The Lure of Share Buyback
November 16th 2007 14:03
As we all know, to invest in productive activities and make a profit companies have to raise equity. To do so companies issue shares which, if they are starting sell on an initial public offering and subsequently through rights issues or private placement.
Quite often companies find out that they need, in excess of raised equity, some debt which they raise either through the banking system or through the issue of debentures or unsecured notes. Equity plus debt comprises a company’s capital.
Debt is cheaper to incorporate than equity and that is because, at least in Australia, the interest on it can be tax deducted. One of the reasons why equity is more expensive than debt is that shareholders are normally paid dividends.
There has been a trend around the world to incorporate more debt into companies’ balance sheets which has been tamely termed ‘balance sheet re-structuring’. Companies often charge themselves with debt that is frequently 40 per cent of capital and sometimes more, up to 60 per cent. The environment that prevailed up to the sub-prime mortgage crisis of cheap and easy credit is if a factor here.
Either because of the above reasons or just because the business environment so demands it, companies sometimes find themselves with excess equity. And appropriately they return it to shareholders who then are free to find productive employment for that money. How they do it? Through a share buyback.
Interestingly enough, in this decade share buybacks have become fashionable and almost all companies’ boards dream of returning equity to shareholders. What is then the lure of share buybacks?
The first and obvious effect of a share buyback is that the shareholder gets a payment for his shares, which is certainly handy, but could have a few other advantages. Firstly, he may get an ideal price and does not have to pay broker’s fees in the sale; secondly, the payment can often be made to best taxation advantage, being that often that payment takes the form of income rather than capital, therefore avoiding capital gains tax; thirdly, the remaining shareholders get an augmented percentage owning of the company’s equity.
Other effects are more subtle but no less important: earnings per share and dividends per share may increase and return on equity may also increase in a significant way. And these are the real winners for the company buying back shares.
EPS increases because, for the same net profit after tax, there will be fewer shares to divide it for. Dividends per share increase for similar reasons, being that there will be lesser shares to distribute the dividend for. Return on equity is calculated by dividing the NPAT by the equity of the company and it increases because the equity decreases.
Such is the lure of share buyback.
Quite often companies find out that they need, in excess of raised equity, some debt which they raise either through the banking system or through the issue of debentures or unsecured notes. Equity plus debt comprises a company’s capital.
Debt is cheaper to incorporate than equity and that is because, at least in Australia, the interest on it can be tax deducted. One of the reasons why equity is more expensive than debt is that shareholders are normally paid dividends.
There has been a trend around the world to incorporate more debt into companies’ balance sheets which has been tamely termed ‘balance sheet re-structuring’. Companies often charge themselves with debt that is frequently 40 per cent of capital and sometimes more, up to 60 per cent. The environment that prevailed up to the sub-prime mortgage crisis of cheap and easy credit is if a factor here.
Either because of the above reasons or just because the business environment so demands it, companies sometimes find themselves with excess equity. And appropriately they return it to shareholders who then are free to find productive employment for that money. How they do it? Through a share buyback.
Interestingly enough, in this decade share buybacks have become fashionable and almost all companies’ boards dream of returning equity to shareholders. What is then the lure of share buybacks?
The first and obvious effect of a share buyback is that the shareholder gets a payment for his shares, which is certainly handy, but could have a few other advantages. Firstly, he may get an ideal price and does not have to pay broker’s fees in the sale; secondly, the payment can often be made to best taxation advantage, being that often that payment takes the form of income rather than capital, therefore avoiding capital gains tax; thirdly, the remaining shareholders get an augmented percentage owning of the company’s equity.
Other effects are more subtle but no less important: earnings per share and dividends per share may increase and return on equity may also increase in a significant way. And these are the real winners for the company buying back shares.
EPS increases because, for the same net profit after tax, there will be fewer shares to divide it for. Dividends per share increase for similar reasons, being that there will be lesser shares to distribute the dividend for. Return on equity is calculated by dividing the NPAT by the equity of the company and it increases because the equity decreases.
Such is the lure of share buyback.
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