Under a stock repurchase plan, a firm buys back some of its outstanding stock, thereby decreasing the number of shares, which should increase both EPS and the stock price. Unlike stock dividends and stock splits, share repurchases use corporate cash. This is an alternative way of paying cash dividends.

Shares that have been issued and subsequently repurchased become treasury shares, which are not considered for dividends, voting, or computing earnings per share.

Reasons for Share Repurchase

There are different reasons for share repurchases:

• Repurchase announcements are viewed as positive signals by investors because the repurchase is often motivated by management's belief that the firm's shares are undervalued. There is no question that the company has more information about itself than does any other entity; it is therefore the ultimate insider.
• A company can remove a large block of stock that is overhanging the market and keeping the price per share down.
• If the excess cash is thought to be only temporary, management may prefer to make the distribution in the form of a share repurchase rather than declare an increased cash dividend which cannot be maintained.
• Companies can use the residual model to set a target cash distribution level, then divide the distribution into a dividend component and a repurchase component. The company has more flexibility in adjusting the total distribution than it would if the entire distribution were in the form of cash dividends.
• In some countries the tax rate on capital gains is lower than that on cash dividends.
• Repurchases can be used to produce large-scale changes in capital structures. For example, if a firm's capital structure is too heavily weighted with equity, it can sell debt and use the proceeds to buy back stocks, thus increasing the debt ratio.

The disadvantages are:

• Stockholders may not be indifferent about dividends and capital gains (e.g., different tax treatments), and the price of the stock might benefit more from cash dividends than from repurchases.
• Repurchases normally occur in the greatest number when times are good and companies have lots of cash and, concurrently, when share prices are relatively high. The corporation may pay too high a price for the repurchased stock, to the disadvantage of remaining stockholders.

Repurchase Methods

The four most important methods are:

• Open market repurchases through a designated broker. This is the most common method of repurchase, often used to support the share price.
• Fixed-price tender offers. Usually there is a premium offered to induce shareholders to sell. If management thinks the stock is undervalued, it is willing to pay a premium.
• Dutch auction. A Dutch auction specifies a price range within which the shares will ultimately be purchased. Shareholders are invited to tender their stock at any price within the stated range. The purchase price is the lowest price that allows the firm to buy the number of shares sought in the offer, and the firm pays that price to all investors who tendered at or below that price.
• Direct negotiation with major shareholders. Shares are often acquired at a premium to the market price. One purpose is to prevent raiders from acquiring company at an attractive price.

Practice Question 1

The most common share repurchase method in the U.S. is ______.

A. open market purchase
B. fixed-price tender offer
C. direct negotiation

Correct Answer: A

It represents almost 95% of all purchases in the U.S.

Practice Question 2

Which of the following would not be considered a disadvantage of a stock repurchases?

A. They may not have the same positive effect on stock prices that a cash dividend would have.
B. They may invite lawsuits from stockholders who had insufficient information about future prospects before selling.
C. The firm may pay too high a price for the repurchased stock.
D. They signal management's perception that the company's stock is currently undervalued.

Correct Answer: D

One of the advantages of a stock repurchase is that it may signal management's perception that the firm's stock is undervalued.

Practice Question 3

Why do companies use share repurchase programs?

I. To increase share price over the long term by increasing a continuing shareholder's portion of the future cash flows
II. To optimize the company's capital structure
III. To return capital to shareholders in a more tax-efficient manner than cash dividend payouts
IV. To offset the dilutive impact of other share issuance programs such as stock option programs
V. To redeploy excess cash flow

Correct Answer: I, II, III, IV and V

Practice Question 4

In order to keep a large block of shares from overhanging the market, a company may choose to use ______ to deter a takeover attempt.

A. a Dutch auction
B. a fixed-price tender offer
C. direct negotiation

Correct Answer: C

The most notorious examples of these negotiations are greenmail transactions, which occur when the target of a takeover attempts to buy off the hostile bidder by repurchasing any shares that it has acquired.

Practice Question 5

A company may use ______ to keep a large block of shares from overhanging the market (and thus dampening the share price).

A. a Dutch auction
B. a fixed-price tender offer
C. direct negotiation

Correct Answer: C

A company may try to prevent an activist shareholder from gaining representation on the board of directors.