Leveraged Recapitalization - Explained
What is Leveraged Recapitalization?
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Table of ContentsWhat is Leveraged Recapitalization?How Does Leveraged Recapitalization Work?Advantages of Leveraged RecapitalizationDisadvantages of Leveraged Recapitalization
What is Leveraged Recapitalization?
Leveraged recapitalization can be defined as a strategy whereby an organization takes on additional debt so as to pay out large dividends or repurchase shares. It is also defined as a process in which a company's capital structure is changing the company because it has raised debt and reduced equity. In simple terms, a company will borrow money (i.e. issue bonds) in order to generate cash proceeds. These proceeds will then be used to repurchase shares which were previously issued and decrease the proportion of equity in the company's capital structure. Hence the term, leveraged recapitalization. The term "capitalization" reflects how a company is capitalized, that is, the amount of debt and equity it has.
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How Does Leveraged Recapitalization Work?
Leveraged recapitalizations are launched by issuing bonds in order to raise money and use the proceeds to buy the company's stock or to pay dividends. When such a movement is initiated by an external party, it is called a "leveraged buyout" but when it is initiated by the company itself for personal reasons, it is called a "leveraged recapitalization". These types of recapitalization can either be slight adjustments to the capital structure of the company or can be massive changes involving a change in the power structure as well. Leveraged recapitalizations are majorly used by privately held companies as a strategy for refinancing.
Advantages of Leveraged Recapitalization
- There are several mathematical proofs that show the advantages of leveraged recapitalizations. One of these mathematical proofs is the Modigliani-Miller theorem, which shows that debt provides a tax benefit or interest tax shield that equity does not.
- The use of debt to purchase stock or pay off older debt reduces the opportunity cost of the company having to use its earned profits to do so instead.
- Companies may want to take advantage of the low-interest rates to perform a leveraged recapitalization.
- The issuance of new shares doesn't prevent shareholder equity from dilution but debt prevents dilution of shareholder equity, thereby, creating a positive effect on the shareholders.
Disadvantages of Leveraged Recapitalization
Leverage Recapitalization also has its disadvantages, despite its many advantages.
- Some economists argue that due to its inability to take a longer-term view, leveraged recapitalizations restricts the growth potential of a company.
- The current debt environment which may not remain fixed is often taken into account by a leveraged capitalization. An interest rate change may reflect a negative effect on the company by increasing interest expenses.
- A change in the capital structure to a huge debt raises a company's risk and if things don't go as planned, it might end up in the destruction of a lot of shareholder value.