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earnings, declining growth etc. If the price drop is justified, a stock buyback program can, at best, provide
only temporary respite.
3 Lakonishok, J. and T. Vermaelen, 1990, Anomalous Price Behavior around Repurchase Tender Offers,
Journal of Finance, v45, 455-478


Table 11.2: Returns around Stock Repurchase Tender Offers
1962-1979 1980-1986 1962-1986
Number of 131 90 221
Percentage of shares 15.45% 16.82% 16.41%
Abnormal return to 16.19% 11.52% 14.29%
all stockholders
On average, across the entire period, the announcement of a stock buyback increased
stock value by 14.29%.
In Practice: Equity Repurchase and the Dilution Illusion
Some equity repurchases are motivated by the desire to reduce the number of
shares outstanding and therefore increase the earnings per share. If we assume that the
firm™s price earnings ratio will remain unchanged, reducing the number of shares will
usually lead to a higher price. This provides a simple rationale for many companies
embarking on equity repurchases.
There is a problem with this reasoning, however. Although the reduction in the
number of shares might increase earnings per share, the increase is usually caused by
higher debt ratios and not by the stock buyback per se. In other words, a special dividend
of the same amount would have resulted in the same returns to stockholders.
Furthermore, the increase in debt ratios should increase the riskiness of the stock and
lower the price earnings ratio. Whether a stock buyback will increase or decrease the
price per share will depend on whether the firm is moving to its optimal debt ratio by
repurchasing stock, in which case the price will increase, or moving away from it, in
which case the price will drop.
To illustrate, assume that an all-equity financed firm in the specialty retailing
business, with 100 shares outstanding, has $100 in earnings after taxes and a market
value of $1,500. Assume that this firm borrows $300 and uses the proceeds to buy back
20 shares. As long as the after-tax interest expense on the borrowing is less than $ 20, this
firm will report higher earnings per share after the repurchase. If the firm™s tax rate is
50%, for instance, the effect on earnings per share is summarized in the table below for
two scenarios: one where the interest expense is $ 30 and one where the interest expense
is $ 55.


Effect of Stock Repurchase on Earnings per Share
Before After Repurchase
Repurchase Interest Expense = $ 30 Interest Expense = $ 55
EBIT $ 200 $200 $ 200
- Interest $0 $ 30 $ 55
= Taxable Inc. $ 200 $ 170 $ 145
- Taxes $ 100 $ 85 $ 72.50
= Net Income $ 100 $ 85 $ 72.50
# Shares 100 80 80
EPS $ 1.00 $ 1.125 $ 0.91
If we assume that the price earnings ratio remains at 15, the price per share will change in
proportion to the earnings per share. Realistically, however, we should expect to see a
drop in the price earnings ratio, as the increase in debt makes the equity in the firm
riskier. Whether the drop will be sufficient to offset or outweigh an increase in earnings
per share will depend upon whether the firm has excess debt capacity and whether, by
going to 20%, it is moving closer to its optimal debt ratio.

Choosing between Dividends and Equity Repurchases
Firms that plan to return cash to their stockholders can either pay them dividends
or buy back stock. How do they choose? The choice will depend upon the following
Sustainability and Stability of Excess Cash Flow: Both equity repurchases and

increased dividends are triggered by a firm™s excess cash flows. If the excess cash
flows are temporary or unstable, firms should repurchase stock; if they are stable and
predictable, paying dividends provides a stronger signal of future project quality.
Stockholder Tax Preferences: If stockholders are taxed at much higher rates on

dividends than capital gains, they will be better off if the firm repurchases stock. If,
on the other hand, stockholders prefer dividends, they will gain if the firm pays a
special dividend.
Predictability of Future Investment Needs: Firms that are uncertain about the

magnitude of future investment opportunities should use equity repurchases as a way


of returning cash to stockholders. The flexibility that is gained will be useful, if they
need cash flows in a future period to accept an attractive new investment.
Undervaluation of the Stock: For two reasons, an equity repurchase makes even more

sense when managers believe their stock to be undervalued. First, if the stock remains
undervalued, the remaining stockholders will benefit if managers buy back stock at
less than true value. The difference between the true value and the market price paid
on the buyback will be accrue to those stockholders who do not sell their stock back.
Second, the stock buyback may send a signal to financial markets that the stock is
undervalued, and the market may react accordingly, by pushing up the price.
Management Compensation: Managers often receive options on the stock of the

