Buying back of shares is a dangerous financial strategy as it
increases the company’s capital gearing”
Over time, organizations have been in the dilemma of the effects
that various financial actions on their leverage. While the some of these
actions have no effect on gearing ratios, they affect other aspects of the
organization. One of the actions that a company undertakes in its course of
life is a share repurchase. A share or stock repurchase is the act of an
organization purchasing some or all of its shares from the existing stock
holders. This can be done in phases or in one time offer. There are various
implications of this move. One of them is signaling. A share repurchase does
signal different and conflicting information to shareholders and potential
buyers. It could be a signal that the management views their stock as
undervalued in the market. By repurchasing the investors see this as a sign of
higher future returns. It also reflects the fact that the organization lacks
profitable projects to invest in. In this case, they will not be motivated to
buy.
A stock buyback also has some profound effects on a firms leverage
or gearing. The degree of financial leverage measures how a firm’s cash flows
change with the fluctuation in operating income. The degree of operating
leverage reflects the sensitivity of income to fluctuations in sale revenue.
Therefore, change in the cash available has an effect on the degree of a firm’s
leverage because it is paid with cash from the organization’s reserves.
Organizations repurchase their stock from the existing shareholders
for various reasons. A firm may repurchase some or its entire stock if, in
their view, it is undervalued. The company’s stock prices may be pushed down by,
for example, poor economic conditions. The management may be having more
information than the investors about the stock price. Their expectations of
future earnings are unknown to the investors. In the event of a buyback, it may
signal to investors that the market has lowered it prices below their expected
price. A company may also repurchase some of its stock to avoid dilution. Increase
in shares erodes share value as well as weaken it financial outlook. Buyback
can be used to reverse this effect.
Another motivation for a stock repurchase is to improve its
financial indicators like financial gearing and EPS (earnings per share). An
indicator such as return on assets increases because the company’s overall
assets diminish with buy back. Cash is taken as an asset hence the decline in
assets. Buying back shares requires use of a company’s cash reserves eroding
its assets. The return of equity also improves because the number of shares
diminishes as a result of a buyback. Stock repurchase can be used to avoid a takeover.
Improved financial indices coupled with increased value of stock can shield a
firm from a hostile takeover.
The notion that share buyback is a dangerous strategy as it
increases the company’s capital gearing is a valid one. However, the benefits
outweigh the disadvantages. A share repurchase essentially refers to a company buying
back its equity stock from the existing shareholders. This involves the use of
cash reserves to finance this project.[1]
This increases a firms gearing by reducing the overall value of outstanding
shares.[2]
The increase in gearing increases the overall value of the firm but increases
its exposure to risk. The benefits that a firm derives from the repurchase far
much outweigh the risk involved. The firm, however, has to find the optimal
tradeoff between the risk and the benefits. There is an optimum point at which their
risk is unbearable and can lead to liquidation.
Stock is usually charged a withholding tax. By selling back their shares;
investors are not taxed as would be the case with a cash dividend. This implies
that investors stand to benefit from the capital gain.[3]
Another important benefit that arises from the stock repurchase is the
flexibility associated with the practice. It gives the company another option
of distributing excess income to shareholders. There is managerial reluctance
to increase cash dividends. As a result, managers, issue excess cash to the
company stock holders by buying back their shares. This way, they can keep a
stable dividend policy while still passing excess cash flow to shareholders.
According to Acta,[4]
other motivations for buybacks are better explained by investments and leverage
hypothesis. Leverage hypothesis talks about adjustments in the organization’s
capital structure or the change in the ratio of debt to equity ratio with time.
Companies that are overcapitalized would wish to adjust their leverage ratios.
This makes stock repurchase a useful tool for this purpose. This effect
originates from a decrease in a company’s equity as a result of a repurchase.
It also emanates from an increase in leverage if the company chooses to use
debt to finance stock repurchase.
Investment hypothesis, on the other hand, offers that rise in share
buyback and payout has a direct relationship with a decline in viable
investment projects. A firm issuing dividend payout and share repurchase are an
indication that a company is lacking investment opportunities. That is why it
will issue excess cash buy back shares because they do not want to raise the
payout ratio.
