Capital Reconstruction free essay sample

The act of placing a company into voluntary liquidation and then selling its assets to another company with the same name and same stockholders, but with a larger capital base. It is the  complete  overhaul of the  capital  of a distressed company  to save it from  liquidation. The object of it is to enable the company to continue as a going concern by the removal of the burden of immediate debt, the attraction of additional  capital  and the creation of a viable financial structure. Definition:- The reconstruction of  capital, which is also known as  capital  reconstruction, is defined as the plans made by  a company  for the restructuring of its capital  base. Capital  reconstruction involves major  alterations  in the  capital  base of  a company. It is related to the term  capital  restructuring. OR A company gains the agreement of its shareholders and creditors to vary the rights of its members and creditors, by altering the capital structure in a way that allows the existing company to continue in business. Types of Capital Reconstruction:- There are two types of  capital  reconstruction. These are splits and  consolidations. Split is an easy  principle  to understand. 1. Splits:- Under the principle of splits,  a company  basically splits its  capital  base. For instance,  a company  may split its base of  capital  by issuing two new  shares  for every  one share  held by the shareholder. For example, if the company has 50, 000, 000  shares  at its disposal, it can split its base of  capital  to 100, 000, 000  shares. Capital  reconstruction may or may not include a return on  capital. 2. Consolidations:- On the other hand,  consolidations  are the opposite of splits. In the above example, the company split its 50, 000, 000  shares  into 100, 000, 000  shares. In the case of consolidations, however, the company may consolidate the 100, 000, 000 ordinary  shares  at its disposal into 50, 000, 000 ordinary  shares  by giving shareholders only one new shares  for every two  shares  they hold. The process of re-engineering the capital base of a company could be done internally or externally. Internal construction is a process where capital is reconstructed within the existing shareholder, while external is where capital is reconstructed among the existing and prospective shareholders. Accounting for Capital  Reconstruction Rationale for Capital Reconstruction To eliminate 3 issues that prevent a distressed company from recovering 1. Negative retained earnings * Companies with accumulated losses are not allowed to pay dividends. One reason is that it prevents the shareholders from withdrawing money and leaving the debt holders high and dry. * This discourages potential investors from investing in the company. * The company will find it difficult to obtain debt financing as well. 2. Overdue interest and debt * Distressed companies are cash strapped. Needing to pay interest puts burden on the company, and prevents it from committing necessary capital to turn around the business. The debt and interest also results in high gearing and low interest coverage ratios, which again prevents the company from obtaining additional debt financing. 3. Overdue dividends on cumulative preference shares * Same reasons as per debt, since preference shares are essentially debt. Types of Entity Construction Schemes (accounting speak) 1. Capital reduction 2. Re construction 3. Liquidation via a new company Capital Reduction Scheme This addresses the 1st point above. A capital reduction scheme essentially recognizes the loss that the equity holders have incurred by adjusting equity reserve accounts. A company * Resets any negative retained earnings account by offsetting it with equity reserve accounts (e. g. share premium account first, followed by share capital account) * Writes off any unpaid share capital by reducing the value of its share capital and restating as fully paid shares. * Writes off share capital not backed by available assets (e. g. reducing intangibles and share capital) Since this would allow equity holders to pay themselves dividends again, court approval is typically required so as to take into account the interests of other stakeholders (e. . debt holders). Reconstruction Schemes This addresses the 2nd and 3rd points above. This involves the company * Writing off overdue debt interest and restructuring debt to have lower interest and extended maturity * Writing off cumulative preference shares dividend owed * Writing off amounts owed to suppliers * Issuing new shares (crediting equity reserves) to the previous debt holders, preference shares holders, suppli ers for accepting to restructure the debts. Essentially debt holders convert to being equity holders, possibly retaining  a lower debt amount. This allows them to recover their funds through the company’s recovery, as opposed to not recovering their funds when the company collapses. Liquidation via a New Company This involves: * Selling assets to another company * Using the proceeds to pay down remaining debts, and liquidating the business. * Profit recognized is based on proceeds less carrying costs of remaining net assets. * The buyer of the assets will still recognize Goodwill based on the fair value of the assets bought. Any of a range of financing transactions aimed at significantly altering the shape of a firms liabilities (cf. ecapitalization; reconstructing). There are three basic ways in which this can happen: increases/decreases in the amount of equity, increases/decreases in debt, and lengthening/shortening debt maturities (cf. buy-out; debt-equity swap; going private; highly-leveraged transaction; refunding; stock repurchase plan). In a capital reconstruction, or capital reorganization, a company gains th e agreement of its shareholders and creditors to vary the rights of its members and creditors, by altering the capital structure in away that allows the existing company to continue in business. Many large companies, including Marconi, attempted to solve problems related to interest payment and principal repayments by converting debt into equity in 2001/2. Reasons for Capital Reconstruction There are a number of reasons why a restructuring may be necessary: ? The company may have become too highly geared and a solution may be to issue equity in place of debt capital. ? The existing capital structure may have become over-complicated with perhaps too many classes of shareholder with different rights to each class. They can be consolidated into one or two classes, but care must be taken to ensure that the relative voting strength remains in the same proportion. ? Capital with prior rights may carry a high fixed dividend which then gives a misleading impression of the company, or preference shareholders may have control of the company. In such cases the structure should be reorganized into a more convenient nature. ? The company may decide to replace preference shares with debentures in order to reduce the corporation tax on the company’s shares. Reasons for Capital Reorganization There are a number of reasons why capital reorganization may be necessary: (a) The company may be at risk of insolvency, due to poor profitability, overtrading or other problems related to cash management. (b) The