Explain why Share buy-backs are seen as an attractive way of altering a company’s capital structure and examine the circumstances in which they can ‘ensure appropriate share prices’.

In small capitalisation firms there are reasons as to why buy back shares are attractive***; one is to generate more proceeds for those shareholders that are 'left standing' when an eventual "value recognition event" occurs when markets realise that the subsequent increase in share price is just a temporary over inflated period, but if the objective is to cause a lasting increase in the share price, the project is destined to fail.5 The fundamental problem with these stocks is they are extremely liquid low and demand is inelastic. History has shown as valuations fall to rather poorly low levels, no new investor interest is generated (Vermilion 1981). Depressed total market capitalisation have cast these firms deeper into obscurity just by decreasing the supply of stock (Fig.1) so it cannot be expected to create any sustainable improvement in the share price.

The capital structure of a company is essentially the way the company is composed in terms of the permanent

long-term financing of the firm, including long-term debt, common stock and preferred stock (weighted assets of debt and/or equity) and retained earnings. It differs from financial structure, (which includes short-term debt and accounts payable). The capital structure will change when costs are more internalised after the buy-back.

To illustrate6 how share repurchasing by firms can alter the company's capital structure, we can imagine a company where:

* Capital structure is assembled with 1000 shares and £1000 of shareholder equity (so the company's assets exceed its liabilities by £1000), which include profits of £100 earned during a year.

* Assume that it has £100 of capital, which is surplus to requirements - cannot be put it to good use within the company and will therefore be returned to shareholders.

* The company's book value is £1 per share [£1000/1000 shares] = E.P.S. which earnings per share are £0.10. Return on shareholders' equity (R.O.E.) is 10%. [£100/£1000].

* Finally, perhaps assume the company shares market price is £1 (i.e., ten times the E.P.S.) and that every shareholder has bought his or her shares at this price.

If the company distributes its excess capital in the form of a dividend, then the dividend is £0.10 per share and all shareholders earn 10% (£0.10/£1.00) on their investment. If in the following year it again earns £10, then E.P.S., ROE and book value will remain exactly as mentioned above.

If, however, the firm uses the £100 of excess capital to repurchase 100 of its own shares at the prevailing market price, then those who sell into the buyback receive, £1 per share. The company then would cancel the repurchased shares so its capital structure shrinks to 900 shares and £900 of shareholders' equity. Book value remains £900/900 shares or £1 per share.

If, say in the next year the company again earns £100, then E.P.S. and ROE increase, respectively to £0.111 and 11.1% (and if the price-earnings ratio remains at 10); then the price of each share will increase to £1.11. The share buyback has thus increased the efficiency with which the company uses its capital. In doing so and even though its profits have not increased, the resultant increase in price returns 11% ((1.11-1)/1) to the remaining shareholders. Over time, then, and given a cetirus paribus conditions, a given amount of capital returned via a buyback can be worth more to the remaining (long-term) shareholders than the same amount returned via a dividend. As well as providing a direct return to remaining shareholders, a buyback can also signal Directors' determination to allocate the company's capital more effectively by altering the capital structure proving to be a good way for a firm to de-equitise. The main point here is the price at which the company may repurchase the shares:

Repurchase @ £0.80

Repurchase @ £1.00

Repurchase @ £1.25

Book Value

£ 1.029

£ 1.00

£ 0.978

E.P.S.

£ 0.114

£ 0.111

£ 0.109

R.O.E.

1.1%

1.1%

1.1%

Return (Holders)

4%

1%

9%

Return (Sellers)

-20%

0%

25%

A final point emerges from this example: there is no reason to believe that the effect of a buyback will be immediate. Although short-term speculators may well bid up the price of the shares, the key benefit is to long-term investors and will manifest itself over time. When ensuring 'appropriate' share prices the faintest rumour of share buy-back by firms hopes ride on any announcement will alleviate the pressure upon their price. Circumstances when signalling projections are given off by the market from the share buyback, are when the buyback process is perceived to be a coded way of telling the market the company is postulating the fact the firm is expecting to have increased future cash-flows, but this also implies that the firm has exhausted profitable investment opportunities. Therefore the signal could be interpreted as good or bad news by shareholders.

Share repurchase are attractive on lieu of altering a company's structure of capital as it has exactly the same effect as dividend payment that the form of payment is capital gain rather than gains from dividend income. Adopting share buy-back strategy has long been seen as a way of elevating the businesses share price to reflect its 'impressive' performance indices and confidence from company itself- this should protect the shares from being under-priced in the market. Most companies may be likely to capitalise on this system to buy-back their shares at a time there is overabundance of shares and falling prices. The aim is to purchase and hold until such a period when the market returns to bullish trends. There yet remains strong uncertainty as to the acceptability or motive behind the rudiments of the buy-back system. There naturally remains counterarguments from leading chief executives who suggest refusal to succumb to suggestion of adopting a share buy-back strategy as a means of lifting up a firm's share price. In contribution, it is popular belief market players should make use of information available on the corporation's performances indicators to reflect in its equity price. During the period of sustained share price, positive news on companies share prices emulates aiding the image and perception of the enterprise in shareholders eyes. It is worth mentioning here too that not all proposed share re-purchasing is seen through to the end; merely rumours are proliferate, effectively 'deceiving' in my opinion, the shareholders****. Indeed, one of the trends these days is for some companies to use this 'signalling effect' to raise share prices. Generally speaking, leverage increasing exchange offers have significant affirmative announcement effects, where debt-to-debt exchanges in shares have no relevant effect on shareholders wealth an leveraged decreasing exchange offers have a significant depressing effect (Dietrich 1984).

Further, these points place into context the results of a study, published in, of buybacks undertaken in the U.S. during 1999. It listed the 50 companies in the Standard & Poor's 500 which repurchased the biggest percentage of their shares. The market price increases of only 8 of the 50 exceeded that of the S&P. Indeed, the prices of 33 of the 50 decreased and their weak results had continued into 2000. There can be further reasoning behind this however (report from CS First Boston, who compiled the data), with an offered explanation with many companies last year, big buybacks were more a reaction to some sort of distress than any portent of success.

Corporate Finance and Derivative Products. 2001 Assessment Essay_________________________________________________________Arpita Khanna