CHAPTER 2

LITERATURE REVIEW

2.0 Introduction

Recapitalization places the company on a sound financial

footing. www.businessdictionary.com defined recapitalization as
altering the capital structure of firm in reaction to the changed
business condition or as a means to fund the firm’s growth
plans. This chapter delineates the body of research carried out
by other scholars on recapitalization. Methods of recapitalizing
the company are sighted and evaluated, recapitalization
challenges and also factors to consider when selecting the best
strategy to recapitalize the company was looked at. The aim of
this was to find out how these authors re suggesting as basis
for successful recapitalization.

2.1 An overview of recapitalization

2.1.1 Recapitalization defined

Recapitalization according to www.emerldinsight is the planned placement of firm’s facility
subsystem such as roofs utilities heating, ventilation and air conditioning. Similarly Selman
(2003) defined recapitalization as a planned replacement of facility subsystems, which refers
to capital assets for the industry. Aduloju (2007) however discussed recapitalization in the
context of the minimum paid-up capital for insurance companies, which is the minimum
amount of capital resources that those providing or who intends to provide insurance services
should have in their books to ensure the protection of policyholders. The views of Aduloju
were also echoed by B. Lorent (2008) who also explained recapitalization in the context of
Minimum Capital Requirements (MCR) and the Solvency Capital Requirements (SCR). B.
Lorent (2008) went further by defining two concepts that are closely linked to
recapitalization, which he defines as follows:

The Solvency Capital Requirement (SCR) is the target capital requirement. Bafin (2007)
considered the view that the SCR should reflect the economic capital of the company taking
into account its true risk profile. If a company goes below the Solvency Capital
Requirements, the supervisory authority is informed. The company should then take all the
necessary measures to retrieve a solvency situation.

The Minimum Capital Requirements (MCR) is a safety level. B. Lorent (2008) held the view
that the MCR is a trigger level under which a company’s capital should not go below.
Otherwise, supervisory authorities can take severe actions going from an intervention in the
management actions to the company’s closing. This double trigger system protects
shareholders and the top management against a regulatory bias toward excessive
interventionism (Plantin and Rochet 2007). Thus when the company runs as a well-
capitalized undertaking, shareholders pilot the top management actions without interferences
from the supervisory authorities. A. L Awoponle (2007) described the minimum capital
requirements as the minimum paid-up capital that forms the capital base of companies.

Van Horne and Wachowic (2003, 471) defined recapitalization as an alteration of a firm’s
capital structure for example a firm may sell bonds to acquire the cash necessary to purchase
some of its outstanding stock. www.businessdictionary.com defined recapitalization as
altering the capital structure of firm in reaction to the changed business condition or as a
means to fund the firm’s growth plans. Mclaney (2006) pointed out that recapitalization
occurs when the firm changes its capital structure proportion of equity to debt. This for
instance may occur as part of debt restructuring, when the creditor exchanges an outstanding
loan for a stake in the company. While aim for recapitalization is normally to improve debt
equity ratio, it can also be used to fend off hostile takeover in which case the company makes
itself unattractive by increasing the level of debt in its capital and using the funds to pay
special dividends to shareholders.
This shows that recapitalization takes place mostly when the organization is under the threat
of becoming insolvent. Also the above definitions by Van Horne and Wachowic (2003),
Maclaney (2006) and the businessdictionary.com reveal that recapitalization and capital
restructuring can be used interchangeably. Capital restructuring was defined by as the
fundamental, voluntary change in a firm’s capital structure effected by altering the voting
rights of the providers of equity capital and/or loan capital, such as by converting common
stock (ordinary shares) into redeemable preferred stock. It is resorted to in case of serious
financial and operating problems such as loss of a major customer or imminent bankruptcy.

2.1.2 What Does Capital Structure Mean?

Van Horne and Wachowic (2003, 468) defined capital structure as the mix (or proportion of
firm’s permanent long term financing represented by debt, preferred shares and common
stock equity. This definition has limited capital structure to long term financing only which is
opposed by the following definition which include short term debt. Capital Structure is a
mix of a company's long-term debt, specific short-term debt, common equity and preferred
equity. The capital structure is how a firm finances its overall operations and growth by using
different sources of funds. Debt comes in the form of bond issues or long-term notes payable,
while equity is classified as common stock, preferred stock or retained earnings. Short-term
debt such as working capital requirements is also considered to be part of the capital
structure, www.investopedia.com.

www.mysmp.com defined capital structure as the mix of a company's financing which is

used to fund its day-to-day operations. According to www.mysmp.com these sources of
funds can originate from equity, debt and hybrid securities. The equity will come in the form
of common and preferred stocks. The debt is broken out into long-term and short-term
debts. Lastly hybrid securities are a group of securities that are a combination of debt and
equity. Keown et al (2002,514) defined capital structure as a mix of long term sources of
funds used by the firm. They distinguished capital structure and financial structure by
defining financial structure as the mix of all funds sources that appear on the right side of the
balance sheet. He expressed the relationship between the two in equation form

(Financial structure) – (current liabilities) = capital structure

The objective of capital structure management is to mix the permanent sources of funds used
by the firm in a manner that will maximize the company's common stock price

Thus from the above definitions capital structure involves all the long term financing of the
company meant to facilitate overall operations and growth of that company. A firm's capital
structure is then the composition or 'structure' of its long term liabilities. For example, a firm
that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and
80% debt-financed. The firm's ratio of debt to total financing, 80% in this example is referred
to as the firm's leverage. In reality, capital structure may be highly complex and include tens
of sources. Gearing Ratio is the proportion of the capital employed of the firm which come
from outside of the business finance, for example by taking a short term loan.

2.2 Recapitalization challenges

Recapitalization challenges may differ from company to company, country to country and
region to region. Thus they mostly depend on the size of the company, country in which the
company is located and whether the company is in a developing or developed country. The
following are recapitalization challenges faced by companies worldwide.

