SHARE REPURCHASE

Outlines:
1. Share repurchase mean.

2. Reasons for share repurchase.

3. Ways to share repurchase.

4. How dividend is determined.

5. Dividend policy controversy.

6. Corporate valuation and share repurchase.

7. Implication.

8. Conclusion.

1) Share Repurchase Mean: A program by which a company buys back its own shares from
the marketplace, reducing the number of outstanding shares. This is usually an indication that
the company's management thinks the shares are undervalued.

 An alternative to cash dividend

 A company's plan to buy back its own shares from the marketplace, reducing the
number of outstanding shares

 Re-acquired shares are kept and can be resold

 Dividends are taxed as ordinary income, but stockholders who sell shares back to firm
pay tax only on capital gains realized from the sales

2) Reasons For Share Repurchase:

 If shares are perceived to be undervalued

 A company has no need for free cash flow (not always)

 To generate more income for new projects or line of business

 To buyout troublesome stockholders

3) Ways To Repurchase Shares:
 Open market
 Direct negotiations
 Greenmail transactions

4) How Dividends Are Determined:

John LINTNER (1956)
Most common approach. It can be summarised thus:
 Firm has long-run target dividend payout ratios
 Managers focus more on dividend changes than on absolute levels
 Dividend changes follow shifts in long-run, sustainable earnings
 Managers are reluctant to make dividend changes that might have to be
reversed The model

DIV1 = target dividend

= target ratio x EPS

Dividend change would equal

DIV1 – DIV0 = target change

= target ratio x EPS1 – DIV0

 For firms with target payout ratio, her dividends will have to change whenever
earnings changes
 Model suggests that dividend depends in part on the firm’s current earnings and
on the dividend for the previous year, which in turn depends on that of the
previous year
 If Lintner is correct, we can describe dividends in terms of a weighted average of
current and past earnings
 Although the Lintner analysis is fairly okay, it should also take into account future
prospects as well as past achievements when setting the payment
5) The Dividend Policy Controversy:

The controversies about dividend policy irrelevance or otherwise, boils down to

imperfection of the markets, inefficiencies etc.

Leftists
 This is the radical school
 Dividend policy is irrelevant
 Whenever dividends are taxed more heavily than capital gains, firms pay the
lowest cash dividend they can get away with. Available cash should be retained
or used to repurchase shares
 By shifting their distribution policies in this way, corporations can transform
dividends to capital gains

Rightists

 Believe that dividend policy matters!!!

 It is KEY in the business and investment communities
 Stockholders/investors continually pressurize treasurers to increase dividend
 Yes, the recipient of an extra cash dividend forgoes an equal capital gain, but if
the dividend is SAFE and the capital gain is RISKY, isn’t it the stockholder ahead?
 Again, dividend policy are more predictable than capital gain. Managers can
stabilize dividends but they cannot control stock price
 Can managers be trusted to spend retained earnings judiciously?
Larger empire or profitable firm, which is best?

Ignores risk of MM(Miller and Modligliani published a theoretical paper highlighting the
irrelevance of the dividend policy in a world without taxes, transaction costs and other
imperfections. They are said to be founders of the middle-of-the-road (MOTR) theory)

 For MM, dividends are cash in hand while gains are at best in the bush, but if the
dividend is safe and the capital gain is risky, isn’t the shareholder ahead?
 True, dividends are more predictable than capital gains. Managers can stabilize
dividends but they cannot control stock price
 A dividend increase leads to a transfer of ownership. This means they have
traded safe receipt for an uncertain future gains
 6) Corporate Valuation and share repurchase:
Valuation is very important in Capital Structure analysis.
Various methods are used:
 Discounted cash flow,
 Price earning multiple, and
 Net asset value.
Hypothetical Example:
Scenario I
 Company X has 100 shares outstanding. It earns $1000 a yr
 Pays all out as dividend
 Dividend per share $1000/100 = $10
Suppose that investors want the dividend to be maintained
indefinitely, and return should be 10 percent. What happens?
 Pv Share = $10/0.1 = $100
Since there are 100 shares outstanding, the total market value of the
equity is
 Pv Equity = 100 x $100 = $10,000
Discounting cash flow method will also give the same result
(Pv Equity= $1,000/0.10 = $10,000)

Suppose, the company decides that instead of paying cash dividend, it will spend the money on
repurchasing its shares. The expected cash flows to share holders (dividends and cash from
repurchase) are unchanged at $1,000.

 Dividend = $1000/90.91 = $11 per share

So after the repurchase, shareholders have 10 percent fewer shares, but earnings and dividends
per share are 10 percent higher.

Hence, an investor who owns one share today that is not repurchased will receive no dividends
in year 1but can look forward to $11 a year after.

The value of each share is therefore:

11/(0.1x1.1) = $100

Hence, total value of equity also remains $1,000/(0.1) = $10,000.

Now think about those shareholders who plan to sell their stock back to the company. They will
require an ROI of say 10 percent. So the price for buy backs must be $110.
The company starts with 100shares, it buys back 9.09, and therefore 90.91 shares remain
outstanding.

7) Implications:
 Company value is unaffected by the decision to repurchase stock rather than to
pay a cash dividend

 When valuing the entire equity you need to include both the cash that is paid out
as dividends and the cash that is used to repurchase stock

 When calculating the cash flow per share, it is double counting to include both
the forecasted dividends per share and the cash received from share repurchase

 A firm that repurchases stock instead of paying dividends reduces the number of
shares outstanding but produces an offsetting increase in earnings and dividends
per share

8) Conclusion:
 Share repurchase is mostly common in the United states. Not all share
repurchase announcement is completed
 It is illegal not to complete share repurchase program
 Although, share repurchase is not a substitute for dividend, investors usually
interpret it, as an indication of optimism
 If we live in an ideal and perfect world, then choices will not matter. The
controversy centers on our flawed world
 Dividend policy actions by companies is usually a reflection of the shareholders’
preferences
 The middle stance of the road proponents seem quite appealing but information
content is usually misinterpreted