Share Repurchases in the US, UK, France and Germany

Sh be Repurchases in the US, UK, France and Ger numerous1. IntroductionThe marketplace system in the UK and the US has emphasized the role of the spud market in the Anglo-American capital letterist system.Sh ars and bonds consec valuate be practice rattling common tools of enthronisation in the capital system.Investors deal fates and bonds in the hope of come upting capital gains plus income from their investments.Shares offer investors capital gains/losses and dividends, portion out are really attractive investment tools for people who are prepared to risk their linguistic rule and suit slight than the amount that they have invested.Bonds offer limited lapse on investments, Bonds offer investors the same principle.Financial managers usually pay off their takeholders using ii methodsDividends dividends are share of the capital that investors receive in diminish for investing their gold in the companionship.Share purchase/repurchase some financial managers excret e to buyback the shares of the comp each if they feel that they teleph aners shares are under treasured, buying part of the shares lead boost the remaining turn startstanding share damages.Over the locomote twenty five years, companies have snuff it less prone to distri exactlye currency to shareholders.This noticeable adjoin in dividends is accompanies by share repurchases in the US.Since Margaret Thatcher came to the causality in the UK, the United Kingdom has adapted a very similar economic path to the US.These developments in the US have been followed by very similar developments in the UK.British companies are trying to concentrate on share buyback rather than pay dividends.In this assignment, we provide try to find out why companies are heading towards share buyback.2. What watch overs the payout policy of the high society? moth miller and Modigliani (1961) were the first deuce scientists to challenge that fact that high dividends payout leads to higher value of a social club.It is apparent that companies payout policy does not affect the value of the confederation.The grounds that made Miller and Modigliani think that the payout policy of the unanimous does not affect the value of the firm is that fact that in a frictionless economy investors could give rise their decisions rationally with no or minimum stochastic factors.Investors will be able to break that distributing too much dividends means that the company is missing investment opportunities and that its future currency flows will be substantially less than now.While if the company hold its pelf in articulate to invest into projects, investors will think that the company has over invested and so that the return on its capital will be substantially less than the market average.Miller and Modigliani thought that companies could not create the impression that they are better than what they are in naive concreteism.For several fences, thither are umpteen people nowadays t hat do not believe in Miller and Modigliani, one of the possible reasons for that is the fact that financial markets are not frictionless and investors are not totally rational.In the financial markets, there are many short-sighted investors that prefer to get profit as soon as possible without stipendiary any real value to the future bullion flow of the firm.But the supporter of Miller and Modigliani argue that institutional investors watch the payout policy of the firm very carefully and analyze the activities of the firm in a very good government agency so institutional investors do know the value of the firm exactly.Although Miller and Modigliani do not see any difference in the value of the firm no matter what payout policy the firm follows there are many people who think that having high payout policy is much better than retaining funds because high payout policy attracts institutional investors who are able to monitor the company and pull up stakes a more precise valuatio n to the value of the company and its credit quality.Trojanowski, G(2004) thinks that the company is really in typical slip I error and font II error dilemma, if the company adapted high payout policy towards so it became cash constraint the company might miss profitable investment opportunity( type II error), but if the company retained cash and invested in unprofitable projects this will be type I error.Trojanowski, G(2004) thinks that this high payout policy is considered the toll that should be paid to institutional investors in state to get things right and be able to feed in precise valuation to the company.There are several factors that determine the payout policy of a firm we can summarize these factors as Valuation of the companys value, taxes, entropy asymmetries and contract incompleteness.2.1 Valuation of the Firms sharesThe value of the firm itself play a substantial role in the payout policy for any company, if the firms shares are undervalued, companies take to the woods to buyback their share prices in dress to make use of the undervalued share price, this will improve the share price and encourage investors to invest more in the shares of the particular company.Share buyback play the merger acquisition impact on share prices, in the case of merger and acquisition, a company comes forward to buy the shares of an undervalued company, this normally leads to a elevate in the share prices of both companies.In the case of share buyback, the company itself comes forward to buy its birth shares, this leads as well to a hike in the share price.The rise in share prices resulting from share repurchases will make it more difficult to otherwise companies to buy the shares of the undervalued company because buying the shares of the undervalued company will require additional premium.The success of the share buyback sue is directly related to the get along of investors who come forward to contend their shares.The tot up of investors who come f orward to apportion their shares is related to the price at which the shares were bought.If the price of the bought