Cable Corporation of India
Recently, my friend told me that he has managed to get hold of some shares of Cable Corporation of India. I was curious how this stock could be so attractive so asked him more on why he was bullish on the stock. As it turned out, the company recently went through restructuring and so had a great potential.
I checked out and could not believe my eyes. The share price had rose from 1.63 Rs to more than 60 Rs withing a span of six months. Could anyone ever have believed that?
The prime purpose of this article is not to tell you about the exciting thing happening in the market but to give you an overview of what restructuring exactly is and how does it affect company's health.
Let me start with the fact that in every company, there are two kinds of stakeholders. "Stakeholders" is not the same as "shareholders", but all the people who have invested money in the company in some way.
Stakeholders are usually of two broad types:
- Creditors
- Shareholders
Creditors are the people who have provided loans to the company at a fixed or floating rate of interest. The main creditors could be banks or venture capitalist firms, or may be a rich person.
Shareholders are the people with whom the ownership of the company vests. If company does well, it's good for them but if the company runs into trouble, their money runs into trouble as well.
From a financial perspective, main difference between the two is that the company is BOUND to return the interest and make principal payments to the creditors while there is no such obligation to the shareholders. Shareholders have taken the risk while creditors have not. At the same time, shareholders can get great benefits if the company does well, while creditors will still get the same amount they originally agreed upon. If the company does bad, creditors or lenders still have very less risk because they still get paid their money.
But sometimes, a firm does so badly that it can not even make payments to the creditors. This is called defaulting on the loans which is the worst thing to happen to a firm. At default, the creditors can point the guns to the firm and force it to sell some of its assets and pay back the money to them.
When the firm is forced to be liquidated, i.e. auction off all its properties and assets, it will FIRST use all its money to pay back the creditors. As a shareholder, you do NOT get anything till all the loans of the shareholders have been paid off.
If the total loan of the company is greater than the total value of assets of the firm, then shareholders do not get anything. Effectively speaking, the share price IS ZERO in this case.
At loan default, however, company can make an effort to survive. It can use bankruptcy laws, go to the court and apply for restructuring. You must have seen in the news and financial papers that always a court is involved which allows company to restructure itself.
When the matter is in court, creditors can not force the company to pay back. However almost always, the outcome of restructuring is bad for shareholders. Let me give a typical example of restructuring.
Suppose that a company has 50 Rs raise from loans (creditors) and it has 50 Rs of shareholders capital (total market capitalization). It is required to pay 6 Rs per year as interest to the creditors towards the interest of 50 Rs.
It may happen that at the time of payment, company does not have 6 Rs and it defaults. It goes to the court and applies for restructuring. The court says that you can continue to function for another year but as now, the creditors will have 90% of company's ownership (equity) while the shareholders will only have 10% of the equity.
What happens here? You have got a very bad deal. But it is slightly better than what could have happened in case there were no restructuring. The value of your share is magically reduced to 1/5 of its original value (10%/50%). However, the creditors have got a good deal. Their loan of INR 50 has been converted to equity which may be equal to Rs 90 in case the value of total assets of the company is Rs. 50.
How has it helped the company? First, the company can keep running in this case. Second, it does not have to make those interest payments on which it originally defaulted. So it may now use the profits it generates for growth and other good things.
How does company suffers? First, huge money goes into dealing with changes of restructuring and lawyer fees. Remember, this company already was short of cash. Second, now creditors become the owners of the company. They have all the control so can do things which benefit themselves and not truly the company.
In most cases, the outcome of restructuring is much worse than this example. Remember Enron? This company had its share price plummet to ZERO because it defaulted on the loans and was liquidated. At liquidation, there were not enough assets to pay back all the loans to there was no residual value and no share value as well.
I wonder why investors get fooled by share prices which are increasing crazily on the news of restructuring.