Question

Discuss at least one reason why a company would buy back its own stock and provide an example to support your points. Also, discuss any potential negative effects of the stock repurchase. Please support using a scholarly source.

Answer 1

Share buyback is a process where the management seeks to retain control over the shareholding by buying back it's distributed stake with different shareholders. This is a very common process specially with companies that turn highly profitable with cash surplus and the founder(s)/core management wants to retain control over it's affairs. Share buyback reflects the confidence and positive future outlook from the management to consolidate its position in market.

Apple Inc. & Amazon.com are great examples to talk about share buyback.

Following are top reasons why share buybacks work:

• Tax-efficient means of returning excell capital to shareholders
• Positive signal for undervalued firms for consolidation
• Size of repurchase & time horizon is crucial to make the program a success

While there are successful cases, potential negative effects of stock repurchase have also been experienced in the industry. In case of over-valued stocks, it's repurchase destroys the value in the market. In other words, value is destroyed if share are re-purchased above intrinsic value. One of the best example is Bank of America's two year program for $ 18 Billion upto 2007, and their shares subsequently fell by 60% in 2008. Another example is AIG repurchasing its stock for $ 6 Billion in 2007 and it's value fell by 96% in 2008.

Here are few top reasons for buyback failure

• Financial Engineering to reduce stock options seldom works
• Ambiguity in disclosure and share buyback policies
• Lack of clear language in launching buyback program
• Lack of robust capital allocation