Question

Some financial analysts claim that the rise of the US stock market over the past decade is largely due to the repurchase of common stocks by big corporations using debt financing, such as Boeing and Intel. Is this claim valid? Explain carefully. In your explanation, explain under what circumstances this assessment would be valid, and state and explain the important assumptions in your arguments. (15 pts)

Answer 1

Solution:

Claim of financial analysts is justifiable considering that buy back of stock would lead to lesser number of shares available to trade in the market, and investors will get short term boost of their share prices. This would lead to rise of stock value for short duration.

Public companies with reasonable profit margins are expecting earning per share (EPS) to rise. And fewer number of shares in the market can make a difference in the rate at which EPS rises. This helps company to keep up market expectations for their performance and assist them to increase stock value.

Companies with better performance are expecting stock price to go high, and it would provide them higher rate of return, hence they intend to buy back their when it is undervalued in the market for various reasons and may use debt for the same purpose. Using debt for stock repurchase would mean that company doesn’t have excess cash available or it want to utilize the excess cash in expansion or other growth opportunities. This indicates that return of their investment would be higher than the interest rate they pay for debt. Companies also considering the tax benefits they can get as interest on loan is tax deductible.

Companies buyback its shares considering that share prices are undervalued in the market. Undervaluation of stock could be triggered by various reasons for example poor performance for some quarters, negative news overall bad market sentiment etc. Hence companies invest in their own stock hoping to capitalize when share prices finally started to reflect reasonable price level. This move also helps company increasing their equity capital without issuing new shares which would dilute their ownership.

However, it may be noted that repurchase of shares often benefits large shareholders. Stock buyback usually boost stock price in short term, and investor then exercise its option to sell the shares in the market when stock reaches its expected level and book profit. This is usually against the corporate governance practices of the company, and company should only buyback when it intends to retain the shares for longer duration. This also leads to credit rating downgrades.