A buyback is a transaction in which a company buys back its own shares. It is capitalization of its own surplus cash. hence it can also be viewed as an alternative to cash dividends. Shares that have been issued and subsequently buyback are classified as treasury shares. They are not then considered for dividends, voting rights or computing earnings per share(EPS). Some of the basic reasons for share buyback or repurchase are:
1. Management perceived shares in the company to be undervalued in the market place or more generally to support the share price. Company intrinsic value is more than market price.
2. There is no better opportunity to deploy cash, which can generate better returns than cost of capital.
3. Tax efficiency in distributing cash, in market in which the tax rate on cash dividends exceeds the tax rate on capital gains.
4. To absorb increase in share outstanding resulting from the exercise of employee stock options.
5. Capitalization of reserve and surplus to improve ROE.
Various share buyback method used by the companies are:
1. Buy in the open market
2. Buyback of fixed number of shares at a fixed price
3. Dutch Auction
4. Buyback by direct negotiation
Post buyback will lead to the change in the earning per share and book value per share.
Change in the Earnings per share- The buyback may increase , decreases or have no effect on the EPS. The effect depends on whether the buyback is financed internally through cash surplus or externally through borrowings. In the case of internal financing , a buyback increases EPS only if the funds used for the buyback would not earn their cost of capital if retained by the company. In the case of external financing , the effect on EPS is positive if the earning yield ( EPS/Market Price ) exceeds the after tax cost of financing the buyback. There is no change in the EPS if the earning yield is equal the after tax cost of financing the buyback. The effect on the EPS is negative if the earning yield is less than after tax cost of financing the buyback.
Change in Book Value per share- when the market price per share is greater than book value, any share buyback will reduce the book value per share. When the market price per share is less than book value , book value per share increases.
There are many IT companies announced buyback offer to the investor in the past and generally uses buyback of fixed number of shares at a fixed price. Buy in the open market gives more flexibility and less compliance to the companies to buyback their own shares at lowest levels.
If we consider the case study of Infosys which has announced buyback on Saturday,
19th Aug 2017, The Infosys has announced buyback of fixed number of shares at a fixed price.
It is clear strategy of the board to boost the sentiments in the market and further arrest the fall in the price. It
is opportunity for retail investor (amount of investment up to Rs 2 lacs) to buy the share from the open market and tender the share for buyback offer and
earn an upside of 31.5%. The probability of acceptance in retail category (appox – 60%) is quite high because of lower retail client base.