Bank lending and credit crunch

A credit crunch is generally defined as a decline in the supply of credit because although
banks are less willing to lend, lending rates might not rise. According to Green and Oh
(2002), a credit crunch is an inefficient situation in which credit worthy borrowers can not
obtain credit at all, or cannot get it at reasonable terms, and lenders show excessive caution
which may or may not be traceable to regulatory distortion, leaving the would be borrowers
unable to fund their investment projects.

A number of researches suggest that most bank lending policies in several countries are
affected by credit crunch. Harholf and Korting find out that firms face comparatively high
line of credit availability. Pazarbasioglu (2002) also suggest that banks become less willing to
supply credit during periods of deteriorating asset quality and reduced profits. In 1990 – 1991
US banks curtailed their lending, Sharpe (1995) claims that this occurred because of losses of
stringent bank capital bank regulatory standards and heightened market scruinity of bank
capital.

The reduced credit occurrs when banks are facing difficulties in meeting their minimum
capital adequacy requirements. This is the very situation occurring in Zimbabwe in which
banks are facing liquidity challenges and have resorted to shortening the lending period to 3
months. Only the Commercial Bank of Zimbabwe (CBZ) and First Banking Corporation
(FBC) are lending for six months which also is not enough lending period to finance
recapitalisation.

With lines of credit not in sight most companies seem to have little options but to scout for
partners, fast. But possible suitors have been shy to offer their hand preferring to observe the
sincerity of the partnership proposals from a distance as the country’s political situation
continues to send out conflicting signals that are confusing the potential investors.

Dollarisation

The restriction on the role of Reserve Bank of Zimbabwe ( RBZ) as the lender of last resort is
one of the cost of dollarization. According to Davies (2003) the institution such as the Central
Bank, has the ability to produce at its discretion, currency or “ high powered money” to
support institutions facing liquidity difficulties, enough base money to offset public desire to
switch into money during crisis and to legal insolvency of an institution, prevent fire sales
and calling for loans. However Jacome and Luis (2004) argued that, when an increase in the
financial dollarization is accompanied by a continual decrease in central bank reserves,
financial safety nets will become inefficient, central bank’s capability as a lender of last
resort will be restrained and government to manage banking crisis will get curtailed.

The above explanation is seen in Zimbabwe in which under normal circumstances the RBZ
provides loans to banks facing liquidity problems but now printing money is no longer a
feasible source of liquidity as the central bank has become incapable of playing the role of the
lender of last resort. The RBZ has only managed to prescribe minimum capital levels and
reserve ratios (which were set at 10%). This implies that banks have to manage their own
solvency and liquidity risks. The Banks and Banking Survey (2009) pointed out that the
Zimbabwean commercial banks are facing dilemma as the Reserve bank of Zimbabwe is
inadequately capitalised to be the lender of last resort (LOLR) hence the relaxation by
commercial banks to advance loans.

Therefore absents of lender of last resort combined with extremely volatile nature of deposits
tricking into the banking sector has led to the decline in the loans to deposit ratio (LDR) in
Zimbabwe. It is almost impossible for Zimbabwean companies to recapitalise without vibrant
and adequately capitalised financial institutions to price risk and to advance credit to
companies that need funding.

Gustafsson H (2002) states that there a cost of losing a guarantor, usually the central bank, as
a lender of last resort in full dollarized countries. After the

dollarisation the central bank cannot print money to give loans to the bank system and
depends

on the amount of foreign currency entering from abroad. Though, some are arguing that this
will

lead to the discovery of structural problems in the financial sector, because the moral risk
disappears

concerning that the Central Bank is no longer the lender of last resort.

The indigenisation law in Zimbabwe

The indigenisation law requires all foreign investors to cede 51% of their investment to
‘indigenous’ people. According to the Banking and Banking Survey (2009) the Zimbabwean
Stock exchange regulations allows a foreign investor to hold only up to 10% of the issued
share capital of the listed company. The total shareholding that foreigners can collectively
have in a listed company is 35%. Therefore it is very difficult under the current ZSE
regulations and the indigenization law for a foreign investor to invest in a Zimbabwean
banking institution for only 10% or maximum of 35% equity.

Existing shareholders of banks and other companies in the country are unlikely to put in new
capital considering the lack of liquidity in the economy Ideally, external funding is required
but the restrictive ownership threshold will deter investors. It is also difficult for locals to
attract foreign capital given the negative perception of investing in the country. Trading on
Zimbabwe's stock exchange has plummeted from a daily average of US$2 million to US$500
000, since a controversial empowerment law was published.

Lack of shareholder participation

The easiest way to finance company is through selling shares to the existing
shareholders especially when debt capital is difficult to raise. Therefore lack of
commitment by shareholders or illiquid shareholders pose a challenge to
recapitalization since they are the major sources for recapitalization funds. As
sighted above, most Zimbabwean shareholders are unlikely to put in new capital
considering the lack of liquidity in the economy.

Bank Capital

Van Den Harvel (2004) highlited that bank capitalaffects lending even when
regulatory constraints are not binding and that shock to bank profits such as loan
defaults, can have a persistant impacton lending. These results are in line with
recent Europe evidence which suggests that capital can indeed have an impact on
bank lending, Garmbacota and Mistrulli, (2009).It is highly probable that during crisis,
capital constraints on many banks might have limited supplied lending, Hampell and
Lock- Sorensen,(2009). The amount of capital that banks can have dertemines the
amount to be advanced as loans.

Lack of collateral security

Prokop S (2010, 12) states that most business owners face challenges in raising
working capital facilities with traditional Canadian chartered banks. Banks by their
nature and charter wish to loan against good collateral, which in many cases cannot
be raised by the entrepreneur. The business owners and financial managers find that
the banks find it very challenging to lend to their business simply because it is
difficult to assess the risk. In general commercial chartered banks in Canada do not
make sizeable loans to small and medium sized firms. Certainly banks are
approached by them but the business owner soon finds that the banks simply do not
understand their business. In many cases the firm has acquired possibly too much
debt already, and at the end of the day there is just not enough collateral for the
bank. Therefore under such circumstances it will be very difficult to recapitalise a
company through debt financing.

