A capital increase or capital reduction is about increasing or decreasing the equity capital of a company. Equity capital has the advantage of usually being available for longer than debt capital and does not have to be repaid. Even with equity, however, there are still capital costs. These are the dividends the investor receives.
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. In this article, we explain what a capital increase or capital reduction means.
Capital increases: more equity for companies limited by shares
There are many reasons why a company might increase its capital. They include the following:
- It is planning to invest in or take over another company
- It wants to improve its balance sheet structure and, in turn, increase its equity ratio
- It wants to cut the share of debt capital in order to reduce interest costs or dependence on external creditors
- It needs more equity in difficult times to ensure its survival
The share capital can be increased by issuing new shares
The company can, for instance, increase its 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.
It means the “old” shareholder’s share becomes “diluted”, and this dilution causes the shares to decrease in value. To avoid it, 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.
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.
Capital increases without subscription rights must be agreed to first.
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.