Another hypothesis about stock repurchase is about free cash flow. A
buyback in this case is a reflection that the management is not willing to
channel capital to unviable uses. Availability of free cash balances increases
stock repurchases.[5]
This is so because a repurchase is associated with payment flexibility. Flexibility
derives from the common knowledge that a company has an alternative method of
distributing its earnings to shareholders. Shareholders, on the other hand, prefer
this method because of the tax advantage. If they are going to make considerable
capital gains, shareholders will not stand to lose any income to the tax
authority.
There is a strong correlation between a leverage ratio and weak
portfolio returns.[6]
Accordingly the debt overhang theory suggests offers that an increase in
leverage raises the chances that a firm might have to forego viable investment
opportunities in the future. The simple reason is that the project’s NPV will
end up being less than the initial outlay after adjustments for debt
obligations. The firm stays under invested as a result of the repurchase. Therefore,
one can say that a decrease in a company gearing can decrease the real
investment by the firm. In an organization low investment of funds reduces its
potential for growth. Therefore, for those keen on the market, a share buyback
should always worry them because everything remaining constant the stock price
will decrease further in the event of a buyback.[7]
There is also an argument suggesting that the risk of default has a
price. When a firms gearing increases, it also increases a firm’s probability
of defaulting on future debt obligations. If; therefore, there is a price tag
to the increase in leverage, the stock price will come down as fast. The stock market
reacts with a decrease in prices as a result of the excess debt capacity that
the firm is taking making it more prone to liquidation than if had no debt.[8]
Dimitrov and Jain in a 2008 study find that there is a strong
negative connection between fluctuation in gearing and stock returns for the
current and coming year yields on stock. They propose that a firm can increase
its level of debt when they predict that their performance will decline. Their
major point of argument is that gearing ratios communicate volumes about a
company performance especially the future yields from the stock.
Greater gearing increases the likelihood that a firm might
experience a debt overhang. As a result, the firm value will decline. There is
no direct negative relationship between gearing and indicators of future
performance from operations. These include Return on Assets and Earnings before
interest tax depreciation and amortization (EBITDA). These two are not prone to
effects of interest charges on leverage.
Nevertheless, high gearing has a profound effect on the performance
of the company. To understand this, there are factors that influence a
company’s gearing. One of these factors is sales or profits. Companies with
stable earnings and growths rates are better placed to use debt financing. This
is because they can sustain the interest charges that accrue from the debt.
They are also able to repay the capital in time. The higher the profits, the
higher the gearing a firm can use. Another factor affecting the level of gearing
in a company is the interest charges. In the event that a firm is in a high
risk position, then it cannot borrow more to finance its operations. If at all
it can borrow, then the interest cost would be high to cover the risk. A
company also needs enough cash flow to meet current obligations as they arise. Previous
loan covenants can restrict a company from acquiring additional debt to finance
operations. An example of a borrowing restriction is a loan covenant.[9]
A lender also considers the industry trends and norms before
advancing credit to the company.[10]
Highly volatile sector companies will have low leverage ratios because of the
unpredictability of the company returns. Those in stable industries have relatively
stable revenue and can maintain a higher leverage ratio. Security is also
another major factor affecting a company’s leverage. A lending institution will
need security for their debt instruments. If a security is not available; a
firm cannot raise additional capital. Stake holders have a say in the company’s
capital structure. While the managers are the ones in control of the company’s
leverage ratios, stakeholders also have their say in the same. Their attitude
towards the financial risk that a higher leverage places on a company will
determine a company’s gearing. Availability of alternative sources of funds
also affects how a company is geared. If the company can get cheaper
alternatives to borrowing, it will most probably go for it. This will dictate
if a firm is going to use additional debt to finance operations.[11]
It is clear that a stock repurchase will affect a company’s level of
gearing. This is because as the company repurchases its shares it will need
cash to give back to shareholders. This cash can be from their internal
earnings or borrowed. Either way it will have an effect on the level of
gearing. This change in leverage comes as a result of changes in the cash
balances of the company.
Companies retain earnings to reinvest in projects with a positive.
The reason is that retained earnings bear no extra costs to the organization.
When a company is retains earnings, it foregoes the option of raising extra
capital through expensive methods like selling or issuing shares or purchasing
debt instruments. When a company wants to buy back shares, it has to use the
excess cash it has to finance the operation. This cash could have been employed
into another project if there is one. This shows that a firm that is
repurchasing its shares lacks profitable projects to invest in. This signal is
bad for business because in an imperfect market where only the management knows
the real motivation for a share buyback. In that case, investors are going to
judge that the firm has run out of investment ideas and can only buy back its
shares to distribute earnings.