Cost of debt

The cost of funds on the debt side was high in India and this resulted in most firms in
the country failing to lend adequate funds. International debt was cheaper, but the
on-going sub-prime mortgage issue in the US is made it tougher for corporate to
borrow funds abroad, lenders abroad were unwilling to commit monies, Pinto S V
(2007). This therefore was a challenge for a company to recapitalise during that time
in India. Also according to Banking and Banking Survey (2009) given the short-term
nature of deposits, financial institutions in Zimbabwe are forced to structure their
lending in short-term credit financing largely comprising 90 days at effective
annualized lending rates ranging from 8% to 16%, which remains too expensive
compared to the regional average lending rate of 7%.

No borrowing by banks to foreign Private Equity funds

Sidharth J Negandhi (2010) highlighted the challenges of recapitalising through

buyouts.The biggest impediment to the deal flow of buyouts has been the regulatory
framework relating to capital markets and fund raising in India. The biggest chunk of
buyout deals is typically large publicly listed firms which are taken private by the
private equity fund post the buyout. However, delisting norms in India are onerous
and the cost of taking a firm “private” is significantly higher.

The most significant impediment has been the regulation relating to funding for
acquisitions by banks and financial institutions. The Reserve Bank of India prevents
Indian banks from lending against the security of promoters’ shares and securities
except for working capital financing. Further, foreign investment companies (a
structure followed by most global Private Equity funds in India) are also prevented
from borrowing funds for acquisition in India. Raising external debt for acquisition
financing is costly and also exposes the company bought out to significant foreign
exchange risk. This may explain why most buyouts in India have been companies
which have an export driven business model, acting as a natural hedge to the foreign
debt.

An important part of the fund’s post-acquisition strategy is to close down non-

performing parts of the business with the objective of raising funds for the remaining
business. However, Indian regulations relating to closure of business involve a lot of
bureaucracy and do not allow for a quick and simplified exit. This creates significant
challenges in nurturing the company post-buyout and preparing it for the subsequent
exit.

The ultimate realization of returns is through an exit. Exits typically are through Initial
Public Offerings or strategic sale. Regulations for Initial Public Offerings require that
the promoter must hold at least a 20% stake post- Initial Public Offering. This stake
is also subject to a three year lock-in after the Initial Public Offerings. This prevents
the fund from getting a full exit through an Initial Public Offering and impairs the most
lucrative exit option for buyout funds. These challenges therefore pose significant
barriers to the development of a large buyout market.

Political risk

Richard Kamidza in his assessment of political risk in the southern region highlighted the
following challenges in recapitaling companies in the Southern region. The donor industry,
which is not only becoming politically influential, but also act as foreign policy outreach of
Western governments is known to pursue the interest of the developed countries, especially in
cases where this relates to the protection of foreign capitalism and its expansion. They
threaten to either cut or completely withdraw financial support until its interests is saved.

This has been the case in Zambia, Malawi, Zimbabwe and Botswana. In these countries and
many others in the region, donors have threatened and eventually withdrew aid resources
largely due to either poor relations (Malawi, Zambia and Zimbabwe) or the desire to test the
resilient of the renown democratically model in Africa (Botswana). This affects projects or
programmes implementation, especially in cases where the implementation agents has been
the government. Therefore, donors’ withdrawal of resources has direct impact to government
projects, Institutions of the World Bank and the International Monetary Fund.

International investors that were expected to buoy the equities market following the coming
on board of the inclusive Government in Zimbabwe adopted a wait-and-see attitude since
March 2009 as they would want to ascertain the level of commitment by parties to the
political agreement. Any lackadaisical attitude towards full commitment to the GNU
provisions would be heavily penalised by foreign investors who are very sensitive to
sovereign risk that affect their investments.

Absence of Risk free asset portfolio

The absence of risk free asset portfolio in Zimbabwean market has reduced the credit flow.
Banks require risk free asset portfolio in order to hedge against risk and also which is
marketable on the secondary market, assured for liquidity when need arises.

Liquidity challenges in the stock market

Levine (1997), states that stock market liquidity is a catalyst for long-run growth in
developing countries. He further argues that without a liquid stock market, many profitable
long-term investments would not be undertaken because savers would be reluctant to tie up
their investments for long periods of time. In contrast, a liquid equity market allows savers to
sell their shares easily, thereby permitting firms to raise equity capital on favorable terms.
Low liquidity means that it will be harder to support a local market with its own trading
system, market analysis, brokers, and the like because the business volume would simply be
too low (Yartey and Adjasi,2007). The low market capitalization and low liquidity are the
main reasons why the global emerging market funds are ignoring Africa’s listed securities. It
is argued that a stock exchange must have US$50 billion in market capitalization and US$10
billion in value traded to attract any interest from global emerging market funds (World Bank
2006). Only the three big stock exchanges in the continent South Africa, Egypt and Nigeria,
hit these requirements. Therefore it will be very difficult for the local stock exchange to
finance recapitalisation during times of low liquidity.

2.2.1Resolving recapitalisation challenges

Velde et al (1999) stated the consequences of adopting the dollar by Argentina resulted in no
Argentine institution being able to act as lender of last resort to the banking sector through
issuing currency to financial institutions in distress. Again, Argentina did not have that ability
since 1991. However, it devised alternative mechanisms to deal with liquidity crises.

