A Considerable Degree of Impact on a Companys Capital Structure - Research Proposal Example

Share Buyback Executive Summary Share repurchase program has the ability to affect the capital gearing of a particular company. In light of this, a report is prepared to analyse share buyback methods that are applied by a company and the motives behind it. It also highlights the affect of share repurchase activities on the capital gearing of a company. The chosen company for the report is Microsoft Corporation. The researcher was able to comprehend that share repurchase programs does have a considerable impact on a company’s capital gearing. This was evident from Microsoft’s increasing level of long term debts as well the corresponding interest expenses. Nevertheless, the researcher was able to conclude, despite the rising the rising level of debts, Microsoft was able to maintain a stable gearing ratio by financing its repurchase with a healthy proportion of debt, retained earnings and cash. This enabled the company to keep its capital gearing within a controlled level. Therefore, the research suggested that share repurchase does have a considerable impact on a company’s capital gearing however if a proper financing structure is adopted in order to fund the repurchase program it can prove to be an extremely beneficial strategy for a company. Table of Contents 1.Introduction 5 2.Theoretical groundwork 5 2.1. Association between capital gearing and share buyback 5 2.2. Theory of Capital structure 7 M&M Theory of dividend policy 7 3.Share buyback 8 3.1. Methods of share repurchasing 8 3.2. Rationale behind share buyback 9 3.3. Impact of share buyback on capital gearing 10 4.Practical scenario 10 4.1. Microsoft’s strategy for share buyback 10 4.2. Impact of Microsoft’s strategy on the company’s capital gearing 11 Dividend Policy of Microsoft 13 Price earning for Microsoft 14 5.Conclusion 15 16 17 Reference List 17 Appendix 1 19 Appendix 2 19 List of figures Figure 1: Microsoft’s share price movement (2012-current).........................................................11 Figure 2: Microsoft financials........................................................................................................12 Figure 3: Microsoft key financial ratios.........................................................................................13 1. Introduction In spite of considerable number of researches done in the field of share buyback, academic scholars have failed to provide a convincing scenario that explain the reasons behind companies choosing to repurchase their shares. However, some researchers have made several attempts to provide their own standpoint as far as explaining the reasons behind share repurchase is concerned (Babenko, Tserlukevich and Vedrashko, 2012). According to Fenn and Liang (2001), organizational managers may often choose to repurchase shares from the shareholder when they believe that their company is being undervalued in the market. This provides them with the option of issuing the shares later when the price appreciates. Another perspective was provided by Rau and Vermaelen (2002) who stated that managers often choose to buy back share from the shareholders in order to pay them the excess cash rather than paying dividends. Conversely Dittmar (2000) argued that share repurchase is an essential element of an organization’s capital restructuring strategy. Conversely, Kahle (2002) explained that the underlying rationale behind share buyback is to fund an employee’s share option rights. The variance in the ideas regarding the rationale behind an organization’s share repurchase program is widely evident in the dissimilar point of view of the authors mentioned above. However, one thing that all these authors have stated in common is that share repurchase strategies have a considerable degree of impact on a company’s capital structure. Although, share repurchase is considered to be an advantageous strategy, but exercising this option increases a company’s gearing ratio by a significant level thereby enhancing the company’s chances of becoming insolvent the capital restructuring strategy fails somehow. In light of the facts that have been mentioned in this section, what follows is a critical analysis of statement that states that buying back of shares is a dangerous financial strategy as it increases the company’s capital gearing ratio. 2. Theoretical groundwork 2.1. Association between capital gearing and share buyback In order to have a thorough understanding of the association between capital gearing and share repurchase, it is important to learn the meaning of the above mentioned financial terminologies. Generically speaking, organizational managers often think of rewarding their shareholders’ loyalty by paying them excess cash generated by the company through their operations (Chen, 2014). These excess cash are sometimes either paid as dividends for every share owned by the shareholders and sometimes their shares are bought back by the company in return for cash (Grullon and Michaely, 2004). So, share repurchase can be termed as a company’s act of reacquiring its shares by paying the shareholders equivalent price for the number of shares held by them (Berk and DeMarzo, 2007). Companies often make this choice of distributing excess cash to their shareholders when they do not have a prospective investment opportunity at their disposal anytime soon. That is why they decide against retaining the case for no reason and instead distribute it to shareholders by buying back shares or dividends in order to re-establish their self-assurance. Organizational managers may often choose to buy back their own shares from the shareholders in order to maintain an optimal capital structure. They may prefer to increase their possession of debt which can be used to finance the company specific operations. This is precisely because interest payments associated with debt are tax deductible and this makes it a relatively cheaper