The Buying Back of Shares Is a Dangerous Financial Strategy as It Inrss the Cmnys Citl Gring - Term Paper Example

COURSE-WORK ASSIGNMENT The buying bасk of shares is а dаngеrоus finаnсiаl strategy as it inсrеаsеs the соmраny’s сарitаl gеаring”. Еvаluаtе this stаtеmеnt. Introduction It has been the major concern of the organizations that what capital structure can provide them financial leverage and which financial strategy can enhance the financial leverage. Different financial strategies have different effects on the firm’s value and capital gearing. Among these strategies, a financial strategy seems to be illegal in some countries and legal in others, is quite a recent phenomenon. This strategy is known as “buying back shares” or “shares repurchase”. A share repurchase is such a move performed by the organization, where the company buys its existing outstanding shares from its shareholders, usually at premium prices to make the shareholders willing to sell (McMenamin, 2002, p. 498). While in the late 20th century, there has seen the share repurchase activity at the global level (Vermaelen, 2006). Though, due to the financial crises of 2007-2009, the share repurchase activity has lowered but still it seems to be an attractive strategy by a number of companies (Prince, 2008). However, the motivations to share repurchases and their impacts over the firm’s value and performance has been the major concern of organizations. There are a number of motivations for the companies to go for share repurchase. But most of the companies are motivated to gain the benefits of financial leverage from this move. As the share repurchase is usually attributed towards enhancing the financial leverage or, in other words, the capital gearing, so the companies majorly go for repurchasing their own shares in order to enhance the financial leverage (Dixon, et al., 2008). But the impact of this strategy over the company’s leverage can pose other threats as well. So, the purpose of this paper is to evaluate the argument that “the buying bасk of shares is а dаngеrоus finаnсiаl strategy, as it inсrеаsеs the соmраny’s сарitаl gеаring or financial leverage”. This argument is evaluated from the theoretical perspectives provided by a number of researchers in literatures as well as by explaining through a practical example of a real life organization. Theoretical Perspectives on Share Repurchase and Capital Gearing The literature has suggested a number of motivations for the repurchase of stock, why the firms go for repurchase of their own shares (Clayman, et al., 2012; Dittmar, 2000; McMenamin, 2002; Dixon, et al., 2008; Kahle, 2002; Bierman, 2001). With respect to the reasons for buying back the shares, Clayman, et al. (2012) has provided a number of reasons which can be the main motives for the share repurchase, such as to gain the possible tax benefits, market signaling as firm regard its shares as a good investment opportunity in order to boost the investment by more investors, to get the supplementary management flexibility, to counterbalance the dilution of power from the grant of employee’s stock options, and lastly to increase the capital gearing or financial leverage (Clayman, et al., 2012, p. 280). In addition, Dittmar (2000) has also presented these motives for share repurchase, where it is argued that the firms in repurchasing the stock show that they have an excessive amount of cash, which can be used to either repurchase the stock or to distribute this cash to shareholders as dividends. Dittmar (2000) also assumed the market signaling to improve the share value in order to increase investment in their own company as a motive to repurchase stock, but it is also argued that the firm may not offer more shares and hold them after repurchasing in order to gain the corporate control (Dittmar, 2000, p. 335; Nohel & Tarhan, 1998). There is much consistency in the literature with regard to the motivation of repurchase stock, and some have also classified these motivations in different categories, such as value enhancing motives or non-enhancing motives (Kahle, 2002), however, the capital gearing and financial leverage is the common motive provided by all researchers. Capital gearing, also called as “financial leverage”, can be defined as, “… the proportion of capital, which is financed by debt as opposed to equity, therefore the higher the leverage, the higher is the amount of debt in the capital structure of a firm…” (Rayan, 2008, p. 6). Where the Firer, et al. (2004) has defined the capital structure as the mix of debt and equity employed by the firm in order to get financing for its operations (Firer, et al., 2004, p. 277). After understanding the concepts of capital gearing and capital structure, the effects of this capital gearing is needed to evaluate. The literature suggests that the repurchase of stock increases the capital gearing, as when the firm repurchase its stock, then there is a decline in the shareholders’ investment in the company which increases the proportion of debt with respect to the equity employed in the firm, consequently increasing the capital gearing with more debt by the use of fixed costs (Bierman, 2001, p. 23). So, when the firms have the issue of the lower gearing ratio than the optimal level of leverage, then they can go for the stock repurchase in order to increase the financial leverage to the optimal level. As Dhanani and Roberts (2009) have also argued that “…if a company believes it is under-geared then it can reduce its level of equity by repurchasing a proportion of its shares…” (Dhanani & Roberts, 2009, p. 18). The case