Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

Discuss the main features of:

(i) Corporate share repurchases (buy-backs); and
(ii) Share (stock) splits;

and why companies might use them. Include in your discussion comment on the possible effects on share price of share repurchases and share (stock) splits in comparison to the payment of dividends.
ANSWER
Share repurchases are a way for companies to distribute earnings to shareholders other than a cash dividend. They are also a means of altering a target capital structure; supporting the share price during periods of weakness; and deterring unwelcome take-over bids. Companies typically repurchase shares either making a tender offer for a block of shares, or buying the shares in the open market. In the absence of taxation and transactions costs share repurchase and the payment of dividends should have the same effect on share value. However, the different treatment of taxation on dividends and capital gains in many countries may lead to a preference for share repurchases investors.

If the repurchase of shares is means of a tender offer, this will often be at a price in excess of the current market value, and may have a different effect on overall company value.

An important question for share value is what information a share repurchase conveys to the market about the company and its futures prospects.

Managers should take decisions that maximize the intrinsic value of the firm. This, in theory, involves undertaking the optimum amount of positive NPV investments. The use of share repurchases, and the payment of dividends, will therefore be influenced the amount of investment that the company undertakes. When a company does not have sufficient investments to fully utilize available cash flow, the payment of dividends or share repurchases are more likely.

Analysts are believed to normally consider an increase in dividends or share repurchases as good news, as they suggest that the company has more cash, and possibly greater potential, than previously believed. However, if this subsequently proves not to be so, share prices will adjust downwards.

Share repurchases in themselves do not create value for the company, but the market may see the information or signals that they provide as significant new information that will affect the share price.

Share splits are the issue of additional shares at no cost to existing shareholders in proportion to their current holdings, but with lower par value. Share splits have no effect on corporate cash flows and, in theory, should not affect the value of the company. The share price, in theory, should reduce proportionately to the number of new shares that are issued.

Motivates for share splits include:

A company wishes to keep its share price within a given trading range, e.g. below £10 per share. It is sometimes argued that investors might be deterred a high share price, and that lower share prices would ensure a broader spread of share ownership. Shareholders could actually lose from lower prices, as the bid- offer spread (the difference between buying and selling prices) is often higher as a percentage of share for lower priced shares.

Companies hope that the market will regard a share split as good news, and that the share price will increase (relative to the expected price) as a result of the announcement. Evidence suggests that even if such reaction occurs it is short-lived unless the company improves cash flows, increases dividends etc. in subsequent periods.

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