One it used the foreign exchange reserves that the central bank had accumulated in excess of
the requirements of the convertibility law. These stood at about $3.6 billion, about 4% of the
banking sector's total deposits. The central bank managed to lend these excess reserves to
illiquid banks on a short-term basis against collateral. Another mechanism was the imposition
of reserve requirements on banks. The banks could mange to meet the requirement with
interest-bearing dollar-denominated assets held either in a foreign bank account or at the
central bank. The central bank had total discretion in setting the reserve requirements. In
1999 these reserves amount to $16.8 billion, about 20% of deposits. A third mechanism was a
deposit insurance fund, created in 1995, to which banks were supposed to contribute on a
risk-adjusted basis; it was intended to reach the level of 5% of deposits. Finally, Argentina
arranged a contingent repo facility with a consortium of private foreign banks. This facility
gave the central bank the right to exercise a put option on Argentine bonds for cash at any
time, subject to repurchase at the end of the agreement period. The facility amounts to $6.7
billion, about 8% of total deposits. These mechanisms provided protection for nearly 40% of
Argentina's deposits, or more than double the monetary base.
There is more to it than just saying the U.S. dollar is Panama’s currency and this is the
justification for investing there, (Paul Smith (1999))

Panama’s banking and monetary system are defined by two essential elements that produce
financial integration with international markets: its own monetary system that uses the U.S.
dollar as the national currency and the participation of international banks. The results are a
performance equal to the optimum monetary policy, but without any government
intervention. Financial integration produces low interest rates and almost unlimited credit for
all economic sectors. The system is stable with low inflation and without macroeconomic or
banking crises. The system is attractive to foreign investors for direct investment and
financial investment because of its stability, the absence of exchange or inconvertibility risk
and financial crises. These factors attract more foreign investment and therefore tend to
produce greater growth.

In the mid 1980s after the 1982 debt crisis, many Latin American governments were faced
with unmanageable budget deficits created in part by policies of subsidizing certain costs to
the consumers They began to make some adjustments and common reaction to these
adjustments was widespread political instability in many countries and affected external
borrowing due to high risk high risk involved.

Panama was not affected in this way because of the adjustment mechanisms available in their
monetary system and the fact that the government had not subsidized prices to the consumers.
To the contrary, the military government had early on increased the prices of the public utility
services as a source of general funding. It had passed on to the consumer the price increases
caused by the 1973 and 1979 oil shocks, avoiding the social consequences of the costly
structural adjustments experienced by other countries. The decision to pass on the prices was
made necessary because the government did not have access to the resources to finance the
budget deficit a subsidy would have caused. The Panamanian people saw that the price
increases were not caused by any action of their government and therefore accepted the price
increases and made their individual adjustments.

The Panamanian consumer tolerates shocks for three important reasons: because his
experience has been that financial shocks do not affect the value of the local currency against
the dollar so there cannot be a devaluation and therefore the level of his savings is not
affected; shocks have not affected the availability of credit except momentarily; and interest
rates have remained stable over the long term allowing him to borrow for housing. Evidence
of the Panamanians’ confidence in their monetary system is, uniquely for Latin America, the
great volume of home mortgage loans outstanding, collectively the best quality loan portfolio
of the banking system.
The system has effective self-adjusting mechanisms for shocks. Financial integration with the
international markets allows the use of external financial resources when required and it
avoids that political crises turn into economic crises through the banking system. Also, the
Panamanian system requires less international reserves than those required in an autonomous
system. Panama’s system is less expensive to operate, it does not require a costly supervisory
organization, nor does it bear the expense of maintaining a central bank.

It is important to recognize that it is not dollarization per se that has brought so much stability
to Panama, but rather dollarization together with a financial center that allowed Panama’s
monetary system to integrate with the world financial markets. As a result, the Panamanian
financial system is characterized by a large number of international banks that are indifferent
at the margin between lending their resources in the local market or placing them abroad.
This gives rise to financial integration. In Panama, banks play an essential balancing role by
continuously adjusting their local and external portfolios in response to market forces.
Confronting an excess supply of funds, banks fund profitable projects (at acceptable levels of
risk) and place excess liquidity abroad. As a result, the adjustment mechanism for the
economy is brought about through changes in the banks’ net foreign placements and
investments instead of by selective interest rate changes by a monetary authority to manage
the demand for financial resources within Panama. Because money that cannot be lent
prudently within the country flows back out, Panama avoids a build-up of net domestic credit
that might otherwise cause inflationary pressure. Even large inflows or outflows of capital
have not significantly altered the price level.
This contrasts sharply with developing economies where the government blocks financial
integration and protects local banks from international competition. It also draws attention to
the very bad advice that some policy makers have given in favor of capital controls. It is
precisely full capital mobility that provides the safety valve for excess funds. As to a
deficiency of funds, sudden outflows in anticipation of a devaluation are unheard of because
of the fact that uncertainty about the value of the currency is not in play.

Panama’s macroeconomic stability is, in large part, the result of a money supply that is
demand determined instead of supply determined by government policy; the case in most
countries. Thus, the Federal Reserve does not run Panama’s monetary policy. Fed policy
affects Panama only to the degree that it affects all countries by altering the global supply of
dollars, the international reserve currency, or by affecting global interest rates. Panama’s
financial integration creates market-determined prices in the real exchange rate, interest rates,
asset prices, and arguably real wages. As a result, financial decisions such as borrowing or
the quantity of money held are in equilibrium. The banking system takes funds from the local
or international markets to meet loan demand. It does not store excess funds for the
eventuality that there might be loan demand.

One myth about dollarizing is that it fosters instability in the banking system and creates the
need for a lender of last resort or a large amount of reserves to support the system. The
Panamanian case refutes this. In Panama, the government has no responsibility for stepping
up to rescue banks, nor does it have the means to do it. There are no legal reserve
requirements on deposits that serve as a liquidity reserve, nor is there deposit insurance.
Despite this, there has never been a systemic bank crisis. Indeed, in several instances
international banks have acted as the system’s lenders of last resort.

The great capitals of South America look tired, run down, and unkempt because the investors
in old real estate do not want to make the investment in repairs of buildings and sidewalks in
the face of an inflationary climate. This fear of inflation prevents long range planning and
investment in favor of day to day speculation for survival against devaluations.

