In addition to the reasons discussed in Chapter for repurchasing stock, share repurchases can be undertaken as part of the firm’s dividend decision. According to the passive residual dividend policy, a firm that has more funds than it needs for investments should pay a cash dividend to shareholders. In lieu of, or in addition to, cash dividends, some firms also repurchase outstanding shares from time to time. Since the 1980s, share repurchases have become increasingly popular.
One study found that aggregate repurchases represented 26 percent of common stock earnings over the 1983–1997 period, compared with only 3 percent during the 1973–1977 period.The volume of announced share repurchases was approximately $177 billion in 1996.29 Over a 3-year period from 1995 to 1997, IBM bought back over $20 billion of its common stock.
Companies engaging in large buyback programs typically have large cash flows and an insufficient number of positive NPV investments in which to invest. For example, Quaker Oats (acquired by PepsiCo in 2001) repurchased 20 million shares during the late 1980s and early 1990s and was planning the repurchase of an additional 5 million shares.
Quaker Oats treasurer Janet K. Cooper explained, “We spend on new products, we make acquisitions, and we raise the dividend, and we still can’t soak up all the cash.”Firms that are under threat of a hostile takeover sometimes announce large share repurchase programs designed to drain “excess” cash from the firm, thereby making it a less desirable takeover target.
Procedures for Repurchasing Shares
Firms carry out share repurchase programs in a number of ways. For example, a company may buy directly from its stockholders in what is termed a tender offer; it may purchase the stock in the open market; or it may privately negotiate purchases from large holders, such as institutions.When a firm initiates a share repurchase program through a tender offer, it is, in effect, giving shareholders a put option—an option to sell their shares at a fixed price above the current market price for a limited period of time.
Repurchased shares become known as treasury stock.
Treasury stock is often used to facilitate mergers and acquisitions; to satisfy the conversion provisions of some preferred stock and debentures, as well as the exercise of warrants; and to meet the need for new shares in executive stock options and employee stock purchase plans. From the stockholders’ perspective, share repurchases increase earnings per share for the remaining outstanding shares and also increase stock prices, assuming that investors continue to apply the same price-to-earnings (P/E) ratio to the earnings per share before and after repurchase.
(Recall from Chapter that the P/E ratio is equal to the price per share divided by the earnings per share.) For example, if a stock sells for $40 per share and earns $8 per share, its P/E multiple is 5 (40/8). The P/E multiple indicates the value placed by investors on a dollar of a firm’s earnings. It is influenced by a number of factors, including earnings prospects and investors’ perceptions regarding a firm’s risk. Normally, a firm will announce its intent to buy back some of its own shares so that investors will know why there is sudden additional trading in the stock.
An announcement of repurchase is also useful to current shareholders, who may not want to sell their shares before they have had an opportunity to receive any price appreciation expected to result from the repurchase program.
Share Repurchase Example
Suppose that the Hewlett-Packard (H-P) Company (electronic equipment manufacturer) plans to distribute to its shareholders $750 million in the form of either a one-time extra cash dividend or a share repurchase. The company has expected earnings of $625 million during the coming year and approximately 250 million shares currently outstanding. The current (ex-dividend) market price of H-P stock is $50 per share.
The company can pay a one-time extra cash dividend of $3 per share ($750 million divided by 250 million shares). Alternatively, it can make a tender offer at $53 per share for 14,150,943 shares ($750 million divided by $53 per share).
If H-P decides to declare a one-time extra cash dividend of $3 per share, shareholder wealth would be $53 per share, consisting of the $50 (ex-dividend) share price plus the $3 dividend. The effect on shareholder wealth before and after the stock repurchase is shown in Table, assuming that the price –earnings (P/E) ratio remains the same at 20 ($50 stock price per share divided by $2.50 earnings per share). If H-P repurchases $750 million worth of its common stock (at $53 per share), then shareholder wealth is $53 per share, with $3 of this value representing price appreciation. Note that the pretax returns to shareholders are the same under each alternative.
Hewlett-Packard Company Share Repurchase
Ignoring taxes, transaction costs, and other market imperfections, shareholders should be indifferent between equivalent returns from cash dividends and share repurchases. In other words, the value of the firm should not be affected by the manner in which returns (cash dividends versus capital gains) are paid to shareholders. However, empirical studies suggest that share repurchases do increase stock prices (i.e., value of the firm).Some reasons why this occurs are examined next.
In the context of dividend decisions, tax considerations have historically been the primary reason why firms decided to repurchase their own stock in lieu of, or in addition to, payment of cash dividends. Because taxes on capital gains can be deferred into the future (when the stock is sold), whereas taxes on an equivalent amount of dividend income have to be paid in the current year, firms still have substantial tax reasons to make distributions in the form of share repurchases.
Although a stock repurchase program seems like a desirable way of distributing a firm’s earnings, repurchases may be deterred by the IRS. Specifically, the IRS may not permit a firm to follow a policy of regular stock repurchases as an alternative to cash dividends, because repurchase plans convert cash dividends to capital gains. The IRS looks upon regular repurchases
as essentially equivalent to cash dividends and requires that they be taxed accordingly.
Substituting discretionary stock repurchases for all or part of regular cash dividends (i.e., stable dollar dividend policy) provides a company with greater financial flexibility. Under such a strategy, when the company has profitable uses for its funds, it can defer the buyback of its stock (and the corresponding cash outflows) until a more appropriate time in the future. The company thus avoids incurring the costs associated with raising the external equity capital needed to finance investments. Likewise, when the company accumulates excess funds, it can undertake periodic stock repurchases.
Like the signaling effects of cash dividend increases, share repurchases can also have a positive impact on shareholder wealth. A share repurchase may represent a signal to investors that management expects the firm to have higher earnings and cash flows in the future.
Advantages and Disadvantages
Let us summarize the advantages and disadvantages of share repurchases as an addition to, or as a substitute for, cash dividends.
Advantages Share repurchases effectively convert dividend income into capital gains income. Shareholders in high (marginal) income tax brackets may prefer capital gains income because of the ability to defer taxes into the future (when the stock is sold). Also, share repurchases provide the firm with greater financial flexibility in timing the payment of returns to shareholders. Finally, share repurchases can represent a signal to investors that the company expects to have higher earnings and cash flows in the future.
Disadvantages A company may overpay for the stock that it repurchases. If the stock price declines, the share repurchase represents an unprofitable use of the company’s resources. Also, a share repurchase may trigger IRS scrutiny (and possible tax penalties) if the buyback is viewed as a way for shareholders to avoid taxes on cash dividends. Finally, some current shareholders may be unaware of the share repurchase program and may sell their shares before the expected benefits (i.e., price appreciation) occur.
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