Examine whether the use of cash reserves for the acquisition of other companies would increase a Company’s share price. Is this a good alternative to share buy-back?
Examine whether the use of cash reserves for the acquisition of other companies would increase a Company's share price. Is this a good alternative to share buy-back?
The assessment of an expansion as such from a firm attaining another enterprise relies upon the circumstances of the acquisition made and the environment in which the firm operates. The 1980's situation where there was a boom in takeovers and mergers boom provides a good source of analysis in this subject matter. There is no uncertainty about the effect of leveraged acquisitions on the shareholders of companies that were takeover targets, from historical data on this subject matter. By the end of the 1980s, shareholders in leveraged acquisitions gained significant wealth. Analysts disagree only over the amounts gained. It seems that on average, stock prices increased 20 percent over pre-announcement prices for mergers, 30 percent for tender offers, and 20 percent to 37 percent for leveraged buyouts7.
With bidding firm shareholders breaking even and target shareholders enjoying significant gains, leveraged acquisitions in the past two decades have produced a total shareholder wealth increase. It was found that average value improvement (the total gains by bidder and target shareholders) was 45 percent of the value of the target. (Bhagat & Hirshleifer, 1995).
The process of a share buy-back incurs the transfer of 'excess' capital from company to its shareholders, cancellation of shares and a final reduction in amount of shareholders equity. The procedure for such reduction includes amending the articles and memorandum of association where they do not have prior provision for share reduction. Other 'costs' associated with share repurchasing includes as previously stated a reduction of equity base, which may impinge on future financial flexibility. It may act as a signal takeover target; if over subscribed at low end of the range a signal sends the message out to a significant number of shareholders to exit leading to complexities limiting a positive signalling effect. Unsolicited acquirers may view share buybacks as a sign of weakness especially from the highly public profile of the buy-back announcement. From sources*****, the amount of equity in issue on the UK stock market dwindled by a cumulative £28bn over the 1995-97 period. A negative stance sees this as a representation that UK companies have run out of 'profitable' business opportunities. Optimally one takes the view that British firms are finally living up to old school theory that companies should return surplus cash to shareholders who can then invest in other projects or groups which need the money.
I believe an acquisition of another firm would be a preferred alternative to a share buy back as the benefits would outweigh the costs relative to a share buy back. This would manifest itself in a few ways. Economies of Scale are the first obvious motive for merging or acquired companies, as are the benefits to be derived from the potential gains of careful extrapolation of each parties resources such as development and research excellence, the allocation of more appropriately acquired managers in different areas of business where they may perform more efficiently (usually seen from vertical style ...
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I believe an acquisition of another firm would be a preferred alternative to a share buy back as the benefits would outweigh the costs relative to a share buy back. This would manifest itself in a few ways. Economies of Scale are the first obvious motive for merging or acquired companies, as are the benefits to be derived from the potential gains of careful extrapolation of each parties resources such as development and research excellence, the allocation of more appropriately acquired managers in different areas of business where they may perform more efficiently (usually seen from vertical style integration). Share repurchases are generally capital base reducing where a newly obtained firm to another expands markets and finance sources in funding exploration of new or increasing penetration of markets the corporation may or may not have existing expertise in. if the company shrinks its capital base to raise share prices and regain firmer control on the business it cannot be as beneficial as the 'expansion' that has future ramifications and implications a non share buy back firm can for future growth, as such maturing firms can gain from fresher, younger companies joining them to repair or restore a growth impulsion8 as well as the most understandable reason too: to gain higher percentage of market share and obtain higher earnings from a more monopoly/oligopolistic industry as a result of 'elimination' of the competition, from horizontal, vertical (backwards or forwards approach) integration or conglomeration. It is also evident the more diversely risk is spread, from an acquisition, the better the environment the company can confidently perform in. A few costs however associated with receiving dividends could be examined further: (a) Tax disadvantages of receiving income in forms of dividends; (b) Cost of raising external capital for the firm if dividends are paid out; (c) Opportunity cost of using payout for productive investments******. Even if competing bidders do not appear, a seller's shareholders could use the bidder's disclosures to price their stock before consummation of the acquisition, capitalising the expected gain in the pre-acquisition stock price. The run-up in target stock price affects the acquisition price. At minimum, a seller's managers would bargain for an advantageous price based on the bidder's disclosures. What seller in any line of business would not want credible evidence of a buyer's bottom line price? The early disclosure requirements exacerbate two of the market phenomena mentioned above. Both the winner's curse and competition among bidders weakens winning bidders when all bidders are required to reveal their material information on the potential benefits of the target's assets.