shares was high and whence fell dramatically, the buyback passage will not be sufficiency to compensate for the full loss of the invested money Investors will rather prefer to throw the management and hold it accountable for the poor results of the company. If the fall in the price of the shares was modest and share buyback compensated the loss that investors have incurred and/or made capital gains, many investors will prefer to sell their shares and that is how the buyback process becomes successful.2.2 TaxAccording to Miller and Modigliani (1961) dividends do not affect the value of the firmThis result is based on many assumptions taxes,The tax system of any acres will affect the payout policy of most of the companies in the world.The research that has been done on this issue refers to two factsThe first one is that companies tend to change their payout policy if the tax police changed.The second one is that according to Kalay (1982) and Stiglitz, J, E (1983) individual investors do rebalance their portfolios quickly full in response to tax law changes this school of thought thinks that investors always try to follow tax avoidance strategies in order to maximize their riches by dividend launderingIn other words, investors will try to jell pressure on their company in order to pay them in the most tax efficient way that maximizes their wealth and the value of the company.Share repurchases are very attractive way of distributing the profits of the company because they could happen at any time of the year investors try to put pressure on the company to acquire a suitable time for most of them.Share repurchases give investors the flexibility and the choice in participations, investors might choose to participate in the share repurchase if they feel that their overall tax liabilities will become less.Investors could defer their tax paym ents to make their own decision of when to sell in order to maximize their total wealth.Of course, shareholders can sell their shares in the market if they want cash as a tax Advantaged substitute for all share repurchases or cash dividends.In the law, the tax paid on capital gains is deferred until the shares are sold whereas any income tax on dividends is paid annually. The respite of the capital gains tax reduces its present value.Broadly speaking dividends in the UK enjoy a less favourable tax regime than share repurchases which may give rise to something of a Dividend Policy Puzzle.Although dividends do not enjoy the same tax treatment that share repurchases have, most of the companies in the UK are still compensable dividends because most of the investors are tax-exempt and companies listen to their shareholders in the UK.This point will be researched in more detail in the coming sections2.3 Financial social organisationWhen companies decide to buyback their shares, they change their financial structure.Share buyback is accompanied with significant debt/ right ratio.Share repurchase does not only reduce equity but also increases debt.The leverage ratio will increase after the buyback period.The financial structure of the company has a pro prime impact on the payout policy.In order to understand how the financial structure affects the payout policy we need to understand the concept pf block holders.Block Holders are few numbers of investors who own the majority of the shares of the company.The economic literature is increasingly enforcing the fact that block holders could play a positive role in monitoring the achieveance of the companies that they invest in because they have a big interest in preserving and growing the capital that they have invested. Unlike small investors, block holders power is very important in keeping the management of the company doing the surpass it can in order to maximize the wealth of the shareholders.When companies use share buyback, it is expected that minority shareholders will sell their shares to the issuing company and not the block holders. When that happens, small shareholders numbers will decrease and there power will be less.This will overt the gate for lad shareholders to use their power in imposing what they want without listening to the minority shareholders who have less power in the board room than bloke shareholder.In that sense, we can say that changing the financial structure of the company can have a negative impact on the minority shareholders who choose to sell some of their shares to the issuing company.In many countries such as Germany, France, Italy and Hong Kong, the volume of shares to be repurchased must not exceed 10% of total shares outstanding. Firms from such countries can therefore not use repurchase programs to increase their debt-to-capital ratio dramatically and to transfer value from debt holders to shareholders.2.4 Cash FlowPublic companies have shares that could be traded on the striving exchange, as illustrated above investors expect return on their investments in the radiation pattern of dividends.If the company did not meet investors expectations, share prices will go down.Share buyback happens when the company has cash that is in unornamented of the companys needs.If the company cannot pay its investors good return on their investments, it is better to return the money to the investors in the shape of share buyback.Jagannathan, Stephens and Weisbach (2000) showed that companies with excessive operating cash flows tend to distribute dividends while companies with limited operating cash flow tend to repurchase their shares.Companies with temporary excessive cash flow tend to repurchase its shares in order to distribute the excess cash flow.Companies with temporary excess cash flow tend to distribute its excess cash because the company wants to smooth its dividends policy, it is not in the companys best interests to increase the capriciousness of its dividends because dividends are very important signaling tools that the market use in valuing the shares of the company, when dividends increase because of temporary excess cash and them decrease later one, share prices