2.2.2 Successful recapitalization

BIW Technologies, one of the world’s leading providers of online construction and
engineering project control software, announced a successful recapitalization backed
by the company’s largest shareholder to provide a strong, debt-free platform for
continued success in September 2009. In addition to the settlement of all
outstanding corporate debt (amounting to GBP3.5m in aggregate) the deal secures
around GBP300,000 of new working capital to further develop the business. BIW is
now wholly financed by equity and, as a result, there is no ongoing burden of cash
interest or dividend payments to its financiers. As a result, the directors of the
Surrey-based company believe that with profitable trading, cash reserves and no
debt, it is significantly more financially secure than its peers and is best placed to
capitalize on any upturn in the economy. BIW is now financially and operationally far
stronger, there is no debt and they have strong cash reserves.

Media Works New Zealand Limited completed a successful recapitalization in

December 2009. Shareholders have made an increased capital commitment of
$70m which has been used to repay senior debt, reset fixed interest rate swaps and
provide ongoing liquidity to the Company. This has been accompanied by a
comprehensive restructure of the Company’s banking arrangements. Funds advised
by Iron bridge contributed $50m of the new capital and they remain the Company’s
majority shareholders. The recapitalization, combined with the restructure of the
Company’s banking arrangements, has placed the Company on a sound financial
footing. This, together with the improving ad market conditions, places the Company
in an excellent position for 2010 and beyond. The improved banking package and
lower cash interest costs delivered by the restructure will ensure the business is well
placed to take advantage of improved trading conditions.”

Cosmos Bank, Taiwan (Cosmos) announced that its recapitalization has completed
successfully in 2007. An affiliate of S.A.C. Private Capital Group (SAC PCG) and
New York Stock Exchange have injected new capital of approximately US$ 900
million (NT$29.7 billion) into Cosmos Bank. In addition, approximately US$400
million (NT$13 billion) of outstanding debt have been partially converted by
bondholders of Cosmos into Cosmos equity and partially redeemed by cash. Under
the terms of the recapitalization plan, SAC Private Capital Group had acquired a
58.5% fully diluted stake in Cosmos through subscription for newly issued
convertible preferred shares and convertible bonds at an aggregate price of
approximately US$650 million (NT$21.45 billion). GE Money has invested an
additional amount of approximately US$250 million (NT$8.25 billion) in newly issued
common shares and convertible bonds, translating into a fully diluted shareholding of
23.2%. In addition, the conversion of approximately NT$13 billion of debt to equity
and cash has allowed pre-existing bondholders to acquire an 11.5% stake in
Cosmos on a fully diluted basis.

Recapitalization of Tata Steel Company - India succeeded after implementation of

different sources of funds between 2007and 2008. The company, for one, raised
$6.1 billion in debt through its subsidiary Tata Steel UK. It employed a similar
strategy to raise about $2.66 billion in bridge loans from its Singapore subsidiary
Tata Steel Singapore Holdings. An additional $1.8 billion was raised with the help of
internal accruals ($700 million), external commercial borrowings ($500 million) and a
preferential issue of equity shares to Tata Sons ($640 million). The company raised
a further amount of $2.3 billion through a rights issue of equity shares ($862 million),
a convertible preference share issue ($1 billion) and a foreign issue ($500 million).

2.3 Recapitalization strategies

Recapitalizing the company involves altering the capital structure of the company. This is
done through raising long term capital in a different way from the previous. It involves an
increase or decrease in debt to equity ratio. Thus the strategies involves raising equity
capital, debt capital or both.

2.3.1 Capital Markets

Goodspeed (2001) defined capital markets as the markets in which institutions, corporations,
companies and governments raise long-term funds to finance capital investments and
expansion projects. Blake (1997) could not go long in defining the capital markets; he
defined capital market as a market, which deals with securities with more than one year to
maturity. Thus, both authors shared the same notion that capital markets are long-run markets
mainly for long-term projects.

A. Krause (2006) suggested a three tier capital for expected, unexpected and stress losses as
sources of capital. Tier I Capital should consist of paid-in shares and disclosed reserves,
mostly originating from retained earnings. Unexpected losses reduce the risk capital, which
provides the Tier II Capital. The sources of this capital would be undisclosed reserves, unpaid
capital, and hybrid instruments like convertible bonds. Tier III Capital covers stress losses,
that is the signaling capital. The sources of this capital can be guarantees from owners or
parent companies and subordinated debt or loans from affiliated persons. These debts are in
many cases easily converted into equity when the company faces bankruptcy.
Pinches (1994, 515). Stated that firms raise long term funds from two sources that is
internally generated funds that are reinvested in the firm and external funds obtained by
selling equity or debt. He presented them as follows

Fig 1. Methods of securing funds

Methods of securing
funds
Externally
Internally generated
generated

Public Issue Private placement Shelf registration

General cash
Rights offering
offering

Source: Pinches (1994), Financial Management, Pp 515

According to Pinches the internally generated funds are from the retention of cash flow
generated by the firm. Raising funds externally has three basic alternatives. First is public
issue which include cash offering( issuing common stock, preferred stock and long term debt)
and rights offering which is available to the firm’s current stockholders. Second is the shelf
registering and lastly private placement. Attrial (2003, 177) supported Pinches’ views as he
defined external sources as sources that require the agreement of someone beyond the
directors and managers of the business for example finance from the issue of new shares
because it requires the agreement of potential shareholders. He also defined internal sources
as sources that do not require the agreement from other parties or those that arise from
management decision for example retaining profits because directors have the power to retain
profit profit without the agreement of shareholders.
The above definations shows that retaining profits is the only source of internal funds.
However Pinches contradicts himself by stating that retained profits are under common stock
yet common stock is refered to as the external method of raising funds. Thus to ease this
confusion, the views of Mclaney (2006) and Van Horne (2003) which presents the sources of
capital as loan and debentures, equity and leasing are considered.

www.bized.co.uk listed the methods as retained profits, shareholder’s capital, retained

profits, overdraft, bank loan, leasing, hire purchase, selling assets, debtors and factoring.
However some of the methods do not change the capital structure of the firm for example hire
purchase since it is short term method which will contradicts with the definition of capital
structure at 2.1.2 above.

