Assume you are the CFO of a company that has accumulated a significant amount of
ID: 2457309 • Letter: A
Question
Assume you are the CFO of a company that has accumulated a significant amount of cash, well beyond its foreseeable needs. The company’s CEO has asked your opinion about using the cash to repurchase company shares or using the cash to distribute an extraordinary dividend to your shareholders. In a brief memo, explain to the CEO what the pros and cons of each of these are. You may assume your company is a fictitious one and assign to it whatever circumstances you like or you may assume your company is an actual existing corporation. Your memo should include at least two references to published works like books, articles, etc.
Explanation / Answer
If the company has excessive cash it has following negative effects -:
1) It lowers return on assets of company
2) It increases cost of capital
3)It increases overall risk therby reducing business value.
When company uses excessive cash to repurchase company share -
Share repurchase means buying of company's own share from open market it is also called stock buy back.
these sahres are kept in treasury stock of comapny for reissuance.a company can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company's outstanding equity
Some of the benefits of share repurchase are:-
1)Increased shareholder value-if earnings are constant and number of outstanding shares decreases it result in increase in EPS therby increasing shareholders value.
2)Higher Stock Prices - An increase in EPS will often alert investors that a stock is undervalued or has the potential for increasing in value. The most common result is an increase in demand and an upward movement in the price of a stock.
3) Doenot lead to cash flow problem because there is less cash balance.
4)Income taxes-As excessive cash leads to distribution of dividend ,shareholders often have the opportunity to defer capital gains and hence decreases tax if share price increases
Limitations or disadvantage-:
1)Manipulation of earnings
2)Higher stock prices
When company uses excessive cash to distribute dividend -
Dividend means distribution of profit to shareholders of company in ratio of shares held by them.
it reduces tax liabilty on company.
If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then – finance theory suggests – management should return some or all of the excess cash to shareholders as dividends. This is the general case, however there are exceptions.
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