Dilip D. Kare and C. Don Wiggins
What is the smallest amount of stock you need to repurchase in order to prevent the share price from decreasing?
Each year, many companies buy back some of their own stock. They repurchase it instead of issuing regular cash dividends, or they have limited investment opportunities and want to return cash to stockholders. Whatever the reason for the repurchase, there are five basic effects on companies and/or stockholders when stock is repurchased:
- Information or Signaling – A company’s willingness to distribute cash to its stockholders may be interpreted as a signal in two ways: The company expects future cash flows to increase, or it has no profitable investment projects available and has chosen to return cash to stockholders.
- The Leverage Effect – If a firm buys back stock by issuing debt, its leverage will change, creating a twofold effect on the stock price. The firm will seem more risky to investors, so its market value may go down, but there may be an offsetting effect in that dividends and earnings per share may increase with a positive effect on the stock price.
- Dividend Tax Avoidance – The income received by stockholders in a stock repurchase may be taxed as capital gain rather than as ordinary income if the repurchase meets IRS guidelines. In such a case, stockholders may prefer repurchases to a large extraordinary dividend. Because capital gains treatment was eliminated by the Tax Reform Act of 1986, this motivation for stock repurchase will disappear.
- Bondholder Wealth Expropriation – If stock repurchase reduces a firm’s asset base, then fewer assets will be available to distribute to bondholders, so the company’s “wealth” might transfer from bondholders to stockholders. In effect, some stockholders will get first priority in the distribution of company assets.
- Wealth Transfer among Stockholders – When stock repurchase is carried on through a tender offer, wealth may be transferred from tendering to non-tendering stockholders.