This begs the question ultimately as to whether share repurchases are preferable to dividend payment in view as a means for distributing cash to shareholders. Repurchases permit the shareholder to collect cash payment than dividend returns. A shareholder who pays a higher tax rate on this income than capital gains would prefer repurchases to dividend payout. To see a brief example of share repurchasing benefiting in the same way as shares we assume9:
* Company A earns £4.4 million in 1981 and wishes to pay out half of this as dividends or repurchase.
* The company has 1,100,000 shares outstanding with a market value of £22 per share. It can pay dividends of £2 per share or repurchase shares at £22 each.
* The market price of share repurchase is £22 rather than £20 because £22 will be the price per share after repurchase.
In demonstration, we know the current value of the pure equity firm is £24.2 million. For £2.2 million in cash, it could repurchase 2.2 = £2.2 million and with 1,00,000 shares outstanding the price per share is £22. Therefore in theory, there is no price effect in repurchase. In comparison of shareholders wealth pre tax it can be shown the as the same with either payment technique. If dividends are paid every shareholder receives a £2 dividend and the ex-dividend price for every share is £20 (£22 million / £1.1 million shares). As shown above each share is worth £22 under repurchase and shareholder who needs cash can sell off a portion of their shares. The preferred form of payment will depend on shareholders tax rate (dividends vs. repurchase).
The acquisition of other companies by a firm can increase or decrease the share price initially of the enterprise but eventually after time, the share price will find its true reflective equilibrium price offering. The company in question would experience an increase in share price if speculators in the market believe the firm being acquired is currently undervalued and has potential to reinforce good growth potential in the overall future company's potential. The spin-offs from the attained business this way are vast and I feel it is more advantageous with the right management; incredibly constructive and profitable. It may be from bad forecasting, poor rumour fuelled supposition or indeed factual evidence the company acquired in the incorrect circumstances (the purchasing firm branching into new markets or industries with little or insufficient knowledge on the new venture-poor judgement), will lead shareholders to 'bail out' from foresight of potential downturn in their share values or discourage new investors to devote capital into the firm. A dividend announcement from an acquisition, projects signalling in the market, I think is far better. It is also desirable to pursue a stable dividend policy as this allows shareholders to gravitate towards firms where payout policies suit certain payout policies to correlate with investors income needs and tax positions. This way, allows firms to build positive rapport with clientele attracted by their particular dividend pattern, but still approve with the reasoning for companies to use temporary cash flows with the residual effects of raising Earnings per Share (a buy product of a share buy back) so thus providing a stage for subsequent share rights issues for needs in development funds.
Classic business school theory (Miller and Modigliani), suggests the value of a company shouldn't be affected if by it is financed by debt or equity. This however, doesn't consider effects of taxation, which skews sums heavily for British businesses for example*******. As mentioned before, debt interest is tax deductible, while the cost of dividends is not. The abolition of advance corporation tax, and 1997's ditching of the associated dividend tax credit, has decreased attractiveness of dividends to non-taxpayers such like pension funds - that can no longer reclaim the credit. It has also made it easier for companies to return cash to shareholders via share buy- backs. Companies are therefore developing an improved understanding of the "cost" associated with equity (which is equivalent to the rising dividend payments businesses are expected to make.)********
I know buybacks can also be beneficial in the alternative for paying high unsustainable dividends, whilst 'preserving choice for investors' (long-term pay out ratio sufficient to satisfy shareholder needs shareholder needs).10 I do think ultimately the optimal and effective way to raise a share price of companies is to acquire a firm with cash reserves (that may deplete in the short term) and the long run benefits are more profound providing the managers have scrutinised the project in every scenario and aspect, otherwise the cash reserve that would be '...burning a hole in companies pockets..'(Wagener, Director-general of the Association of Corporate Treasurers). For consideration though, is the danger managers with excess capital obtain a sense of comfort, and power to take on riskier projects (in the form of perhaps furthering firm acquisition), will take on other business ventures mindlessly, dipping into activities they have no real knowledge of.
