RecapitalizationExplained & Defined

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Written By:
Adiste Mae

What is Recapitalization?

Recapitalization is the manner of reorganizing a company’s capital structure to stabilize it.

From having a large percentage of equity financing, companies can shift to a debt financing structure instead or vice versa.

Understanding Recapitalization

Companies practice recapitalization of capital to adhere to a more beneficial capital structure that can improve their economic standing.

The recapitalization involves an alteration of the existing debt-to-equity ratio depending on the analysis made by the management.

The reasons for recapitalization are:

  • Decrease in share prices
  • Preventive measures for a possible hostile takeover
  • Cost minimization strategies like reduction of tax obligation, etc.
  • To use it as an exit strategy for venture capitalists
  • Due to bankruptcy

Debt financing influences the capital leverage of the company.

The drawback if the company restructures and decreases the percentage use of debt and equity financing is the decrease in its leverage and earnings per share.

However, this strategy has advantages like reducing the risk of interest payment through loan obligations.

Instead of paying the interests, the company may use the profits as dividends to shareholders.

Reasons to Consider Recapitalization

recapitalization

There are several reasons why companies consider the recapitalization strategy:

  • Prevent Hostile takeover – the company shifts its capital financing to increasing its acquired debt so interested acquirers are discouraged from acquiring the company.
  • Reduce financial obligation – since the loan gives the borrower the privilege of using the cash for its intended purpose, there is a corresponding interest payment for this lending service transaction.

Through recapitalization, the company reduces its use of debt financing and shifts to equity financing to decrease its interest payment obligation.

  • Viability of share price – many factors affect the viability of a company’s share, and one strategy to keep it viable or even increase such price is through debt acquisition.
  • Debt-to-equity diversification to improve the company’s liquidity ratio – recapitalization helps the company with cost minimization. Also, it can be used as an exit strategy for venture capitalists, or to prevent bankruptcy.

Types of Recapitalization

Different ways to recapitalize are through:

  • Equity Recapitalization. This strategy is done by replacing debt financing with equity financing through a buyback agreement of debt securities. This way, the equity securities will have a greater percentage as a source of capital financing than debt.
  • Debt financing requires a regular amortization payment and a settlement of the principal amount on its maturity period. Investing more in equity financing reduces the interest payments attached to debts that could lead to more residual cash. The company may utilize excess cash for dividend distribution, other product improvements, etc.
  • On the other hand, if the company wants to increase its debt capitalization, it may issue debt securities, and proceeds can be used in dividend distribution or buyback of its issued shares to other investors. The advantage of acquiring debts is that the interest payments from the acquired loan are tax-deductible, which helps decrease the taxable amount.

Companies have reasons why they implement the recapitalization method, such as to improve their financial standing, decrease the risk brought by acquired debt securities, etc.

In some cases, the government also influences recapitalization brought about by an economic crisis.

For example, back in 2008, during the financial crisis, the U.S. Government used recapitalization through the Troubled Asset Relief Program (TARP), especially in the banking industries by increasing equity securities percentage in the market to keep the solvency and liquidity of banks and the financial system.

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  1. NYU Stern "Leveraged Recapitalizations and Exchange Offers" Page 1 . October 18, 2022