In theory, a company's rationale for implementing a capital reduction program is to optimize its capital structure for a better ratio of debt to cash reserves. Many domestic companies have recently carried out such reduction programs, but their success has come to figure large in the debate about corporate financial health and the state of the investment environment in Taiwan.
For companies that have suffered a complete erosion of their net worth -- such as last year's case involving workstation and server-equipment maker Cradle Technology Corp -- capital reduction constitutes one tool in a reorganization effort designed to enable a company to recover a part of its accumulated losses. This step is normally taken before the firm begins work on reorganizing its capital structure by raising fresh funds.
There are also companies that use capital reduction programs to generate the most efficient returns from capital resources, thus enhancing shareholder value.
Firms falling under this category include Sunplus Technology Co, which designs integrated circuits for electronic consumer applications, and Formosa International Hotels Corp, which runs Grand Formosa Regent Taipei. These companies announced earlier this month that they would reward shareholders with higher earnings per share through capital reduction schemes.
Other companies that have accumulated ballooning cash holdings -- like telecom operators Chunghwa Telecom Co and Taiwan Mobile Co -- are also considering capital reductions and other capital management initiatives to maintain high dividends.
Regardless of the motives that are behind capital reduction, most companies claim their financial position will remain strong afterwards, with leverage at a comfortable level. They also reassure shareholders they will receive an improved return on equity (ROE) because the number of issued shares decreases.
But from a long-term perspective, shareholders will not benefit if companies reduce capital out of a conservative outlook on future business performance. This concern is exacerbated when the rate of development in a prospective industry matures, if no new products are in the pipeline or if the nation's economic structure changes.
Capital reduction is not necessary for efficient capital utilization; companies can achieve greater improvements in their capital structure and cash flow by streamlining their business processes instead.
Returning capital to shareholders will only create a short-term ROE effect. After all, such reductions do not change the market's competitive environment.
The government should be wary of companies that undertake capital reduction programs to circumvent regulations governing the remittance of capital abroad, particularly to China. While the government maintains a firm 40 percent net value cap on Taiwanese companies' China-bound investments, it should not neglect the fact that many of these firms now require more capital for business expansion there than in the past, and it should be wary about attempts to do so through capital reduction.
The decision last month by Singapore-registered food producer Want Want Group to drastically cut its Taiwan subsidiary's capital from NT$450 million (US$13.5 million) to NT$10 million was just the latest in a string of cases that have raised concerns about a worsening investment environment for companies planning to invest across the Taiwan Strait.