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Buy back of shares-a financial analysis.

Introduction

Buy back of equity shares is a capital restructuring process. It is a financial strategy that allows a company to buy back its shares. It is a new vista that has been opened for flexible capital structuring by companies as and when necessary without involvement of any external regulatory mechanism. It helps to reshuffle loaded capital structure. It results in reduction of floating stock from the market. Creating shareholder's value is the primary objective of corporate management. It is difficult to service a large equity and add shareholder's value. Buy back offers a straight route for swapping equity for debt. When equity appears to be costlier to debt buy back would help to reduce overall cost of capital and increase shareholder's value. Buyback is reverse of issue of shares by a company where it offers to take back its shares owned by the investors at a specified price; this offer can be binding or optional to the investors.

In a share buy back program, the company distributes the excess cash flow among the shareholder by way of repurchasing its own shares, generally at a premium. The former option results in reduction of the paid up capital, and consequently higher earning per share. The reduction of share capital strengthens the promoters' control and enhances the equity value for shareholders .In the later option, companies buy their shares from open market and keep these as treasury stock. Buy back of shares by a company is guided by the principal that the intrinsic worth of the shares is substantially higher than the market price. By buying back its shares, the company will allow some desperate shareholders to exit and enhance the value of the remaining shareholders. Thus the basic objective is to facilitate capital restructuring of companies through the mechanism of buy back which is likely to benefit not only to the shareholder and companies but also economy as a whole. Among the various reasons for doing so, the most prominent is the fact that the company wants to indicate to the shareholders that it has huge confidence in itself. In India, shares buy back were introduced in 1998 and has received attention of all major companies. . It has been introduced with the Section 77A, 77AA and 77B by Companies (Amendments) Act, 1999. Before 31-1-1998 Companies Act 1956 restricted buy back of shares under Section77, the only way was to follow the cumbersome and time consuming process of reduction of share capital with the permission of shareholders and court under Section 100 to 104 of this Act.

Buyback of shares, i.e., buying of own shares by a company having substantial cash reserves, has been permitted in India with effect from 31st October, 1998.Till then, an Indian company could buy its own shares only in consequence of reduction of capital under Sections 100 to 104 of the Companies Act, 1956 or, if so ordered by the Company Law Board under Section 402, to give relief in a petition of oppression / mismanagement. The Government of India in consensus with the captains of industry and stock market fraternity decided to introduce buyback in company legislation in order to give the necessary fillip to the stock market. Earning per share (EPS) is one of the performance indicators of a firm and it boosts the market sentiments.

A stock repurchase occurs when a company with excess cash buys back stock for any number of reasons. Once a corporation buys back its stock, it is termed treasury stock and is ineligible to collect dividends. Some reasons corporations repurchase stock include: preventing a hostile takeover, acquiring shares for future distribution for employee options and for converting securities. The main benefits from buying back stock are raising the earnings per share on remaining shares outstanding and eliminating the dividend burden on the shares repurchased. Likewise, a stock repurchase can be an effective tool used by companies, especially in times of undervaluation and high taxes to attempt to raise the market price of their stock.

Methods of Buy Back Of Shares

A company can repurchase its shares three ways. These are as follows:

1. From Existing Shareholders on Proportional basis through Tender Offer.

2. From Open Market

a) Through Book Building Process

b) Through Stock Exchange

3. Odd Lot Holders.

Review of Literature

This section discusses the review of the studies that have been conducted in the area of buy back of shares. The main issues of these studies are to examine the operating and financial characteristics of the firm that repurchases their own stock and the effects of the repurchase on the price of stock and on the wealth of the stockholders.

On the first issue, the consensus is that firm repurchasing their own stock has had less leverage, inferior operating performance and slower growth than in the case for non-repurchasing firms. But the answer to the second issue regarding effects of the repurchase on the price of stock and on the wealth of the stockholders does not provide any productive results.