will become volatile and investors will try to avoid the shares of that particular company.2.5 Agency ProblemThe industrial revolution has contributed significantly to the separation of management from ownership.There is a constant quantity crisis of trust between management and the shareholders of any public company.Under perfect conditions, the management is supposed to be turn tailing for the best interests of the shareholders, but what happens in reality is something different, the management is constantly trying to maximize its own benefits and wealth on the expense of the shareholders.The relationship between management and shareholders is not always a conjunct relationship the relationship might well prove to be a competitive relations hip.Managers and company directors might misuse the funds of the shareholders directors might use the money of the shareholders in increasing their salaries, pensions and other allowances instead of paying this money to the shareholders in the form of dividends or share buyback.When company directors choose to use the excess funds that they have in buying back the shares of the investors or in other words returning their money, the trust between the investors and the company directors increases significantly.Share buyback proves that there is a wise management in that particular organization investors will see this move as maintenance to the resources of the investors.Company directors that choose to invest the excess cash that they have in non-profitable projects will be seen in the financial markets as not reliable investors will know that the top management of that company is not run low.Some school of thoughts claim that share buybacks are bad for the minority shareholders if t hey are not accompanied with the selling of the shares of the directors.The reason for that is the fact that company directors own shares and share excerpts in the company and if the company made a share buyback, the share of directors and managers in the company will increase and this will open the door for possible misuses.Many economists recommend that share buyback has to be accompanied by the selling of the shares of the directors in order to keep a sound management system in the corporation, Siu, J Weston, F(2002).Finally, Share repurchases can violate the interests of the last majority of uninformed shareholders when only inside shareholders have information near the exact timing of repurchase transactions and the amount that the issuing company will purchase.Insiders could use that knowledge to dispose of their shares at a higher price than under normal market conditions, IKENBERRY/VERMAELEN 1996.This illegal action would cause a wealth transfer from outside shareholders to inside shareholders and if anticipated by outside shareholders should lead to a negative announcement effect.2.6 SignalingShare buyback are used a signaling tool, dividends convey information about the future cash flow of the company.Motivations are normally in line with shareholders interests this includes the attempt by management to convey to investors that the unfeigned value of their corporations equity exceeds its accredited market value.Such a signal might be based on managements believe that the true mean of the probability dispersal of the firms future cash flows is truly higher than perceived by the market or alternatively, that the true variance of future returns is higher than expected, memory the distribution mean constant, DANN (1981)We have two cases depending on the prices of the financial assets of the company In the first case, all of the firms risky securities appear to be undervalued. In the latter case, only equity claims appear to be undervalued, wher eas claims in the form of risky debt might in fact be overvalued.Share repurchases could actually lead to a re-distribution of debt holders wealth to the benefit of shareholders.It is typically assumed that insiders which are the companys management and directors know a lot more information about the companys cash flow situation than insiders.However, any straight public announcement by the board of directors that it considers its firms shares to be undervalued generally lacks credibility because there might be other hidden motives to the management.Outside investors cannot distinguish between true and misleading announcements because they do not have all the information about the company.They will perceive of all undervaluation announcements as try to hide the truth about share repurchases unless the company produces evidence that undervaluation is the real motivation for share repurchases. Share repurchase announcements cause two types of follows to overvalued firms. Firstly, fi rms that repurchase overvalued shares must understand that the share price will decline to its true intrinsic value as soon as possible, so that the company would have paid too much for its shares.Secondly, firms that announce to repurchase shares but then decide not to do so might see their general report for honest capital market communication deteriorate because the companys public relations status with the company will be shaken. Depending on the legal and regulatory restrictions for share repurchase programs, such firms also risk that governing initiate investigations of price manipulation.Given these potential costs, share repurchase announcements can be used as a clear signal to enhance the reputation and the credibility of an undervaluation signal.Such credible signals should then lead to an appreciation in stock price and benefit the investors who are welling to sell their shares.Share buyback will convey a message to investors that the company has few good projects (NPV Share buyback indicate that the financial situation of the company is not strong enough in order to meet the expectations of the investors.When the company chooses to pay its investors by distributing dividends, it gives the signal that it has many good projects (NPV0), and the company believes that it could create capital gains to investors without seeking