companies that they manage. The prevalence and magnitude of such option-based
compensation can affect whether firms use dividends or buy back stock. The payment
of dividends reduces stock prices, while leaving the number of shares unchanged. The
buying back of stock reduces the number of shares, and the share price usually
increases on the buyback. Since options become less valuable as the stock price
decreases, and more valuable as the stock price increases, managers with significant
option positions may be more likely to buy back stock than pay dividends.
Bartov, Krinsky and Lee examined three of these determinants “ undervaluation,
management compensation and institutional investor holdings (as a proxy for stockholder
tax preferences) “ of whether firms buy back stock or pay dividends.4 They looked at 150
firms announcing stock buyback programs between 1986 and 1992 and compared these
firms to other firms in their industries that chose to increase dividends instead. Table 11.3
reports on the characteristics of the two groups.
Table 11.3: Characteristics of Firms Buying Back Stock versus those Increasing
Firms buying back stock Firms increasing Difference is significant
Book/Market 56.90% 51.70% Yes
Options/shares 7.20% 6.30% No

4 Bartov, E., I. Krinsky and J. Lee, 1998, Some Evidence on how Companies choose between Dividends
and Stock Repurchases, Journal of Applied Corporate Finance, v11, 89-96.


No of institutional holders 219.4 180 yes
While the option holdings of managers seemed to have had no statistical impact on
whether firms bought back stock or increased dividends, firms buying back stock had
higher book to market ratios than firms increasing dividends, and more institutional
stockholders. The higher book to price ratio can be viewed as an indication that these
firms are more likely to view themselves as under valued. The larger institutional holding
might suggest a greater sensitivity to the tax advantage of stock buybacks.

11.1. ˜: Stock Buybacks and Stock Price Effects
For which of the following types of firms would a stock buyback be most likely to lead to
a drop in the stock price?
a. Companies with a history of poor project choice
b. Companies which borrow money to buy back stock
c. Companies which are perceived to have great investment opportunities

A Cash Flow Approach to Analyzing Dividend Policy
Given what firms are returning to their stockholders in the form of dividends or
stock buybacks, how do we decide whether they are returning too much or too little? In
the cash flow approach, we follow four steps. We first measure how much cash is
available to be paid out to stockholders after meeting reinvestment needs and compare
this amount to the amount actually returned to stockholders. We then have to consider
how good existing and new investments in the firm are. Thirdly, based upon the cash
payout and project quality, we consider whether firms should be accumulating more cash
or less. Finally, we look at the relationship between dividend policy and debt policy.

Step 1: Measuring Cash Available to be returned to Stockholders
To estimate how much cash a firm can afford to return to its stockholders, we
begin with the net income ““ the accounting measure of the stockholders™ earnings
during the period ““ and convert it to a cash flow by subtracting out a firm™s reinvestment
needs. First, any capital expenditures, defined broadly to include acquistions, are
subtracted from the net income, since they represent cash outflows. Depreciation and


amortization, on the other hand, are added back in because they are non-cash charges.
The difference between capital expenditures and depreciation is referred to as net capital
expenditures and is usually a function of the growth characteristics of the firm. High-
growth firms tend to have high net capital expenditures relative to earnings, whereas low-
growth firms may have low, and sometimes even negative, net capital expenditures.
Second, increases in working capital drain a firm™s cash flows, while decreases in
working capital increase the cash flows available to equity investors. Firms that are
growing fast, in industries with high working capital requirements (retailing, for
instance), typically have large increases in working capital. Since we are interested in the
cash flow effects, we consider only changes in non-cash working capital in this analysis.
Finally, equity investors also have to consider the effect of changes in the levels
of debt on their cash flows. Repaying the principal on existing debt represents a cash
outflow, but the debt repayment may be fully or partially financed by the issue of new
debt, which is a cash inflow. Again, netting the repayment of old debt against the new
debt issues provides a measure of the cash flow effects of changes in debt.
Allowing for the cash flow effects of net capital expenditures, changes in working
capital, and net changes in debt on equity investors, we can define the cash flows left
over after these changes as the free cash flow to equity (FCFE):
Free Cash Flow to Equity (FCFE) = Net Income
- (Capital Expenditures - Depreciation)
- (Change in Non-cash Working Capital)
+ (New Debt Issued - Debt Repayments)
This is the cash flow available to be paid out as dividends.
This calculation can be simplified if we assume that the net capital expenditures
and working capital changes are financed using a fixed mix5 of debt and equity. If δ is the
proportion of the net capital expenditures and working capital changes that is raised from
debt financing, the effect on cash flows to equity of these items can be represented as