This section has been divided into two sub-sections. Sub-section-I deals with brief discussion on studies conducted in the field of buy back of shares; where as, sub-section-II provides the summary and research gap that exist in this field.

In brief these all above study provides the researcher a gap to be filled, the main emphasis of these studies are as; Stewart (1976) found that the effect of repurchasing on stock price is neutral in short run but positive in long run. Young also found no significant price effects in short run. Nantell and Finnerty (1980) found immediate and significant positive effects on stockholders wealth. Marks found, for open market repurchase there was no price effect and tender offer there was a positive price effect which was somewhat offset when the tender offer terminated. Some studies shows that market reacts positively to stock buy back announcements. (Dann and Vermaelen, 1981 and Lakanishok and Vermaelen, 1990). More commonly accepted theories for the positive reaction includes the signaling theory (John and Williams, 1985),Agency/Free Cash Flow Theory (Jenson, 1986) and Capital Structure Theory (Diittman, 2000) Signaling theory shows that manager repurchase shares to signal that firms future profitability will be higher than market is expecting. Jagannathan Stephen and Weisback (2000) find a rise of 650 percent in numbers and 750 percent in value of open market share repurchase between 1985 and 1996. Grullen and Michaely (2002) report 41.8 percent of total earnings are used to repurchase share in 2000 as compared to 4.8 percent in 1980.

The Agency theory argues that buyback disperse frees cash flow and thereby reduces the amount of excess funds that manager can waste through investments in negative net present values projects. The Capital Structure Theory argues that the firm is under valued and the stock repurchase raise the firm's leverage towards a mere optimal capital structure. So it can be concluded that empirical research done till date has give mixed conclusions, in order to over come this research gap the present study has been conducted.

Objectives, Data Base and Research Methodology

This section discusses the universe of the study, sample selection, techniques of data collection, statistical tools used in the analysis of data in this study. This section is again divided into three sub-sections. Section I explains the objectives of the study. Sub-section II gives information about data base and methodology. Sub-section III explains the limitations of the study. Section IV states the organization of the whole study.

Objectives of the Study

The study was undertaken with the following objectives:

1. To study regulatory framework of buy back of shares under Companies Act 1956 and SEBI.

2. To make a comparative analysis of buy back program recently made by companies on the basis of various parameters such as method of buyback like tender method or open market method

3. Offer size, offer price, sources used, necessity of buy back; and

4. To study the stock price behavior empirically in the Indian stock market around repurchase announcement.

Database and Methodology

(i) Sample and Period of Study: The sample consists of 97 buy back programs announced by companies in India during the period April 2007 to 2009. Sample Companies have met the following criterion:

1. The companies announced buy back are listed on Bombay stock Exchange.

2. Companies have adopted either tender offer or open market route.

3. Data regarding closing prices of share of the companies are available on BSE website.

Out of sample of 97 buy back program announced during the period April 2007to 2009 the sample comprises of 25 buy back program announced during the period April 2007to 2009 was taken. For collection of this sample the following criterion was used:

1. The companies announced buy back are listed on BSE.

2. Companies have adopted either tender offer or open market route.

(ii) Type of Data: Sample selection is guided by availability of data. Data regarding buyback announcement has been collected from secondary sources. Such as various issues of Journals, websites of SEBI, Economic Times, and Bombay Stock Exchange where the company has revised the timetable for buy back, the revised data of announcement has been taken. Data regarding buyback of companies has been collected from secondary sources such as website of SEBI and Economic Times. Data consists method used by companies to buy its shares back, no of shares bought back , total value of shares bought back (offer size),buy back Price (selection is guided by availability of data). 25 companies, which recently announced to buy back its shares are taken and analyzed upon various parameters.

(iii) Methodology of Analysis: The relationship between buy back announcement and behavior of shares is analyzed by using comparison period approach used by Masulis, R. (1980) in analyzing stock price behavior around repurchase.

