A company is running out of cash. Its bank wants repayment, its suppliers are unpaid and its shareholders hold shares of little value. Liquidation would sell the assets in a hurry and leave most creditors with cents on the naira. A reconstruction offers another way: everyone gives something up so that the business can survive and, with luck, repay more than liquidation would.
This topic covers what a capital reconstruction is, its purpose, why it is hard to agree, how a scheme is executed in the statement of financial position, and how to comment on a proposed scheme. The previous topic covered financing acquisitions. The next covers business reorganisation, demergers, divestments and management buyouts. Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on reconstruction schemes.
In 30 seconds
A capital reconstruction is a major reorganisation of the capital structure of a company in financial difficulty. It may involve revaluing assets, raising new capital, converting debt into equity and changing the form of shares. Its purpose is to avoid insolvency and liquidation, so it is worth doing only if it gives all parties more than liquidation would and the company has a good chance of becoming profitable again.
The difficulty is finding a scheme that every party (shareholders, banks, bondholders, creditors) accepts. To execute a scheme, rebuild the statement of financial position with new asset values, write off the accumulated loss, adjust each class of capital, and take the balancing figure to a capital reserve. To comment on a scheme, ask: (1) what is the new capital structure? (2) will the company be profitable and cash-positive? (3) what does each investor group get with and without the scheme?
Key terms in plain English
| Term | What it means |
|---|---|
| Capital reconstruction | A major reorganisation of a distressed company’s capital |
| Debt-for-equity swap | Lenders give up debt in return for shares |
| Accumulated loss | Losses carried forward that wipe out equity |
| Capital reserve | A balancing figure created when capital is written down |
| Liquidation | Closing the company and selling its assets to pay creditors |
Syllabus check
This topic is in syllabus area D (mergers and acquisitions, organic growth and corporate restructuring). It covers:
- explaining, executing and evaluating a group reconstruction.
CAMA 2020 and reconstructions
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 710 | An “arrangement” is any change in the rights or liabilities of members, debenture holders or creditors of a company or any class of them | A reconstruction changes these rights |
| s. 711 | The Court may order separate meetings; members representing three-quarters in value of those present and voting at each must agree; the scheme binds the companies once sanctioned | The approval and sanction steps |
| s. 715 | The Court may refer a scheme to the SEC to test its fairness | Protection of the parties giving up rights |
| s. 305 | Directors must act in good faith in the best interests of the company | Directors proposing a scheme |
What a reconstruction is
A reconstruction usually follows financial difficulty. Cash flow and profit projections may show that collapse is certain unless action is taken (a bankruptcy prediction score may also warn of it). It may involve:
- revaluing assets to realistic values;
- raising new capital;
- converting debt into equity;
- converting equity shares from one form to another.
Existing shareholders may be asked to surrender their shares for a much smaller number of new ones, while lending banks or bondholders may end up holding most of the new shares.
Purpose and problems
The purpose is to let the company continue and avoid insolvency. It is worth considering only if (a) it is likely to be better for all parties than liquidation, and (b) the reconstructed company has a good chance of surviving and returning to profit. It may reduce total debt by swapping some for equity and defer repayment of the rest, which can allow profit and positive cash flow.
If the company recovers, lenders who became shareholders can share in the rise in value.
The problems are finding a scheme that benefits everyone and getting everyone to agree: shareholders, banks, bondholders and unpaid trade creditors. Each compares what it would get if the scheme goes ahead with what it would get in liquidation. All creditors (or the number required by company law) and the shareholders must agree.
Executing a scheme
The easiest way is to build the new statement of financial position from the new asset and liability values, write the accumulated loss to zero, adjust each class of capital as the scheme says, and take the balancing figure to a capital reserve.
ICAN’s example (₦000). Before: property, plant and equipment 1,000; goodwill 500; receivables 300; inventory 400 (total 2,200). Ordinary capital 1,500; preference capital 200; accumulated loss (300); 10% debentures 500; overdraft 300.
The scheme:
- revalue plant to 980, goodwill to nil, receivables to 290, inventory to 350
- ordinary shares are surrendered and reissued at 250 for each 1,000 held
- existing ordinary holders subscribe new shares of nominal value 250 for 750
- preference capital is cut by 25%
- debenture holders take shares of nominal value 125 for debentures of 250
- the loss is written off
- Ordinary capital.
1,500 × 25% = 375 + 250 new + 125 issued to debenture holders = 750.