source of capital when compared to the returns paid to equity holders. Therefore, a capital structure with a considerable proportion of debt with respect to the equity will enable companies to generate higher returns. Nonetheless, this positive effect of increased leveraging is withered off by the negative effects that this may cause.In case of the former, the company’s liquidity is depleted by a drastic level and this is one of the reasons why managers have the propensity of funding their share repurchase with the help of debt (Lie, 2005). This is precisely the reason why academic scholars throughout the world consider share repurchases to be a fundamental determinant of a company’s gearing ratio. Capital gearing ratio on the other hand is a measure of a company’s proportion of total debt with respect to its total equity. Also referred to as leverage ratio, this multiple indicates the extent to which a company’s operations are financed through debt capital (Grullon and Ikenberry, 2000). The facts that share repurchase increases a company’s capital gearing ratio can be justified through the formula for calculating the debt ratio and the debt to equity ratio. While debt ratio is the ratio between a company’s total debt to equity and total debt, debt to equity ratio is the ratio between a company’s total debts to total equity (Cornett and Saunders, 2003). Consequently, when a company repurchases shares from the shareholders it does so by paying a significant quantity of equity capital to the shareholders as cash. Thus, a reduction in equity capital with respect to the company’s debt capital increases the capital gearing ratio. Additionally, managers also sometimes choose to fund their share repurchase program by issuing debts such bonds and debentures. This increases the company’s proportion of debt capital which in turn also increases the capital gearing ratio by a considerable margin (Arnold, 2008). The facts that have been mentioned in this section provide a thorough explanation of the association between capital gearing and share repurchase. 2.2. Theory of Capital structure A firm’s capital structure depicts the proportion of debt and equity capital that has been used so as to fund business operations. According to Modigliani and Miller’s capital structure insignificance scheme, in a perfect market the capital structure that is chosen by a company to fund its business does not have much relevance. They proposed that the fundamental determinants of a company’s market value are its earning strength and the risk of the assets possessed by the company itself. Therefore, it makes the firm’s value independent of the capital structure that is chosen to fund operations or to distribute dividends (Margaritis and Psillaki, 2010). Modigliani and Miller’s proposition where based on key assumptions such no taxes, no bankruptcy cost and no transaction costs be associated with the capital structure opted by a company. Therefore, if this theory is accounted for, if a company repurchases its shares there will be no significant effect on its capital structure. Modigliani and Miller also proposed the trade off theory which suggests that it is always beneficial for a company to finance its operations through debt till the most constructive wealth structure is attained. This theory takes into account the fact that the interest spending associated with debt issuances are tax deductible. Therefore, issuance of bonds and debentures effectively minimizes a company’s tax liability. However, this theory fails to consider the probability of company becoming bankrupt by not taking into account the bankruptcy risks that are associated with over funding business operations with the help of debt (Sheikh and Wang, 2011). M&M Theory of dividend policy The theory states that the different categories of retained earnings attached with new investment and the dividends do not have any impact on the value of a firm. The investment pattern and the corresponding earnings have considerable affect on the share price movement or even the value of firm. The following assumptions are significant for the theory: 1. Every investors behave rationally in a perfect capital market. 2. Information are freely available to the investors so that they can make any investment decision. 3. There is no transaction cost or time lag. 4. The securities can be easily spilt into different divisions. 5. There is no floatation cost or taxes attached to a investment. 6. The capital markets are observed to be highly efficient. 7. The investment decisions are taken based on the calculated profit, which is certain. However, the dividend policy does not have any effect on the decision of a firm. There is irrelevance in this model as the shareholders invest different amount and thus the dividend and retained earnings are not same. A firm search for new opportunities by utilising its retained earnings or issue new share in order to raise capital for its operation. The dividends, which are paid out by the firm are replaced by capital that is raised through issuance of new shares. 3. Share buyback 3.1. Methods of share repurchasing A number of options are available to companies which can be exercised by managers while repurchasing shares. The choice of these options depends largely upon the end objective that is to be achieved as well as the way in which the repurchase is to be financed. The share buyback methods involve repurchasing shares in the open market, buying back a predetermined number of shares at a predetermined price and Dutch auction. This section will provide the readers with a brief explanation of the types of methods used by companies to repurchase their shares (De Jong, Van Dijk and Veld, 2003). Share repurchase in the open market is the most common way adopted by companies to buy shares. By adopting this method companies are able to buy back their shares directly from the market at the price at which the shares are being currently traded. However, for such form of share