Share repurchases are cash offers for outstanding shares of common stock Share repurchases change the book capital structure of the firm by reducing the amount of common stock

1. Share Repurchases

2. Introduction
• Share repurchases are cash offers for
outstanding shares of common stock
• Share repurchases change the book
capital structure of the firm by reducing
the amount of common stock

3. • Effects on leverage ratio
– Leverage ratio increases because the
amount of common stock is reduced
– Leverage ratio is magnified if excess cash,
which is used to extinguish common stock,
is no longer deducted from debt to
measure leverage ratio
– If additional debt is used to buy common
stock, similar magnification of leverage
ratio

4. • Some factors in the growth of share
repurchases
– Tax savings
• Cash dividends subject to maximum individual
tax rate of 39.6%
• Returns of cash from share repurchases may
qualify for long-term capital gains rate of 20%
– Timing of taxes
• Shareholders can choose whether or not to
participate in a buyback program
• Shareholders can choose to defer tax payments

5. – Management incentives
• Share repurchases increase the percentage
ownership of the firm for nonparticipants such as
officers and directors
• Incentives of officers and directors to think as
owners will be strengthened
• Reduce agency problems
– Management responsibility
• Returning excess cash to shareholders may
demonstrate that officers and directors acted in
the best interest of shareholders
• Shareholders' trust in their officers and directors is
strengthened because excess funds were not
used for negative NPV investments

6. – Undervaluation signal
• Non-participation of officers and directors in
buyback programs may signal that stock price is
undervalued
• Cash flows are likely to increase in the future
– Sharp price declines
• After sharp decline in the stock market in
October 1987, many firms initiated substantial
share repurchase programs
• Share repurchases represent a statement by
management that overall market decline did not
justify the sharp drop in their firm's share price
• Special case of undervaluation scenario

7. – Greater flexibility
• Market rewards a history of consistent increases
in dividends and punishes company that fails to
do so
– Patterns of dividend behavior by individual firms are
established over time
– Earnings rise with fluctuations while dividends
increase in a stair step fashion with a lag behind
growth in cash flows
• In share repurchases, the expectation is that
cash will be returned to shareholders when
funds are available in excess of needs to finance
sound investment programs

8. – Accounting treatment
• Accounting for shares repurchases
– Reduce (debit) shareholders' equity account
• Accounting principles permit charge at cost or market
• Common practice is to charge the actual amount paid for
shares (at market)
– Reduce (credit) cash by the required outlay
• Accounting effect after share repurchase
– If net income remains at the same level, EPS increases
– If P/E ratio remains at the same level, market price per
share will rise and market capitalization will remain the
same
– Book value per share will decrease since book
shareholders' equity decreases by more than book value
of shares when market to book ratio is greater than 1
– Return on book equity will increase

9. – Debt to equity ratio
• Share repurchases increase leverage ratio
• Share repurchases could be used to move the
firm toward its target debt leverage ratio
– Offset stock options
• Stock options increasingly used in executive
compensation programs and in employee
incentive plans
• Exercise of stock options increases firm's
shares outstanding creating downward
pressure on the firm's stock price
• Share repurchases can be used to offset the
potential dilutive effect of stock options

10. – Takeover defenses
• Share repurchase price may be viewed more
favorably than takeover price
• Share repurchase may cause takeover bidders
to offer a higher premium
– When a firm tenders for 10% or 20% of its shares,
shareholders who offer their shares are those with the
lowest reservation prices
– Shareholders who did not tender have the highest
reservation prices
– In order for takeover bidder to succeed, he must offer
a higher premium to the remaining higher reservation
price shareholders
– Required higher premium may deter potential bidders

11. Types of Share Repurchase
Fixed Price Tender Offers
• Tender offer
– Company sets number of shares it is offering
to purchase
– Company sets price at which it will
repurchase shares
– Company sets period of time offer will be
open
– Officers and directors of repurchasing firm
do not participate in tender offer

12. • Tender price
– Average 20% over prevailing market price
– Tendering shareholders receive full tender
offer price
• Tendering shareholders pay no brokerage fees
• Company pays any transfer taxes levied
• Number of shares
– Offer specifies maximum number of shares
the firm will buy

13. – If oversubscription
• Company may buy pro rata basis from all
tendering shareholders up to a maximum
• Company may buy all tendered shares
– If undersubscription
• Company buys all shares tendered
• Company may cancel offer if it includes a
minimum acceptance clause
• Company may extend offer period
• Company purchases shares offered during
extension period either pro rata or on basis of
order in which shares are offered

14. • Stock repurchase model
– Assumptions
• Efficient markets — prices reflect all publicly
available information
• Informationally efficient market — information is
costless and is received simultaneously by all
• Perfectly competitive securities markets —
individuals are price takers
• Wealth-maximizing investors
• Homogeneous expectations
• Maximum limit offers
• Price changes are net of market-wide effects

