of its
reduced earning capacity and the market price of the shares which falls consequently. The
credit-standing of a corporation is relatively poor. Consequently, the credit-standing of a
corporation is relatively poor. Consequently, the company may be forced to incur unwieldy
debts and bear the heavy loss of its goodwill In a subsequent reorganization.

The Shareholders bear the brunt of over capitalization doubly. Not only is their capital
depreciated but the income is also uncertain and mostly irregular. Their holdings have little
value as collateral security. An over-capitalised company tries to increase the prices and
reduce the quality of products, and as a result such a company may liquidate. In that case the
creditors and the Labourers will be affected. Thus it leads to the misapplication and wastage
of the resources of society.

Corrections for over-capitalisation:

Overcapitalization can be rectified if the following steps are taken:

1. Reorganisation of the company by selling shares at a high rate of discount.

2. Issuing less interested new debentures on premium in place of old debentures.

3. Redeeming preference shares carrying high dividend

4. Reducing the face value (par value) of shares.

Under-Capitalisation:

Generally, under-capitalisation is regarded equivalent to the inadequacy of capital but

it should be considered as the reverse of over-capitalisation i.e. it is a condition when the real
value of the corporation is more than the book value.
The following are the causes for under-capitalization:

1. Underestimation of earnings:

Sometimes while drafting the financial plan, the earnings are anticipated at a lower
figure and the capitalisation may be based on that estimate; if the earnings prove to be higher
the concern shall become under-capitalised.

2. Unforeseeable increase in earnings:

Many corporations started during depression find themselves to be under-capitalised

in the period of recovery or boom due to unforeseeable increase in earnings.

3. Conservative dividend policy:

By following conservative dividend policy some corporations create adequate

reserves for depreciation, renewals and replacements and plough back the earnings which
increase the real value of the shares of those corporations.

4. High efficiency maintained:

By adopting latest techniques of production many companies improve their

efficiency. The profits being dependent on the efficiency of the concern will increase and,
accordingly, the real value of the corporation may exceed its book value.

Effects of under-capitalisation:

The following are the effects of under-capitalisation:

1. Causes wide fluctuations in the market value of shares.

2. Provoke the management to create secret reserves.

3. Employees demand high share in the increased prosperity of the company.

Difference between Over Capitalization and Under Capitalization of Company!

Over Capitalization:

A company is said to be overcapitalized when the aggregate of the par value of its
shares and debentures exceeds the true value of its fixed assets.In other words, over
capitalisation takes place when the stock is watered or diluted. It is wrong to identify over
capitalisation with excess of capital, for there is every possibility that an over capitalised
concern may be confronted with problems of liquidity. The current indicator of over
capitalisation is the earnings of the company.

If the earnings are lower than the expected returns, it is overcapitalised.

Overcapitalisation does not mean surplus of funds. It is quite possible that a company may
have more funds and yet to have low earnings. Often, funds may be inadequate, and the
earnings may also be relatively low. In both the situations there is over capitalisation. Over
capitalisation may take place due to exorbitant promotion expenses, inflation, shortage of
capital, inadequate provision of depreciation, high corporation tax, liberalised dividend policy
etc. Over capitalisation shows negative impact on the company, owners, consumers and
society.

Under capitalization:

Under capitalisation is just the reverse of over capitalisation, a company is said to be

under capitalised when its actual capitalisation is lower than its proper capitalisation as
warranted by its earning capacity. This happens in case of well established companies, which
have insufficient capital but, large secret reserves in the form of considerable appreciation in
the values of fixed assets not brought into books. In case of such companies, the dividend rate
will be high and the market value of their shares will be higher than the value of shares of
other similar companies. The state of under capitalisation of a company can easily be
ascertained by comparing of a book value of equity shares of the company with their real
value. In case real value is more than the book value, the company is said to be under
capitalised. Under capitalisation may take place due to under estimation of initial earnings,
under estimation of funds, conservative dividend policy, windfall gains etc. Under-
capitalisation has some evil consequences like creation of power competition, labour unrest,
consumer dissatisfaction, possibility of manipulating share value etc..
WATERED STOCK

Watered stock is an asset with an artificially-inflated value. The term is most

commonly used to refer to a form of securities fraud common under older corporate laws that
placed a heavy emphasis upon the par value of stock.

