Analyzing the Effects of Return of Capital and Capital Reduction to Cover Losses on Stock Returns and Operating Performance

This study investigates the influence on stock prices and operating performance when a company returns its capital to share holders (return of capital) or writes down its capital to cover loss (capital reduction to cover loss). The influence on stock prices is analyzed using Abnormal Returns (AR), Cumulative Abnormal Returns (CAR), and Buy-and-Hold Abnormal Returns (BHAR). The influence on operating performance is analyzed using t-test on the changes of eight financial ratios, namely, return on assets (ROA), returns on equity (ROE), net profit to sales ratio, operating cash flow to total assets ratio, earnings before interest, taxes, depreciation, and amortization (EBITDA) to total assets ratio, asset turnover, free cash flow to total assets ratio and liability ratio after capital reduction. This study finds a positive announcement effect for return of capital. However, the effect does not last long. There are negative abnormal returns on stock prices, measured by BHAR, one month after return of capital is announced. When capital is reduced to cover loss, there is a negative announcement effect and the abnormal returns last for six months at least. Moreover, we find that there are abnormal returns on stock prices prior to the announcement of both capital reductions. Return of capital has no influence on operating performance. Capital reduction to cover loss has positive effects on the growth of return on assets, returns on equity, and earnings before interest, taxes, depreciation, and amortization (EBITDA) to total assets ratio in the first and the third year after capital reduction. This study postulates two possible reasons for this finding. First, when a company writes down its capital to cover loss, its executives expect the operating performance to be improved in the following year. If the expectation is correct, the operating performance in the year after capital reduction will be better than that in the year before capital reduction. Second, those companies that are unable to improve their operating performance after capital reduction, are de-listed in the second year or the third year after capital reduction in general. As a result, the average operating performance for all the sample companies in the second year will be affected negatively by the poor performance of those companies that are de-listed subsequently. As most of the companies with poor performance have already been de-listed in the third year after capital reduction, the average operating performance for all the sample companies this year will be better than in the year before capital reduction.