Question

What are the advantages and disadvantages of stock buyback? Give 1 reason for each.

Answer 1

Stock buyback is the re-acquisition of stocks by the company. The number of stock outstanding decreases.

Advantage - One of the most important reasons of stock buyback is to reduce the cost of capital for the company by reducing cost of equity through buyback. When number of stocks reduce, the dividend payments it has to make in the future decreases. Thus the burden of equity gets reduced. When company has excess cash and the stock is undervalued then company may opt for buying back.

Disadvantage - When a company buys back its stocks, it uses cash which it could have used to expand its business. Raising equity is difficult and reducing equity by buying back adds to the costs. Equity and debt help to fund growth. Buying back stock may signal to investors that the company has nothing better to invest in. It could have increased marketing, expanded production, launched a new product etc. But it decided to buy back shares. Also, shares may be over valued. Judgement error may be there regarding valuation which may lead to poor utilisation of capital.