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Created on 10.07.2019

Corporate actions: capital increases and reductions

Financial markets are dynamic, and companies are constantly on the move. Events are always unfolding that have an impact on a company and its capitalization, and these can of course affect the money you have invested. Corporate actions can be executed in various different ways: capital increases, splits, spin-offs, mergers and acquisitions, stock market flotations or even delistings. In this article, we are going to explain capital increases and reductions.

Capital increases: more equity for companies limited by shares

There are many reasons why a company might increase its capital.

  • It is planning to invest in or take over another company
  • Perhaps it wants to improve its balance sheet structure and so increase its own equity ratio
  • Or maybe it wants to reduce its share of debt capital in order to reduce interest costs or its reliance on external creditors
  • It may also be because a company requires more equity in difficult times to secure its very existence

Equity has the advantage of generally being available for longer than debt capital, and there is no need to repay it. Even with equity, however, there are still capital costs. These are the dividends the investor receives. They are generally also granted a right of involvement. Generally speaking, a company with a sensible equity/debt capital ratio is in a good position.

It is possible to accumulate equity capital by issuing new shares.

The company can, for instance, increase their share capital by circulating additional shares. This means the number of shares is increased, which in turn reduces the proportion of the shares held by the previous shareholders. The “old” shareholder’s share is “diluted”, and this dilution causes the shares to decrease in value. To avoid this, first-time shareholders are usually granted a subscription right to new shares. This follows a very basic principle: the more shares a person already has, the more subscription rights they receive. This dilution protection means the company can ensure that first-time shareholders do not have to see the percentage of their equity interest diluted as new shares are issued. The issue of subscription rights reduces the theoretical value of a share by this amount. Should the price of a share change, other effects are certainly possible. These subscription rights are booked to the shareholder’s custody account.

Generally speaking, these subscription rights can, much like shares, also be traded on the stock markets. It is up to a company whether it decides to trade these subscription rights. Ultimately, there are two ways shareholders can use these rights. If they wish to purchase more shares, they can exercise their subscription rights and purchase new shares at the issue price. If they do not wish to purchase any new shares, they are often able to sell their subscription right to another investor via the stock market. A shareholder will usually have to pay fees to sell these rights. They are also subject to fluctuations in supply and demand. A shareholder who does not exercise a subscription right may have to contend with a decline in price, though this usually isn’t for very long.

Capital increases without subscription rights must be agreed to first.

There are also have capital increases without any subscription rights. In Switzerland, it is down to the shareholders to decide whether they wish to permit capital increases without subscription rights. The subscription right can only be cancelled if there are solid grounds for doing so, for instance in the event of takeovers or participations. If the shareholders are in agreement, the company issues new shares. Any market participants can purchase them, so it is exactly the same as a stock market flotation.

Capital reduction: only possible with a resolution of the GM

Increasing capital is not the only thing companies can do – they can also reduce it. A company limited by shares (Ltd) can only reduce capital if it does not infringe on the rights of creditors. In any case, this requires a resolution to be passed by the General Meeting. There is no need to seek the approval of the shareholders in the event of a reduction in capital, in other words if the capital being reduced is to be completely replaced by new capital.

Many reasons for definancing

If liquid assets go towards paying financial liabilities or the partial repayment of equity, this is known as “definancing”. There are many reasons for definancing. Excessive liquidity, for example, can be reduced. Other reasons include overcoming an accumulated loss, or distributing surplus capital among shareholders. The latter two examples are instances of nominal/actual capital reduction.

Share buyback or reducing the nominal value

A company can reduce capital by decreasing the nominal value of each share. It can alternatively also buy its own shares back from the previous shareholders, and then destroy these shares. The technical term for this type of reduction is “accretive” In this scenario, earnings generally increase for each share (“earnings per share”, EPS). However, this does not mean that the share price is also driven up.

So it’s worth keeping a close eye on when a company increases or reduces its capital. For you as an investor, corporate actions such as capital increases or reductions usually have an impact on your investments.

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