The Financial Engineer's Most Versatile Tool - Dissertation Example

The Financial Engineer's Most Versatile Tool Summary There has been a rise in the share buyback programs of the companies. This can be an efficient instrument of financial re-engineering provided the firm managers use it in the due interest of the company and the investors. However the managers biased in favour of debts use this mechanism to substitute equity with debt. This raises serious financial issues for the company. Besides increasing the gearing ratio of the company it impacts important ratios. The impact of leveraged buyback of shares on Vodafone Plc has been explained with the help of qualitative and numerical analysis. The EPS graph of the company has been shown for a five year period to highlight the rise in the earnings per share due to a stock repurchase program. The deterioration in the important financial ratios like interest coverage, return etc has also been shown with the help of suitable graphs. Introduction An announcement of a share repurchase by a company is valued highly by the market participants interpreting it as a ‘buy signal’ for its stock. So the company has good reasons to buy-back its stocks but sometimes these share buyback programs go awry. Despite the popularity of such programs as evident from the recent buyback deals there are concerns whether the firm or the shareholders derive any gains from it. One reason favouring the buyback deal is that at any point of time the surplus cash lying with the management can be used for buyback of shares thereby returning the funds to the shareholders. It has been seen that idle cash makes the managers complacent so buying back of shares can be one way of instilling confidence among the investors. From the view-point of the company stock buyback results in increased Earnings per share (EPS), share price and increases the value of “executive stock options” (Ogilvie, 2006, p.51). However, the share buyback strategy can be dangerous if the company finances the buyback of equities using borrowed funds. Financing buyback using loan stock may look tempting in the short term but some years down the line the company has to pay back the loan. In the event of an economic recession the company will have to struggle with fund shortage. A rise in the share price, increase in company EPS are all good signs but not at the cost of endangering the position of the company in the future. The board of directors must keep the interests of the shareholders in mind while considering share buyback programs. Evidence behind share repurchases A significant research has been conducted especially in the area of share repurchases. The evidences from this research indicate that there is a strong market response on the announcement of share repurchase program. In the studies conducted by Asquith & Mullins (1983) and Damn et al (1981) it has been shown that the market responds positively to stock repurchase announcements, be it in the form of an “open market repurchase” or “a self tender offer”. There have been abnormal returns in the case of share repurchase offers. A study on long term market returns, by C.J. Loomis analysed the repurchase offers during the period 1974 to 1983. His studies revealed that the shareholders of the companies that undertook stock repurchase programs earned a compounded yearly return of 22.6% with the S&P 500 reporting a return of 14.1% during the same period. Though the above evidences support a positive response to the share repurchase offers some papers some papers have highlighted the negativity associated with such programs. As per the papers against share repurchase, the stock repurchase decisions by the company manifest signs of poor financial and operating performance, in fact it signals that the company has limited potential investment opportunities. Studies conducted by R. Norgaard and C. Norgaard (1974) shows that the managers of the firms involved in share repurchase offers have poor anticipations about the future earnings prospects of the firm (Hunt, 2009, p.376-378). Share buyback program of Vodafone Plc The company initiated a number of share buyback programs in recent years. Om May 24, 2005 the directors of Vodafone Plc set aside £4.5 billion for its share purchase program for the financial year ending March 2006. Recently in the financial year 2008 the Board introduced a share repurchase programme of £1 billion. At the time of making these decisions the Board of directors review the anticipated fund requirements, credit profile, gearing impact, dividends etc. The share purchase programmes in the company are considered in conjunction with an impact on credit ranking. Vodafone Plc aligns its share purchase programmes so as to maintain its “single A credit rating” (Vodafone Limited, 2010). Arguments in favour of share repurchase A common argument in favour of share repurchase deal is that it tackles the problem of dilution of ownership giving the managers the flexibility to take prompt decisions. Unlike the cash dividends that force upon the company to make regular dividend payments the share repurchases is a ‘one time’ cash return deal for the company. If the management thinks that the excess cash flows are only temporary it can distribute it among the shareholders in the form of share repurchase and avoid paying high dividends which the company may find difficult to sustain in the future. The stock repurchase program has an impact on the firm’s ownership structure. One motive of the firm behind such deal can be ‘control issue’ as it can serve as a defence mechanism against “hostile takeovers”. This can increase the ownership concentration of the insiders vesting stronger voting power and control in their hands (Baker & Powell, 2005, p.435). The stock repurchase program by the company management can disseminate positive signal to the various market participants. This kind of repurchase indicates that the management is bullish about the company’s stock. Moreover share repurchases competes more favourably with other investing options like acquisitions and other internal investments. Besides the repurchase of company’s