SET-3 CASE

Share repurchase (or stock buyback) is the re-acquisition by a company of its own
stock.[1] It represents a more flexible way (relative to dividends) of returning money to
shareholders

Why would a company

buyback its own shares?
By Investopedia
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A:
Stock buybacks refer to the repurchasing of shares of stock by the company that
issued them. Essentially, a buyback occurs is when the issuing company pays
shareholders the market value per share and re-absorbs that portion of its
ownership that was previously distributed among public and private investors.
Since companies raise equity capital through the sale of common and preferred
shares, it may seem counter-intuitive that a business might choose to give that
money back. However, there are numerous reasons why it may be beneficial to a
business to repurchase its shares, including ownership consolidation,
undervaluation and boosting financial ratios.
Each share of common stock represents a small stake in the ownership of the
issuing company, including the right to vote on company policy and financial
decisions. If a business has a managing owner and one million shareholders, it
actually has 1,000,001 owners. Companies issue shares to raise equity capital to
fund expansion, but if there are no potential growth opportunities in sight, holding

on to all that unused equity funding means sharing ownership for no good
reason. Shareholders demand returns on their investments in the form of
dividends called the cost of equity capital so the business is essentially
paying for the privilege of accessing funds it isn't using. Buying back some or all
of the outstanding shares can be a simple way to pay off investors and reduce
the overall cost of capital.
Another major reason why businesses repurchase their own shares is to take
advantage of undervaluation. Stock can be undervalued for a number of reasons,
often due to investors' inability to see past a business' short-term performance or
sensationalist news items. If a stock is dramatically undervalued, the issuing
company can repurchase some of its shares at this reduced price and then reissue them once the market has corrected, thereby increasing its equity capital
without issuing any additional shares. For example, assume a company issues
100,000 shares at $25 per share, raising $2.5 million in equity. An ill-timed news
item questioning the company's leadership ethics causes panicked shareholders
begin to sell, driving the price down to $15 per share. The company decides to
repurchase 50,000 shares at $15 per share for a total outlay of $750,000 and
wait out the frenzy. The business remains profitable and launches a new and
exciting product line the following quarter, driving the price up past the issuing
price to $35 per share. After regaining its popularity, the company reissues the
50,000 shares at the new market price for a total capital influx of $1.75 million.
Because of the brief undervaluation of its stock, the company was able to turn
$2.5 million in equity into $3.5 million without further diluting ownership by issuing
additional shares.
Buying back stock can also be an easy way to make a business look more
attractive to investors. By reducing the number of outstanding shares, a
company's earnings per share ratio is automatically increased. In addition, shortterm investors often look to make quick money by investing in a company right
before a scheduled buyback. The rapid influx of investors artificially inflates the
stock's valuation and boosts the company's price to earnings ratio.

ADVANTAGES AND ISSUES ASSOCIATED WITH

SHARE BUYBACK
Benefits of Stock Buybacks
Increased Shareholder Value - There are many ways to value a profitable company but
the most common measurement is Earnings Per Share (EPS). If earnings are flat but
the number of outstanding shares decreases. . Voila! . . A magical increase in period-toperiod EPS will result.
Higher Stock Prices - An increase in EPS will often alert investors that a stock is
undervalued or has the potential for increasing in value. The most common result is an
increase in demand and an upward movement in the price of a stock.
Increased Float - As the number of outstanding shares decreases, the shares remaining
represent a larger percentage of the float. If demand increases and there is less supply,
then fuel is added to a potential upward movement in the price of a stock.
Excess Cash - Companies usually buy back their stock with excess cash. If a company
has excess cash, then at a minimum you can bank that it doesn't have a cash flow
problem. More importantly, it signals that executives feel that cash re-invested in the
corporation will get a better return than alternative investments.
Income Taxes - When excess cash is used to buyback company stock, in lieu of
increasing or paying dividends, shareholders often have the opportunity to defer capital
gains AND lower their tax bill if the stock price increases. Remember that dividends are
taxed as ordinary income in the year they are received whereas the sale of appreciated
stock is taxed when sold. Also, if the stock is held for more than one year the gain will
be subject to lower capital gain rates.
Price Support - Companies with buyback programs in place use market weakness to
buy back shares more aggressively during market pullbacks. This reflects confidence
that a company has in itself and alerts investors that the company believes that the
stock is cheap. Frequently you will see a company announce a buyback after its stock
has taken a hit, which is merely an overt action to take advantage of the discount on the
shares. This lends support to the price of the stock and ultimately provides security for
long-term investors during rough times.
Now that we've shown a few reasons to be bullish on "buyback stocks," should you go
out and buy every buyback you can find? Definitely not. Not all buybacks are equal and
some buybacks seem to be nothing more than an attempt to manipulate the stock price.