Origin of term

"Stock watering" was originally a method used to increase the weight of livestock
before sale. It entailed tricking cattle to bloat itself with water before it was weighed during a
sale transaction. Its introduction to the New York financial district is popularly credited to
Daniel Drew, a cattle driver turned financier.

Explanation

American stock promoters in the late 1800s could inflate their claims about a
company's assets and profitability, and sell stocks and bonds in excess of the company's
actual value. To do so, they would contribute property to a new corporation in return for
stock at an inflated par value. On the balance sheet, the property would be the corporation's
only capital, and because legal capital was fixed to aggregate par value, the value of the
property would go up. While the promoter had $10,000 in stock, the corporation might only
have $5,000 worth of assets, but would still be worth $10,000 on paper. Holders of watered
stock could be personally liable if creditors foreclosed on the corporation's assets.

If they had received $10,000 in stock for a $5,000 capital contribution, they would
not only lose their $5,000 investment but would also be personally liable for the additional
$5,000, whether they were the aforementioned promoter lying about the value of their
contribution, or an innocent investor relying on par value to gauge the true value of the
corporation. Because par value was such an unreliable indicator of the actual value of stock,
and because high par values could create liability for investors if the corporation went into
bankruptcy, corporate lawyers began advising their clients to issue stocks with low par
values. The legal capital or "stated capital" of the corporation would still be determined based
on par value, but the balance sheet would include the investment over par value as a capital
surplus, and everything would still balance.
 In 1912, New York authorized corporations to issue "no par stock" with no par value
at all, in which case the board of directors would allocate the incoming capital between stated
capital and capital surplus. All other states followed suit. Thanks in large part to a
proliferation of low par and no par stock, watered stock is less of an issue these days. The last
major American court case dealing with watered stock was in 1956.

Examples

In 1866-1868, during the so-called Erie War, Cornelius Vanderbilt was defrauded by
James Fisk, Daniel Drew and Jay Gould who sold $7,000,000 worth of watered stock
to him in his attempt to acquire the Erie Railroad.
In 1873, the Railway Commissioners of Illinois reported that the stock of the railway
companies in the state was inflated to $75,000,000 bringing $6,000,000 in yearly
profits. In particular, the investigation uncovered that 75% of the Central Pacific
Company's assumed capital was fictitious.

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. 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 over-trading and when the company earns high profits as compared to other
industry. Overcapitalization shows the rate of return as declining entity whereas
undercapitalization shows the rate of return as increasing entity.

DEFINITION of 'Watered Stock'

Stock that is issued with a value much greater than the value of the issuing company's
assets. Watered stock can be caused by excessive stock dividends, overvalued assets and/or
large operating losses.

INVESTOPEDIA EXPLAINS 'Watered Stock'

Assets can be overvalued for several reasons, including inflated accounting values or
excessive issue of stock (through a dividend or employee stock-option program).
 This term is thought to originate from ranchers who would feed their cattle large
amounts of water before market day to make them heavier, fetching a price higher than their
worth.

REFERENCES

http://www.yourarticlelibrary.com/financial-management/types-of-capitalization-
over-and-under-capitalization-financial-management/29394/
http://www.yourarticlelibrary.com/difference/difference-between-over-
capitalization-and-under-capitalization-of-company/29382/
http://www.careerride.com/fa-overcapitalization-vs-undercapitalization.aspx
http://en.wikipedia.org/wiki/Watered_stock
http://www.investopedia.com/terms/w/wateredstock.asp