Know what is Buy-Back of Shares:

Buy Back of Shares # Meaning:

When a Company utilizes its accumulated profit which is supported by sufficient liquid funds in order to cancel a portion of its shares by purchasing either from the open market or by direct purchase from the shareholders. The primary object of the cancellation of shares is to distribute the surplus cash among the shareholders, i.e., the shareholder will get liquid cash for the shares that he purchased. The logic behind this principle is that so long as the earning remains constants, the cancellation or repurchase of share will, no doubt, reduce the total number of shares which, in other words, will increase the earning per share (EPS) as also the market price (MPS).

In short, the EPS and MPS of each share will be increased. When a company wants to repurchase its shares the same must be informed to the shareholders. However, in India, a continuous demand has been rising from the corporate sector to buy-back shares in order to increase the rate of earning and also the market price per share for the remaining shares after cancelling a part of the shares.

In other words, if the earnings of the company remains constant, buy-back of shares will result in an increase of EPS and MPS—and creating a healthy situation from the financial standpoint.

Consider the following example:

Example

10,000 equity shares of Rs. 10 each full paid

(a)     MPS                                                       Rs. 50.00

(b)     EPS                                                        Rs. 2.50

© Price Earning Ratio (a/b)       Rs. 20.00

Now, the net profit (after tax) is Rs. 25,000 (Rs. 10,000 x Rs. 2.5) (expect to maintain same level in the next years).

Declared dividend @ Rs. 2 per share, having total dividend Rs. 20,000.

As a result, the market price of a share rises up from Rs. 50 to Rs. 52 (including dividend).

Again, if the company wants to buy-back its shares instead of paying dividend, it can re-purchase by investing Rs. 20,000, only 385 (Rs. 20,000 /  Rs. 52) shares. Thus, the remaining shares will be 10,000 – 385 = 9,615 shares.

EPS will be Rs. 25,000 ÷ 9,615 = Rs. 2.60

MPS will be Rs. 52 (Rs. 2.60 x 20).

Comment:

If the cash dividend is paid to the shareholders, they would get Rs. 2 as dividend in cash and the market price of the shares would be Rs. 50 (without dividend). But, if buy-back is made, the remaining shareholders will get Rs. 2 as an increase in the market price of shares, i.e., from Rs. 50 to Rs. 52 (as an increase in EPS from Rs. 250 to Rs. 2.60).

It must be remembered here that the shares may be purchased at Rs. 52 so that the price earning ratio remains same, i.e. 20. Now if the shares are purchased at a smaller value than Rs. 52, shareholders’ gain will be highest.

As a result of Buy-back of shares, there will be a reduction in total number of shares which, ultimately, increase the EPS. Consequently, there will be a higher degree of leverage which increases the risk and the PR ratio will be lower.

If a company wants to buy-back its share, it must make complete disclosure relating to all facts in the notice convening the special resolution where it will be passed by the members.

Such disclosure must include:

(a) The necessity for buy-back of shares;

(b) Class of securities/shares to be acquired;

(c) Amount required for buy-back;

(d) Time limit for completing the buy-back matters.

(e) A full and complete disclosure of all material facts.

As per SEBI (Disclosure and Investors’ Protection) Guidelines, 2000, any buy-back arrangement of the shares proposed in any public issue shall be finalised by the issuing company with the lead merchant banker in advance and disclosed in the prospectus. Such buy-back arrangement shall be made available only to all original resident individual allottees and shall be limited up to a maximum of 1,000 shares per allottee.  A company  cannot buy-back its shares if it fails to redeem its preference shares or debentures or repay the loan taken from the financial institution.

Buy Back of Shares # Objectives:

The shares are bought back to:

(a) Increase the EPS (Earning Per Share);

(b) Increase the holding of the promoters;

(c) Distribute the surplus cash among the shareholders;

(d) Increase the market price of the shares;

(e) Thwart takeover bid;

(f) It being against the Capital structure of the company to write-off Capital which is not supported by assets;

(g) Improve the financial health after buy-back;

(h) Improve company P/E Ratio.

 

Buy Back of Shares # Conditions:

No company can purchase it own shares or other specified securities as referred to above unless:

(a) The buy-back is authorised by its Articles;

(b) A special resolution has been passed in general meeting of the company authorising the buy- back;

(c) The buy-back does not exceed 25% of the total paid-up capital and free reserves of the company purchasing its own shares or other specified securities (other specified securities mean and include: Employees’ stock option or other securities as may be notified by the Central Government);

(d) The ratio of the debt owed by the company is not more than twice the capital and its free reserve after such buy-back;

(e) All the shares of other specified securities are fully-paid up;

(f) The buy-back of shares or other specified securities listed on a stock exchange is in accordance with the regulations made by the SEBI in this behalf;

(g) The buy-back in respect of unlisted shares or other specified securities is in accordance with the guidance as may be presented. — Sec. 77A (2).

Buy-back option shall remain open for not less than 15 days and not more than 30 days.

Buy Back of Shares # Notice of the Meeting:

According to Sec. 77A (3), the notice of the meeting at which special resolution is proposed to be passed shall be accompanied be an explanatory statement stating

(a) A full and complete disclosure of all material facts;

(b) The necessity for the buy-back;

(c) The class of security intended to be purchased under buy-back;

(d) The amount to be invested under the buy back;

(e) The time limit for completion of buy-back;

(f) The price at which buy-back of securities shall be made;

(g) If the promoter intends to offer these shares.

Buy Back of Shares # Maintenance of Register and Filing of Return:

According to Sec. 77A(a), where a company buys back it securities, it shall maintain a register of the securities so bought, the consideration paid for the securities bought back, the date of circulation of securities, the date of extinguishing and physically destroying of securities and such other particulars as may be, described.