Potential Pitfalls
Manipulation of Earnings - Above we described how a buyback improves the earnings
per share number. Analysts rate stocks on many factors, but one of the most important
numbers is the Earnings Per Share. Assume that an analyst estimates earnings using a
higher number of outstanding shares existing before a buyback is executed. If the timing
is right, companies could buyback shares and appear to beat consensus estimates that
were based on a larger number of outstanding shares. So, watch out for
announcements just prior to earnings.
Buyback Percentage - The higher the percentage of the buyback, the greater the
potential for profits. Unfortunately, the buyback percentage is not typically part of an
announcement so in order to determine if there is any significance to the announcement
you'll need to do some research. Don't assume that a large number of shares is
necessarily a large percentage.
Execution of Buyback - There is a difference between announcing a buyback and
actually purchasing the stock. A buyback announcement may initially boost the price of
a stock, but this phenomenon (when it occurs) is usually short lived. Don't be fooled into
believing that all announcements are implemented. A good portion of announced
buybacks are not executed in full.
High Stock Prices - Beware of a buyback program announced when a stock is at or
nearing an all-time high. A stock buyback can be used to manipulate less than desirable
EPS expectations. One way of investigating this is to compare the P/E (Price/Earnings)
ratio relative to other stocks in the sector or industry. If a higher than normal P/E ratio
exists, then it doesn't make a whole lot of sense for a company to buy it's stock at a
premium unless there is something in the works that will add substantially to earnings.

Do Buybacks Destroy
Shareholder Value?
[ANALYSIS]
By Rupert Hargreaves on July 15, 2014 10:40 am in More Top Stories

There is nothing that divides the investment community more than share buybacks.

However, despite the wealth of information, and studies on the benefits/drawbacks of

repurchases, a solid universal conclusion has remained elusive.

Opposition to buybacks
In the UK, buybacks are generally considered a waste of shareholder funds. British
investors prefer their investments to pay hefty dividends. Many reasons are
citied against the use of buybacks:

The stock market is supposed to be a long-term compounding machine. Replace

dividends with buybacks and compounding takes a hit.

As an executive with a compensation plan linked to share performance, if you buyback

and bump the share price up, your options are suddenly worth more.

Buybacks destroy shareholder funds.

They offer a disproportionate benefit to employees via share options.

They represent the gradual expropriation of shareholder assets and the regular
misallocation of capital.

They enrich the investment banks

Surprisingly, the British hold a negative view against buybacks despite their tax
advantages the UK has one of the highest income tax rates in the world.
Dividends are subject to double taxation on both corporate profits and at the investors
marginal rate. In comparison, buybacks have tax advantages.
If debt is used to buy back stock, interest payments are tax deductible, reducing the tax
bill. Further, the investor has no additional tax to pay. A back-of-the-envelope sum; $100
of corporate profit taxed at 35% = $65 paid out to investors as a dividend, is then taxed
at a further 30%, reducing the profit paid out to $45.5 a near 55% reduction.

Do buybacks really destroy value?

The main argument against the use of buybacks, as mentioned above, is the
destruction of shareholder value. But is this really the case?
The Real Effects of Share Repurchases, was a study conducted at the University of
Illinois last year. The study attempted to study the consequences of repurchases
motivated by earnings management and whether or not the buyback destroyed
shareholder value.
The study quotes several previous papers, which found that; repurchases can be used
to hit earnings targets; cash-rich companies tend to generate greater abnormal
announcement returns when starting new repurchase programs; managements use
repurchases to reverse the dilutive effect of stock options; CEOs with shorter pay
duration are more likely to repurchase shares following good stock performance.
However, The Real Effects of Share Repurchases study finds that EPS-motivated
repurchases are not detrimental to ?rm performance. Whats more, it was found that
while companies are willing to trade-o? employment and investment for stock
repurchases, this trade-o? does not appear to be detrimental to ?rm performance and
shareholder value.

Intrinsic Value and Buybacks

On a basic level, a company is creating value when it buys back shares
below their intrinsic value. Conversely, it destroys value when it buys back
shares above their intrinsic value. This is simple enough, but companies very
rarely view buybacks in these terms.