Stock Buyback Essay

A stock buyback is process in which a firm buys back its own stock.

There are three conditions which could make firms to buyback stock.

1. A company may want to increase its leverage by issuing debt and using the proceeds to buyback stock.

2. Many firms give their employees stock options, and they repurchase stock for use when employees exercise the options. In this option, the number of outstanding shares reverts to its pre-repurchase level.

3. A company has excess cash, it may be due to a sudden cash inflow, such as the sale of a division of business, or it may simply be that firm is generating more free cash flow than it needs for its operation and expansion plans.

Stock buyback is made in one of the three ways:

1. A firm can simply

Firms are normally reluctant to increase the dividend if the increase cannot be maintained in the future—managements don’t wish to reduce cash dividends because it sends negative signal to investors. Hence, if the excess cash flow is thought to be only temporary, management would prefer share repurchase rather than to declare an increased cash dividend.

Disadvantages of Repurchases:

1. The shareholders who sells the stocks may not be fully aware of all the implications of a buyback, or may not have all the pertinent information about the firm’s present & future activities. But, firms generally announce repurchase programs before embarking on them to avoid potential stockholder suits.

2. The firm may pay too much for the repurchased stock, to the disadvantage of remaining stockholders. If the firm seeks to acquire a relatively large amount of its stock, then the price may be bid above its equilibrium level and then fall after the firm ceases its buyback operations.

Comments on Stock buyback:

1. Lower capital gains tax rate and the deferred tax on capital gains, buyback has a significant tax benefit over dividends as a way to distribute cash to shareholders. Also buyback is reinforced by the fact that it provides cash to stockholders who want cash while allowing those who do not need current cash to delay its receipt. On the other hand, dividends are more dependable and are thus better suited for those who need a steady source of

Buyback is useful when a firm wants to make a large changes in its capital structure, and to distribute cash from a one-time event such as the sale of a division of business.

The Impact of Stock buyback

Suppose a firm has extra cash due to the sale of a division, and it plans to use the cash to buyback stocks. We consider that the firm is unleveraged. The current share price, P0, is Rs.30 and the firm has 10 lacs outstanding shares (N0). So market capitalization is Rs.3crores. The firm has Rs.30 lacs from the sale of a division.

As discussed in the Corporate Valuation, the firm’s value V is the present value of its expected future cash inflows, discounted at the weighted average cost of capital (WACC). Since the buyback will not affect the future cash flows or the cost of capital, so the repurchase doesn’t affect the value of firm. The total value of the company is the value of its present operations and the value of the extra cash generated from sale of division. So the share price, P0, can be obtained by dividing the total value by total outstanding number of the shares.

P0 = (V + Extra