2.3.2 Raising long term capital

2.3.2.1 Equity capital

This capital may be in the form of funds invested in the firm directly in exchange for new
shares of common stock or it may occur through the action of the firm’s board of directors by
retaining funds other than authorizing them to be paid out in the form of cash dividends,
Pinches (1994). This was the same view by Maclaney (2006) who states that equity capital is
obtained from the issue of ordinary shares and additional equity is obtained through retaining
profits, bonus shares and rights issue.

Retaining profits

Rights issue

2.3.2.1.1 Factors to consider on equity financing

Mclaney (2006, 216) came up with five factors to consider when choosing equity financing.
Issue cost- they very considerably according to the method used to rise the new equity and
the mount raised ranging from virtually nothing up to bout 15% of the new finance raised.
Jeckinson (1990)

Servicing costs – The capital appreciation results from the fact that sooner or later profits not
paid out s dividends re expected to end up in the hands of the shareholder even if they have to
wit until the business before this happens.

Obligation to pay dividends – The dividend must be pod but shareholders cannot directly
force payment of particular level of dividend in particular year.

Obligation to redeem the investment – There is no such obligation unless the business is
liquidated. Finance provided by ordinary share does not normally impose legally enforceable
cash flow obligation on the firm.

Tax deductibility of dividends - In contrast to the servicing of virtually all other types of
finance, dividends are not tax deductible in arriving at the business corporation tax liability.
This tends to make dividends more expensive on similar gross equivalent loan interest rate.

2.3.2.2 Bank Loan

This is lending by a bank to a business. A fixed amount is lent for a fixed period of
time, for example years. The bank will charge interest on this, and the interest plus part of the
capital, (the amount borrowed), will have to be paid back each month. Again the bank will
only lend if the business is credit worthy, and it may require security. If security is required,
this means the loan is secured against an asset of the borrower,
www.mortgagesforbusiness.co.uk

2.3.3 Private placement

www.investorwords.com defined private placement as securities directly to an institutional

investor such as banks, mutual fund or foundation. It does not require stock exchange
registration provided the securities are bought for investment rather than resale. Kolb et al
(1999, 231) defined private placement as the issue of sales on entire bond issue to a single
buyer or to a consortium of buyers and the issuer never makes the bond available to the
puplic. Thus according to the authors, private placement does not go through the stock
exchange and thus not offered to the public.

Advantages of private placement

www.investorwords.com and http://sbinformation.com sighted the following advantages

High degree of flexibility in amount of financing ranging from 100 thousand to 10-20
million with combinations of debt, equity, or debt and equity capital.
Investors are more patient than venture capitalists, often seeking 10 to 20% return
on investments over a longer term of 5 to 10 years.
Much lower costs than approaching venture capitalists or selling the stock to the
public as an IPO (Initial Public Offering).
Quicker form of raising money than usual venture capital markets.

2.3.4 Shelf registration

A registration of new issue which can be prepared up to two years in advance so
that the issue can be offered as quickly as the funds are needed or when market
conditions are favorable, www.investorwords.com. According to Pinches (1994) shelf
registration is when a firm

2.3.5 Loan stock and debentures

Many business borrow securities with a fixed interest rate payable on the nominal or
face value of the securities ( known as coupon rate) and a prestated redemption
date known as loan stock debentures or bonds. They are typically issued for ten to
twenty five years though some are issued for periods outside the range. This attracts
all types of investors who seek relatively low risk returns. The issue costs are
relatively low estimated 2.5% of the value of cash raised on them. Since loan stock
represent a relatively low risk investment to investors expected returns turns to be
low compared to those typically sought by equity holders
Loan stock holders have the basic right under the law of contract to enforce payment
of interest and repayment in case of failure to meet the due date for repayment.
They also have the contractual right to take more direct action for example effective
seizure of an asset on which their loan is secured. This dear obligation to pay
interest can make servicing the loan stock finance a considerable milestone around
the neck of the borrowing business. Also failure to make those payments can
considerably limit the freedom of action of the business but however control in the
case of voting rights is not usually involved with loan stock. The interest is fully
deductable from profit for corporation tax purposes and this has tended to make
interest payment cheaper than ordinary and preference dividends.

2.3.6 Term loans

Van Horne and Wachowicz (2003,72) defined term loans as debt originally
scheduled for repayment in more than one year but generally in less than ten years.
They are repayable in installments. He distinguished them from other types of
business loans as having a maturity of more than one year and that it most often
represents credit extended under the formal loan agreement. Mclanely (2006)
echoed the same sentiments only that he went on further to state its advantages.
According to him, term loans account for as much as 25% of new finance raised by
businesses. They tend to be very cheap to negotiate that is issue cost are very low
since the borrowing business deals with only one lender and also there is room for
flexibility in the condition of the loan than is possible with an issue of loan stock.

2.3.7 Leasing
A leasing is now a popular method of long term finance. It is gradually gaining
ground in developing and developed countries of the world. It is a contract for the
hire of a specific asset. Van Horne and Wachowicz (2003, 577) defined a lease as a
contract under which one part agrees to grant the use of one asset to another, the
lessee in exchange of periodic rental payments. www.blurtit.com described leasing
as follows. A business may get plant, equipment and land on a long term hire
purchase. The business in this way has the use of assets which it does not own. It
has however to pay regular payments to the lesser under the agreement. Mclanely
(2006) identified three types of lease as operating lease, finance lease and sale and
lease back. On the contrary Van Horne and Wachowicz (2003) identified them as
sale and lease back, direct leasing and leverage leasing.

The advantages claimed for leasing are that there is no pressure on existing
resources of the business. It assets are also not tied up as security of loan. The rent
is paid from income generated by the use of asset
According to www.mysmp.com when analyzing a company it is important to note
their mix of debt and equity, because it gives a firm picture of the financial health of
the company. The higher the company's debt-to-equity ratio, the greater the risk of a
potential investment. Therefore, in theory, regardless of where the capital structure
mix starts, it ultimately should shift towards less debt and more cash on hand.
Usually a company more heavily financed by debt poses greater risk, as this firm is
relatively highly levered.

