Have you ever wondered what happens when a company has more money than it needs? How does it return the excess cash to its shareholders? And how does it affect the value of its current shares? This is basically termed as the capital reduction in the stock market.
But how does capital reduction work? What are the objectives of capital reduction?
If you are new to stock market trading, understanding capital reduction is important. This is because it can affect the value of the shares you own in a company. It can have various benefits for both the company and the shareholders.
In this blog, we will explain the reasons for capital reduction and the concept of a capital reduction account.
What is Capital Reduction
Capital reduction is when a company reduces its shareholder equity by cancelling or buying shares back. This helps simplify the company’s financial structure. It can also increase shareholder value. The process must follow legal rules and involve several steps to ensure compliance.
Capital reduction can be done in multiple ways, such as:
1. Making payments to shareholders out of the capital
2. Share buyback
3. Extinguishing or reducing the liability on any of the shares.
Capital reduction is governed by section 66 of the Companies Act 2013. The process requires the approval of the National Company Law Tribunal (NCLT).
Reasons for Capital Reduction
Companies might reduce capital to:
- Increase money available for dividends.
- Return extra money to shareholders.
- Simplify their financial structure.
- Address financial losses or adjust their market value.
Capital Reduction Account
This account is useful during the process of capital reduction. It helps adjust the company’s financial statements to show the new, lower capital amount. Companies prepare this account during internal restructuring, mergers, etc.
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How Does Capital Reduction Work?
When capital is returned to shareholders, individual consent is not required.
However, the company must ensure it follows all relevant rules and regulations during the capital reduction process. They must also obtain proper approval before taking any action.
The company must follow these steps for the capital reduction process:
- Notify the company’s creditors about the resolution for capital reduction.
- Submit an application to reduce the share capital within a specified timeframe after issuing the initial notice.
Once the capital reduction is registered in the commercial register, they can distribute the reduced capital amount to shareholders and formally decrease the share capital.
What Happens After Capital Reduction?
After capital reduction, the number of shares in the company will reduce by the reduction amount. Basically, it means that even though the shareholders will have a more significant part of the company. However, the overall worth of the company won’t go up.
So, while the shareholders have more control, the company’s value stays the same.
Another thing that can happen because of capital reduction is a “squeeze-out” of minority shareholders. This means they might be forced to sell their shares to the company or the owners at a fair price.
This can benefit the owners by giving them more control and the minority shareholders by letting them cash out their investments.
Objectives of Capital Reduction
Here are some common reasons why a company might choose to reduce its capital:
- Creating Distributable Reserves
The company may decide to set aside reserves that can be used to pay dividends in the future.
- Returning Surplus Capital to Shareholders
A company may give back excess capital that the company doesn’t need for its daily operations. This can improve the company’s return on equity.
- Simplifying the Capital Structure
A streamlined structure can attract more investors and be easier to manage.
- Addressing Accumulated Losses
If a company has some lossed, it can pay them from the company’s balance sheet. This can improve financial health and make the company more appealing to investors and creditors.
- Improving Financial Ratios
In order to enhance financial ratios like earnings per share (EPS) and return on equity (ROE), a capital reduction may be adopted. Better ratios can positively affect the company’s stock price and market perception.
- Corporate Restructuring
Capital reduction also helps in mergers, de-mergers, or other restructuring efforts. This can help achieve strategic goals and improve efficiency.
- Legal or Regulatory Compliance
There may be legal or regulatory requirements for a company to reduce its capital.
Example of Capital Reduction
Let us say that Company XYZ has 2,000,000 shares outstanding, and the share price is ₹50, resulting in a market capitalisation of ₹100 crore for Company XYZ.
Due to excess cash reserves, Company XYZ decides to undertake a capital reduction by cancelling a portion of its shares.
Company XYZ announces a capital reduction plan and cancels 500,000 of its shares.
As a result, these shares are no longer available for trading, reducing the total number of shares outstanding to 1,500,000 shares.
With 1,500,000 shares outstanding at a share price of ₹50, the company’s market capitalisation decreases to ₹75 crore. The capital reduction program leads to a decrease in the company’s market capitalisation by ₹25 crore.
This capital reduction helps Company XYZ optimize its capital structure and allocate excess funds efficiently. It may also improve financial ratios and enhance shareholder value.
What is the Difference Between BuyBack and Capital Reduction
The difference between share buyback and capital reduction is how a company handles its shares.
- In a share buyback, the company purchases its own shares from the market and cancels them.
- In a capital reduction, the company reduces the nominal value of its shares or cancels some shares for zero consideration.
Both methods aim to return capital to shareholders and increase the value of each remaining share. However, they have different implications:
- Tax
Capital reduction is usually more tax-efficient for shareholders. It is treated as a return of capital rather than a taxable dividend.
Share buyback may be subject to capital gains tax.
- Financial statements
Capital reduction significantly affects the company’s balance sheet by reducing share capital and reserves.
Share buyback mainly impacts cash reserves without directly affecting the balance sheet.
- Cost
Share buyback can be more expensive as it involves buying shares at market price.
Capital reduction doesn’t have a direct cost.
- Signalling effect
The share buyback is often seen as positive. It means that the company believes its shares are undervalued.
Capital reduction may not signal the same confidence.
Tax Implications of Capital Reduction in India
Capital reduction can impact taxes for both companies and shareholders.
- If the capital reduction involves distributing accumulated profits to shareholders, this is treated as dividend income under Section 2(22)(d) of the Income Tax Act, 1961.
These distributions are taxable as dividends for the shareholders.
- If shareholders receive an amount that exceeds the accumulated profits, the excess is considered capital gains.
Shareholders may face capital gains tax on the amount received above the accumulated profits.
Conclusion
Capital reduction is an important concept for investors, as it can affect the value of the shares they own in a company. It can also signal the company’s confidence, efficiency, or growth potential. Therefore, it is essential to be aware of the reasons for capital reduction before investing in a company that is undergoing or planning to undergo capital reduction.
FAQs| Capital Reduction
Capital reduction involves decreasing shareholder equity by cancelling shares, repurchasing them, or returning capital to shareholders.
Capital decrease or capital reduction means lowering the paid-up amount of a company’s shares. This can be done by paying shareholders an amount equal to the face value of the shares or cancelling some shares for no consideration.
Capital reduction under the Income Tax Act occurs when a company distributes its accumulated profits to shareholders upon reducing its capital.
The most crucial reason for capital reduction is to optimise the company’s capital structure by lowering its cost of capital and enhancing financial flexibility.
Reduced capital means a company is lowering its shareholder equity. This can happen by cancelling shares, buying back shares, or giving some capital back to the shareholders.
According to the Companies Act, 2013, capital reduction means decreasing share capital through a special resolution, which also requires approval from the National Company Law Tribunal (NCLT).
Capital reduction can be good because it can simplify the company’s capital structure, enhance shareholder value, and remove accumulated losses. However, it needs to be handled carefully.
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Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.