Edited by Jan Toporowski and Jo Michell
Chapter 36: Overcapitalization
The efficient functioning of the capital market depends on the scarcity of capital in at least two respects. In the first place it depends on the scarcity of capital in the market for securities so that there are willing buyers of securities in the market and firms can thereby raise capital for productive purposes. Second, capital market efficiency depends on the scarcity of capital inside the firm, so that companies apply their scarce capital to the most productive uses of that capital, rather than squandering it on unnecessary investment, management and conspicuous aggrandisement. Overcapitalization, that is, the issue of equity or common stock in excess of what is required for the productive and commercial activities of a firm, makes the capital market less efficient. By keeping capital in firms that have run out of profitable investment opportunities, overcapitalization means that a firm’s excess capital may not be reallocated through the capital market to other firms where it may obtain a higher return. Furthermore, companies that are overcapitalized are under less internal financial pressure to allocate their capital to the most efficient uses.
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