Why does this reduce capital, and why does this reduce the company’s ability to pay creditors?
In: 141
Sorry but a lot of answers here don’t hit the point.
When a company buys back stocks, it either is dissolved and the total number of shares outstanding reduce (mostly done) , or it goes in the treasury which doesn’t reduce total number of shares outstanding (less frequent)
In theory:
What happens to stocks?
Buying back shares reduces the number of shares outstanding in the market. But also reduces market capitalization by a proportional amount so the share price stays the same.
Why is it done?
1) This is done to increase the debt to equity ratio which provides certain tax benefits (called a tax shield in finance).
2)It also betters financial ratios like Return on Equity (ROE) and Return on Assets (ROA). As earnings would stay the same, reducing cash balance would reduce Assets (more accurately current assets) and reducing the number of shares outstanding reduces total shareholder equity (total number of shares in the market multiplied by the price of each share).
3) To prevent dilution of shares through employee stock options. Basically by giving employees stocks, they don’t want to increase the number of shares outstanding.
In PRACTICE:
Buying back shares tells investors that the company believes in itself. Which is sometimes true and other times not true. But almost always, the share price of the stock will go up. Which the company wants, as they feel that the market is undervaluing the shares, which is their primary motive.
Also, if a company has no good investments that it could make into their ventures, they give back wealth to shareholders (which in finance is the ideal thing to do as shareholders can then re-invest in something else that can generate greater returns), as it’s not the management’s decision on what it should do with shareholder wealth. Although this doesn’t happen always, especially in France, where they often go for mergers or acquisitions of other unrelated business to diversify risk, which never works bar some exceptional cases.
Sorry if this is too long but there was no other way to explain the reasoning.
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