Share premium = 750 − 250 = 500. - Cash from the subscription = 750, less 300 to repay the overdraft = 450. Preference capital = 150. Debentures = 250.
- Total assets.
980 + 290 + 350 + 450 = 2,070.
Capital and liabilities before the capital reserve = 750 + 150 + 500 + 250 = 1,650, so the capital reserve = 420 (balancing figure).
Commenting on a proposed scheme
Exam questions give a distressed company and a scheme and ask for comment. Consider three aspects.
- The new capital structure: how many shares, who owns them, how much debt and at what interest rate.
- Viability: analyse whether the company will become profitable with positive cash flow. If it will not survive, the scheme should not be supported.
- Each investor group: ordinary shareholders, preference shareholders, bondholders and banks. For each, compare what happens if there is no reconstruction (liquidation) with what happens if there is. Any group that does not benefit will not support the scheme. Those with most to lose should give up more; creditors will not reduce their rights unless shareholders contribute more.
The rules in more depth
Why the scheme must beat liquidation
Each party can reject it and take its liquidation share. A scheme that offers less will fail.
Why shareholders give up most
They rank last, so in liquidation they receive little or nothing. They must accept the biggest reduction in their claim to win creditors’ agreement.
Why new money is usually needed
The business must pay for its recovery. Existing shareholders’ willingness to put in fresh capital shows their confidence.
Why the capital reserve appears
Writing assets and capital down leaves a balancing credit after losses are cleared. It is not a profit.
Effect on analysis
State the new structure, test viability and assess each group’s position before and after.
Worked examples
Example 1: the liquidation test. Assets would fetch ₦60m in liquidation. Secured creditors are owed ₦30m and unsecured creditors ₦40m. Shareholders hold the rest.
- Secured creditors are paid in full: ₦30m.
- Unsecured creditors get 30 ÷ 40 = 75%.
- Shareholders get nothing, so they gain from any scheme that lets them keep something.
Example 2: debt for equity. Debentures of ₦200m are swapped for shares of nominal value ₦50m.
- Debt falls by ₦200m.
- Interest cash flow falls with it.
- The lenders now share in any recovery through their shares.
Example 3: writing off a loss. Ordinary capital is ₦400m and the accumulated loss is ₦150m. Capital is reduced to ₦250m.
- Capital reduction = ₦150m.
- This is applied against the accumulated loss, which is cleared.
- The company can then pay dividends again when profits return.
Example 4: new money. Shareholders subscribe for shares of nominal value ₦150m at a price of ₦450m.
- Cash raised = ₦450m.
- Share capital rises by ₦150m.
- Share premium.
450 − 150 = ₦300m.
How to score full marks
- Rebuild the statement of financial position with new values.
- Check that the balancing capital reserve makes it balance.
- State the new capital structure first.
- Test viability with cash flow and profit.
- Compare each group’s outcome with liquidation.
- Conclude whether the scheme should be supported.
Common mistakes in the exam
- Forgetting to write off the accumulated loss.
- Not putting the share premium on new money.
- Leaving out the overdraft repayment from the cash raised.
- Commenting on one group only.
- Not comparing with liquidation.
- Calling the capital reserve a profit.
Quick revision
- Reconstruction: revalue, new capital, debt to equity, change share form.
- Worth it only if better than liquidation and viable.
- Execute: new statement, loss to nil, capital reserve balances.
- Comment: structure, viability, each group with and without.
- Those with most to lose give up most.
- CAMA 2020: ss. 305, 710, 711, 715.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. A capital reconstruction usually follows:
- Financial difficulty
- Rapid growth
- A dividend increase
- A takeover bid
Show the answer
A. To avoid liquidation.
Question 2. A scheme is worth doing if it gives all parties:
- More than liquidation would
- Less than liquidation
- The same as a dividend
- Only equity
Show the answer
A. Otherwise they will refuse.
Question 3. A debt-for-equity swap:
- Reduces debt and gives lenders shares
- Increases debt
- Cancels equity
- Raises interest
Show the answer
A. Lenders share in recovery.
Question 4. When executing a scheme, the accumulated loss is:
- Written off to zero
- Increased
- Paid as dividend
- Ignored
Show the answer
A. Capital is reduced against it.
Question 5. The balancing figure in the new statement of financial position is a:
- Capital reserve
- Profit
- Liability
- Tax
Show the answer
A. It is not a profit.
Question 6. In commenting on a scheme, the first step is to find the:
- New capital structure
- Directors’ pay
- Tax rate
- Share price history
Show the answer
A. Then test viability.
Question 7. Those with most to lose should:
- Give up more
- Give up less
- Pay nothing
- Vote last
Show the answer
A. Creditors need to see shareholders contribute.
Question 8. If the company will not survive in its new form, the scheme should be:
- Not supported
- Supported
- Doubled
- Delayed only
Show the answer
A. It only delays liquidation.
Question 9. Shares issued for ₦450m nominal ₦150m create share premium of:
- ₦300m
- ₦150m
- ₦450m
- ₦600m
Show the answer
A. 450 − 150.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Explain the purpose of a capital reconstruction. (4 marks) (b) Explain why it is difficult to arrange. (3 marks) (c) State the three aspects to consider when commenting on a scheme. (3 marks)
Question 12 (20 marks). A company has (₦000): property, plant and equipment 800; goodwill 200; inventory 300; receivables 250; cash nil (total 1,550). Ordinary capital 1,000; accumulated loss (400); 12% debentures 600; overdraft 350.
Scheme: revalue plant to 700, goodwill nil, inventory 250, receivables 220; ordinary capital cut to 25% of its present amount; existing holders subscribe for new shares of nominal value 150 at a price of 450; debenture holders take shares of nominal value 100 for debentures of 300; the loss is written off and the overdraft repaid from the subscription. (a) Prepare the statement of financial position after the scheme.
(10 marks) (b) Comment on the scheme under the three aspects. (6 marks) (c) State two problems of reconstruction. (4 marks)
Question 13 (10 marks). (a) Assets would fetch ₦60m in liquidation. Secured creditors are owed ₦30m and unsecured ₦40m. State what each group receives. (4 marks) (b) Explain why shareholders might accept a scheme. (3 marks) (c) Explain the capital reserve. (3 marks)
Model answers
Show the model answer to Question 11
(a) Purpose (4 marks). To let a company in financial difficulty continue and avoid insolvency and liquidation. (2) It reduces and defers debt so the company can become profitable and cash-positive. (2)
(b) Difficulty (3 marks). A scheme must benefit every party more than liquidation. (1.5) All parties, shareholders, banks, bondholders and creditors, must agree. (1.5)
(c) Aspects (3 marks). The new capital structure; whether the company will be profitable with positive cash flow; each investor group’s position with and without the scheme. (1 each)
Show the model answer to Question 12
(a) Statement (10 marks).
- Ordinary capital.
1,000 × 25% = 250 + 150 new + 100 to debenture holders = 500. (2) - Share premium.
450 − 150 = 300. (1.5) - Cash = 450 − 350 = 100. (1.5)
- Debentures = 600 − 300 = 300. (1)
- Assets.
plant 700 + goodwill nil + inventory 250 + receivables 220 + cash 100 = 1,270. (2) - Capital and liabilities before reserve.
500 + 300 + 300 = 1,100, so capital reserve = 170. (2)
(b) Comment (6 marks). New structure: 500 of ordinary capital partly held by lenders, debt halved to 300 and no overdraft. (2) Viability: lower interest cost and fresh cash of 100 may allow profit and positive cash flow, but this needs forecasts.
(2) Each group:
- shareholders keep some value and put in new money
- debenture holders swap half for shares and keep a lower claim, which beats liquidation only if recovery is likely
- the bank is repaid in full
(2)
(c) Problems (4 marks). Finding a scheme that benefits every party. (2) Getting every party to agree. (2)
Show the model answer to Question 13
(a) Liquidation (4 marks). Secured creditors receive ₦30m in full. (1.5) Unsecured creditors receive ₦30m against ₦40m, or 75%. (1.5) Shareholders receive nothing. (1)
(b) Shareholders (3 marks). In liquidation they get nothing. (1.5) A scheme lets them keep an interest and share in any recovery. (1.5)
(c) Capital reserve (3 marks). It is the balancing credit left when capital and assets are written down and losses cleared. (2) It is not a profit. (1)
Pathfinder on Reconstruction schemes, debt for equity and commenting on a scheme
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic. November 2014 question 2 compared closing a company with a management buyout, which uses the same comparison against liquidation. Worked examples 1 to 4 show the steps.
Revise first: Worked examples
Questions give a scheme and ask for comment. See the section on the three aspects.
Revise first: Commenting on a proposed scheme
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: No stand-alone question in the May 2014 or November 2014 Pathfinder.
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