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

A share is a piece of paper. It’s a contract that says you own some percentage of a company.

As the company goes along, sometimes it needs money. To get that money, it can either sell part of itself (issue shares) or borrow money. To get lots of money (there are factories that cost a billion dollars to build, and some that cost more), they issue bonds. Like shares, they’re contracts, but bonds are to simply pay interest until the maturity and then pay off the principal.

Corporations are (mostly) large. They generate lots of money every year, but they use lots of money every year. Much of the money they use comes from the money they get. But sometimes they make more money than they need. There are several things they can do with this money.

1. They can pay larger dividends to the shareholders. This makes the owners happy, but it also creates the expectation that next year the dividend should be even larger, and if it isn’t then the shareholders get mad.
2. They can use it to expand the business. Open more stores, build more factories, whatever.
3. They can save it for when they do need the money. This is dangerous because corporate raiders tend to buy companies with large cash reserves (“unused assets”) and then use the cash to pay off the loans they took out to buy the company. Just like a dragon sitting on a hoard of gold, you have to watch out for adventurers.
4. Or they can use it to buy shares on the open market, essentially giving the shareholders the choice of selling (turning their shares into cash) or holding (having a shares that are worth more). This gets rid of that juicy target for adventurers to come in and steal their gold.

When they own the shares, they become what are called treasury shares. The corporate charter says how many shares they can issue. If they just sit in the treasury, they can just choose to sell them any time they want. If they retire them, then in order to issue more they have to issue new shares, go through SEC registration, pay one of the financial banks (not commercial banks) to sell them, and so forth. Lots of work and expense.