ACCA Financial Management (F9) Certification Practice Exam

What does over-capitalisation refer to?

1. Excess of liabilities over assets

2. Higher than optimal cost of capital

3. Insufficient investment in working capital

4. Excessive equity relative to fixed assets

The correct answer is: Higher than optimal cost of capital

Over-capitalisation refers to a situation where a company has raised more capital than it can profitably use or needs for its operations. This typically results in a higher than optimal cost of capital because the company must generate sufficient returns to cover the cost of the excess finance it has raised. When a business is over-capitalised, the average cost of capital increases, which can lead to diminished returns on investment and decrease shareholder wealth. The firm may struggle to achieve the necessary returns to justify the capital raised, leading to pressures on profitability. This concept is particularly important because capital structure decisions impact financial performance and investor expectations. Investors expect a return on their investments, and a higher cost of capital can lead to lower profitability margins, which can be detrimental in a competitive market. Understanding over-capitalisation helps businesses manage their equity and debt levels effectively to avoid unnecessary costs associated with excess capital.