15. – Model variables
• Po = preannouncement stock price
• PT = tender price
• PE = postexpiration share price
• No = preannouncement number of shares
outstanding
• NE = postexpiration number of shares outstanding
• W = shareholder wealth effect
• FP = fraction of shares repurchased = (No - NE)/No
• 1 - FP = fraction of untendered shares = NE/No

16. – Model
PE NE = Po No - PT (No - NE ) + W (18.1)
• Total share value postexpiration (PE NE) is equal to:
– total share value preannouncement (Po No)
– minus the total value of shares repurchased [PT (No - NE)]
– plus the change in shareholder wealth associated with the
repurchase offer (W )

17. • In rate of return form
W/(No Po) = FP [(PT - Po)/Po]
+ (1 - FP)[(PE - Po)/Po] (18.2)
• Total return associated with repurchase,
W/(No Po) is made up of two components
– Return received by tendering shareholders, weighted by
percent of shares purchased, FP[(PT - Po)/Po]
– Return received by nontendering shareholders,
weighted by percent of nontendering shares,
(1 - FP)[(PE - Po)/Po]

18. • Empirical studies
– General patterns
• Initial premium = (PT - Po)/Po = 15-25%
• Fraction of shares repurchased = FP = 15-20%
• Wealth effect = W/(No Po) = 10-16%
• Premium of postexpiration price = (PE - Po)/Po =
11-15%
• Percent wealth effect to tendering shareholders
= FP[(PT - Po)/Po] = 3-5%
• Percent wealth effect to nontendering
shareholders = (1-FP)[(PE - Po)/Po] = 10-13%

19. – Premium of postexpiration price = (PE - Po)/Po
(Assume FP = 20%)
• If (PT - Po)/Po = 20% and W% = 15%
15% = 0.20(20%) + 0.80(X)
X = 13.75% = (PE - Po)/Po
– Of 15% wealth effect associated with share repurchase
offers,
• 0.20(20%) = 4% went to tendering shareholders
• 0.80(13.75%) = 11% went to nontendering
shareholders

20. • If (PT - Po)/Po = 15% and W% = 10%
10% = 0.20(15%) + 0.80(X)
X = 8.75% = (PE - Po)/Po
– Of 10% wealth effect associated with share repurchase
offers,
• 0.20(15%) = 3% went to tendering shareholders
• 0.80(8.75%) = 7% went to nontendering shareholders

21. • Rationale for postexpiration price
changes
– Introduction
• Size of premium offered to shareholders to
tender about 15-20% over prevailing stock price
• At expiration of tender offer period, price of stock
remains 8-10% above pretender offer
announcement price
• What is the source of the postexpiration stock
price increases associated with share
repurchase programs?

22. Dutch Auction Repurchases
(DARs)
• Implementation
– Firm specifies number of shares and range
of prices for share repurchase
– Shareholders can tender shares at any
price within stated range
– Firm puts together shareholder responses
into supply schedule curve for the stock

23. – Firm repurchases shares at lowest price
(purchase price) that allows it to buy
number of shares it sought in offer
– Purchase price is paid to all shareholders
who tendered at or below purchase price
– If oversubscribed — firm purchases shares
tendered on pro rata basis

24. Transferable Put Rights
(TPRs)
• Implementation
– Firm issues put options to shareholders in
proportion to number of shares owned
– If firm wishes to repurchase 10% of
outstanding shares, it gives shareholders 1
TPR per 10 shares owned
– Each TPR gives shareholder right to sell
one share back to firm at fixed price within
specified period

25. – All shares put back to firm are repurchased
— no prorationing occurs
– Shareholders that do not wish to sell shares
back to firm can sell their TPRs in open
market
– If significant premium of put price over
prevailing market price
• TPRs have value
• Trading in TPRs will take place
• TPR trading can discover market
clearing price of shares company seeks
to repurchase

26. • TPRs vs. fixed-price offer
– In fixed-price offers, shareholders avoid
risk of prorationing by selling shares to
arbitragers
– Arbitragers can accumulate shares and
achieve strong bargaining position
– TPRs prevent arbitrager from driving up
prices in fixed-price offers

27. • TPRs can be used to consolidate control
position of a group
– TPRs are issued with put price at a
substantial premium
– Dissident group happy to accept the
substantial premium
– Noncontrolling group purchases TPRs from
control group
– After TPRs plus stocks are put, control
group ends up with increased ownership
percentage of firm

28. • Use in takeover defense; trading in
TPRs result in
– Low reservation price shareholders put
their shares for repurchase
– Remaining shareholders will be high
reservation price shareholders

29. Open Market Share
Repurchases (OMRs)
• Firm repurchases its common stock in
open market transactions
• OMRs outnumber other three methods by
at least 10 to 1
• OMRs involve a smaller percentage of
total shares outstanding than other
methods — average 5% vs. 16% for fixed
price tender offers