Question

What are the advantages and disadvantages of the residual policy? (Hint: Don’t neglect signaling and clientele effects.)

Discuss the advantages and disadvantages of a firm repurchasing its own shares.

Answer 1

The advantages and disadvantages of residual policy:

The primary advantages of such kind of policy is that (1) the firm can have the maximum use of retained earnings which comes at a lower cost, this would result in (2) minimization of floating cost and hence overall cost of capital. Negative signals related to stock issues would be avoided through this policy. However, under this policy, the dividend payment may get fluctuated from year to year due to need of cash flows for internal use etc. Hence, this will result in (1) conflicting signals to investors regarding the future of company and its business (2) this will lead to investors leaving the firm and investing in a new firm with higher dividend payout ratio. Therefore, the clientele will get affected. These signal and clientele effect will increase the overall required return on equity and thus higher cost for the company.

Advantages and Disadvantages of a firm repurchasing its own shares

Advantages:

• A repurchase announcement sends a positive signal in the market among investors that the stock may be undervalued in the market.
• It can be used for making radical changes in the capital structure of a firm, thereby increasing the stake of promoters or equity holders in the longer run, which ois good from a firm’s perspective.
• Repurchases can be different in different years, there is no necessity to have a similar pattern within the same like dividend policy etc.
• Stock repurchases is not an obligation of a firm that investor excepts from the firm, however, if the excess cash is used to pay dividend then the firm will have to maintain the same to avoid any adverse reactions among the stock prices.

Disadvantages:

• It may lower the stock prices, because investor may think of it as misuse of the excess cash and an unproductive alternative for use of cash.
• The firm may end paying quite higher prices for the shares in the process of bidding.
• If repurchases are made with an aim to avoid taxes on dividends and the same is established by agencies, penalties may get imposed on the firm for such acts.