stock helps in thwarting takeover bids induced by low price of stock (Angel, et al., 1999, p.34). The stock repurchases are initiated by the company at a time when the management feels that the shares of the company are undervalued. If the management of company is confident about the potential of the company then it tends to buy back the shares from the market. Often the market participants fail to assess the true strength of the company resulting in low valuation of its stock. In these situations the buyback by the company management sends out positive signals to the investors (Investopedia, 2011). A share buyback lowers the number of shares in the hands of the public resulting in increased earnings per share for the company. The fall in the number of shares impacts major financial ratios like EPS and ROE. A company can achieve an ideal mix of safe and risky assets by taking part in share buybacks. Vodafone Plc has initiated a number of share repurchase programs over the last decade. In 2009 the company management purchased 736 million shares from the market at an average price of 135.84p. Owing to the frequent stock buybacks of the company the EPS of the company has maintained a sustained rise over the period (London Stock Exchange plc, 2011; Vodafone Group Plc, 2009). From the above table it is clear that the EPS of the company has moved up from 10.11p in 2006 to 16.11p in 2010. This is in line with the aforementioned statement that the share repurchase increase the EPS. In 2009 the company reported the highest rise in the EPS. It increased from 12.56p in 2008 to 17.17p in 2009. In the same year Vodafone Plc had undertaken the share repurchase program of £1 billion. The net profit of the company dropped from £6756 million in 2008 to £3080 million in year in which the company undertook the repurchase program. Despite this the earnings of the company increased on a per share basis for 2009. The profit of the company nearly halved in 2009 but the EPS moved up in the year. This can be due to the reduction of the outstanding equity. Buoyed by the company’s announcement of a stock repurchase the share price of the company rose by nearly 2.4 to close at 131.4p. The Board of directors viewed the stock price of the company to be undervalued by the market (White, 2008). This may be one of the reasons for the announcement of the stock repurchase program as it has already been stated that stock undervaluation is one of the reasons for the companies to indulge in buyback activities. At the time of making the share buyback programs the management of Vodafone Plc reviews the impact of the program on the availability of free cash flow, effect on gearing etc. This is important as financing the share repurchase program from raising debt is not in the financial interest of the company. Though this looks attractive in the beginning it can have future repercussions. Arguments against share repurchase The share repurchase when financed out of idle cash resources can increases the EPS of the firm. However if the stock repurchase transactions are financed put of the new debt then it raises the financial risk of the company. For the companies that are already neck-deep in debt participating in share buyback programs can prove to be a financial hazard. The stock buyback programs are also criticised citing reasons like it is a way of boosting falling share prices or a way of veiling poor performance. Therefore though some of the firms have legitimate reasons to go for stock repurchases the management must weigh the benefits with the pitfalls. The stock repurchase plans give rise to agency conflicts. By acquiring the shares from the public the proportional ownership of the managers goes up. This concentrates the control in the hands of the managers. It can lead to wrongful decision making. The managers not being the real owners may partake in risky business ventures thereby giving rise to agency conflicts with the shareholders of the company. The stock repurchase program is touted as a way of avoiding hostile takeover bids but this increase the entrenchment of the managers. To invest in a business venture the managers of the company have to obtain the approval of the majority shareholders. The share repurchase reduces the formalities associated with approval but at the cost of increasing the business risk. The share repurchase offers may attract penalties if the Internal Revenue Service (IRS) finds a repurchase offer to be biased in the favour of the shareholders. In other words, if the repurchase program is viewed as a means of tax evasion then the tax authorities can prohibit such programs. The firms are often said to indulge in share repurchases in a bid to manipulate stock prices. So the regulatory authorities like Securities and Exchange Commission (SEC) can take strict action on companies that try to inflate their stock prices by way of stock repurchase programs. The share repurchase offers is also said to impact the trading activity of the company’s stocks due to lesser number of outstanding equity. The fall in the level of trading activity of the company’s shares impacts the liquidity of the stock. The buyback along with the merger related deals eats away the stock available to the shareholders. As per analysts this is the main reason for some of the bullish movements in the market. The prudent investor scans through the facade of share repurchase offers to gauge the reasons for such deals. This helps them in assessing whether the offer is worth taking up or it is best to be avoided. The employees of the company are entitled to buy the shares at less than market prices as per the terms of employee option plans but the company acquires the shares at the price prevailing in the market. In monetary terms the outstanding shares of the company may appear to be shrinking as the company spends more on buying shares from the market than the amount shelled out by the employees to acquire the shares whereas the number of outstanding shares may remain the same or may even rise. The report prepared by the department of equity-strategy at Salomon Brothers states that if the shares issued under