Tutorial 5:Explain the factors that influence firms’ decision to do a share buyback. Flashcards
How can share buybacks positively affect firm value?
1) +VE SIGNALLING EFFECT –> repurchasing shares may demonstrate managers confident in company’s future prospects by using excess cash to invest in company’s growth –> can increase investor confidence.
2) +VE LEVERAGE EFFECT –> firm’s debt-to-equity ratio increasesif cash (part of equity) used to buy back shares:
–> TAX BENEFITS –> debt acts as tax shield as interest is tax-deductible –> may increase firm value.
–> DISCLIPINARY EFFECT ON MANAGEMENT –>risk of financial distress & pressure of meeting debt obligations i.e. principal & interest payments may incentivise managers to allocate capital more efficiently & max. firm returns.
How can share buybacks negatively affect firm value?
1) CONTRADICTORY SIGNALS –> i.e. if other actions of firm are -ve (e.g. aborted acquisitions, protracted business restructuring, declining profitability etc.) this may negate +ve impact of share buybacks –> may decrease investor confidence & perceived company value, leading to -ve mkt reaction i.e. decrease in share price or mass sale of shares.
2) LACK OF INVESTMENT OPPORTUNITIES –> in industries where rapid innovation & growth are crucial, a share buyback may signal to investors that company lacks significant new opportunities for investment, R&D & expansion into new mkts –> may decrease investor confidence in firm’s long-term prospects –> may decrease share price or encourage mass sale of shares.
3) MANAGERS SELLING SHARES –> if managers participate in share buyback by selling their own shares, it may suggest to mkt that they do not have confidence in company’s value or future growth potential & should instead capitalise on short-term gains –> weakens +ve signaling effect of buyback, as investors may interpret manager sales as lack of alignment between management & shareholders, potentially decreasing company’s perceived value i.e. decrease in share price or mass sale of shares.
