Question

1. Lender Scenario:
   You are the loan officer for a commercial lender. You have just received a request from the company you are researching to provide loan funds that will allow the company to buy back 3% of its outstanding common stock. The company has indicated to you that it feels their stock is undervalued at this time.
   
   • What is your response to their request?
   • What will this do to the company’s various debt and equity ratios?
   • Given the competition, should the company alter its capital structure in this way?
   • What interest rate would apply to the loan, and what will happen to the company’s TIE/FCC calculations if the loan is pursued?

Answer 1

Answer :-

A buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors.

With stock buybacks, aka share buybacks, the company can purchase the stock on the open market or from its shareholders directly. In recent decades, share buybacks have overtaken dividends as a preferred way to return cash to shareholders. Though smaller companies may choose to exercise buybacks, blue-chip companies are much more likely to do so because of the cost involved.

As a loan officer i would like to suggest on the undervalue of stock :-

Company genuinely feel their shares are undervalued. Undervaluation occurs for a number of reasons, often due to investors' inability to see past a business' short-term performance, sensationalist news items or a general bearish sentiment. A wave of stock buybacks swept the United States when the economy was undergoing a nascent recovery from the Great Recession. Many companies began making optimistic forecasts for the coming years, but company stock prices still reflected the economic doldrums that plagued them in years prior. These companies invested in themselves by repurchasing shares, hoping to capitalize when share prices finally began to reflect new, improved economic realities.

If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re-issue them once the market has corrected, thereby increasing its equity capital without issuing any additional shares. Though it can be a risky move in the event that prices stay low, this maneuver can enable businesses who still have long-term need of capital financing to increase their equity without further diluting company ownership.

My response on company's view on the buy back of their shares which are undervalued is company first should buy back their shares at lower price and than re-issue the shares at higher price so it can have the additional capital without issue the fresh shares.

What will this do to the company’s various debt and equity ratio :-

Debt to equity ratio measures the financial leverage of the company.

It is calculated by dividing the Total debt by the Total Equity during the year

It represents the proportion of debt a company takes to finance its operation.

Buyback of shares reduces the equity of the company.

Since the equity of the company is reduced it increases the debt to equity ratio of the company.

For Example, a company has debts amounting to 50 crores.

The company’s equity is 100 crores before the buyback.
The company has undertaken buyback worth 10 crores during the year which reduces the equity of the company to 90 crores (100-10).

Hence the debt to equity ratio deteriorates from 0.5 (50/100) before buyback to 0.55 (50/90) post buyback

Thus a rise in debt equity ratio negatively impacts a company’s profitability

Impact on book value of shares

Book value per share is derived by dividing shareholder’s equity by the total outstanding shares.

A company’s book value per share will decrease after a share repurchase if the market price per share was greater than the book value per share prior to the repurchase and vice versa.

Hence if company buy back their shares than it will increase its equity which will increaases its debt equity ratio .

Given the competition, should the company alter its capital structure in this way?

Finance research shows capital structure has an important effect on the product-market competitiveness of firms. Our paper documents an asymmetric effect of capital structure on firms’ competitiveness. Firms whose capital structure is characterized by a low leverage but rapid leverage growth has a dominant position in their product market. The industry average leverage ratio is also a critical factor influencing firms’ competitiveness. High debt levels hinder firms’ competitiveness. The influence of capital structure on firms’ product-market competitiveness varies based on the extent of industry concentration. In highly concentrated industries, high leverage level and slow leverage growth suppress firms’ competitiveness to a larger extent compared with industries with low concentration.

Capital structure influences a firm’s and its competitors’ selections of competitive strategies in the product market and further influences the competition results. However, in previous studies, theories on the relationship between the selection of capital structure and product competitiveness have diverged.

Strategic commitment theory supports that high leverage is favorable to product-market competitiveness. Concerning output competition in the product market, debts imply a firm is committed to increasing productivity, expanding the market share, and performing more aggressive actions. After paying interest, the free cash flow remaining for shareholders decreases for a firm with increased leverage. In addition, because of the limited liability effect , shareholders aim to increase the production output to obtain high revenue. In an industry with low concentration and without technological barriers and where competitors generally have low debt levels, the increase in a firm’s leverage ratio is favorable for increasing output and enhancing its product-market competitiveness.

Hence company should alter its capital structure accordingly the competitivness in thee market it should first research the market than only it have to alter the capital structure.

What interest rate would apply to the loan, and what will happen to the company’s TIE/FCC calculations if the loan is pursued?

In the past, a number of the heaviest repurchasers — including Apple Inc. and Microsoft Corp. — funded their buybacks not with cash, but rather with debt. This is because prior to tax reform, when interest rates remained low, it made financial sense for certain investment-grade issuers to take on debt domestically while keeping large piles of cash overseas as the interest rates on the debt were significantly lower than the tax rates the companies would have faced for repatriating their cash.

That strategy has now been turned completely on its head as companies simultaneously pay down debt and pay out for enlarged capital return programs, debt analysts said.

The spike in buybacks comes at the same time that the U.S. Federal Reserve is raising its benchmark interest rate. The Federal Open Market Committee recently set a target range for the federal funds rate of 1.75% to 2%, up 25 basis points from the previous level. Moreover, the central bank signaled it may take a faster path on rate hikes this year, with some Fed officials favoring increasing the rate four times in total this year.

"At the end of the day, companies are starting to balance the needs of the two constituents — both equity holders and debt holders. So there will be significant buybacks but for mega caps that had significant amounts of debt … they are also likely to unwind their debt position as well," Andrew Chang, director of S&P Global Ratings services, said in an interview.

In particular, he expects a "significant increase in share repurchases in calendar 2018 and even in 2019 mostly led by the bigger caps such as Apple, Oracle [Corp.] and Cisco [Systems Inc.] — the really large companies who have been parking their cash overseas in lieu of repatriation for many years." He noted that these repurchases will be funded with cash on hand.

Hence it will apply fixed rate of intrest to the loan .