<p>A firm's Output $Y$ (in <em>value-added</em> terms, i.e. over and above the value of purchases of third-party services and materials) is distributed as reward to the factors of production. Denote $K$ the <em>book value</em> of the company's assets.  Use the standard notation $L$ for payments to the labor/human capital input to production. Denote $r$  the capital rate of return as measured with respect to the book value of firm's capital and denote $w$ the average remuneration of human capital services. Then we have</p>

<p>$$Y = rK + wL$$</p>

<p>Depending on the market, the industry, and a few other things, we can estimate  $r^*$, the rate of return that the firm "should" have on average, if it should be judged as an efficient user of capital allocated to it, for given output and human capital costs. $r^*$ is usually estimated by what are the returns on the market and the industry (we do not go outside the industry since we recognize the existence of "asset specificity"). Associated with $r^*$ goes the efficient level of capital, $K^*$. So we also have</p>

<p>$$Y = r^*K^* + wL$$</p>

<p>leading to </p>

<p>$$rK = r^*K^*  \implies r = r^*\frac {K^*}{K}$$</p>

<p>If we have that </p>

<p>$$r &lt; r^* \implies r^*\frac {K^*}{K} &lt; r^* \implies K^* &lt; K$$</p>

<p>and we can say with some certainty that the inequality does not show a tendency to change in the near future, then we can argue that the company does not make efficient use of the current amount of capital it appears to have, either due to "functional inefficiency" (how things are organized and work inside the company and in the delivery of of its business, a qualitative aspect), or due to plain under-utilization of the existing capital (a quantitative aspect).  </p>

<p>The "over-capitalization" story essentially assumes "functional efficiency" but it sees under-utilization of capital, and so it advocates the reduction of the capital/assets currently under the control of the company.</p>

<p>To measure it we have the relation ($K_E=$ Excess Capital)</p>

<p>$$ K_E = K - K^* = K- \frac {r}{r^*}K = \left (1-\frac {r}{r^*}\right)K$$</p>

<p>$r$ and $K$ is measured from the firms financial statement, while $r^*$ from Industry weighted averages.</p>