The purchase of shares using
cash reserves reduces the assets of the company. The reduction in the number of
assets increases a company’s leverage. If the company purchases debt
instruments then the leverage ratio increases further. An increase in company
leverage has its implications. One, the increase in debt increases the value of
the firm. Secondly, it increases company’s exposure to risk. Organizations need
to strike a balance between risk and benefit. The organizations
Firm value under two scenarios reveals that a levered firm yields a
higher firm value theoretically. It also shows that the firm has more returns
due to the tax effect on debt.
Hypothetical
case
The
assumption that a firm can use excess cash to buy back its shares is
illustrated as shown below. The action reduces the number of outstanding
shares. The net income remains income might remain constant, but the EPS will
rise after the buy back. This means that the buyback will reduce the number of
shares that the earnings will be distributed to in the future. A dividend is
taxed at a certain percentage depending on the country policies. The use if
share back could be a great way to maximize the shareholders wealth.
ABC COMPANY’S
POST BUYBACK PROJECTIONS BY MANAGEMENT
ITEM
|
CURRENT
|
AFTER BUYBACK
|
NET INCOME
|
1,000 DOLLARS
|
1,000 DOLLARS
|
ORDINARY SHARES
|
200
|
100
|
EQUITY
|
10,000 DOLLARS
|
5,000 DOLLARS
|
Earnings Per Share
|
5 DOLLARS
|
10 DOLLARS
|
P/E Multiple
|
10 times
|
10 times
|
PRICE
|
50 DOLLARS
|
100 DOLLARS.
|
From above
it is clear that the investors benefit from a rise in earnings per share (EPS)
as well as an increase in the share price
The
company’s Earnings before Interest and Tax is fifty thousand dollars and management
forecasts that it is going to increase by ten percent in the next period after
buy back.
A report by
the company shows that the sales for the ABC Company were one hundred thousand
and are expected to rise by five percent in the next accounting cycle (period
after buy back), the degree of combined leverage (financial and operating
leverage)
As a conclusion, it is clear from the above that the company is
highly levered as much as the gains from the share buyback are high. The value
of the firm if it decided to use debt to finance its operations in future will
be greater than if it did not have debt. However, it will be riskier than a
company which has a low leverage. The tax advantage will be huge, as well.
BIBLIOGRAPHY
Alpha Dhanani
and Roydon Roberts. “Corporate Share
Repurchases; The perceptions and
Practices of UK financial
managers and corporate investors”. Edinburgh, Scotland: Institute of Chartered Accountants of Scotland, (2009).
Cai, J and
Zhang, Z. Leverage change, debt overhang
and stock prices. (Philadelphia,
Drexel University; 2010). 3-21
Grullon,
Gustavo & David, L. What do we know
about stock repurchases? Journal of applied
corporate finance 13:1
(2000) 31-51
Malcolm, A. Gearing. ACCA (2000) retrieved March
17, 2014 from
http://www2.accaglobal.com/archive/2888864/31074?session=fffffffeffffffff0a01213951271d185af215fce2ae09d76d2193f0ed964abe
Myers, S. C.
Determinants of Corporate Borrowing.
Journey of Financial Economics 5, (1977)
: 141-179
Ross, A.,
Westerfield, R. and Jaffe, J. Corporate
Finance. 7th edition, (Irwin, 2005)
University
of Wasaensia. Liquidity effects, timing
and reasons for open market share
repurchases. ACTA WASAENSIA 133. (2004): 8-63
[1] S A Ross and R W Westerfield and J F Jaffe: corporate Finance, 7th
edition, Irwin, 2005
[2] Alpha Dhanani and Roydon Roberts: Corporate Share Repurchases; The
perceptions and Practices of UK Financial Managers and Corporate Investors.
Edinburgh, Scotland: Institute of Chartered Accountants of Scotland, 2009.
[3] Acta Wasaensia on liquidity Effects timing and reasons for open
market share repurchases. University of Wasaensia, 2004.pg 10-
[4] Acta Wasaensia
[5] Grullon et al 2000: what we about stock repurchase
[6] Jie Cai and Zhe Zhang
[7] Myers 1977: corporate borrowing
[8] Cai and Zhan 2004. The market price reaction to leverage is affects
even firms with a healthy financial record.
[9] Myers 1977
[10] Myers, 1977
[11] Malcolm Anderson 2000. About gearing and the effects factors
affecting gearing
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