Share RepurchaseSANJAY MEHROTRA

M.B.A., C.A.

Dividend Vs. Stock Repurchase:factors influencing choice

• Undervaluation of the firm

• Management Compensation

• Taxation impact

• Capital structure adjustment.

WHY DOES A FIRM BUY BACK SHARES?

• Signaling Effect- – Cash flow signaling – Market Undervaluation – Investment in own shares

• Agency Costs-– Distribution of free cash flows

• Leverage Effect-– More Levered Capital Structure – Debt disciplines management

• Takeover Defense-– Get rid of dissatisfied shareholders– Consolidate control

• Capital market allocation

Share repurchase: regulatory environment in India

• Section 77A of the Companies Act:– Sources of funds for buy back-

• Free reserves• Securities Premium• Proceeds of any shares or other specified securities

– Buy back is equal to or less than 25% of total paid up capital and free reserves.

– Buy back of equity shares in any financial year shall not exceed 25% of total paid up capital in that financial year.

Share repurchase: regulatory environment in India

• Debt-equity ratio post-buy back not to exceed 2:1.

• Every buy back should be completed within 12 months of passing a special resolution to this effect.

• Special resolution is not necessary if the buy back percentage does not exceed 10%.

Share repurchase: regulatory environment in India• Types of Share Repurchases:

– Fixed-price tender offer.– Book building (Dutch-auction) tender offer.– Open market repurchase programme. – Employee stock (issued out of ESOP/sweat equity)

• Shares bought back are to be cancelled and physically destroyed.

• A company is not allowed to issue fresh shares within 24 months from the date of buy back (exceptions apply)

Share Buy-back: SEBI Regulations

• In case of tender offers and offers through book building , even promoters can participate.

• In case of buy back of shares through stock exchanges, promoters or persons in control of the company are not allowed to participate.

• The promoter or person in control of the company shall not deal in the shares or other specified securities of the company in the stock exchange during the period the buy-back offer is open.

I n t e r e s t r a t e o n d e b t ( % ) 8T a x r a t e ( % ) 3 0E P S S e n s i t i v i t y E x i s t i n g

4 0 1 0 0E a r n i n g s 5 0 0 4 8 8 . 8 4 8 8 . 8N o . o f s h a r e s ( i n m i l l i o n ) 1 0 0 9 5 9 8E P S 5 5 . 1 5 4 . 9 9E P S R i s k 0 . 5 0 . 5 5 0 . 5 3P / E 8 7 . 7 7 2 0 . 0 5

A f t e r - r e p u r c h a s e a t R s .

Sensitivity of EPS impact of share repurchase to share price

EPS Sensitivity ExistingAfter-repurchase at

Rs.

40 100 200

Earnings 500 488.8 488.8 488.8

No. of shares( in million) 100 95 98 99

EPS 5 5.15 4.99 4.94

EPS Risk 0.5 0.55 0.53 0.53

P/E 8 7.77 20.05 40.51

Share buy-back: Case of Britannia Industries• Operates in bakery industry.• One of the largest players in the biscuit market in the

country with the sale of over 250,000 tonnes of biscuits in FY 2003.

• Current Debt-Equity ratio 0.42.• Intended to buy back (third round) a maximum of up to

2.5 million shares at a price not exceeding Rs.650 per share payable in cash for an aggregate amount not exceeding Rs.780 million.

• The buy back size represents 20.09% of the aggregate of the Company’s paid up capital and free reserves as on 31 March, 2003 and 9.5% of the paid up equity capital.

• Mode of buy back: from the open market through stock exchanges using the electronic facilities of the BSE and NSE.

Britannia Industries: Rationale for buy back• The Company currently has substantial reserves that are

deployed in financial assets that yield below the desired rate of return for the shareholders.

• The Company believes that it would keep generating enough cash flows to meet the requirement of the present business.

• Hence, the Company intends to return surplus cash to its shareholders.

• This offers a reasonably fair exit opportunity to those shareholders who so desire, in a manner that does not substantially impact the market price of the Company’s share to the detriment of the continuing shareholders.

