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What are the effects of Share Buyback?
By buying back the shares, companies usually see a positive effect on the utility of their surplus funds. As the shares bought back are extinguished and not re-issued, the value of outstanding shares in the market goes up. This imparts a positive effect on the valuation of both the companies and the shareholders’ wealth.
Increases the EPS
If a company has surplus cash and manages its operational efficiency, the Earnings Per Share (EPS) will increase after the buyback process. Moreover, as the Price Earning (P/E) ratio remains the same, the price of the share will go up. This is so because the earnings value of the share will increase after the buyback. With the increase in pricing, the shareholders’ wealth may increase significantly.
Improves the Debt-Equity Ratio
Another effect of the share buyback is an increase in the debt-equity ratio as the value of equity dives down but the debt remains the same. Therefore, with increased debt-equity, the companies can reach the target capital structure more easily.
If the company tends to keep the debt-equity ratio the same, it will have to reduce the debt which it can do with the surplus of reserves. Thereby, the debt value of the company shall also come down due to share buyback.
It is notable that the shareholders’ anticipated benefit is more when the company’s share is quoted below the book value. Accordingly, both the EPS and share price increase with the buyback of shares. The book value debt-equity ratio also goes up with share buyback as quoted above. However, even after share re-purchase, the market debt-equity ratio remains unchanged.
Requirement of Funds for Buybacks
The effect of share buyback is more profound in the case of smaller shares or the ones that are undervalued before the buyback. The companies with high capitalization require huge amounts of cash to buy the shares back, even if the buyback is in a fraction of the total shares.
Many of these companies can have a high-value debt to equity ratio which may increase after the buyback of shares. This may affect the credit ratings of the debt instruments of these firms. Further, companies cannot issue more buyback freshly until one year of a buyback of shares. Therefore, the companies tending to buy the shares back should have a huge surplus of funds so that they can absorb the after-effects of a share buyback program.
Share buyback is usually related to large corporate firms that have a huge surplus of cash but only a few opportunities to use the cash in terms of newer investments. Smaller companies cannot afford share buybacks often because it hits the bottom-line of a company in a profound and striking manner.
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