Meaning and Definition of Under-Capitalization:
Generally under-capitalization denotes the inadequacy of capital; i.e., the shortage of capital. It is a condition when the real value of the company based on its earnings is more than the book value. A company is said to be under-capitalized when its actual capitalization is lower than its proper capitalization as warranted by its earning capacity. In the words of Hoagland, “Under-capitalization is an excess of true asset values over the aggregate of stocks and bonds outstanding. In the words of Charles W. Gerstenberg, “A corporation may be undercapitalized when the rate of profits ti is making on the total capital is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry, or when it has too little capital with which to conduct its business.” Sometimes a company, on the face of it, may have insufficiency of capital but it may have large secret reserves or its promoters might have under-estimated it his situation will not be treated as Under-capitalization. In short, under-capitalization is a state of affairs when the actual capital is short of the requirements of the company.
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Causes of Under-capitalization:
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There may be a number of causes of under-capitalization. However, the main causes of under-capitalization are – (i) Under-estimation of earnings; (ii) Under-estimation of capital requirement; (iii) Promotion of company during the period of depression; (iv) Unforeseen increase in earnings, such as, during boom period, the company will find itself under-capitalized when its earnings exceed the increase in the amount of capital employed; (v) Conservative dividend policy of the company; (vi) Sound financial management with high efficiency; (vii) Tight conditions in the money market.
Merits of Under-capitalization:
The main advantages/ merits of under-capitalization are -(i) Creation of secret reserves, (ii) Higher rate of dividend, (iii) Rapid increase in the prices of shares in the stock exchange; (iv) Symptom of economic prosperity of the company; (v) Increase in the rate of profits of the company; and (vi) Shares can be sold easily.
Evils/ Demerits/ Disadvantages of Under-capitalization:
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The evils of under capitalization are- (i) Wide fluctuation in the prices of shares etc., (ii) Increase in competition, (iii) Increase in speculative activities, (iv) Increase in opportunities for manipulation by management, (v) Industrial relations tend to be strained, (vi) Dissatisfaction amongst consumers, they feel they are being exploited by the company, (vii) Increase in the tax burden of the company, (viii) Increased Government interference etc.