Limitations of the Study

The following are the limitations of the present study:

1. The sample chosen is based upon the availability of data.

2. Study is limited to the buy back announcement and programs made in India only.

3. To make comparative analysis buy back announcement of only those companies have been taken whose public announcement are available on SEBI website.

Buy Back of Shares by Indian Companies--A Comparative Analysis

Comparative analysis gives the following results:

* Buy back activity has increased substantially after the relaxation of buy back norms in 2001.

* Use of open market method is increasing over tender method. Analysis reveals that 73 percent companies use open market method and 27 percent of the company use tender method to buy its shares back.

* 85 percent of the company used free reserves as a source of buy back securities Premium A/c is used by 70 percent of companies make use its liquid assets.

Funds are hardly borrowed for buy back. Funds are made available usually from operating cash inflows internally accounts. Sale of under utilized assets, sale of liquid assets cash and bank balance.

* 55 percent of companies take into consideration both book values and market values as basis of offer price, 50 percent of companies consider post buy back scenario before setting up offer price. 90 percent of companies take market price quotation as offer price base with its average for particular period or at some percentage of premiums on market price beside. Weighted average price quotation return on equity, earning per share are other factor effecting after price.

* Near about 60 percent of the companies go for buy back to return its supply cash to shareholder because of extra free reserve and satisfactory liquidity and no immediate need of money because of lack of profitable opportunity . Almost 100 percent of the companies aim to increase long term shareholder value and return on equity.

Some other common reasons are:

* To provide exit opportunity to these shareholder who deserve the sell their equality

* To correct under valuation of shares.

* To reduce service burden of equity.

* To reduce O/S share.

* To realign capital structure.

* To improve validity: state prices.

Buy Back of Shares and Behavior of Share Prices an Empirical Analysis

The intention to buy back shares is aimed at improving market valuation. The buy back of shares are now considered as the latest tool to control the downfall in shareholder's value .Theoretically it's seems to be sound objective but various empirical studies have given puzzling results about stock price behavior around repurchase announcements.

Shares repurchase itself reduce the number of shares outstanding and increase the corporate EPS with fewer shares outstanding .The future growth is net income need not be a great in order to produce a higher rate of increase in EPS so buy back have the way for increase in market price through future dividend.

Some analysts feel that buy back of shares create shortage of shares in the market and increase the share prices .According to Pettet buy back create value in two ways . One is the buy back announcement its terms and the way it is implemented, all convey signals about company prospectus and plans. Second, if financed through debt it changes capital structure and give leverage effect.

Negative aspect of buy back is that announcing a buy back to the market that firm has run out of profitable investment opportunities.

Looking upon practical examples nearly all the buy back announcement have received a positive response from the market nearly in all cases prices have come closer to offer prices immediately after the announcement . Companies with good cash flow position and having a view that their stocks are largely undervalued at the market or for buy back route.

Bajaj Auto is a prime example, when the buy back scheme was announced, the stock was available at Rs.320 and after announcement it touche a peak of Rs.393 .However, it failed to cross the level of Rs. 400 at which the company was making the offer.

In case of Mastic Ltd., market price increased from Rs.326 to Rs.397 after announcement. Similarly in Bosch Ltd. company, the stock price was moving from Rs.2949 to Rs.3058 when the buy back was announced. The reaction to India info-line buy back offer was also positive some other companies also give positive response.

Same thing has been observed in international market. In 1997, Coca Cola opted for buy back of 83 percent of their equity that raised the price of the scrip by a whooping 42 percent in the NYSE. Major global companies opted for buy back in last couple of years include IBM HP, Washington Post, Nestle etc.

