Question

Why do firms buy back the shares from investors? What do they gain? Briefly explain the economics of such a decision and its effects on value of a firm.

Answer 1

Buy Back of shares means the issuing company intends to repurchase some or all of the outstanding shares originally issued to raise capital. In exchange for giving up ownership in the company and periodic dividends, shareholders are paid the fair market value of the stock at the time of the buyback.

A company may buy back shares to reduce its cost of capital which means replacing equity financing with more cost effective debt financing. Companies may also use buybacks to profit off of undervalued shares or consolidate equity ownership. Companies may buyback to  inflate important financial metrics or free up profits to pay executive bonuses.

The most common interpretation of buybacks is that company is financially sound and does not require equity funding. So, in order to reduce financial burden in the form of equity funding and payment of dividends company wants to refund shareholders investments. This will help in reducing Average cost of capital. High level companies who are at dominate position may buy back as they may feel that there is no room left for growth, thus large capital reserves are not required. The company may buyback to capitalize the undervalued shares. If the company feels that it's shares are undervalued then it can buyback at low prices and once the market rise up it can sell the shares at high price, thus increasing total equity capital.