5 The mix has to be fixed in book value terms. It can be varying in market value terms.


Equity Cash Flows associated with Capital Expenditure Needs = “ (Capital Expenditures
- Depreciation) (1 - δ)
Equity Cash Flows associated with Working Capital Needs = - (” Working Capital) (1-δ)
Accordingly, the cash flow available for equity investors after meeting capital
expenditure and working capital needs is:
Free Cash Flow to Equity = Net Income
- (Capital Expenditures - Depreciation) (1 - δ)
- (” Working Capital) (1-δ)
Note that the net debt payment item is eliminated, because debt repayments are
financed with new debt issues to keep the debt ratio fixed. It is particularly useful to
assume that a specified proportion of net capital expenditures and working capital needs
will be financed with debt if the target or optimal debt ratio of the firm is used to forecast
the free cash flow to equity that will be available in future periods. Alternatively, in
examining past periods, we can use the firm™s average debt ratio over the period to arrive
at approximate free cash flows to equity.

In Practice: Estimating the FCFE at a Financial Service Firm
The standard definition of free cash flows to equity is straightforward to put into
practice for most manufacturing firms, since the net capital expenditures, non-cash
working capital needs and debt ratio can be estimated from the financial statements. In
contrast, the estimation of free cash flows to equity is difficult for financial service firms,
due to several reasons. First, estimating net capital expenditures and non-cash working
capital for a bank or insurance company is difficult to do, since all of the assets and
liabilites are in the form of financial claims. Second, it is difficult to define short-term
debt for financial service firms, again due to the complexity of their balance sheets.
To estimate the FCFE for a bank, we begin by categorizing the income earned
into three categories - net interest income from taking deposits and lending them out a
higher interest rate, arbitrage income from buying financial claims (at a lower price) and
selling financial claims (of equivalent risk) at a higher price and advisory and fee income
from providing financial advice and services to firms. For each of these sources of
income, we traced the equity investment that would be needed:


Type of Income Net Investment Needed
Net Interest Income Net Loans - Total Deposits
Arbitrage Income Investments in Financial Assets - Corresponding Financial Liabilities
Advisory Income Training Expenses
(Net Loans = Total Loans - Bad Debt Provisions)
The first two categories of net investment can usually be obtained from the balance sheet,
and changes in these net figures from year to year can be treated as the equivalent of net
capital expenditures. While, in theory, training expenses should be capitalized and treated
as tax-deductible capital expenditures, they are seldom shown in enough detail at most
firms for this to be feasible.

Illustration 11.2: Estimating Free Cash Flows to Equity “ Disney, Aracruz and Deutsche
In Table 11.4, we estimate the free cash flows to equity for Disney from 1994 to
2003, using historical information from their financial statements.
Table 11.4: Estimates of Free Cashflows to Equity for Disney: 1994-2003
Change in FCFE FCFE
Net Capital non-cash (before Net CF (after
Year Income Depreciation Expenditures WC debt CF) from Debt Debt CF)
1994 $1,110.40 $1,608.30 $1,026.11 $654.10 $1,038.49 $551.10 $1,589.59
1995 $1,380.10 $1,853.00 $896.50 ($270.70) $2,607.30 $14.20 $2,621.50
1996 $1,214.00 $3,944.00 $13,464.00 $617.00 ($8,923.00) $8,688.00 ($235.00)
1997 $1,966.00 $4,958.00 $1,922.00 ($174.00) $5,176.00 ($1,641.00) $3,535.00
1998 $1,850.00 $3,323.00 $2,314.00 $939.00 $1,920.00 $618.00 $2,538.00
1999 $1,300.00 $3,779.00 $2,134.00 ($363.00) $3,308.00 ($176.00) $3,132.00
2000 $920.00 $2,195.00 $2,013.00 ($1,184.00) $2,286.00 ($2,118.00) $168.00
2001 ($158.00) $1,754.00 $1,795.00 $244.00 ($443.00) $77.00 ($366.00)
2002 $1,236.00 $1,042.00 $1,086.00 $27.00 $1,165.00 $1,892.00 $3,057.00


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