the various option plans of the companies under the S&P500 stock index are accounted in terms of market value, the figures would reveal a net issue of new shares rather than a reduction in the number of stock. Besides the issue of new shares under the stock option plans another factor that undermines the benefits arising from share repurchase plans is debt-financing of buyback deals. The managers are always biased in favour of debt issue as the cost of debt is less as compared to equity. Besides the interest paid on loan funds is a tax deductible expense thereby, reducing the tax outflow. Recently the firms are financing their share repurchases using debt. These moves are beneficial from the view-point of taxation but it simply substitutes equity with debt implying that the shareholders derive the benefits at the cost of an increased leverage. Using the borrowed funds jeopardises the long term prospects of the business as in times of economic downturn the servicing of debt can become a real burden for the company. It has been seen that the companies indulge in share buyback plans by cutting down the dividends and raise additional debts to finance its share repurchase programs (Mcgee & IP, 1997). A positive association between the repurchase and cash resources is more pronounced in the case of companies with low levels of gearing. However if the buybacks increase the company’s gearing ratio then it raises concerns relating to financial distress thereby, questioning the usefulness of a stock repurchase program. A positive association is said to exist when there are limited investment opportunities. Dittmar (2000) shows that the share repurchases plans are negatively linked with gearing. An important argument in favour of share acquisitions using debt is that it lowers the corporate taxes and hence reduces the average cost of capital for the firm. However another explanation highlighting the negative relation between share reacquisition and debt is that debt contracts are binding in nature and raises the risk of insolvency. The firms with high gearing ratios have to often let go off lucrative investment opportunities (Oswald & Young, 2002). In the case of Vodafone Plc also there has been a steady rise in net gearing. In the year 2006 the company reported a net gearing of 95.47%. This increased to 140.19% in the following year. In the recent years the net gearing of the company has more than doubled. For 2009 the net gearing was maximum at 325.15%. The company undertook the share repurchase program of £1 billion in the same year. In the year of share repurchase the debt componnet of the company jumped to an unprecendented level. This is reflected from the high net gearing of the company for the financial year 2009. A high gearing detreiorates the financial strength of the company with a fall in the important efficiency and return ratios. In the case of Vodafone Plc the share repurchase program has coincided with a fall in the interest coverage. The interest covergae ratio reported by the company for the year 2009 dropped to 3.4. This was 7.2 in the preceeding year. So the interest covergae ratio declined by nearly half in 2009 (Msn Money, 2011). Another argument in favour of repurchase that it raises return on equity has also ben disproved in the case of Vodafone Plc. Going by this argument after the share repurhase program conducted by Vodafone in 2009 the ROE of the company should have moved up however the ROE of the company dropped this year (Morningstar Inc, 2011). From the above figure it is clear that the ROE of Vodafone declined significantly in the year 2009. This contradicts the view that share repurchase programs enhance the ROE of the company. One reason for this can be ‘falling profitability’. Even in the case of Vodafone Plc the profits for the year 2009 reduced by nearly half from £6756 million in 2008 to £3080 million in 2009. This can be explained by the steep rise in the interest obligations of the company. For Vodafone Plc the net interest increased from £1300 million in 2008 to £1624 million in the following year. The rise in the fixed debt obligations has mainly been on account of the rising leverage of the company. Therefore financing a stock buyback program with the help of leverage can be a dangerous financial strategy. The managers undertake this strategy with a view to lower corporate taxes but if the ideal level of leverage is breached then it can expose the company to serious financial hazards. It is believed that the firms use repurchase as the means to achieve an optimal capital mix. However, tests conducted on UK firms reveal the contrary. Studies on UK firms does not give credence to the view that the UK firms make use of the share repurchase as a mechanism to manage their capital base when gearing drops below a pre-set optimal level (Oswald & Young, 2002). Conclusion On the whole it can be said that buying back of shares is an important way of using idle cash resources. However this mechanism can prove to be useful provided one can do away with the abovementioned inconsistencies and anomalies. This strategy must be used as a means of enhancing the value of the company and not as an instrument to trick the investors. The leverage if at all used for financing share repurchases deals must be kept within the acceptable limits. The purpose of undertaking a buyback program is value maximisation. If the managers feel that its shares are undervalued by the market participants then the share repurchase programs are justified. The buying back of shares at the prevailing market price can give out positive signals to the investors provided the managers act in the common interest of the company and the investors. Reference Angel, J.J. Gastineau, L.G. Weber, J.C. Fabozzi, J.F. (1999). Equity flex options: the financial engineer's most versatile tool. John Wiley and Sons. Baker, K.H. Powell, E.G. (2005). Understanding financial management: a practical guide. 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Available at: http://www.bloomberg.com/news/2010-09-19/stock-buybacks-surge-as-companies-borrow-cheaper-debt-for-share-purchases.html Read More