Share Buyback: Apple Case Study - Essay Example

Share Buyback: Apple Case Study Introduction Organizations use different strategies in order to boost their financial performance. However, there is uncertainty concerning the effects of various financial actions in organization’s leverage or gearing (Alpha & Roydon, 2009). Share buyback is one of those strategies used by companies to improve their financial performances. The company can repurchase some or all of its shares from the existing shareholders either intermittently or in a single offer. Such decision could have an implication that the management of the company is lacking better investment opportunities in which case it may discourage investors from investing their resources in the company (Ross et al., 2005). Alternatively, share buyback could be an indicator that the management of the company perceived the stock of the company is undervalued in the stock market (Bose, 2010). In this case share buyback implies future price increase thus offering investors with better investment opportunities. This study examines the effect of shares buyback on companies gearing using the case study of Apple Inc. Theoretical Background Leverage or gearing refers to techniques used by the managers of the company to increase gains and losses of the company. Businesses acquire funds to purchase their assets and invest in income generating activities (Bose, 2010). They borrow funds with expectations that the gains from the investments will be greater than the cost of borrowing hence increase the business revenue. However, the acts results to increase in business risk because there is the probability that the cost of borrowed funds will be higher than the returns of the investments thus result to loss for the company (Alpha & Roydon, 2009). Therefore, leverage impacts the income of the company due to changes in sales revenue and the cash fluctuations that result to reduction in cash held in the business. Companies’ decision for buying back shares from the existing shareholders can be contributed by several factors (Cahill, 2013). For example, the managers may decide to repurchase shares in order improve returns from the business such as earning per share (EPS) and leverage. These are financial indicators of how the company is performing and the debt-equity ratio of the company. When company repurchases shares the returns increase due to decreasing supply of the number of shares in the market (Apple, 2013). The cash held by the company is treated as assets and once the company decides to repurchase shares its assets diminishes which results to an increase in the earnings of the shares. When company repurchases its shares, it increases its control over the business and diminishes the possibility of a takeover by other companies that may occur when another company decides to buy a huge quantity of shares of another company (Alpha & Roydon, 2009). Therefore, improved financial performance and value of the company’s stock safeguards the company against aggressive takeover. Also, when the management is convinced that the market value of its shares is below the shares book value they may decide to repurchase them hoping their prices will rise in the future and resell them to the investors at a profit (Grullon & David, 2000, p. 37). The value of company shares can cause to decline due to several factors. For example, when the general economic status of the country is deteriorating the value of assets tends to decline because investors may fear losing their investments. On the other hand, the management may have undisclosed information to the investors concerning the stock value of the company (Fabozzi, 2008). Therefore, when the management is aware about the prospective financial position of the company because they are better informed than the investors they may decide to repurchase the company’s shares in order to avoid maintain the value of its assets (Cahill, 2013). Furthermore, the managers may be concerned that having too many shares in the market may result to dilution of the shares in the market. Share dilution is where the shares value decline due to oversupply of shares in the market. The decision of the company to repurchase shares enables the company to adjust its leverage ratio or adjust the capital structure in case they are overcapitalized (University of Wasaensia, 2004). For example, when the company uses its resources to repurchase the stock it will result decreased leverage. On the other hand, when the company decides to use borrowed funds to repurchase shares it will result to an increase in leverage of the company (Grullon & David, 2000, p.41). Therefore, share buyback offers the company an opportunity to balance between equity and debt ratio. Shareholders get dividend based on the number of shares they own and the revenue the company attains from it trading activities (Haigh, 2013). When a company repurchases shares, it increases it flexibility of distributing its surplus income to shareholders. Although companies are hesitant to pay a huge dividend to shareholder's share buyback enable companies to continue distributing surplus cash to the shareholders during the purchase of shares (Fabozzi, 2008). This gives the companies an opportunity to maintain a steadily divided policy while sharing the surplus income with shareholders through stock purchases (Grullon & David, 2000, p. 45). This is possible because the company can share it income