Buy Back of Shares/ premium buyback
Buy-back of shares is a method of financial engineering. It can be described as a procedure which enables a company to go back to the holders of its shares and offer to purchase the shares held by them.Buy-back helps a company by giving a better use for its funds than reinvesting these funds in the same business at below average rates or going in for unnecessary diversification or buying growth through costly acquisitions.
When a company has substantial cash resources, it may like to buy its own shares from the market particularly when the prevailing rate of its shares in the market is much lower than the book value or what the company perceives to be its true value.
This mode of purchase is also called ‘Shares Repurchase’. A company can utilize its reserves to buy-back equity shares for the purpose of extinguishing these or treasure operations. The former option results in reduction of the paid up capital, and consequently higher earnings and book value per share. Naturally, the market price of equity goes up.
The reduction in share capital strengthens the promoter’s control and enhances the equity value for shareholders. In the latter option, companies buy their shares from open market and keep these as ‘treasury stock’.
This enables the promoters to strengthen their control over the shares bought back, without any investment of their own. In case of treasure operations, there is a diversion of company’s funds to buy shares and reduction in the value of equity for the shareholders.
The main aim of shares repurchase might be reduce the number of shares in circulation in order to improve the share price, or simply to return to the shareholders resources no longer needed by the company.
The shares repurchase may be by way of purchase from the open market or by general tender offer to all shareholders made by the company to repurchase a fixed amount of its securities at pre-stated price.
Reasons for Buy-Back:
There are reasons why a company would opt for buy-back:1. To improve shareholder value, since buy-back provides a means for utilizing the companies surplus funds which have unattractive alternative investment options, and since a reduction in the capital base arising from buy-back would generally results in higher earnings per share (EPS).
2. It is used as a defense mechanism, in an environment where the threat of corporate takeovers has become real. Buy-back provides a safeguard against hostile take-over by increasing promoter’s holdings.
3. It would enable corporate to shrink their equity base thereby injecting much needed flexibility.
4. It improves the intrinsic value of the shares by virtue of the reduced level of floating stock.
5. It would enable corporate to make use of the buy-back shares for subsequent use in the process of mergers and acquisitions without enlarging their capital base.
6. Buy-back of shares is used as a method of financial engineering.
7. It is used for signaling the effects of buy-back on the share price.
Financing Aspects of Buy-Back:
Finance is the nerve centre for the business activities and success is more depending on the better and efficient management of funds and finance. In order to buy-back of shares and securities in large numbers, the company needs huge amounts of capital and funds which may be mobilized through one or more of the sources viz.1. Internal sources
2. Sufficient cash position
3. Selling of temporary investment with the least possible loss
4. Raising of working capital needs
5. Raising cash by issuing fixed deposits
6. Raising by issue of debentures and loan bonds
7. Cash credit from commercial banks
8. Overdraft from commercial banks etc.
Benefits of Buy Back:
The benefits derived from share repurchase program are as follows:1. Firms whose profitability was below their industry average enjoy greater share price growth after shares are repurchased than firms whose profitability was above their industry average.
2. Firms whose sales growth was below their industry average enjoy greater share price growth after shares are repurchased than firms whose sales growth was above their industry average.
3. Profitable and growth firms that repurchase shares provide a clear indication to the investors about the strengths of the company.
4. Repurchasing firms with debt ratios below but sales growth rates above their industry average experience substantially higher share price growth after repurchasing than firms with debt ratios above but sales growth below their industry average.
5. Repurchasing firms with profitability and debt ratios below their industry average demonstrate higher share price growth after repurchasing than firms with profitability and debt ratios above their industry average.
Drawbacks of Buy Back:
The shares repurchase is criticized for the following reasons:1. This could enable unscrupulous promoters to use company’s money to raise their personal stakes.
2. It opens up possibilities for share price manipulation.
3. It could divert away the company’s funds from productive investments.
