Why companies purchase their shares back

Why companies purchase their shares back

Share repurchasing has become a headline in number of instances. And you and I of course wonder why on earth a company should buy back its shares after issuing it. There are many reasons behind it,

• If the shares are undervalued

If the shares are undervalued the company could increase the value by repurchasing the shares at a higher price.

• The company is at the risk of being taken over

Despite the fact that the company is performing well, if a competitor approaches the share owners of the company and offer them a better price for their share they would be compelled to buy those shares.

But if this is not in line with the best interest of the company, the company can repurchase the shares back to the company and make it private equity.

• Optimize future dividends

The company has done well in a particular year and increased dividend in the year would require company to increase the dividend in the future years as well. And the company thinks that there are better investment opportunities to maximize share holder wealth, it might decide to repurchase a proportion of shares so that future dividend would be optimized.

This could be further analyzed using an example,

Maintains a constant payout ratio, (http://sajithexplains.blogspot.com/2010/05/one-of-methods-of-maximizing-share.html) of 50%, and the number of share holders are 10000. And the profit is $10M

Dividend per share = 10 000 000 * 50%

10 000

= $ 500

If the company buys 2000 of the shares,

Dividend per share = 10 000 000 * 50%

8000

= $ 625

Because the company had purchased 2000 shares, the dividend per share ratio has improved and also the earning per shares. Because of these improvements the market value of the shares would automatically increase.

Why do share holders like this???

• Share repurchase is normally done at a higher value than the current market value, hence share holders can gain instant capital gain
• There is a signaling effect to the market the share has been undervalued and hence would attract potential share holders as well.

So when you see news of a company repurchasing shares, dont get all excited.. just remember these points... :D

One of the methods of maximizing share holder wealth

As we all know, the main objective of the existence of any business is maximizing the wealth of the share holders. For a listed company there are mainly two main methods,

1. Capital gains - The gain due to the increase in share price

2. Dividends - explained

Dividends decision is very important for any company because it is a realized gains for share holders in compared with capital gains after selling the shares, there are mainly four main policies which could be identified,

a) Constant dividend policy - There is no rocket science, as the name implies it is a dividend policy where a company decides to pay a constant amount each year, for instance 50 cents for $10 share.

Pros - This would quite attracting for pensioners who can be reliant on a constant return for the investment.

Cons - Even if the company is achieving sky rocketing profit levels, still the share holders would not be able to gain from the increased profits. And also it is a fact that we cannot buy what we buy for 50 cents in a years time hence this policy does not consider time value for money.

b) Constant growth in dividends - The dividend amount increases yearly at a constant percentage. ex: The company would increase the dividend by 5% each year.

In three years time = 50 cents* 1.05*1.05*1.05 = 58 cents

This method mainly focuses on giving a time value for money. Yet in an instant where the companies making high profits, this does not increase the profits.

c) Constant pay out ratio - Under this method there is a constant ratio that will be distributed. For example if the pay out ratio is 40%, then an instance where the company makes a profit of $1 million, the share holders would be awarded with 0.4m. Under this method when the company is earning high profits the dividend would also increase proportionately. But when the company does not make any profit neither the share holder will earn any dividend

d) Residual dividend policy - This policy is the most famous amongst companies. This is where a company keeps the amount needed for future investments and distribute the rest to its share holders. It is very simple even in our life, when we get our salary we keep the amount that we would need for the months expenditure, and we save the rest in a savings account or invest.

A company has to make the most suitable dividend policy with intention of maximizing share holder wealth.

Weighted average cost of capital - Rocket science

For some of you, the person that you most hate in the organization is the accountant... Simply because he goes on crumbling about cost cutting.. and dashing out words like weighted average cost of capital... showing off is his vocabulary, building his personality and standing at a high position in the company and get paid....

lets try to understand whether this WACC is really a rocket science.....

What is cost of capital.... The cost of capital is simply the additional the things that you have to give to get money.... In simple terms to earn a salary to live, we have to spend sleepless nights spending times at the office....

In that simple scenario,

- Investment/funding requirement is to live

- cost of that capital is the hard work that we do(the portion that is actually beyond the preconditioned work), to get that money....

In a balance sheet language, to fund the fixed assets and the net working capital, what is the additional interest that we pay on Equity and Debt.

The share holders expected return on Equity is the cost of equity(Ke),

The interest rates that should be paid to gain a loan is the cost of debt(Kd), the other important thing when it comes to interest is, it is tax deductible(See the P &L of your company). Hence the original cost of debt should be, Kd(100%-t%)

When evaluating a project it is important that a company's WACC is used to reflect how much would be the cost of debt and cost of equity. Because those to are the only financing sources a company has mainly.

Hence to get an average figure = The Total cost of capital

The total capital

Capital generated from equity = Ve

Capital generated from debt = Vd

Total capital generated = Vd + Ve

Cost of equity = Ve*Ke

Cost of debt = kd*(100%-t%)*Vd

Total cost of capital = Ve*Ke + kd*(100%-t%)*Vd

WACC = Ke*Ve + Kd*(100%-t%)*Vd

Vd+Ve

So the next time your accountant tries to full you with greekish words like WACC, don't forget to ask him to deduct taxation when you take into account cost of debt..... :D

EQUITY VE	FIXED ASSETS
DEBT VB	NET WORKING CAPITAL