repurchase to happen, the managers need to get an approval from the board members. Repurchasing shares in the market has an advantage as it offers companies with the flexibility to repurchase the shares at a favourable time. Moreover, this method is very effective when compared to the other options (Brau and Holmes, 2006). Companies also have the option of repurchasing a predefined number of shares at a predetermined price which is actually higher than the present market price of those shares. For example, a company may propose to buy 5 million shares at $10 per share (this price is generally higher than the price at which the share is currently being traded in the market). However, if the shareholders reject the offer of selling back 5 million shares and instead want more shares to be sold then in that case the company may seek to buy shares from other shareholders on a proportional basis (Ahn, Cao and Choe, 2001). The Dutch auction is nearly same as that of the fixed price process with a minor difference. In this form of share repurchase, the company instead of specifying a fixed price of the shares to be bought, a range of prices (maximum and minimum) are proposed. For example, a company may decide to buy 5 million shares between a price range of $10 and $15 per share. After the proposal is made, all shareholders prepare a bid regarding the price at which they are keen on selling their ownership shares. Following the completion of the bidding process, the company will start qualifying these bids from the specified minimum share price until the number of shares reaches 5 million. Upon reaching this level the price at which the 5 million shares were qualified will be evaluated. If the price at which the 5 million shares were qualified reaches $13, then all the shareholders who bid the share price between $10, $11 and $ 12 will be paid $15 per share for all the shares that they sell. 3.2. Rationale behind share buyback Companies opt to repurchase their shares in order to divert cash from investments and developed sectors to a relatively new sector and in developing nations. The activity of buying back shares is becoming increasingly regular among corporations and is also considered by financial analysts as healthy phenomena (Vernimmen, 2014). Normally, when companies have no such prospective investment options at their disposal they often decide against retaining meanings and instead choose to distribute them either as dividends or cash by repurchasing shares from the shareholders. The underlying rationale behind such a strategy is to restore the confidence of the shareholders as well as reward the shareholders for the loyalty shown by them towards the company. Managers often choose to repurchase shares in order to provide shareholders with the options of making new investment according to their liking. According to Jensen’s (1986) theory of free cash flow, a company by repurchasing its shares is not over investing or undergoing a risk diversification process (Décamps, et al., 2011). 3.3. Impact of share buyback on capital gearing Share repurchases has a significant impact on a company’s gearing ratio. Provided that by repurchasing its own shares a company is actually paying back its equity capital, this amplifies the company’s percentage of debt with respect to its equity which in turn may increase the gearing ratio. When a company repurchases its shares just by paying cash to its shareholders, it’s gearing ratio increases precisely because the equity capital decreases. Moreover, if the share buyback is financed through debt capital it increases the company’s leverage ratio by an even bigger margin. Now, provided that companies are often rated by banks and credit rating agencies on the basis of the capital structure maintained, their credit ratings may get downgraded simply because of an increasing leverage ratio and decreasing equity capital (which sends a bad signal regarding a company’s financial performance). A credit rating downgrade will increase the amount of interest payments for the company which in turn will deteriorate its financial performance as well as may render it insolvent. 4. Practical scenario 4.1. Microsoft’s strategy for share buyback Immediately after the market opened on September 17, 2013, Microsoft announced a share repurchase program besides an increase in the dividend payout. The new share repurchase program was proclaimed following the previous buyback program worth $40 billion that will expire on 30 September, 2013. This announcement was a means of communicating Microsoft’s wish to invest cash in its own shares. The repurchase strategy also included an increase in dividend by $0.05 (from $0.23 to $0.28) (Dillet, 2013). Microsoft has been generating profits in billions over the last few years and therefore the investors are willing to return some of the cash to the company’s shareholders. The share repurchase program could augment the company’s share prices appreciably. This is specifically because investors were enthusiastically waiting for the declaration of this program. According to efficient market hypothesis, a financial market always incorporates the information that is available in the market. The announcement of the share buyback program was equivalently complimented through an appreciation in the company’s share price by 1.83%. In the pre-market trading, the stock of Microsoft Corporation was priced at $33.40 (Dillet, 2013). Microsoft’s previous $40 billion share buyback program which saw the company repurchase $3.614 billion worth of its shares from the $40 billion program. In the month of June 2013, the company purchased $771,593,256 worth of shares (Wilhelm, 2013). The company invested close to $600 million per month for repurchasing its shares (Wilhelm, 2013). The underlying strategy behind the enactment of this stock repurchase program was to reward the shareholders with cash as the company had not many prospective investment opportunities. The company also intended to increase the price of its shares by making sure that lesser number of shares circulated in the market. Microsoft’s share prices increased following the enactment of this plan by 0.39% (Wilhelm, 2013). However, the share price growth rate still trailed the index’s growth rate of 0.76% (Wilhelm, 2013). 