Capital reduction is defined as the process of decreasing a company’s shareholding equity through share cancellations and share repurchases. Companies may undertake capital reduction for various reasons, including restructuring, mergers and acquisitions, and increasing shareholder value. In India, capital reduction falls under the purview of the Companies Act of 2013. If you have just started investing in stock market, it's crucial to understand the meaning of capital reduction, its rationale, and its impact.
Key takeaways
- Capital reduction involves decreasing a company's shareholder equity, which can be executed through measures such as share cancellations, paid-back capital, or share buybacks.
- Companies undertake capital reductions for various reasons, including increasing shareholder value, improving earnings per share (EPS), or streamlining their capital structure for better efficiency.
- The process of capital reduction must adhere to legal requirements, ensuring the company completes all necessary procedural steps to lawfully implement the reduction.
How does capital reduction work?
Companies can undertake capital reduction in one of two ways:
- Pay back the amount the shareholders paid in acquiring the company’s shares.
- Cancelling a certain number of shares.
The decision for capital reduction does not require permission from each shareholder. In other words, the company can return the capital to shareholders without their consent. That said, companies are required to comply with certain regulations and follow a set process when implementing capital reduction. Here’s a step-by-step guide on how capital reduction works:
- The company must send a notice to its creditors outlining the capital reduction resolution.
- Next, the company must submit an application for the decrease in share capital within a stipulated period after the publication of the initial notice.
- Once the share capital reduction decision is noted in the commercial register, the company has to disburse the capital amount to its shareholders within a few months.
Note: While these are the general steps to capital reduction, the specifics may vary depending on the country in question. Different countries may have different sets of rules and compliance regulations vis-a-vis share capital reduction.
Why does capital reduction take place?
Learning about capital reduction is a part of share market basics. Therefore, every investor must understand why companies undertake capital reduction. We have outlined why capital reduction occurs below:
- Establishing distributable reserves.
- Pay dividends in the future.
- Returning surplus capital back to shareholders.
- Facilitate corporate restructuring.
- While undergoing a de-merger.
- Reducing paid-up or unpaid shares.
- Meet revenue loss.
- Return excess capital to shareholders.
What are the benefits of capital reduction?
Capital reduction helps lower the equity share capital of a company. It can be a prudent strategy that offers various benefits to the company in question. Here’s why capital reduction is beneficial:
- Offset accumulated losses of the company.
- Simplify a company’s capital structure to make it more efficient.
- Create distributable reserves for smooth dividend payments to shareholders, increasing their value.
- Aid in the transfer of non-cash assets to shareholders.
Reasons for capital reduction
When accounting for capital reduction, companies put forward a range of reasons. We have discussed the most crucial ones below:
- Dealing with accumulated losses: Capital reduction can help companies deal with accumulated losses on the balance sheet.
- Improve financial ratios: Lowering equity base leads to higher ROE or return on equity if profits remain stable.
- Return capital to shareholders: Giving surplus capital back to shareholders can help boost confidence among shareholders, demonstrating proactive financial management.
- Corporate restructuring: Companies may use capital reduction strategies when undergoing mergers and acquisitions. This helps realign the company structure with the current operations and future goals.
- Efficient capital structure: Capital reduction can help remove idle or ineffectively used capital and make the capital structure much more manageable and efficient.
- Regulatory compliance: Sometimes, capital reduction can be undertaken to ensure compliance with regulatory requirements like changes in the rules relating to the distributable reserves limit of a company.
- Avoiding diluting value: Capital reduction can help when the market value of a company is less than its stated capital. It can realign the book value of the firm with its market value, avoiding diluting value for its existing shareholders.
Example of capital reduction
Let’s consider Company XYZ Ltd., an Indian company listed on the stock market. XYZ Ltd. has 2,000,000 shares outstanding, with a current share price of Rs. 50 per share, resulting in a total market capitalisation of Rs. 100 crore.
XYZ Ltd. decides to implement a share buyback programme, repurchasing 800,000 shares from the market. These shares are subsequently retired, reducing the total number of outstanding shares to:
2,000,000 - 800,000 = 1,200,000 shares
After the buyback, assuming the share price remains at Rs. 50 per share, the new market capitalisation of XYZ Ltd. is:
1,200,000 × Rs. 50 = Rs. 60 crore
Through this buyback, the company has reduced its market capitalisation by Rs. 40 crore. Such actions can benefit shareholders by potentially increasing the EPS and indicating confidence in the company's financial health.
What is the difference between buyback and capital reduction?
Both capital reduction and share buyback are common strategies used by companies to reduce share capital. The primary difference between the two lies in how they handle the shares. Here’s a quick break-down of the differences between these two strategies to clarify things further:
- Capital reduction lowers the company’s share capital by making payments to shareholders out of its capital. Share buybacks reduce a company’s share capital by repurchasing its own shares from the shareholders.
- Companies do not require the consent of shareholders to implement capital reduction. For share buybacks, shareholders offered a buyback can evaluate the offer and decide if they wish to sell or retain their shares. In other words, shareholders can object to share buybacks.
Conclusion
Capital reduction accounts for a strategic tool companies leverage to lower their share capital and meet various goals. By lowering share capital via share cancellations or other such strategies, companies can boost their distributable reserves and better manage equity.
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