2.5 Does ownership structure affect capital structure.

http://ppers.ssm.com states that the effects of separation of control from cash flow rights on
capital structure and firm value also depends on the separation of control from management s
well s on legal rules and enforcement defining investor’s protection. This view has given rise
to the need to look at change of ownership since they can also later the capital structure and
be means of rising capital.

2.6 Mergers and Acquisitions

2.6.1 Mergers and acquisitions defined

A Merger involves the combining of two or more firms in which only one firm saves as a
legal entity G. F Stanlake (1983).A Merger occurs when two or more firms are combined
together and the resulting firm maintains the identity of one of the firms also assuming the
assets and liabilities of the smaller firm. Only one firm survives the fusion J Beardshaw
(2004:822). Copeland and Weston- Financial (1998) differentiated consolidation, which by
contrast to merger, involves the combination of two or more firms to form a completely new
corporation that will normally absorb the net assets and liabilities from which it is formed.
However, the distinction is one of a degree as the two concepts mean the same thing.
According to Oxford dictionary, an acquisition is an outright gain of possession. Therefore,
an acquisition occurs when one company acquires another as part of its overall business
strategy. The predator organization acquires sufficient number of shares to gain control or
ownership of another company. There is also financial acquisition that occurs when the
acquirer’s motivation is to sell off assets, cut costs and operate whatever remains efficiently
than before. This is done in the hope that the action results in creating value in excess of the
purchase price. Financial acquisition is strategic in the sense that the acquired firm will
operate as an independent standalone entity. A financial acquisition usually involves cash
payment to the selling shareholders financed largely by leveraged buyout.
McManus and Hergert (1988:455-6) defines mergers and consolidations falling under a
parent company to form a holding company. A financially sound company seeking growth
may go on a shopping spree buying other companies .The rationale behind the acquisitions is
to form a holding company, which is purported to be a corporation that has voting rights of
one or more corporations; a typical example of a local case according to the Zimbabwe
Insurance Survey (2003) is that of TA Holdings and ZimRe Holdings. The companies that
fall under the holding company are referred to as subsidiaries.

2.6.2 Types of Mergers

Mergers can also be classified in terms of their economic function. Philippe Jorion (2002) ,
envisaged that mergers can be in many forms depending on the fields of industry the
companies will be coming from. G F Stanlake (1983) classified the mergers into three broad
categories, which are: horizontal merger, vertical merger and conglomerate mergers.

2.6.2.1 Horizontal integration

K. Palepu (1986:61-74) defined a horizontal merger as one combing direct competitors in the
same market and involved in the same product lines. According to F.G Stanlake (1983:80), a
horizontal integration occurs when firms engaged in producing the same kind of good or
service are brought under unified control. He also argued that market domination is
undoubtedly one of the motives leading to horizontal integration. When a number of firms
producing the same or similar products form a single combine there is clearly a reduction in
competition and the unified group will be able to exert more market power by virtue of the
fact that a much greater proportion of the total market supply is under its control F.G
Stanlake (1983:80). P.S Sudersanam shared the same view with F.G Stanlake, as he noted
that mergers and acquisitions in the same level of business reduce competition.

2.6.2.2 Vertical integration

When a merger takes place between firms engaged in different stages of the productive
process we speak of vertical integration G.F Stanlake (1983:78). He further argued that it is
‘vertical’ in the sense that the combination is a movement up or down the productive process
that runs from extraction to distribution.

2.6.2.3 Conglomerate merger

G.F Stanlake (1983:81) defined conglomerates as those mergers or amalgamations which are
neither substantially vertical nor substantially horizontal. They are general understood to be
those combinations of firms which produce goods or services which are not directly related to
one another. For example a firm producing cigarettes may take over a firm producing potato
crisps, or a firm producing fertilizers may merge with an insurance company. G.F Stanlake
(1983) argued that the major aim of conglomerate is clearly to obtain a diversification of
output so as to reduce the risks of trading. Conglomerate mergers may also arise where a firm
believes that there is little scope for any further growth by taking over, or merging with, a
firm in a different industry.

2.6.3 Motives for Mergers and acquisitions

Primarily companies should merge in order to maximize shareholder wealth I Kwesu and E.N
Chikwava (2002:136). They suggested that a merger would take place only if the value of the
combined entity is more than the value of the individual firms. Thus if this were not the case,
both companies would remain independent.

Samuel J et al (1999) identified merger and acquisition as a method of raising long term
finance. Academics and other researchers view profit and value maximization, managerial
ego, the need to reduce risk through diversification and defensive considerations as the
reasons behind mergers and acquisitions. Deangelo and Harry (1983:329) found that a firm
should acquire to avoid being acquired and ensure that growth keeps up with that of
competitors. They further stressed that the need to maintain high levels of corporate reserves
and share valuations as essential motives. Most authors held the view that mergers and
acquisitions are entered into because of the need to maximize shareholder’s wealth and profit
maximization. However, mergers are not only entered into because of the need to increase
profit as reflected in the literature by Bradley and Michael (1993:43), they agreed that not all
companies that have been merged look for value and profits. R.C Higgins (1975:93-114)
identified specific motives behind most mergers and acquisitions transactions. He suggested
fundraising, profit gearing or expense sharing, increased ownership liquidity and defense
against takeover as some of the reasons for mergers and acquisitions

2.6.3.1 Capital or Fund Raising

Mitchell (1992) published that often companies combine to enhance their fundraising ability
so that they can support their retention capacity and maximize on solvency. Samuel J et al
(1999) echoed the same sentiments when he stated that merger and acquisition is a method of
raising long term capital for a firm.

Crouchy et.al (2000) and Gordy (2000) postulated that the more capital a firm has relative to
its assets, the more confident stakeholders are that the firm will meet obligations like claims
and policies due to them. They further concurred when they asserted that capital alone is not
a guarantee of solvency. This implies that if a firm is listed on the equities market, and have
enough capital; investor confidence will result in the firm’s cost of both equity and debt
reducing significantly. It means a lower cost of accessing funds for expansion, thus
increasing value for shareholders. From this perspective, a well-capitalized firm can
administer its claims efficiently without jeopardizing its market position.

