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.
It is a process where a company reduces its share capital.
But how does capital reduction work? What are the reasons and objectives behind it?
If you are new to stock market trading, understanding capital reduction is important because it can affect the value of the shares you own in a company. It’s a way for companies to manage their finances and potentially boost shareholder value.
It can have various benefits for both the company and the shareholders.
In this blog, we will explain what capital reduction is, how it works, and what its objectives are.
What is Capital Reduction
Capital reduction is the process of decreasing a company’s share capital, which is the amount of money raised from issuing shares to the public.
Capital reduction can be done in multiple ways, such as:
1. Making payments to shareholders out of the capital
2. Buying back or cancelling shares
3. Extinguishing or reducing the liability on any of the shares.
Capital reduction is governed by section 66 of the Companies Act 2013 and requires the approval of the National Company Law Tribunal (NCLT).
Let us understand the concept of Capital Reduction:
Imagine a company has some money tied up in its assets, like buildings or equipment.
Now, let’s say the company wants to give some of that money back to its shareholders.
That’s where capital reduction comes in.
Capital reduction is when a company decides to decrease the amount of money it has tied up in its assets and return some of it to its shareholders.
It’s like the company saying, “Hey, we don’t need all this money for our operations right now, so let’s give some of it back to our investors.”
This process usually involves either buying back shares from shareholders or reducing the nominal value of shares.
By doing this, the company can improve its financial health or increase the value of each remaining share.
How Does Capital Reduction Work?
When a company wants to decrease its share capital, it can do so by either paying some of it to shareholders or by cancelling a specific number of shares. This action can be repeated as needed by the company.
When capital is returned to shareholders, individual consent is not required.
The company must ensure it follows all relevant rules and regulations during the capital reduction process and 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, 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 decrease by the reduction amount.
Basically, it means that even though the owners of the company (shareholders) will have a bigger part of the company, the overall worth of the company won’t go up.
This might happen because the company decides to use some of its money to buy back its own shares or pay dividends to shareholders.
So, while the owners 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.
Reasons for Capital Reduction
The company may practise capital reduction due to the following reasons:
• To improve the financial ratios and performance indicators of the company, such as EPS, ROE, book value, etc.
• To enhance the shareholder value and market perception of the company by signalling its confidence and efficiency.
• To avoid over-capitalization, which may result in low returns, high costs, and idle funds.
• To avoid dilution of ownership and control, which may occur due to issuing more shares or granting stock options.
• To provide an exit option to the shareholders, who may want to sell their shares at a premium or receive cash in lieu of shares.
Objectives of Capital Reduction
The objectives of capital reduction can vary depending on the company’s specific circumstances, but here are some common reasons why a company might choose to reduce its capital:
- Efficient Capital Structure: Sometimes, a company may have more capital (money or assets) than it needs for its operations.
Through capital reduction, it can create a more efficient capital structure, which means it’s using its resources in the best possible way to generate profits.
- Return of Excess Capital to Shareholders: If a company has accumulated surplus funds or assets that it doesn’t need for future growth or operations, it may choose to return some of that capital to shareholders.
This can be done through mechanisms like share buybacks or reducing the nominal value of shares.
- Enhancing Shareholder Value: Capital reduction can be a way to increase shareholder value by reducing the number of shares outstanding or by increasing the earnings per share (EPS).
This can make each share more valuable to investors.
- Financial Restructuring: In some cases, a company might be facing financial difficulties or looking to restructure its finances.
Capital reduction can help improve the company’s financial health by reducing debt, strengthening the balance sheet, or improving liquidity.
- Legal or Regulatory Compliance: There may be legal or regulatory requirements for a company to reduce its capital, such as to eliminate accumulated losses or to comply with statutory provisions.
- Facilitating Corporate Actions: Capital reduction can also facilitate other corporate actions, such as mergers, demergers, or reorganisations, by simplifying the company’s capital structure or aligning it with strategic objectives.
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, but they have different implications:
- Tax: Capital reduction is usually more tax-efficient for shareholders, 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: Share buyback is often seen as positive, signalling that the company believes its shares are undervalued.
Capital reduction may not signal the same confidence.
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. Capital reduction can have various benefits and drawbacks, depending on the situation and the outcome of the process.
Therefore, it is essential to be aware of the factors and consequences of capital reduction before investing in a company that is undergoing or planning to undergo capital reduction.
FAQs| Capital Reduction
Capital reduction or buyback is when a company decreases its share capital by cancelling or repurchasing some of its shares from shareholders. This can help the company boost earnings per share, return extra capital to shareholders, or improve its financial structure.
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. This is treated as dividend income for shareholders and is taxable under section 2 (22) (d) of the Income Tax Act, 1961.
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.
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Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.