CC BY-SA 3.0
2015-04-19T06:48:26.557Z
Thanks but I'm concerned about estimating r* as in some instances the whole industry is over capitalized (Oil in the 1980s).
user1627466
CC BY-SA 3.0
2015-04-19T11:51:54.533Z
In Industries were "overcapitalization" can be approached in an "engineering way", i.e. where we can obtain a measure of "installed output capacity" and compare it to actual production, we can have a direct measure of the amount of capital that it "rests idle".
Alecos Papadopoulos
CC BY-SA 3.0
2015-04-18T14:59:06.143Z
2015-04-18T23:55:42.703Z
2015-04-18T23:55:42.703Z
Alecos Papadopoulos
<p>I don't think the term is very well defined. I think it depends on the context. I have maybe two possibilities. I'll try to provide references with each.</p>
<h1>Possible Definition 1</h1>
<p>The first coincides with @Alecos' answer. The following is taken from the beginning of &quot;<a href="http://www.sciencedirect.com/science/article/pii/0165176584901575" rel="nofollow noreferrer">The Over-Capitalization Effect with Diversification and Cross Subsidization</a>,&quot; by Rozek, published in the journal <em>Economic Letters</em>:</p>
<blockquote>
<p>A basic component of the theory of regulation is the model developed
by Averch and Johnson (1962). The main result is that a monopolist,
subject to a rate of return constraint, will select a larger capital-labor
ratio than the one that minimizes costs for the output level it decides to
produce. This result is known as the over-capitalization or A-J effect. A
crucial assumption in this model is that the allowed rate of return is
greater than the market cost of capital. If the reverse is true, the regulated
monopolist will actually under-capitalize.</p>
</blockquote>
<h1>Possible Definition 2</h1>
<p>The second possible definition coincides with <a href="http://www.investopedia.com/terms/o/overcapitalization.asp" rel="nofollow noreferrer">the definition given on <em>Investopedia.com</em></a>.</p>
<blockquote>
<p>When a company has issued more debt and equity than its assets are worth. An overcapitalized company might be paying more than it needs to in interest and dividends. Reducing debt, buying back shares and restructuring the company are possible solutions to this problem. ... The opposite of overcapitalization is undercapitalization, which occurs when a company has neither the cash flow nor the access to credit that it needs to finance its operations. Undercapitalization most commonly occurs in companies with high start-up costs, too much debt and/or insufficient cash flow and can ultimately lead to bankruptcy.</p>
</blockquote>
<p>Whereas the first definition was one that dealt with efficient use of inputs of production this second definition deals more with capital structure in the corporate finance literature.</p>
<p>This reminds me of the &quot;free cash flow problem.&quot; This is an agency problem described in the corporate finance literature that arises in cash-rich firms. I'm assuming that over-capitalization can refer to this situation. That is, they have more cash than is needed to finance their operations. Here is a basic description of the free cash flow problem, given in <a href="https://rads.stackoverflow.com/amzn/click/com/0691125562" rel="nofollow noreferrer" rel="nofollow noreferrer">Jean Tirole's book <em>The Theory of Corporate Finance</em></a>:</p>
<blockquote>
<p>Following Easterbrook (1984) and Jensen (1986,
1989), Section 5.6 focuses on cash-rich firms, defined
as firms with cash inflows exceeding their efficient
reinvestment needs or opportunities. Such
firms have excess liquidity that must be “pumped
out” in order not to be used on wasteful projects,
unwarranted diversifications, perks, and so forth.
Jensen’s (1989) list of industries with potential free cash-
flow problems includes steel, chemical, television
and radio broadcasting, brewing, tobacco, and
wood and paper products.
Overall, the liquidity-shortage and free-cash-flow
problems are two sides of the same coin. The key
issue in the design of long-term financing is to ensure
that, at intermediate stages, the right amount
of money is available for the payment of operating
expenses and for reinvestment and the right amount
is paid out to investors. Whether this results in a net
inflow (the liquidity-shortage case) or outflow (the
free-cash-flow case) is important for the comprehension
of corporate financing, but is a pure convention
as far as economic principles are concerned. And,
indeed, we merely reinterpret the liquidity-shortage
model in order to obtain its flip side, the free-cashflow
model.</p>
</blockquote>

CC BY-SA 3.0
2015-04-20T11:52:50.407Z
"Section 5.6 focuses on cash-rich firms, defined as firms with cash inflows exceeding their efficient reinvestment needs or opportunities." I think it is still the same problem as r*. We agree on its existence but we don't really know how to measure it. This does not seem to be a problem for economists but there isn't a accounting.stackexchange.com
user1627466
CC BY-SA 3.0
2015-04-20T17:01:27.950Z
@user1627466. Are you saying that you believe that the definitions that I listed refer to the same thing? They are not the same. Also, which problem are you referring to when you say that "this does not seem to be a problem for economists?"
jmbejara
CC BY-SA 3.0
2015-04-20T17:38:38.320Z
No I just meant that defining cash-rich firms as cash inflows > efficient reinvestment needs means that you've established this need. Just like Alecos' explanation with r*. Economists like to deal with concepts like capital but are not very interested in their accounting materialization, and I'm saying this as an economics student.
user1627466
CC BY-SA 3.0
2015-04-20T07:00:13.200Z
2015-04-20T07:00:13.200Z
2020-06-17T09:40:54.643Z
jmbejara
<p>Overcapitalization doesn't seem to have a clear-cut definition.</p>

<p>For some it seems to deal with the ratio of current output (Y) over optimal output (Y*). A company would then be overcapitalized if Y &lt; Y*, meaning it could raise its output without having to recapitalize.</p>

<p>Others define it as Equity + Debt > "True Value of assets"</p>

<p>I like the second definition but it is subjective.</p>

<p>I am trying to understand the concept of overcapitalization in the context of a firm's valuation.</p>