of Rio Tino is also evidenced by (McMenamin, 2002), where the company decided to go for repurchasing stock strategy with estimating that for a 1 percent reduction in equity will increase the gearing 1.5 percent, and when the company declared the stock repurchase then the leverage was at 27% considered to be modest and the increasing (McMenamin, 2002, p. 499). In addition to this, with the increase in capital gearing, it also increases earnings per share resulting in higher share value (Agar, 2005, p. 77). But this increase in EPS can be the motive of the company’s management as it may increase the management incentive as suggested by (Lie, 2005). So, it is evident in literature that the repurchase of stock resulted in increased financial leverage or capital gearing. Though the increase in capital gearing provides a number of benefits, but also it increases the risks and threats to the firm, which is why it is considered as the dangerous strategy. The increase in financial leverage also increases the earnings per share, and it can positively affect the firms’ performance as suggested by (Ward & Price, 2006; Sharma, 2006). The increase in corporate control is an added benefit of the increase in financial leverage, as there would be decreased in number of shareholders with repurchasing the shares and the shareholder’s vested interests as well (Dittmar, 2000). In this respect, the increase in financial leverage can cause the most important advantage of reducing the agency costs of the firm, where the Jensen (1985) theory of Free Cash Flow can be applied. As the theory suggests that when there are more free cash flows generated in the company then the agency conflict or conflict on interests among managers and shareholders is increased, which affected the firms payout policy (Jensen, 1986). The firm has to decide that either it should pay this amount to the shareholders as dividends or to the managers as incentives. Then, if the firm opts for the stock repurchase strategy, then this agency cost incurred in satisfying both parties, can be reduced to a greater extent as suggested by (Byrd, 2010). In line with this argument, (Khan, et al., 2012) has also suggested that there is positive relationship between the increase in financial leverage and decrease in the agency costs of free cash flow, and this is consistent with the free cash flow theory (Khan, et al., 2012). In contrary to the above arguments for capital gearing, Rayan (2008) has conducted a study to see the effect of this capital gearing over the firm’s value, where it is found that the increase in financial leverage has a negative correlation with the firm’s value and performance (Rayan, 2008). In line with the findings by Rayan (2008), Rajkumaar (2014) also conducted a study over the relation between the financial leverage and the firm’s performance and found a negative correlation among these (Rajkumar, 2014). This evidence is in line with the main argument of this paper. But the literature has also found evidence of a positive relationship between the firm’s value and financial leverage (Firer, et al., 2004; Sharma, 2006; Ward & Price, 2006). However, Rayan (2008) has further argued that these studies conducted on the basis of assumptions of having a perfect and efficient market, which cannot be the case in the global world of imperfections and volatile markets. Moreover, the macroeconomic factors as well as the management incentives in this respect are some important considerations to be concerned of, (Rayan, 2008). Another argument in line with the dangers of increased capital gearing is that financial leverage or capital gearing is called as the “double edged sword” (Pachori & Totala, 2012). It is considered as the double edged sword, as financial leverage also accounts for the company’s exposure to the financial risk, so at one side, it provides leveraged benefits, but on the other side it exposed the firm towards higher risk of losses. It can be elaborated further in understanding the logic behind the degree of financial leverage, where it is explained as, “…the percentage change in EPS resulting from a unit percentage change in EBIT…” (Pachori & Totala, 2012, p. 23). Here, it suggests that the financial leverage can speed up the earnings per share when the firm is operating in promising economic circumstances, while on the other hand, it can depress the earnings per share in case of bad economic conditions in the market. Such unfavorable impact of the capital gearing on the earnings per share of leveraged firm is much harsher than in the low gearing capital structure of the firm, as Earnings before interest and Tax becomes negative. In this way, the increase in capital gearing can enhance the stockholders’ return, but it can also expose the firm towards more financial risk. As Pandey (2007) has claimed that a firm’s motive behind achieving an increased capital gearing is to earn more by use of fixed cost funds rather than the relative costs, which is also exposed to increased risk of not being able to pay this fixed amount (Pandey, 2007). The financial leverage also increases the financial risk to a much greater extent than without the leverage, due to the fact that financial leverage is dependent upon two factors, which are much volatile; such as the return on assets as well as the cost of debt, i.e. interest rate (Franklin & Muthusamy, 2011). Moreover, Pachori and Totala (2012) has stated the above phenomenon of increase financial risk with more financial leverage, as “…even if the return on equity is high, a substantial financial leverage causes a great instability in the