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.
Most of the comments here are written by business major freshmen. Here’s the simplest answer without going into preferential shares and other technicalities.
Nothing changes. The company spent money to buy an equivalent amount of % of itself.
I am the founder. I decide to sell 500 of my 1000 shares at 10$ per share.
The company is worth 10,000$ but only 50% is available for purchase. I get 5,000$ cash and still “own” 50% of it.
Investors expect a return so unless they’re dumping stock, I can only buy my own shares back at the asking price at any time. Normally this doesn’t make sense as I’m just buying back at a higher price what I myself sold.
Let’s say my company doubled in value, it’s now worth 20,000$. Half of it still belongs to other investors. If I want to buy the shares from them at “current” price so i have to pay 10,000$. If I do so, I now own 100% of my company and have 10,000$ cash left. We’re back to where we started, it’s a net zero transaction. The only benefit is now I own 100% and can resell it if I choose to do so.
There are cases where this is beneficial but generally stock buy back is a financial instrument tied to ownership, dividend split and some other stuff.
Use profits to increase share price for investors and pay less tax on profits. Then get greedy, do it too much, artificially inflate share price, have no safety net, something bad happens, ask the government for a bailout using tax payer money, profit.
If you have 100 dollars to pay your bills this month but you spend that cash and buy 100 dollars of candy, you no longer have that money to pay any bills.
Capital, in this example is just money (or an asset that can be quickly turned into money). So turning cash into candy reduces your capital.
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.
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