FMT2 - Session 2: Pradeepta Sethi Tapmi

FMT2 Session 2
Pradeepta Sethi
TAPMI
Stock repurchases
Buying own stock back from stockholders.
Distributing cash to existing shareholders.
Reduction in the cash balance.
Reduces the book value of equity.
Reduces the number of shares outstanding.
Profit per share increases.
Once repurchased, the shares become treasury

stock.
Why repurchase stock?
Investor tax argument
Leverage hypothesis
Uncertainty about the ability to continue generating these

cash flows in future periods
A repurchase is a signal that stock is underpriced.
Executive compensation is often affected by share buybacks.
Increasing insider control in firms.
Supporting stock prices when they are declining.
Allow to maintain flexibility for future periods.
Share Repurchase Methods

Buy in the
Open Market
Fixed Price
Tender Offer
Dutch Auction
Tender Offer
Direct
Negotiation
Use brokers to
buy shares.
Method
provides
flexibility for
the company.
Specify the
number of
shares and the
share price.
Buy pro rata if
oversubscribed
.
Specify the
number of
shares and the
range of
prices.
Shareholders
determine the
number of
shares they will
sell back and
specify the
price within the
range.
Negotiate with
a specific
shareholder.
Method may
be used to
prevent
activist
shareholder
from getting on
board.
SEBI regulations
No offer of buy-back for 15% or more of the paid up capital

and free reserves of the company shall be made from the
open market.
Shall not make any offer of buy-back within a period of one

year reckoned from the date of closure of the preceding offer
of buy-back.
Put 25% of the amount earmarked for buyback in an escrow

account and to complete their share purchase offer within six
months.
Companies to purchase at least 50% of the offer size, failing

which they will have to forfeit 2.5% of the total amount
earmarked.
Advantages of stock
repurchases
Stockholders can tender or not.
Helps avoid setting a high dividend that cannot be

maintained.
Repurchased stock can be used in takeovers or

resold to raise cash as needed.
Income received is capital gains rather than highertaxed dividends.
Stockholders may take as a positive signal-management thinks stock is undervalued.
Disadvantages of stock
repurchases
May be viewed as a negative signal (firm has poor

investment opportunities).
Could attract penalties if repurchases were primarily

to avoid taxes on dividends.
Selling stockholders may not be well informed,

hence be treated unfairly.
Firm may have to bid up price to complete

purchase, thus paying too much for its own stock.
Dividends or Repurchases?
Original balance sheet
Assets
Liablities & Equity
Cash
Rs. 1,50
Debt
Other Assets
Rs. 8,50
Equity
Rs. 1,000
Value of firm
Rs. 1,000
Value of Firm
Rs. 1,000
Share outstanding = 100

Price per share= Rs.1,000/100 = Rs. 10
After cash dividend of Rs. 100
Assets
Liablities & Equity
Cash
Rs. 50
Debt
Other Assets
Rs. 8,50
Equity
Rs. 9,00
Value of firm
Rs. 9,00
Value of Firm
Rs. 9,00
Share outstanding = 100

Price per share=Rs.9,00/100 = Rs.9
Rs. 1 as dividend
After stock repurchase of Rs. 100
Assets
Liablities & Equity
Cash
Rs. 50
Debt
Other Assets
Rs. 8,50
Equity
Rs. 9,00
Value of firm
Rs. 9,00
Value of Firm
Rs. 9,00
At Rs. 10/- share, we could buy 100/10=10 shares

Shares outstanding= 100-10 =90
Price per share=Rs.9,00/90 = Rs.10
Share repurchase and

Earnings Per Share
The Happy New Year Corporation is planning a Rs100
lakh share repurchase. Its current stock price is Rs 25 per
share, and there are 16 lakh shares outstanding prior to
the repurchase. Earnings per share without the
repurchase would be Rs. 3 per share. What is the
earnings per share under each of these two scenarios?
Scenario 1:
Scenario 2:
Use idle cash on hand.

Borrow funds at after-tax rate of 7%.

Earnings Per Share
Scenario 1:
Net income = Rs.3 Rs16 lakhs = Rs. 48 lakhs
l EPS Scenario 1 = Rs.48 lakhs (16 lakhs 4
lakhs) = Rs.4 per share
l
Scenario 2:
Net income = Rs.3 16 lakhs (0.07 Rs.100
lakhs) = Rs.41 lakhs
l EPS Scenario 2 = Rs.41 lakhs (16 lakhs 4
lakhs) = Rs.3.41 per share
l

Earnings Per Share
After-tax borrowing rate = 7%

Earnings yield = Rs.3 Rs. 25 = 12%
After-tax borrowing rate < Earnings yield
Whether EPS , or :
If the after-tax borrowing rate = earnings yield, EPS
unchanged from buyback financed with debt.
If the after-tax borrowing rate < earnings yield, EPS
increases.
If the after-tax borrowing rate > earnings yield, EPS
decreases.
If
l
l
The tax consequences of dividends and capital gains are

the same and
The information content of cash dividends and stock
repurchases is the same,
Then the effects of cash dividends and repurchases on

shareholder value will be the same.
Both cash dividends and stock repurchases:
l
l
l
Reduce assets by the amount of the dividend or

repurchase.
Reduce equity by the amount of the dividend or
repurchase.
Provide investors with the same cash flow.
Choosing between dividends &

repurchases
Sustainability and stability of excess cash flow.
Stockholder tax preferences
Predictability of future investment needs
Undervaluation of the stock
Management compensation
Dividend Policy Survey 2004
Dividend Policy Survey 2004
Summary of views about payout

policy

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FMT2 Session 2

Buying own stock back from stockholders.

Distributing cash to existing shareholders.

Reduction in the cash balance.

Reduces the book value of equity.

Reduces the number of shares outstanding.

Profit per share increases.

Once repurchased, the shares become treasury

Why repurchase stock?

Investor tax argument

Uncertainty about the ability to continue generating these

A repurchase is a signal that stock is underpriced.

Executive compensation is often affected by share buybacks.

Increasing insider control in firms.

Supporting stock prices when they are declining.

Allow to maintain flexibility for future periods.

Share Repurchase Methods

No offer of buy-back for 15% or more of the paid up capital

Shall not make any offer of buy-back within a period of one

Put 25% of the amount earmarked for buyback in an escrow

Companies to purchase at least 50% of the offer size, failing

Stockholders can tender or not.

Helps avoid setting a high dividend that cannot be

Repurchased stock can be used in takeovers or

Income received is capital gains rather than highertaxed dividends.

Stockholders may take as a positive signal-management thinks stock is undervalued.

May be viewed as a negative signal (firm has poor

Could attract penalties if repurchases were primarily

Selling stockholders may not be well informed,

Firm may have to bid up price to complete

Liablities & Equity

Share outstanding = 100

Liablities & Equity

Share outstanding = 100

Liablities & Equity

At Rs. 10/- share, we could buy 100/10=10 shares

Share repurchase and

Use idle cash on hand.

Share repurchase and

Share repurchase and

After-tax borrowing rate = 7%

The tax consequences of dividends and capital gains are

Then the effects of cash dividends and repurchases on

Reduce assets by the amount of the dividend or

Choosing between dividends &

Sustainability and stability of excess cash flow.

Stockholder tax preferences

Predictability of future investment needs

Undervaluation of the stock

Dividend Policy Survey 2004

Dividend Policy Survey 2004

Summary of views about payout

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