The relationship between buy back announcement and behavior of share prices is analyzed by using comparison period approach used by Masulis, R (1980) in analyzing stock price behavior around repurchase. In this approach stock rate of return were analyzed around the offer initial announcement date. The announcement period is defined to include day 0-1 because the vast majority of announcement were actually made the day before the news appeared in the media. If there is no trading on day zero the next day closing price is used as the day 0 the next day closing price. Then we took a time series of stock return of 9 days before the announcement and 10 days after the announcement date defining these return as comparison period return (excluding day 0-1 ) . The mean daily return of this time series represents the security's normal return assuming the return process is stationary and that the time series in representation of security's normal return assuming the return distribution. The means of return distribution for the event for the event day and surrounding days are compared to ascertain the market's perception of buy back announcement. Then student's test is applied to test the significance of the difference between the portfolio's announcement period mean daily returns and comparison period mean daily return. If there is significant announcement effect of the stock prices, the null hypothesis of equal mean is rejected in favour of alternative hypothesis of equal mean.

In short various steps involved in the analysis are as following:

1. Daily return for security (i) from 10 trading days after the announcement (including day 0) of buy back announcement is computed by :

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where

(MP)i t = Market price of security 'i' on day 't'

(MP)i, ( t-1) = market price of security 'i' on day 't-1'

Mean daily return of all the securities is calculated for each relative day by using the following formula

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where n=no. of securities in the port folio during day t t= -10 to +10 days

Significance of MDR is tested through t value by compared MDR of comparison period with that MDR of announcement period.

MPRZ (Mean percentage of return greater than zero) is calculated to find out the percentage of companies experience positive return.

Empirical Results

Table-1 shows the buy-back announcement and security rates of return gives the figure of mean daily return (MDRs) and mean percentage of daily return greater than zero (MPRs) for the days surroundings the buy back announcement. Above the able values of mean standard deviation and t statistics has been given for both observation period and comparison period MDRs.

As calculated value of t=2.24 for buy back announcement, the difference in MDRs of the observation period (2.02) and comparison period (.23) is significant beyond 2.5 percent level .Moreover, the mean MPRs of observation period (5.9 percent ) is greater than that of comparison period(4.5 percent)

So null hypothesis of equal mean between observation period and comparison period is rejected and comparison and alternative hypothesis of greater announcement period return is accepted.

It can be concluded from above results that buy back announcement are associated with positive returns.

Conclusion

Buy back of securities is a new concept in India. It has just been introduced in India few years back. It s a financial tool in the hands of corporate to acquire the required flexibility n their capital structure and financial position. Buy back activities has increased substantially after the relaxation of buy back norms in 2001. To buy back shares use of open market method is increasing over tender offer method. Most of the companies buying back their shares make use of free reserves as a source of buy back their shares. Market price quotation and book value of shares are two important factors taken into consideration as basis for setting up of offer price. To correct under valuation of shares, to realign capital structure, to prevent unwelcome takeover bids, to provide exit opportunity to shareholders, to reduce service burden of equity, to reduce outstanding shares are some important reasons for which companies bought its shares back. Out of these most important is to correct under valuation of shares. The intention to buy back is aimed at improving market valuation. Buy back activities is now considered as a latest tool to control the downfall in shareholders value. Nearly all the buy back announcement has received positive response from the market. Nearly in all the cases prices have come closer to offer prices immediately after the announcement. Companies with good cash flow position and having a view that their stocks are largely undervalued at market go for buy back route. So buy back of shares leave significant impact upon share prices in stock market and increases earning per share and enhance long -term shareholder's value.

A company can repurchase its shares by three ways: these are from existing shareholders on proportional basis through tender offer, from open market i.e. through book building process, through stock exchange and by Odd Lot Holders Method. The SEBI buy back regulations explain condition of buy back procedures through all of these three ways.

The empirical results state that buy-back announcement and security rates of return gives the figure of mean daily return (MDRs) and mean percentage of daily return greater than zero (MPRZs) for the days surroundings the buy back announcement. Above the table of, values of mean standard Deviation and t statistics has been given for both observation period and comparison period MDRs. As calculated value of t=2.24 for buy back announcement the difference in MDRs of the observation period (2.02) and comparison period (.23) is significant beyond 2.5 percent level .Moreover the mean MPRs of observation period (5.9 percent) is greater than that of comparison period(4.5 percent). So null hypothesis of equal mean between observation period and comparison period is rejected and comparison and alternative hypothesis of greater announcement period return is accepted. So from the whole above detail discussions it can be concluded that buy back announcement are associated with positive returns.

