Reasons for Stock Buybacks

Firms that want to return substantial amounts of cash to their stockholders can either pay a large special dividend or buy back stock. There are several advantages to both the firm and its stockholders to using stock buybacks as an alternative to dividend payments. There are four significant advantages to the firm:

• Unlike regular dividends, which typically commit the firm to continue payment in future periods, equity repurchases are one-time returns of cash. Consequently, firms with excess cash that are uncertain about their ability to continue generating these cash flows in future periods should repurchase stocks rather than pay dividends. (They could also choose to pay special dividends, since these do not commit the firm to making similar payments in the future.)

• The decision to repurchase stock affords a firm much more flexibility to reverse itself and to spread the repurchases over a longer period than does a decision to pay an equivalent special dividend. In fact, there is substantial evidence that many firms that announce ambitious stock repurchases do reverse themselves and do not carry the plans through to completion.

• Equity repurchases may provide a way of increasing insider control in firms, since they reduce the number of shares outstanding. If the insiders do not tender their shares back, they will end up holding a larger proportion of the firm and, consequently, having greater control.

• Finally, equity repurchases may provide firms with a way of supporting their stock prices, when they are declining2. For instance, in the aftermath of the crash of 1987, many firms initiated stock buyback plans to keep stock prices from falling further. There are two potential benefits that stockholders might perceive in stock buybacks:

• Equity repurchases may offer tax advantages to stockholders, since dividends are taxed at ordinary tax rates, while the price appreciation that results from equity repurchases is taxed at capital gains rates. Furthermore, stockholders have the option not to sell their shares back to the firm and therefore do not have to realize the capital gains in the period of the equity repurchases.

• Equity repurchases are much more selective in terms of paying out cash only to those stockholders who need it. This benefit flows from the voluntary nature of stock buybacks: those who need the cash can tender their shares back to the firm, while those who do not can continue to hold on to them.

In summary, equity repurchases allow firms to return cash to stockholders and still maintain flexibility for future periods.

Intuitively, we would expect stock prices to increase when companies announce that they will be buying back stock. Studies have looked at the effect on stock price of the announcement that a firm plans to buy back stock. There is strong evidence that stock prices increase in response. Lakonishok and Vermaelen examined a sample of 221 repurchase tender offers that occurred between 1962 and 1977, and at stock price changes in the 15 days around the announcement.3 Table 11.2 summarizes the fraction of shares bought back in these tender offers and the change in stock price for two sub-periods: 1962-79 and 1980-86.

2 This will be true only if the price decline is not supported by a change in the fundamentals - drop in earnings, declining growth etc. If the price drop is justified, a stock buyback program can, at best, provide only temporary respite.

3 Lakonishok, J. and T. Vermaelen, 1990, Anomalous Price Behavior around Repurchase Tender Offers, Journal of Finance, v45, 455-478

Table 11.2: Returns around Stock Repurchase Tender Offers
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