CC BY-SA 3.0
2015-04-18T14:23:07.427Z
It usually means that the amount of capital available to a firm is in excess of what is required by the projects that are available for the firm to undertake (and are expected to provide a sufficient risk-adjusted return). The result of this is that the firm will provide a poor return to its investors. If the firm can't find better opportunities, its best option is to reduce the amount of capital available to it by retiring debt or engaging in stock buy-backs.
dismalscience
CC BY-SA 3.0
2015-04-18T14:26:00.233Z
So could it be approximated by a ratio like Working Capital / Liabilities ? I'm trying to measure it as well as define it.
user1627466
CC BY-SA 3.0
2015-04-21T01:36:41.897Z
Should you change your title to "assets = liabilities + equity?" Did you mean to write "assets = liabilities?"
jmbejara
<value><accounting><capital-structure>
If assets = liabilities + equity, what do we mean by overcapitalization?
user1627466
# If assets = liabilities + equity, what do we mean by overcapitalization?

(Asked by: username_0 on 2015-04-18)

Overcapitalization doesn't seem to have a clear-cut definition.

For some it seems to deal with the ratio of current output (Y) over optimal output (Y\*). A company would then be overcapitalized if Y < Y\*, meaning it could raise its output without having to recapitalize.

Others define it as Equity + Debt > "True Value of assets"

I like the second definition but it is subjective.

I am trying to understand the concept of overcapitalization in the context of a firm's valuation.

**Tags:** value, accounting, capital-structure

> **Comments:**
> **username_1**: It usually means that the amount of capital available to a firm is in excess of what is required by the projects that are available for the firm to undertake (and are expected to provide a sufficient risk-adjusted return). The result of this is that the firm will provide a poor return to its investors. If the firm can't find better opportunities, its best option is to reduce the amount of capital available to it by retiring debt or engaging in stock buy-backs.  
> **username_0**: So could it be approximated by a ratio like Working Capital / Liabilities ? I'm trying to measure it as well as define it.  
> **username_2**: Should you change your title to "assets = liabilities + equity?" Did you mean to write "assets = liabilities?"  

---

## 2 answers

### Answer by username_3 on 2015-04-18. Score: 2

A firm's Output $Y$ (in *value-added* terms, i.e. over and above the value of purchases of third-party services and materials) is distributed as reward to the factors of production. Denote $K$ the *book value* of the company's assets. Use the standard notation $L$ for payments to the labor/human capital input to production. Denote $r$ the capital rate of return as measured with respect to the book value of firm's capital and denote $w$ the average remuneration of human capital services. Then we have

$$Y = rK + wL$$

Depending on the market, the industry, and a few other things, we can estimate $r^\*$, the rate of return that the firm "should" have on average, if it should be judged as an efficient user of capital allocated to it, for given output and human capital costs. $r^\*$ is usually estimated by what are the returns on the market and the industry (we do not go outside the industry since we recognize the existence of "asset specificity"). Associated with $r^\*$ goes the efficient level of capital, $K^\*$. So we also have

$$Y = r^\*K^\* + wL$$

leading to

$$rK = r^\*K^\* \implies r = r^\*\frac {K^\*}{K}$$

If we have that

$$r < r^\* \implies r^\*\frac {K^\*}{K} < r^\* \implies K^\* < K$$

and we can say with some certainty that the inequality does not show a tendency to change in the near future, then we can argue that the company does not make efficient use of the current amount of capital it appears to have, either due to "functional inefficiency" (how things are organized and work inside the company and in the delivery of of its business, a qualitative aspect), or due to plain under-utilization of the existing capital (a quantitative aspect).

The "over-capitalization" story essentially assumes "functional efficiency" but it sees under-utilization of capital, and so it advocates the reduction of the capital/assets currently under the control of the company.

To measure it we have the relation ($K\_E=$ Excess Capital)

$$ K\_E = K - K^\* = K- \frac {r}{r^\*}K = \left (1-\frac {r}{r^\*}\right)K$$

$r$ and $K$ is measured from the firms financial statement, while $r^\*$ from Industry weighted averages.

> **Comments:**
> **username_0**: Thanks but I'm concerned about estimating r* as in some instances the whole industry is over capitalized (Oil in the 1980s).  
> **username_3**: In Industries were "overcapitalization" can be approached in an "engineering way", i.e. where we can obtain a measure of "installed output capacity" and compare it to actual production, we can have a direct measure of the amount of capital that it "rests idle".  

