Journal
of Financial
COMMON
Economics
9 (1981) 139-183.
STOCK REPURCHASES
North-Holland
Publishing
Company
AND MARKET SIGNALLING
An Empirical Study*
Theo VERMAELEN lJ/niversity of British Columbia, Vancouver, BC, Canada V6T 2 W5
Received January
1980, final version
received January
1981
This paper examines the pricing behavior of securities of firms which repurchase their own shares. The results are consistent with a market in which investors price securities such that expected arbitrage profits are precluded. The results are also consistent with the hypothesis that firms offer premia for their own shares mainly in order to signal positive information, and that the market uses the
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The direction of this signal is ambiguous.
It may be that the company perceives no profitable use for internally generated funds because of a lack of growth opportunities.
On the other hand, especially when a company offers to buy its shares at a substantial premium above the market price, management may believe that their company is undervalued.
The tender offer then represents an attempt to pass on the value of this inside information to the current shareholders.
(2)
Dividend or personal
taxation hypothesis
Firms repurchase stock in order to let the shareholders benefit from the preferential tax treatment of repurchases relative to dividends; the tax advantage may be weakened to a certain extent by the provisions of Section
302 of the Internal
Revenue Code, which treats redemption of stock as a capital gain only if one of the following cases applies:
(i) the redemption is ‘substantially disproportionate’ to the extent that after the repurchase, the percentage ownership of the shareholder must be less than 80 7; of the percentage ownership he had, before the repurchase; by railroad companies in certain
(ii) the stock is issued reorganizations, defined by section 77(c) of the Bankruptcy
Act;
not equivalent’ to paying a (iii) the distribution is ‘essentially dividend. It is not
1. Shareholders may be presented with a tender offer whereby they have the option to submit (or tender) a portion or all of their shares within a certain time frame and at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding on to them.
The key issue is what will be the expected EBIT next year and thereafter. If one assumes $514 million, the issuance of $3 billion in debt reduces the expected EPS from $1.33 to $0.41 with repurchase, or $0.32 with dividend. This results simply from increased interest expense and the variation in the number of shares outstanding. Clearly, shareholders should brace for much worse EPS results after the recapitalization.
Another factor for management to consider would involve the clientele effects. Presently the Wrigley family controls 21% of common shares and 58% of Class B common stock. Assuming the Wrigley family do not sell any shares, the repurchase will raising their voting control from 46.6% to a majority control over voting rights at 50.6% (see appendix2.2). This isn’t deemed significant as the Wrigley family already previously possessed majority of voting rights
Management considering share repurchase program should weigh its benefit of financial discipline, efficient corporate strategy implementation and utilization of tax shield against the downside of cost of financial distress. It’s not the possibility of bankruptcy that causes concerns among equity holders regarding extent of leverage but the direct costs (legal, liquidation, administrative etc.) and indirect costs (deteriorated corporate image, management time and attention, agency costs of value-destructing investment, distress asset sales etc.). Exhibit 4 lists the key assumption inputs of approximating quantitative firm value/ equity value accretion. Levering UST to a larger extent by adding $1,000m does increase firm value.
By repurchasing stock rather than offering shareholders a higher dividend, investors will benefit from the comparatively lower capital gains tax (which can be deferred indefinitely) rather than being forced to pay a higher income tax on dividends received. By reducing the total number of shares available, the value
The share price of $270,000 was significantly higher because the “fair value” as perceived by the dissenters, which accounted for the chance of an IPO. Taking into account the recently traded Kohler Co. share prices, the book value of a share, and the possibility of an IPO greatly inflated what the perceived value of each share should be. While Kohler believed their voting control and ownership structure would remain the same, the shareholders believed otherwise. Because shareholders assumed Kohler would go public, they argued for a higher valuation so as to receive the highest price, and thus profit, in the buyout. So based on the highest MVE, we picked Masco as the comparable firm of choice. Using Masco’s MVE, $9838.8, and LTM EBIAT, $437.3, we solved for Masco’s P/E ratio, which was equal to 22.5. By multiplying the P/E ratio by Kohler’s LTM EBIAT (22.5 * $93.76), we projected a market value of $2,109,610,000. To solve for estimated share price, we divided the projected market value by 7,587.89, the number of shares outstanding to obtain an estimated share price of $278,023.47. This estimate is near the $270,000 per share offer price.
Shareholder wealth will be maximized by repurchasing shares from cash and issuances of commercial paper, and debt will be refinanced with similar debt (p.493.)
This document is authorized for use only by Yen Ting Chen in FInancial Markets and Institutions taught by Nawal Ahmed Boston University from September 2014 to December 2014.
The second method to distribute extra cash is through a share repurchase. Share repurchase means a company buys its shares back from the market or from those shareholders who are willing to tender such shares. The buyback methodology is used primarily when companies such as Ford believe that their share price is undervalued. Buying back its stock will help Ford to increase its share price by promoting greater interest in its stock. However, we cannot effectively increase company’s liquidity through a conventional share repurchase. And also for traditional stock buyback, it usually will take years of time to executive. In Ford case, stock buyback option will put Ford’s family’s voting power in the company at risk.
It has the option to distribute the cash in the form of dividends. Shareholders were taxed on cash dividends at ordinary income rates whereas gains realized on shares that were repurchased received capital gains treatment.
From 1993 until the start of 1995, MCI’s stock had outperformed the S&P. However, in 1995, the stock’s performance was poorer than the S&P. With shareholder’s getting restless, the idea of a stock repurchase was being considered. Depending on which option MCI chooses—stock repurchase with debt issuance or open market repurchase program—the message being sent could be different. Let’s consider option one—MCI issues debt and uses the proceeds to repurchase stock. According to the article “Raising Capital: Theory and Evidence” by Clifford Smith, the market would likely react very positively to this leverage-increasing event. Because of the information disparity between a
The repurchase program increases the shareholder’s value. This is because of a rise in the price of the shares of the original shareholders.
The internal and external factors of an organization can affect the stock prices, which leads to perceived valuation of the company. The valuation of an organization’s worth compared to its financial statements is useful to introduce company changes if necessary. There are various factors that can lead to the valuation of a company influenced by the external and internal factors. Proceedings are some internal and external factors that may influence the investor’s decisions to invest in any organization.
Dividends are subjected to higher tax rate compare to capital gain increased due to share buy-back. This discourages shareholders from desire to receive high dividends in place of higher capital gain as share values increase. A comparison is made below between the proposed capital structure and dividend policy.
Our reconciliation for this undervaluation is that the market is already pricing in a takeover. Some evidence of this can be demonstrated by the 1.0 beta of paramount. If we look at the 1992 Q1 to August 30 1993 returns of S&P500 and PCI, PCI is +30.6% and S&P500 is +14.6%, which implies an approximate