References

Dielman, Nantell, and Roger L. Wright. (1980): "Price Effects of Stock Repurchasing: A Random Coefficient Regression Approach." The Journal of Financial and Quantitative Analysis, Vol. 15, No. 1, pp. 175-189.

Dittmar, Amy K. (2000): "Why Do Firms Repurchase Stock." The Journal of Business.

Masulis, Ronald W. (1980). "Stock Repurchase by Tender Offer: An Analysis of the Causes of Common Stock Price Changes." The Journal of Finance, Vol. 35, No. 2, pp. 305-319.

Stewart, Samuel S. (1976): "Should a Corporation Repurchase Its Own Stock." Journal of Finance, Vol. 31, No. 3, pp. 911 -921.

Dann, Larry, (1981): "Common Stock Repurchases: An Analysis of Returns to bondholders and stockholders", Journal of Financial Economics, Vol. 9, pp. 113-138.

Dann, Larry, Ronald Masulis, and David Mayers, (1991): "Repurchase tender offer and earnings information", Journal of Accounting and Economics, Vol. 14, pp. 217-251.

D'Mello, Ranjan, (1995): "Motivations for a repurchase tender offer: The free-cash-flow and the information revealing hypotheses", Working Paper, University of New Orleans

Ikenberry, David, Josef Lakonishok, and Theo Vermaelen, (1995): "Market under Reaction to open market share repurchases", Journal of Financial Economics, Vol. 39, pp.181-208.

Lakonishok, Josef, and Theo Vermaelen, (1990): "Anomalous price behavior around repurchase tender offers", Journal of Finance, Vol. 45, pp. 455-477.

Masulis, Ronald, (1980): "Stock repurchase by tender offer: An analysis of the cause of common stock price changes", Journal of Finance, Vol. 35, pp. 305-321.

Vermaelen, Theo, (1981): "Common stock repurchases and market signaling: An empirical study", Journal of Financial Economics, Vol. 9, pp. 139-183.

Persons, John C. (1997): "Heterogeneous Shareholders and Signaling with Share Repurchases." Journal of Corporate Finance Vol. 3 (3), pp. 221-249.

Swaminathan G. Badrinath and Nikhil P. Varaiyat, and Rhona L. Ferling (2000): The Wall Street Journal.

Singh Balwinder, Karamjeet Kaur," Buy Back Announcements and Stock Price Behavior-An Empirical study "ICfAi Journal of Applied Finance 2003.
Table 1: Buy-Back Announcements and Security Rate of Return

Event Day   MDR (percent)   MPRZ (percent)

   -10          -1.42             3.03
   -9           -0.02             3.65
   -8            0.11             1.78
   -7            1.53             2.87
   -6           -0.18             2.83
   -5           -1.44             1.82
   -4           -2.36             3.55
   -3            2.35             4.21
   -2           -0.72             3.87
   -1           -2.24             4.05
    0            1.56             4.11
    1            0.36             5.43
    2           -0.99             2.49
    3           -0.94             2.25
    4           -0.42             2.01
    5           -4.82             1.38
    6            0.44             2.36
    7            0.35             3.15
    8            1.47             3.72
    9            1.36             2.59
   10            1.20             3.49

Table 2: Showing Descriptive Statistics of Observation Period and
Comparison Period

Parameters           Observation Period   Comparison Period

Mean MDR                    2.02                0.23
Standard Deviation           .018                .016
Mean MPRZ                   5.97                4.87
t- statistics               2.24
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Author:Mahajan, Monika
Publication:Political Economy Journal of India
Geographic Code:9INDI
Date:Jul 1, 2012
Words:3905
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