---

### Answer by username_2 on 2015-04-20. Score: 1

I don't think the term is very well defined. I think it depends on the context. I have maybe two possibilities. I'll try to provide references with each.

# Possible Definition 1

The first coincides with @username_3' answer. The following is taken from the beginning of "[The Over-Capitalization Effect with Diversification and Cross Subsidization](http://www.sciencedirect.com/science/article/pii/0165176584901575)," by Rozek, published in the journal *Economic Letters*:

> A basic component of the theory of regulation is the model developed
> by Averch and Johnson (1962). The main result is that a monopolist,
> subject to a rate of return constraint, will select a larger capital-labor
> ratio than the one that minimizes costs for the output level it decides to
> produce. This result is known as the over-capitalization or A-J effect. A
> crucial assumption in this model is that the allowed rate of return is
> greater than the market cost of capital. If the reverse is true, the regulated
> monopolist will actually under-capitalize.

# Possible Definition 2

The second possible definition coincides with [the definition given on *Investopedia.com*](http://www.investopedia.com/terms/o/overcapitalization.asp).

> When a company has issued more debt and equity than its assets are worth. An overcapitalized company might be paying more than it needs to in interest and dividends. Reducing debt, buying back shares and restructuring the company are possible solutions to this problem. ... The opposite of overcapitalization is undercapitalization, which occurs when a company has neither the cash flow nor the access to credit that it needs to finance its operations. Undercapitalization most commonly occurs in companies with high start-up costs, too much debt and/or insufficient cash flow and can ultimately lead to bankruptcy.

Whereas the first definition was one that dealt with efficient use of inputs of production this second definition deals more with capital structure in the corporate finance literature.

This reminds me of the "free cash flow problem." This is an agency problem described in the corporate finance literature that arises in cash-rich firms. I'm assuming that over-capitalization can refer to this situation. That is, they have more cash than is needed to finance their operations. Here is a basic description of the free cash flow problem, given in [Jean Tirole's book *The Theory of Corporate Finance*](https://rads.stackoverflow.com/amzn/click/com/0691125562):

> Following Easterbrook (1984) and Jensen (1986,
> 1989), Section 5.6 focuses on cash-rich firms, defined
> as firms with cash inflows exceeding their efficient
> reinvestment needs or opportunities. Such
> firms have excess liquidity that must be “pumped
> out” in order not to be used on wasteful projects,
> unwarranted diversifications, perks, and so forth.
> Jensen’s (1989) list of industries with potential free cash-
> flow problems includes steel, chemical, television
> and radio broadcasting, brewing, tobacco, and
> wood and paper products.
> Overall, the liquidity-shortage and free-cash-flow
> problems are two sides of the same coin. The key
> issue in the design of long-term financing is to ensure
> that, at intermediate stages, the right amount
> of money is available for the payment of operating
> expenses and for reinvestment and the right amount
> is paid out to investors. Whether this results in a net
> inflow (the liquidity-shortage case) or outflow (the
> free-cash-flow case) is important for the comprehension
> of corporate financing, but is a pure convention
> as far as economic principles are concerned. And,
> indeed, we merely reinterpret the liquidity-shortage
> model in order to obtain its flip side, the free-cashflow
> model.

> **Comments:**
> **username_0**: "Section 5.6 focuses on cash-rich firms, defined as firms with cash inflows exceeding their efficient reinvestment needs or opportunities." I think it is still the same problem as r*. We agree on its existence but we don't really know how to measure it. This does not seem to be a problem for economists but there isn't a accounting.stackexchange.com  
> **username_2**: @username_0. Are you saying that you believe that the definitions that I listed refer to the same thing? They are not the same. Also, which problem are you referring to when you say that "this does not seem to be a problem for economists?"  
> **username_0**: No I just meant that defining cash-rich firms as cash inflows > efficient reinvestment needs means that you've established this need. Just like username_3' explanation with r*. Economists like to deal with concepts like capital but are not very interested in their accounting materialization, and I'm saying this as an economics student.  

---