After completion of the buy-back, the company must file with the Registrar of Companies and the SEBI a return containing such particulars relating to the buy-back within 30 days of such completion, as may be prescribed— Sec. 77A(10).

Buy Back of Shares # Filing of Declaration of Solvency:

According to Sec. 77A(6), where a company has passed a special resolution or a resolution passed by the Board of Directors at its next meeting to buy-back its own shares or other securities it shall, before making such purchase, file with the Registrar of Companies and the SEBI a declaration of solvency in prescribed form.

The declaration shall be verified by an affidavit to the effect that the Board of Directors has made a full enquiry into the affairs of the company as a result of which it is capable of meeting its liabilities and will not be rendered insolvent within a period of one year of the date of declaration adopted by the Board.

The declaration shall be signed by at least two Directors of the company, one of whom should be the Managing Director, if any. The declaration of solvency is not required to be filed by an unlisted company.

Buy Back of Shares # Extinguishment and Physical Destruction of Securities:

According to Sec. 77A(7), where a company buy-back its own securities, it shall extinguish and physically destroy the securities so bought-back within 7 days of the last date of completion of buy-back.

Buy Back of Shares # Restrictions:

According to Sec. 77A(8), where a company completes a buy-back of its own securities, it shall not make further issue of securities within a period of 24 months. It may issue bonus shares.

Buy Back of Shares # Penalty:

According to Sec. 77A, if a company makes default in complying with the provisions, the company or any officer of the company who is in default shall be punishable with imprisonment for a term which may extend to 2 years or with fine which may extend to Rs. 50,000 or with both.

Buy Back of Shares # Prohibition for Buy-Back (Sec 77B):

No company shall purchase its own shares or other specified securities:

(a) Through any subsidiary company including its own subsidiary companies; or

(b) Through any investment company or group of investment companies; or

(c) If a default, in repayment of deposit or interest thereon, redemption of debentures or v preference shares or repayment of a term loan; or

(d) Interest thereon to any financial institution or bank is subsisting in case it has not complied with provisions of Sec. 159 (i.e. Annual Return). Sec. 207 (failure to pay dividend), Sec. 211 (forms and contents of Balance Sheet and Profit and Loss Account).

Buy Back of Shares # Procedure for Buy-Back:

(a) Where a company proposes to buy-back its shares, it shall, after passing of the Special/Board resolution make a public announcement at least in one English National Daily, one Hindi National Daily, and (a) Regional Language Daily at the place where the registered office of the company is situated.

(b) The public announcement shall specify a date, which shall be “specified date” for the purpose of determining the names of shareholders to whom the letter of offer has to be sent.

(c) A public notice shall be given containing disclosures as specified in Schedule I of the SEBI regulations.

(d) A draft letter of offer shall be filed with SEBI through a merchant banker. The letter of offer shall then be despatched to the members of the company.

(e) A copy of the Board Resolution authorising the buy-back shall be filed with the SEBI and stock exchanges.

(f) The date of opening of the offer shall not be earlier than seven days or later than 30 days after the specified date.

(g) The buy-back offer shall remain open for a period of not less than 15 days and not more than 30 days.

(h) A company opting for buy-back through the public offer or tender offer shall open an Escrow Account.

Buy Back of Shares # Advantages:

A company enjoys several advantages if it buys back its shares or repurchases its shares instead of paying cash dividend to its shareholders out of profits.

The advantages are:

(a) Buy-back of shares helps a firm to be more flexible to reverse the decisions or split the buy-back through longer periods in comparison with the decision to pay cash dividend by a company.

(b) Cash dividends need continued payments in future but buy-back of share is one time payment — payment is made only once. Naturally, a firm who holds excess cash but does not find any way of re­investment may utilise the same for repurchase of shares instead of paying dividend in cash.

(c) Buy-back of shares increases the control of the insiders since it reduces the number of shares, i.e., they enjoy more controlling capacity in the firm than before.

(d) Buy-back of shares helps those shareholders who want to convert their shares into cash, i.e., only the needy shareholders may tender their shares for buy-back purposes. Similarly, the shareholders who do not want immediate cash may hold it for future.

In short, buy-back of shares helps a firm to return cash to the desired shareholders and also becomes flexible for further period for existing shareholders.

But, how far the buy-back of shares are beneficial in comparison with cash dividend depend on:

(a) Nature of Cash flows:

If the cash flows are more or less stable, it is better to pay cash dividend than to re-purchase shares. But if the cash flow timings are unstable it is better to re-purchase shares than to pay cash dividend.

(b) Under-valuation of shares:

Buy-back of shares is applicable particularly where the market value of a share is less than its face value, i.e., when the shares are undervalued. If that be so, the firm may perform two goals, viz.

(i) If the shares are undervalued, the existing or remaining shareholders will enjoy some benefit if the firm buy-back its shares at a smaller value;

(ii) This re-purchase gives an information to the capital market that the shares are under-valued which, in other words, will react also.

(c) Uncertain further Investment:

If the firms are uncertain about their future investment, usually they will prefer to buy-back shares by way of return of cash to shareholders.

The discussion made so far reveals that buy-back of share is a dividend decision, it may also be treated as investment decision or financing decision of a firm.

As an investment decision:

The buy-back of shares may be treated as investment of surplus cash which, in other words, will help to give maximum benefit to the remaining shareholders as investments. When the price of the shares are undervalued the management should re-purchase its own share at a reduced price.

As a financing decision:

Buy-back of shares increases the financial leverage of a firm. The buy-back of shares reduce the amount of paid-up capital having same amount of debt financing, as such, the same will increase the financial leverage.

A firm may change its capital structure after re-purchasing of shares and issuing debt and should ascertain the capital mix between debt and equity. Thus, buy-back of shares is a method to change the capital structure or leverage of a company.