Stock repurchases is a form of dividends. If stock repurchases are made instead of cash payment, it increases the earnings per share of current shareholders and it increases the market price per share.
Market price per share increases because earnings available for distribution to shareholders are now divided among fewer shareholders. Share price also increases because when a firm is buying back its shares it sends a positive signal to the market that management considers shares undervalued. Of course, repurchasing stock is especially beneficial for firm to undertake if the share price is really perceived by management to be undervalued.
Repurchase of stock also discourages unfriendly takeovers. This happens firstly because takeover can be attractive due to a company’s liquidity position. If a company has a lot of cash, it can be used to cover the debt undertaken to finance the acquisition. By using available cash to repurchase stock, a firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes takeover more expensive.
Another benefit of repurchase of stock is that it delays the tax liability of the shareholders. If cash dividends are paid out to the shareholders, then shareholders will have to pay part of it to the government as taxes. Repurchase of stock delays taxes that shareholders will be liable for until capital gain is realized which occurs when shareholder sells stock.
Agency problem also have something to do with managements’ incentive to repurchase stock. Executive’s rewards are often tied to performance measures such as earnings per share. If firms have fewer shares outstanding and earnings stay the same than its earnings per share will inevitably increase.
Therefore, a part of the agency cost that firm has to incur is due to a necessity to monitor management actions to ensure that stock is not repurchased because an executive’s compensation is tied to EPS measure.
Repurchase of stock also allows a firm to buy back shares so that they shares available for employee stock option plans. Buying back shares also temporarily provides a higher floor for the stock price.
Shares repurchase methods
The most common share repurchase method is purchasing shares on the open market. A second option is to negotiate with major stockholders to purchase a large bulk of shares. Another option is a formal fixed price tender offer that can be made to purchase shares at above market price.
Dutch auction tender offer, which originated in 1981, are another option to repurchase stock. This option entails invitation to shareholders to tender their shares at prices within established ranges established by the firm. The firm will try to purchase shares at the lowest possible prices. Thus, if more than enough shares are tendered then shares will be purchased up to a certain price at which an adequate amount of shares will be available. If not enough of shares are tendered then firm can either cancel the offer or buy back all the shares tendered.
Under every method of shares repurchase the reasons behind repurchase of shares must be clearly stated to the shareholders. The intention as to how repurchased shares are intended to be used should also be communicated. For example, it can be used for executive compensation or for trading it in exchange for shares of another firm.
In conclusion, companies need to maintain a target payout ratio which is suitable for the company’s needs. Organizations must also try not to neglect acceptable projects (with NPV higher than zero and IRR greater than weighted marginal cost of capital) to pay out large dividends. The main objective, as always, should be owner’s wealth maximization.
Also it is important to remember that whereas it is important to try not to decrease dividends to ensure that no negative signals are sent to the market, it is also important to maintain a healthy liquidity position. Organizations certainly should not borrow to be able to pay out large dividends.