company may have become too highly geared and a solution may be to issue equity in place of debt capital. (c) The existing capital structure may have become over-complicated with, perhaps, too many classes of shareholder with different rights to each class; they can be consolidated into one or two classes, but care must be taken to ensure that the relative voting strength remains in the same proportion. d) Capital with prior rights may carry a high fixed dividend, which then gives a misleading impression of the company, or preference shareholders may have control of the company. In such cases the structure should be reorganized into a more convenient form. (e) The company may decide to replace preference shares with debentures to reduce corporation tax. If a company needs t o undertake a capital reconstruction because it is short of cash, it is likely to need to raise new capital and make changes in the capital structure that allow it to defer or reduce payments to lenders and creditors. Additional finance may come from existing shareholders or from a bank, generally in the form of equity finance, although some may be in the form of loan stock. Those providing such finance will require profit and cash flow forecasts to show how the business can be turned round and provide a good return for their additional money. In such cases it is wise to maintain the income position of a particular class under the scheme as far as possible. Often more income will be offered as an incentive to the holders of a particular security to agree to the capital restructuring. Different classes of creditors are ranked in order of priority for payment in the event of a liquidation. The order is: _ creditors with fixed charges (for example, bank loans secured on specific fixed assets); _ preferred creditors including employees and tax creditors; _ creditors with floating charges over the assets (generally the current assets of the business) that crystallize on liquidation; _ unsecured creditors, including trade creditors; _ shareholders. Some creditors can have a fixed charge on an asset, with a floating charge over a group of assets for the balance of their loan. This is known as a fixed and floater. A bank that has made a loan secured by shares or other financial securities which have fallen in value since the loan was made could be in this position. Each class must have its claims satisfied completely before any money is available to pay the next class. Depending on the assets tat are likely to be available, this may mean that some classes of creditors can expect nothing in the event of a liquidation, and have an interest in agreeing proposals that will keep the company in operation. Different kinds of creditors have different income objectives and attitudes to risk. It may be possible to devise changes in the capital structure that leave all classes better off than they would be in a liquidation. For example, loan stock holders may be willing to convert some of their loan stock into ordinary shares and have payment of interest deferred if the interest rate on their stock is increased. Trade creditors may be willing to wait for payment if they are paid interest, and may be prepared to exchange part of what they are owed for loan stock. Ordinary shareholders may be willing to have the nominal value of their shares reduced and to subscribe for new shares. Secured lenders may have little to lose in pressing for a winding up (provided there are sufficient assets for them to be paid what they are owed) and may have to be paid in full as part of any reconstruction. A reconstruction scheme must treat all parties fairly and not favor one group over others. The outcome of the scheme should be more beneficial to all classes of creditors than if the company goes into liquidation. If it is not, the class of creditors that does not stand to benefit from the reconstruction may press for the winding up of the company. The increased benefits to creditors (and investors) from the reconstruction scheme can be shown by comparing the liquidation value of the firm and the situation of different classes of creditors in a liquidation with the estimated future results arising from the reconstruction scheme. Each class of creditors must agree to the reconstruction proposals by a 75 per cent majority at a separate class meeting. Given this agreement, the company can apply to the court for approval, after which the reconstruction becomes binding on all parties. Principles of Capital Reconstruction There are a number of points of principle in the design of a scheme of reconstruction. (a)  Firstly, if the company is having problems it is likely to require more finance which may come from either existing shareholders or a bank, generally in the form of equity finance, although some may be in  the form of  loan stock. This new equity may replace existing share capital, or may have a different nominal value to it. Those providing such finance will require profit and cash flow forecasts to show how the business can be turned round and provide a good return for their additional money. In such cases it is wise to maintain the income position of a particular class under the scheme as far as it is  possible. Often more income will be offered as an incentive to the  holders of a particular security to agree to the capital restructuring. (b)  In addition, a reconstruction scheme must treat all parties fairly, and not favor one group over others. The outcome of the scheme should be more beneficial to creditors than if the company went into liquidation, or they may press for the winding-up of the company. Often this is avoided by including in the  scheme provision for paying off the company’s debts in full. The increased benefits to creditors (and investors) from the reconstruction scheme can be shown by comparing the liquidation value of the firm with the estimated future results arising from the reconstruction scheme. (c)  The company must also take account of fixed charges (e. g. a mortgage on a factory) on assets of the business used as security for loans. These charges mean that the creditor is â€Å"secured† and thus entitled to first claim in the process of liquidation (if there are insufficient funds, the creditor becomes unsecured for the balance of the loan unpaid). The charges mean that such creditors may have less incentive to keep the business afloat. Second charges are when the lender has the prior claim on the surplus from the sale of a secured asset after the prior claim has been met. (d)  In addition, the company may have to consider the existence of floating charges over  the assets (generally the current assets of the business which are continually turned over during trading) that crystallize on liquidation thus providing the charge owner with prior call on the funds realized from these assets. Similarly to above, such creditors may have less incentive to keep a business afloat, unless it can be shown that it would be financially beneficial to them to do so. You may also find in practice that certain creditors can have a fixed charge on an asset, with a floating charge over a group of assets for the balance of their loan – this is known as a fixed and floater. Practical Study – Bahria Town Paint Factory amp; Awami Villas Factory:-