What is Recapitalization
Recapitalization is restructuring a company's debt and equity mixture, often with the aim of making a company's capital structure more stable or optimal. Essentially, the process involves the exchange of one form of financing for another, such as removing preferred shares from the company's capital structure and replacing them with bonds.
BREAKING DOWN Recapitalization
Recapitalization can be undertaken for a number of reasons, such as defending against a hostile takeover, minimizing taxes or to implement an exit strategy for venture capitalists. Companies often want to diversify their debt-to-equity ratio to improve liquidity.
Types of Recapitalization
Companies can swap debt for equity or vice versa for a number of reasons. A good example of equity replacing debt in the capital structure is when a company issues stock in order to buy back debt securities, thus increasing its proportion of equity capital as compared to its debt capital. Debt investors require routine payments and a return of principal upon maturity, so a swap of debt for equity helps a company maintain its cash and use cash generated from operations for business purposes, reinvestment or capital returns to equity holders.
On the other hand, a company may issue debt and use the cash received to buy back shares and/or issue dividends, effectively recapitalizing the company by increasing the proportion of debt in the capital structure. Another benefit of taking on more debt is that interest payments are tax deductible, while dividends are not. Thus, by paying interest on debt securities, a company can decrease its tax bill and increase the amount of capital returned in total to both debt and equity investors.
Governments also partake in mass recapitalization of their countries' banking sectors during times of financial crisis and when the solvency and liquidity of banks and the greater financial system come into question. For example, the U.S. government recapitalized the banking sector in the United States with various forms of equity in order to keep the banks and the financial system solvent and maintain liquidity through the Troubled Asset Relief Program (TARP) in 2008.
Effects of Recapitalization
Generally speaking, when a company's debt decreases in proportion to its equity, it has lower leverage and thus, ceteris paribus, its earnings per share should decrease following the change; however, its shares would be incrementally less risky, since the company has fewer debt obligations, which require interest payments and return of principal upon maturity. Without the requirements of debt, the company can return more of its profits and cash to shareholders.