4.2. Impact of Microsoft’s strategy on the company’s capital gearing Figure 4: Microsoft’s share price movement (2012-current) (Bloomberg, 2014) Figure 1 given above suggests that the market reacted optimistically to the share buyback program commenced by Microsoft Corporation. The company’s share price chart depicts an increasing trend over the last few years. The chart also depicts that the company’s share price amplified significantly after June 2013 when the company bought back a considerable proportion of shares ($771,593,256 worth of shares). This was a successful attempt made by the company’s managers in order to make sure that lesser number of shares were outstanding in the market which in turn would boost the per share price of the company. Figure 5: Microsoft financials (Source: Yahoo Finance, 2014, Morningstar, 2014a) Figure 2 reveals that Microsoft’s short term increased in between 2012 and 2013 and subsequently declined in 2014. Simultaneously the company’s long term debt augmented throughout. This means that Microsoft’s share repurchase program was initially funded through the combination of both long term and short term debt but thereafter since 2013, it was long term debt all the way through. Microsoft’s interest expense also tells the same story of the company’s increased exposure to external source of finance which in turn enhances its interest rate risk exposure. Figure 6: Microsoft key financial ratios (Source: Morningstar, 2014b) Figure 3 on the other hand depicts that Microsoft Corporation performed exceedingly well in order to keep its gearing ratio at a minimum level even during the time when the company was going through with the share repurchase program. The interest coverage ratio has also declined in the last four years. This means that Microsoft has maintained a very healthy capital structure while funding its share repurchase program. The company has invested a considerable proportion of its earnings in order to make sure that their gearing ratio stays within a steady level. The decrease in the company’s interest coverage ratio suggests that the company’s net income has decreased considerably owing to the company’s rise in the interest expense due to higher levels of debt. In light of these facts it can be said that share repurchase program does have an effect on a company’s gearing ratio. However, it is up to the company to choose an appropriate capital structure so as to make sure that the gearing stays well below threshold. Dividend Policy of Microsoft The quarterly dividend of Microsoft Corporation has increased by 23% from 13 cents to about 16 cents during 21st September 2010. The management had decided to increase its debt obligation and pay its cash dividend to the investors. It also involved in buy back of shares. However, the Chief Financial Officer of the company had announced that the increase in dividend is another activity apart from the share repurchase program adopted by the company. The company has taken this decision in order to value the confidence of the shareholders and provide them long term prospect (ICMR, 2010). Price earning for Microsoft Figure 7: EPS (Source: Bloomberg, 2014) The earnings per share of the company is expected to rise to a great extent in future due to the increase in investment pattern by the investors. Figure 7: Price earnings ratio (Source: Bloomberg, 2014) The diagram highlights the affect of share buyback by Microsoft on the price earning ratio, which is observed to decrease in future due the increase in capital gearing. 5. Conclusion Organizations often decide to repurchase their own shares when they perceive their stocks to be undervalued. The main reason behind share repurchase is to circulate fewer shares in the market which in turn would amplify the share price of the company. Thereafter the shares can be sold again in the secondary market and greater returns can be generated. Companies also choose to repurchase shares and distribute cash to its shareholders when the former do not have any investment opportunities at their disposal. However, share repurchases have a considerable impact on a company’s capital gearing as buybacks are often financed through debt. This in turn amplifies the organization’s gearing ratio thereby increasing the company’s risk of defaulting. The case study of Microsoft revealed that the company share price augmented considerably after it started repurchasing its shares. Microsoft had to finance the share buyback program though a mix of short term debt, long term debt and quarterly earnings. Exposure to long term debt augmented the company’s interest coverage ratio as the interest expenses rose with respect to earnings before interest and taxes. However, Microsoft’s managers did outstandingly well to keep its gearing ratio at the minimum level even during the times when considerable number of shares was being bought back. It suggests that Microsoft followed a healthy capital structure which in turn kept the company’s exposure to debt at a controlled level. Therefore, the study suggests that share repurchase does have a considerable impact upon a company’s capital gearing. That is why a company has to use a good mix of capital to ensure that the share repurchase program is completed without any hassle. 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Appendices Appendix 1 Microsoft financials 2012 2013 2014 Short term debt $1,231,000,000 $2,999,000,000 $2,000,000,000 Long term debt $10,713,000,000 $12,601,000,000 $20,645,000,000 interest expense $380,000,000 $429,000,000 $597,000,000 Appendix 2 Microsoft financial ratio 2011 2012 2013 2014 gearing ratio 1.9 1.83 1.8 1.92 interest cover 96.16 59.6 64.06 47.6 Read More