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 also called as share repurchase refers to a company buying its own shares with an intent to lower the number of shares of the company in the market.Companies resort to share repurchase with an intent to lower the number of it's shares in the market so that the Earnings per share and value of stock will appreciate.

Tax Aspect

Te tax to be paid on a buy back is often lower than that is to be paid on a dividend since buybacks are taxed using capital gains tax rate and dividends are taxed using the ordinary income tax rates when received .This is beneficial to the investors

Shareholder wealth Maximization

The ultimate objective of a firm(management ) is to maximize the value of its shareholders.During certain times the repurchase of shares or the firm's decision to invest in itself maybe the better option foe shareholder wealth maximization.

Financial Ratio Aspect

when a firm decides to repurchase it's shares it would result in lowering the total equity and subsequent lowering of total asset which would result in an increase with regard to Return on Equity and Return on Asset ratios.A lowering of the number of shares outstanding would result in an increase in earnings per share and lower Price Earnings ratio both of which are favourable to the firm.

Reduction in Dilution

Companies often offer employees stock options in order to retain their employees .The stock options given has the opposite effect of a buy back.So the use of buy back by a firm would lower the dilution of shares which in turn would improve the ratios(EPS) and thereby improve the firm's position in the eyes of a potential investor.

These are the main reasons that a firm would buy back it's shares and it's resulting economic effects.