Lecture 13

Question 1

What are the two methods of carrying out a Stock Repurchase?

Answer 1

• Tender Offer: firm offers to buy back a quantity of outstanding securities at a premium for a limited time (e.g., 20 days)
• Dutch Auction: firm lists different prices at which it will buy shares, shareholders indicate quantities they will sell at each listed price. The firm pays the lowest price for any given quantity.

Question 2

Why do Share Repurchases not affect price per share? What will affect it?

Answer 2

• Company is buying back the shares at the current market price
• BUT if they’re bought at a market premium then the after shares repurchase price will drop (number of shares company can buy decrease => outstanding number of shares is higher, so lower dividend per share and lower price per share)

Question 3

Why do firms choose stock repurchase over dividends?

Answer 3

• Undervaluation: Companies buy back stock because they believe that stock prices are depressed and so a repurchase is their best investment.
• Financial Flexibility: A firm views a dividend as commitment to shareholders. Stock repurchase is more flexible int hat it does not represent similar commitment. A firm With Temporary increases in cash flow chooses stock repurchases.
• Managerial Preference: Managers with stock options prefer stock repurchases because they are not accompanied by a drop in the stock price.
• Tax: Investors prefer stock repurchases because selling shares, rather than collecting dividends, has a more favorable tax (less tax for stock repurchase than dividends)

Question 4

What is the Principle-Agent problem in regards to dividends?

Answer 4

• Manager’s empire building:
  If a firm has free cash flow, the board should impose dividends (despite the adverse tax effect) to curb management’s empire building => idea that if company gets bigger manager has more power (Jensen’s free cash flow hypothesis)
• Expropriation of creditors’ wealth:
  By increasing dividends, the firm has fewer assets against which creditors have a (priority) claim, and thus the value of a creditors’ claim is lower.
  The above problems lead creditors to demand a debt covenant that restricts the amount of dividends that the firm can pay.
  Such restrictions can serve both to protect creditors and to mitigate the underinvestment problem.

Question 5

What does a change in dividend price indicate?

Answer 5

• Dividend increase: board have succeeded in curbing empire building or firm’s supplu of profitable projects have dried up
• Dividend Cut: not successful in curbing empire building or increase in capital expenditure in pursuit of profitable invesments

Question 6

What does a Stock Repurchase indicate?

Answer 6

• Signalling Hypothesis:
  managers buy back share as they believe stock is underpriced => positive market reaction
• Free Cash Flow Hypothesis:
  management has less surplus cash to pursue empire building => positive market reaction
• Expropriation:
  reducing the levered firm’s assets ands its eqioty base, value van be expropriated from creditors