WK 4 Discussion
A stock repurchase refers to a situation in which a firm buys back a portion of its shares
held by shareholders (Fernandes, 2014). When a company conducts a stock repurchase, it
removes the repurchased shares from circulation thus reducing the total number of shares in
investors’ hands and potentially altering the firm’s ownership. A company can typically employ
one of three methods to repurchase stock, which are an open market repurchase, repurchase via a
tender offer, and direct negotiation with a particular shareholder otherwise known as a targeted
repurchase (Bhargava, 2013).
Stock repurchases are usually attributable to three reasons, which are the investor tax
argument, which posits that repurchases are more beneficial than dividend payments. Another
reason is the leverage theory, which argues that a repurchase aids in the alteration of the capital
structure, increases the firm’s debt ratio and thus allows it to benefit from the higher leverage.
The third reason is that companies conducting repurchases are simply acting on the
recommendations of investment bankers (Bhargava, 2013).
However, most managers often posit that the driving force behind stock buybacks is the
feeling that the firm’s stock is underpriced (Hung & Chen, 2010). Thus, a massive stock
repurchase is a potentially invaluable source of information for investors. Such a repurchase
signifies that the management, who are in possession of insider knowledge on the firm’s
position, is convinced that the company’s stock is undervalued (Hung & Chen, 2010).
Additionally, this conviction is so strong that they are willing to buy it back at a premium
regardless of the underlying risk of stock dilution should they be wrong. Thus, one may construe
a significant repurchase for example via a tender offer as signaling the management’s confidence
in the firm’s future prospects (Hung & Chen, 2010).
A stock repurchase is typically a good sign because it is a signal coming directly from a
firm’s management, the insiders. Whereas there is a possibility of false signaling, the costs
associated with the amounts used to finance a repurchase make it unlikely that a firm would opt
to use a buyback as a false signal.
References
Bhargava, A. (2013). Executive compensation, share repurchases and investment expenditures:
Econometric evidence from US firms. Review of Quantitative Finance and Accounting,
40(3), 403–422.
Fernandes, N. (2014). Finance for Executives: A Practical Guide for Managers. NPV
Publishing.
Hung, J.-H., & Chen, Y.-P. (2010). Equity undervaluation and signalling power of share
repurchases with legal restrictions. Emerging Markets Finance & Trade, 46(2), 101–115.
