Share buy-backs

The issue of share buy-backs is part of a wider discussion on dividend policy within financial management.

If a company wishes to return a large sum of cash to its shareholders, then it might consider a share buy-back (or repurchase) rather than a one-off special dividend.

Such shares are then canceled by the company.

When would a company use a share buy-back?

It often occurs when the company:

• has no positive NPV projects
• wants to increase the share price [cosmetic exercise]
• wants to reduce the cost of capital by increasing its gearing.
• wants to give a positive signal to the market. In the real world, since the directors have more information than the investors about the firm's financial position, buying the shares gives a signal to investors that the shares currently represent good value for money.

Why would a company use a share buyback

Advantages

• Giving flexibility where a firm's excess cash flows are thought to be only temporary. Management can make the distribution in the form of a share repurchase rather than paying higher cash dividends that cannot be maintained.
• Increasing EPS through a reduction in the number of shares in issue.
• Effective use of surplus funds where growth of business is poor, outlook is poor (i.e. adjusting the equity base to a more appropriate level).
• Buying out dissident shareholders.
• Creation of a 'market' where no active market exist for its shares (e.g. if the company is unquoted).
• Altering capital structure to reduce the cost of capital.
• Reducing likelihood of a takeover.

For the shareholders, advantages might include:

• Giving a choice, as they can sell or not sell. With cash dividend shareholders must accept the payment and pay the taxes.
• Saving transaction costs.

Constraints

Constraints might include:

• Getting approval by general meeting (arguments about the price at which repurchase is to take place).
• The company may pay too high a price for the shares.
• The shareholders may feel they have received too small a price for their shares.
• Premiums paid are set first against share premium and then against distributable profits (if against distributable profits, this will reduce future dividend capacity).
• Might be seen as a failure of the current management/company to make better use of the funds through reinvesting them in the business.
• Shareholders may not be indifferent between dividends and capital gains due to their tax circumstances.

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