A firm may be unable to obtain funds for its own internal expansion or capitalization but able
to obtain funds through mergers. Quite often than not one firm may combine with another
that have liquid assets and low levels of liabilities. The acquisition of this type of “cash-rich”
company immediately increases the firm’s borrowing power by decreasing its financial
leverage. This should allow funds to be raised externally at lower costs.

2.6.3.2 Synergy
P. Asquith, R.F Bruner and W. Mullins (1998) held the view that synergy occurs when the
whole is greater than the sum of its parts, that is, only when the belief that “1+1=3”. The
synergy of mergers is the economies of scale resulting from reduced overheads of the
combined firms. This is true if the economies of scale are because of a reduction in the
combined overheads spread of a large volume of output / business that will be greater than
the sum of earnings of the independent firms. R.A Brealey and S.C Myers (1991:817-19)
held the view that synergy is the economic gain. They argued that there is an economic gain
only if the two firms are worth more together than apart. According to R.A Brealey and S.C
Myers (1991:818), the economic justification for a merger occurs when the gain is positive.
This occurs when combined present value of two firms is greater than the sum of two firms
when they are independent. I Kwesu and E.N Chikwava (2002:137) found that by merging
companies can create synergy and can benefit from the following:
α) Increased market share/ market power
β) Economies of scale
χ) Improving efficiency

2.6.3.6 Are mergers successful?

The general notion that capital market imperfections could lead to mergers forming have
been advanced in a number of papers including Stulz (1990) and Lessard (1990:33). There
are a number of theories of financial management in these papers, which explains the causes
of failure. These theories prescribed that corporate management is the outcome of non- linear
costs of financial distress, managerial risk aversion, or imperfect market information. Stulz
(1984, 1990 and 1996), Smith and Stulz (1985) and Dermazo and Duffle (1995) agree that
many mergers fail because they will not have been properly managed by the resultant
managers.

The other cause of failure, which calls for effective implementation, is the disgruntlements
that arise in the company where it will be difficult to merge the different management team
and staff into the new company. Many companies because of the similarity in departments
between the acquirer and the acquired, people will be laid off to avoid redundancies and cut
costs. This will cause the business to loose especially those who follow the people they will
have established relationships with. Mclanely (2006, 395) identified the opinion of managers
as the major stumbling block to the success of mergers. His general conclusion of mergers
seems to be that the mergers had not been beneficial. Coopers and Lybrnd (1993) undertook a
study during 1992 which comprise interviews with senior mangers some large United
Kingdom business that had been involved in merger. The study identified several major
causes of failure as below.

Management attitude
Lack of post acquisition integration planning

Lack of knowledge by the bidder of the target and its Indus

Poor management and management practice in the target

Little or no experience of the bidder management in acquiring other business

2.8 Conclusion
In this chapter, much emphasis was given on what different scholars think about
recapitalization and methods of recapitalization. Also sighted are evaluations of these
methods and recapitalization challenges. Mergers and acquisitions are also included since
they are viewed as methods of raising funds that can alter the existing capital structure. The
researcher carried out a lot of research in an attempt to analyze how company can be
effectively recapitalized
References
R.A Brealey and Stewart C. Myers, 1991, Principles of Corporate Finance, Mc Grew Hill
Publications.

R. F. Brunner and J. Mullins, 1998, Bank Mergers and Acquisitions, ordretech/

Boston/London.

I. Godspeed, 2001, Introduction to Financial Markets, SAIFM, January, 2004.

J. R Selman, 2003, Creating a defensible recapitalization program me , Journal of Corporate

Real Estate.

Denault, M.(2001), ‘‘Coherent allocation of risk capital’’, Journal of Risk,Vol. 4 No.1, pp.1-
34.

Zimbabwe Insurance Survey magazines,(2003, 2005,2006,2007).

S.A. Aduloju, A.L. Awoponle, S.A. Oke,2007,Recapitalization, mergers, and

acquisitions of the Nigerian insurance industry,The Journal of Risk Finance,volume 8,
1ssue 5,page 449-466, emerald group publishing limited.
P Asquith, R Bruner, D Mullins (1983), "The gains to bidding firms from merger",
Journal of Financial Economics, Vol. 11 pp.121 - 139.

M Bradley, A Desai, E.H Kim (1988), "Synergistic gains from corporate acquisitions
and their division between the stockholders of target and acquiring firms", Journal of
Financial Economics, Vol. 21 pp.3 - 40.

Brealey, R., and S. C. Myers. Principles of Corporate Finance. 7th ed. Irvin McGraw-
Hill. ... Boston, MA: Harvard Business School Publishing, 1991

A, J Keown, J. D. Martin, J. W Petty and D. F. Scott, 2002, Financial Management

Principles and Application,9th edition, Prentice Hall, London

E. F. Brigham and J. F. Houston, Fundamentals of financial management,(2001),9 th

edition, Harcourt college publishers, New York

Levine, R. 1997. Stock markets, economic development and capital control liberalization.
Perspective, Investment Company Institute, Occasional papers, Vol 3. No.5.
Ndikumana, L. 2001. Financial market and economic development in Africa. Political
Economy Research Institute, University of Massachusetts, Working paper series, No. 17.

Yartey, CA. and Adjasi, CK. 2007. Stock Market development in sub-Saharan Africa.
Critical issues and challenges. IMF Working paper No. WP/07/209.

World Bank 2006. Private Sector Development Blog. A Market Approach to Development
thinking.

Gustafsson M. A. H, (2002), Dollarisation Effects on Investments in Ecuador

Websites

www.sbinformation.com

www.businessdictionary.com

www.emeraldinsite.com

www.investopedia.com

www.mysmp.com

www.bized.com

www.mortagesforbusiness.co.uk

www.inverstowords.com

www.blurtit.com
www.ppers.ssm.com