with the investors while maintain steady dividend policy. Furthermore, when investors sell their shares they are no longer required to pay tax to the government from the share dividends (Ross et al., 2005). Therefore, when company decides to carry out share buyback investors gain from the capital growth because there is no taxation requires, unlike the dividend. Therefore, increasing company’s leverage through share buyback can benefit the investors due to increasing capital gain and tax exemption that would otherwise have been paid on the share dividend (Dow, n.d). Repurchasing the company’s shares reduces the number of shareholders as well as the control of the shareholders in the business (Haigh, 2013). Reduction in the number of shares of the company in the market result to increase in its leverage and the consequent increase in the overall value of the firm (University of Wasaensia, 2004). However, increasing of leverage exposes the firm to risk. Therefore, the firm managers must strive to strike an optimum level between risk and gains. Increase in business risk can be extremely dangerous because it can result to liquidation of the company (Haigh, 2013). Despite the perceived benefits of share buyback there is an intense fear that such a move may appear to the investors as intended to stagnate the business expansion (Alpha & Roydon, 2009). The organizations spend some of its earnings in paying dividends and buy back to the shareholders that result to decrease in cash available for investment opportunities. Therefore, when company starts repurchasing shares it could imply that it has exhausted all its investment ideas and had no hope for expanding its investments (Haigh, 2013). The other concern is the correlation between the leverage ratio and poor portfolio returns. As suggested by debt overhang theory, any offer that raises gearing creates probability that the company may have to sacrifice feasible ventures the future (Dow, n.d, p. 98). This may arise because the net present value of the projects will decrease compared to the initial expenditure after adjustments for debt liability. Therefore, repurchase of shares results to undervaluation of the company because repurchase results to decrease in the real investment of the company. Consequently, reduction in investments in the company diminishes the opportunities for future expansion of the business (Haigh, 2013). Reducing the number of shares in the market through share repurchase can result to reductions in share prices if other factors remain constant. The theory of free cash flow implies that when company repurchase shares could imply that the company is not willing to invest resources in the available opportunities (Cai & Zhang, 2010, p. 9). Availability of more capital in the business results to increased repurchase of shares hence increase in flexibility. Increasing business leverage increases business risks because of high probability of default in repayment of the debt. Repurchase of shares increases results to decrease in share price due to increase in leverage (Cai, & Zhang, 2010, p. 13). Companies that are operating at a profit can make borrowings. There is no lender willing to advance loans to the company with poor performance. Furthermore, companies acquire loans to finance their activities and repay the borrowed capital and interest with income they generate from the business (Vause, 2009, p. 131). However, when company decides to repurchase shares it diminishes its credit rating because the assets of the business are diminishing. This implies that the company may not be able to acquire loans for expanding business activities (University of Wasaensia, 2004). Therefore, when the company decides to repurchase shares they get exposed to the risk of failure to secure financing for future growth. Companies raise funds to finance their business activities from various sources. Use of retained earnings is one of the cheapest sources of business funds because it the company is not expected to repay it back or pay any interest on that amount (Cai, & Zhang, 2010, p. 16). However, when the company repurchases the shares it will exhaust the retained earnings and will not have cash to fund its future activities even if better opportunities become available in the future. It would be better if the company kept the surplus earnings in order to use it for future investment opportunities. It is apparent that repurchasing of shares has benefits and adverse consequences to the company and the investors. However, the benefits seem to offset the negatives thus I believe it is a good business strategy to increase improves business performance (University of Wasaensia, 2004). The company does not have to invest resources in unprofitable activities or acquire a loan if they can afford to raise internal capital to finance its activities. The company can resell the shares to the investors in the future if the intend to raise additional capital (Vause, 2009, p. 153). Apple case study In 2012, the management of Apple established a program to buyback the company shares because they felt that the shares were undervalued. The initial plan was to spend $10 billion dollars (Apple, 2013). However, in April 2013 the company increased the amount set aside for payback by $50 billion dollars to a total of $60 billion dollars. In 2014, the program was further expanded to $130 billion dollars. Upon the establishment of the buyback period, the shares value