net profit, i.e., on the volatility of dividends distributed per share. Therefore, the shareholder will claim a premium to cover the risk. A high level of financial leverage allows shareholders to obtain a high return on equity, but they are also exposed to a higher risk of significant loss if the return on assets is low…” (Pachori & Totala, 2012, p. 24). So with the increasing debt, there is more financial risk, when the return on asset is decreasing. Therefore, it can be suggested here that financial leverage effects are dependent over the market factors, which has much uncertainty, as the interest rates has higher volatility that can impact on the capital gearing effects. In addition to the financial risk, the increase amount of debt resulting in more financial leverage can also be the result of lower control of the firm, as Pachori and Totala (2012) further argued that it would limit the freedom of the management decisions and the creditors may impose more restrictions in the company’s decision in order to save their debt. It is another argument, which can be used against the suggested benefit of gaining control over the company with a stock repurchase strategy (Dittmar, 2000; Nohel & Tarhan, 1998). As in contrary to their arguments, Pachori and Totala (2012) has argued that increase in financial leverage can reduce the management control over the firm’s decisions, as they have vested their interests more than others (Pachori & Totala, 2012). Here, the arguments of financial leverage, being the double edged sword by increasing the return as well as financial risk for the firm, where its outcomes are dependent on the macroeconomic factors, and losing the management control due to creditors’ restrictions imposition, suggest the validity of the argument that the stock repurchase is a dangerous strategy as it increases the capital gearing. Though, there are benefits of the increase in the financial leverage, but they are not the certain benefits, as they depend on economic conditions. As Al-Tally (2014) suggested that when the economic conditions are good, then in the long run, the lower financial leverage provider higher returns on equity as well as assets (Al-Tally, 2014). Thus, it can be said that the buying bасk of shares is а dаngеrоus finаnсiаl strategy as it inсrеаsеs the соmраny’s сарitаl gеаring. Practical Example of Shares Buy Back and Capital Gearing A practical example, can be used to illustrate this argument, where the Microsoft Incorporation is used for analysis. The company has been involved in the number of share repurchase programs in last decade, where the financial leverage has been achieved in some recent years, but in times of financial downturn, it has faced major losses (Dilger, 2013). The company’s press release states that, “…On September 22, 2008, we announced the completion of the two repurchase programs approved by our Board of Directors during the first quarter of fiscal year 2007 to buy back up to $40.0 billion of Microsoft common stock…” (Microsoft, Inc., 2008). These stock repurchases’ effects are shown in later years when the financial crises happened in 2008. There was decreasing operating income and stock performance, as shown by the following figures. (In millions, except percentages) 2011   2010   2009   Percentage Change 2011 Versus 2010   Percentage Change 2010 Versus 2009 Revenue $       2,528   $       2,201   $       2,121                 15%                    4% Operating loss $      (2,557 )   $      (2,337 )   $      (1,641 )                 (9)%               (42)% Figure 1. Revenues and Operating losses. Source: [Mic11] The stock performance after this stock repurchase was also deteriorating, as shown in the figure below. Figure 2. Stock Performance of Microsoft shares. Source: [Mic11] Figure 3. Microsoft Stock Performance in comparison to Apple and NASDAQ. Source:[Dil13] As the financial leverage is determined through the debt ratio and its performance can be measured through the return on equity, which can be compared from 2008 to 2011. Following figure has provided this analysis; In this analysis, the Microsoft’s financial data is retrieved from the (Microsoft, 2011), and using that data the above ratios are calculated. The above analysis shows that with the increase in debt ratios (showing increases in the Financial leverage), there is decreasing trend in return on equity in 2009, when the financial conditions were bad, so it poses more financial threat. But with the improvement in financial conditions, it can be seen that there is an increase in the ROE. This example, supports the argument that the repurchase of shares can be a dangerous financial strategy as it increases the capital gearing. Financial leverage poses threats of higher financial risk, especially in the worst economic conditions where the firms’ losses may also be amplified, as shown by the theoretical discussion above. Conclusion It can be concluded that the buying bасk of shares is а dаngеrоus finаnсiаl strategy as it inсrеаsеs the соmраny’s сарitаl gеаring. The increase in capital gearing depends on the financial condition, where in case of good conditions, it provides a financial leverage that boosts up the financial condition of the firm, but in another case, it can be more hazardous to a much greater extent than in case of ungeared capital. That is why, it is known as a double edge sword. The paper has presented a number of arguments in support of this main argument as well as a practical example is also used to support the argument. References Mic11: , (Microsoft, Inc., 2011), Dil13: , (Dilger, 2013), Read More