• However, the Company does not anticipate any significant change in the earnings from its business, except to the extent of loss in investment income on the amount utilised for funding the buy back.

Britannia Industries: Rationale for buy back

Year Total assets Investments %March,2000 5205 1469.9 28.24March,2001 6432.4 2214.4 34.43March,2002 7486.3 3103.7 41.46March,2003 7584.6 2968.6 39.14March,2004 7137.1 3054 42.79Figures in Rs. Million

Share buy-back: Case of Britannia Industries

% o f s h a r e s B u y b a c kD O A D O C M o d e b o u g h t b a c kP r i c e / s h a r eD O A D O C o n e - m o n t hS i x - m o n t h

1 0 / 1 1 / 2 0 0 1 2 7 / 1 1 / 2 0 0 1 O p e n m a r k e t 3 . 5 9 5 3 3 . 1 5 5 6 3 . 1 5 5 6 5 . 6 5 6 1 6 . 1 5 2 55 / 9 / 2 0 0 2 2 / 6 / 2 0 0 3 O p e n m a r k e t 9 . 3 1 5 2 9 . 1 3 5 4 2 . 5 5 3 2 . 8 5 1 9 . 2 5 4 9 . 2 59 / 6 / 2 0 0 4 1 5 / 0 7 / 2 0 0 4 O p e n m a r k e t 9 . 9 5 6 3 6 . 8 1 5 8 0 6 1 0 . 5 5 6 3 2 . 4 5 6 7 4 . 9

M P M P ( a f t e r )B u y b a c k

Post-buy back Promoters'

  Holding(%)

First buy back 45.34

Second buy back 48.48

Third buy back 50.96

Rationale for share buy-back: Reliance Energy• The buy-back proposal is being implemented in

keeping with the company’s desire to enhance overall shareholder value. The company has accumulated free reserves and satisfactory liquidity. The buy-back would lead to : – a) reduction in outstanding number of equity shares

and consequent increase in EPS of the company; – b) improvement in RONW and other financial ratios; – c) reduction in volatility in the company’s share prices

and lowering of cost of capital;– d) reflection of the under valuation of the company’s

share price; and – e) reduction in floating stock.

Share repurchase: Who gains?

• Post repurchase firm value.

• Full information price.

• Information return

• Tender premium

• Full information premium

Consider a firm that has five shareholders: four outside shareholders and one inside shareholder who controls the firm and does not tender in any buy back programme of the firm. Assume that each of the shareholders holds 20 of the firm’s 100 outstanding equity shares and that the current share price is $10. Now assume the firm proposes a Dutch auction self-tender offer for 20% of the firm’s outstanding shares at prices between $13 and $17. Suppose the price finally discovered is $15. The outside shareholders all have the same view of the firm’s prospects and therefore, each chooses to tender five shares at $15. Assume that the firm has cash holdings of $500 and has future expected annual after-tax earnings of $25 in perpetuity. Assume a 5% discount rate for the firm’s risk class. There is considerable time lag (not less than a month) between the date of announcement and the date of closure of any buy back offer. To the extent that the market views repurchases as positive signals conveying insiders’ confidence about the firm’s prospects, the market will raise its estimate of future earnings during this period- and let us assume that the new expected level is $38 per annum.

Example on Share repurchase

Why do firms split stock?

• Lowers the cost of a marketable lot.

• Increase liquidity.

• Irrational belief of the investors that the probability of a price fall is more in case of highly-priced stock than lowly-priced stock.

• Better signalling effect.

• Empirical favourable evidence.

Stock Split: Few questions to answer

• Do you intend to see your scrip trade within a price band?

• Do you want more marketing support for your stock from the brokers?

• Do you want more retail investors?

• Should you wait to split?

• Would a split send the right signal?

Final thoughts

• Dividend pay out.• Share repurchase.• Stock Split

– Are they related?– Should a company take independent view of

each one of them?– Is this the right way to create long-term

shareholder wealth?