Share repurchase proposal: Currently, the firm has available capital (cash and n

Question

Share repurchase proposal: Currently, the firm has available capital (cash and net income) of approximately $5,000,000. There is a large block of stock available at $25 a share. If the firm decides to spend this amount of excess cash on a share repurchase program, how many shares of stock will be outstanding after the stock repurchase is completed? What are the benefits of repurchasing shares? How will this affect the capital structure of the company? How can this be interpreted in the marketplace? Would a dividend be better? Please discuss the pros and cons of dividends and share buybacks. Make a recommendation to management. 15,000,000 shares outstanding. market price of shares 27.50.

Explanation / Answer

Number of shares repurchased

$ 5,000,000/25 = 200,000 shares

Number of Shares will be outstanding after the stock repurchase is completed

= 15,000,000 – 200,000 = 14,800,000 shares

Pros of repurchases-

1. A repurchase announcement may be viewed as a positive signal that management believes the shares are undervalued.

2. Stockholders have a choice if they want cash, they can tender their shares, receive the cash, and pay the taxes, or they can keep their shares and avoid taxes. on the other hand, one must accept a cash dividend and pay taxes on it.

3. If the company raises the dividend to dispose of excess cash, this higher dividend must be maintained to avoid adverse stock price reactions. A stock repurchase, on the other hand, does not obligate management to future repurchases.

4. Repurchased stock, called treasury stock, can be used later in mergers, when employees exercise stock options, when convertible bonds are converted, and when warrants are exercised. Treasury stock can also be resold in the open market if the firm needs cash. Repurchases can remove a large block of stock that is overhanging the market and keeping the price per share down.

5. Repurchases can be varied from year to year without giving off adverse signals, while dividends may not.

6. Repurchases can be used to produce large-scale changes in capital structure.

Cons of repurchases:

1. A repurchase could lower the stock’s price if it is taken as a signal that the firm has relatively few good investment opportunities. A repurchase can signal stockholders that managers are not engaged in empire building, where they invest funds in low-return projects.

2. The repurchase was primarily to avoid taxes on dividends, then penalties could be imposed. Such actions have been brought against closely-held firms, but to our knowledge charges have never been brought against publicly held firms.

3. Selling shareholders may not be fully informed about the repurchase hence they may make an uninformed decision and may later sue the company. to avoid this, firms generally announce repurchase programs in advance.

4. The firm may bid the stock price up and end up paying too high a price for the shares. in this situation, the selling shareholders would gain at the expense of the remaining shareholders. this could occur if a tender offer were made and the price was set too high, or if the repurchase was made in the open market and buying pressure drove the price above its equilibrium level.

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