Definition
A Capital Reduction is when a company reduces its issued share capital, often to return excess cash to shareholders or to eliminate accumulated losses from its balance sheet.
Mechanics
- Return of Capital: The company pays shareholders cash, reducing the nominal value per share.
- Accounting Adjustment: The company cancels part of its paid-up capital to offset losses, with no cash changing hands.
Example – Return of Capital
A company decides to return $0.20 per share. If you hold 5,000 shares, you receive 5,000 × $0.20 = $1,000 in cash. The share price may adjust downward by a similar amount.
Interview Q / Model Answer
Q: Why would a company do a capital reduction instead of paying a dividend?
A: A capital reduction doesn't require distributable reserves, which dividends do. It's also a tool to clean up the balance sheet by writing off historical losses, making the company more attractive.
Definition
Share cancellation occurs when a company repurchases its own shares and then permanently cancels them, reducing the total number of shares in existence.
Example
A company with 100 million shares and $180 million in net income repurchases and cancels 10 million shares. Its new share count is 90 million.
- Old EPS: $180M / 100M shares = $1.80
- New EPS: $180M / 90M shares = $2.00
The result is a higher EPS, which can lead to a higher valuation.
Interview Q / Model Answer
Q: What is the difference between share cancellation and treasury shares?
A: Cancelled shares are permanently removed. Treasury shares are repurchased and held by the company, and can be reissued later (e.g., for employee stock plans).
Definition
For Exchange-Traded Funds (ETFs) and Unit Trusts, creation and redemption is the process of issuing and cancelling units to meet investor demand. It's how these funds grow or shrink in size.
Mechanics
- Creation: Authorized Participants (APs) deliver a basket of securities to the ETF provider, who in turn issues new ETF units. This increases supply.
- Redemption: APs return ETF units to the provider and receive the underlying securities back. This decreases supply.
This mechanism is key to keeping an ETF's market price aligned with its Net Asset Value (NAV).
Interview Q / Model Answer
Q: How do creations and redemptions help liquidity?
A: They allow the ETF's supply to be dynamically adjusted. When demand is high, new units are created; when demand falls, units are redeemed. This prevents large price swings away from the fund's intrinsic value.
| Action | Definition | Purpose | Effect on Shareholders |
|---|---|---|---|
| Capital Reduction | Reduction of nominal share capital | Return capital or write off losses | Cash returned or balance sheet improved |
| Share Cancellation | Permanent removal of repurchased shares | Improve EPS and capital efficiency | Ownership % and EPS increase |
| ETF/Unit Trust Creation/Redemption | Issuance or cancellation of fund units | Adjust fund size based on demand | Maintains liquidity and NAV alignment |