increased from $564.99 up from $524.75 (Apple, 2013). The company split the shares in the ration of seven to one shares. The intention of splitting the shares was to enable diverse investors from low-income earners because the shares would be affordable to more people (Apple, 2013). The company’s decision resulted to a 15% increase in earnings per share from $10.09 to $11.62 in the previous period and 8% increase in dividend (from $3.05 to $3.29 per quarter (Wakabayashi, 2014). The company’s revenue increased from $43.6 to $45.6 billion compared to the previous period. Furthermore, the company was able to increase sales from 43.7 units of iPhones made by the second quarter way far from the estimated sales of 38.2 million units in the same period (Wakabayashi, 2014). Apple management claimed that they held $151 billion in cash and securities which they intend to spend in repurchasing the shares (Apple, 2013). However, they expect to buy back the shares valued at $130 billion from investors by the 2015. In 2012, the share price was $85, and value investors suggest that Apple should use its net debt balance of $130 billion to acquire a loan of about $50 billion to buy back the shares (Wakabayashi, 2014). The result of the buyback decision implemented by Apply Company has improved the shareholder's income from the increased earnings per share that amounted to $90 billion (Sikka, 2014). The company held 899.74 million shares and anticipates buying back about ten percent of those shares in order to strengthen the value of the shares in the market that they believe are currently undervalued. The company increased its sales from $43.6 billion to $45.6 billion within two-quarters after launching the program (Sikka, 2014). Furthermore, the company believes that there are better opportunities to increase the earning per share and increase sales volumes in the future if the repurchase more shares (McKenzie, 2010, p. 42). Apple Company was able to make more sales, earnings per share, and interests on dividends beyond the projections made by financial analysts. In year 2013, the share value declined from $85 at the time the buyback program was being initiated to $55 before the end of the year (Sikka, 2014). However, studies have indicated that the value of shares has only increased by 3% in the past despite the huge amount of income the company spent in the buyback programs (Wakabayashi, 2014). The value of shares has started increasing in the recent time and is expected to continue rising in the future. Shareholders concur with the management that Apple Company shares are seriously undervalued and recommend the company make even more buybacks. Shareholders believe that the current price of the Apple Company shares is $203. Following Apple’s decision to repurchase the shares, the shareholders stand to gain from the capital improvement, as well as tax exemption (Sikka, 2014). It is a legal requirement that shareholders must pay tax revenue from the dividend the company declares on the ordinary shareholders and that result to reduced shareholders revenue (Apple, 2013). However, when the company decides to repurchase the shares the shareholders can enjoy the entire proceeds from the company without any tax obligations. Since Apple Company has about $151 billion in cash that they intend to spend in repurchasing the shares, it is apparent there will be no available cash for investing in other opportunities (Forbes, 2013). Should an opportunity avail itself in the future after Apple has spent the available cash in repurchasing shares they may not be able to raise the required cash for making investments (Wakabayashi, 2014). For example, the iPhone has not been performing well in the global market apart from China Taiwan and Hong Kong in the recent years because of the stiff competition they experience smartphones. Therefore, Apple Company should be focusing on improving the market for iPhones or launch another product that can compete effectively with smartphones in the global market (Apple, 2013). As they intend to take a loan in order to increase the number of shares, they can repurchase they should preserve the credit balance for future expansion of the company’s activities. Despite the strategies the company has engaged to improve the price of its shares there has been a slight improvement with price, and there is no hope that the shares will regain the estimated market price of $203 (Forbes, 2013). Conclusion The conception that shares buyback is a dangerous approach because it can increase company’s capital leverage is truthful although the benefits of such strategy outweighs the challenges of the outcome as illustrated in the case study of Apple Company. Repurchasing of shares can limit the company’s potential to raise cash, may imply the business has no better investment opportunities, increase gearing ratio, and the company may lose credit rating. However, there are various benefits because the company can get an opportunity to maintain steady dividend policy, balance debt equity ratio, investors increase revenue because of tax evasion, control cash flow, have better control over possible take over and can help the company to generate income in the future by reselling the shares at a profit. Bibliography Apple. (2013). "Carl Icahn Wasn't Joking About That $150 Billion Stock Buyback." Retrieved on 24th Nov. 2014 from Alpha, D. & Roydon, R. (2009). 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