What happens when a company buys its own shares?

Question

Why does this reduce capital, and why does this reduce the company’s ability to pay creditors?

In: 141

Answer 1

Before answering your questions, it’s important to note that a company cannot hold stock in itself. A stock is a claim to the value of a company after it pays its creditors. If a company held its own stock it would be claiming that part of its value is that it would pay itself. When a company buys back its own stock, those shares are retired; they no longer represent a claim against the company.

>Why does this reduce capital

Capital is a (usually large) subset of assets, and cash is part of capital. Spending money to buyback your stock reduces the cash you have. Cash decreasing means capital decreases.

>why does this reduce the company’s ability to pay creditors?

The ability to pay creditors is reduced because there is less cash. The debt covenants (agreements that company makes when borrowing) typically put restrictions on buybacks for that exact reason. If the company spends $10 on buybacks today, it will have $10 less when it comes time to make payments on its debts.