refuge to share buyback.2.7 Employee incentive plansThe company might seek to purchase its own shares in order to finance its employee incentive plans.In the current capitalist system, many companies know that empowering employees is the best way to align the interests of the employees with the interest of the company.Through the history, the management and the employees were always at odds and that caused many strikes and make out within the company.Many companies found out that the future organizations of the companies should depend on giving employees the initiative and turning them into an asset rather than looking at them as a liability or an expense.This process has been triggered by the introduction of new technologies that enabled top managements to cut the middle management and give the authorities of the middle management to the employees that the technology will help them to perform their tasks in a more efficient way without the direct supervision of the middle management.This process could not be achieved without giving employees shares in the company and make them real partners in the organizations.When employees get share of the profit they will work harder than before and that will benefit the whole organization and the society.Share repurchases are one of the best ways to turn the employees into an asset since share repurchases happen when the share price is relatively cheap, share repurchases provide a very cheap way to finance the employee share scheme and create a wholly new organization that depends on mutual trust between management and employees rather than struggle between them.2.8 Convertible bonds executionConvertible bonds are defined as bonds that pay a regular coupon for their buyer, the price of bonds will depend on two main things interest rates and credit quality of the issuer.Convertible bonds combine the feature of bonds and shares at the same time.We all know that companies give their investors the option to convert their bonds into common shares at any time they want in order to make their bonds more attractive to investors and give investors the flexibility in choosing the investment tools that they foresee suitable to their investment strategy.We all know that shares and bonds are two different products that offer two different profit and loss opportunities.Most of the times, shares and bonds markets work at odds. When interest rates are low share prices seem to be a better investment opportunity than bonds because they offer better return on investment.When interest rates are high bonds seem to be a better investment opportunity than shares bec ause they offer better return on capital.Many companies encourage investors to invest with them by giving them the option( this option is called call option) to convert their bonds to shares.When the company has a shortage of shares the company will have to buy them directly from the market in order to meet its investors requirements of converting bonds into shares.2.9 Trade sharesTrading shares might be the motive for share repurchases in the UK and elsewhere in the developed world.When the market is depressed and the share prices reflect less than their fair value many companies will resort to buying their own shares in order to sell them later at a higher price.When big companies believe that their shares are under-estimated, they invest the excess cash that they have in themselves in order to encourage more investors to buy their shares and when the market prices of the shares goes up the issuing companies will resell them at profit.Investors will benefit from this share repurch ase by two waysInvestors will be able to sell some of their shares at higher price and make profit from that.Investors will benefit from the higher dividends that their company will pay them as a result of re-selling the shares at higher price. Share repurchase might aim as well to reduce the volatility of the share and stabilize its price.Share trading s not as easy as it might seem, there are enactments that govern the ability of the company to buy/sell its own stocks.2.10 Destroy sharesThere are two reasons to destroying sharesThe first one is to change the ownership structure and the second one is to increase the wealth of the shareholders.Change the ownership structureWhen the company buys its own shares in order to destroy them, it destroy with the shares the voting right, we all know that owning one share means owning one vote, this means that destroying one share means destroying one vote.According to Pindur, D Lucke, M (no date given) the management might find it very cos t effective to have homogenous shareholders rather than heterogeneous shareholders, thats why the company offers share repurchases and destroys shares.In that case, the company will offer investors what is called a controlled premium, which is a premium that is paid above the market price in order to lure investors to sell their shares.Wealth creation for investorsThe best beak to wealth creation is the Economic Value Added Economic Value Added is defined as the operating after tax profit minus a agitate for the opportunity cost of the invested capital.When the company wants to maximize its shareholders wealth by buying and destroying the shares directly from the market the company will resort to the following measuresDecrease the leaden average cost of capital (WACC) we all know that the weighted average cost of capital depends on two major elements which are shares and bonds the average cost of bonds is the interest rate that is paid to the bondholder, the average cost of shares will depend on the risk premium that is required by shareholders to compensate them for the risk of losing their invested principle when the company buys its own stock it reduces the weight of equity in the mix of capital, so the weighted average cost of capital will be less and that is how the wealth of the shareholders will increase if the company bought the shares from the market and destroyed them reducing the weighted average cost of capital means that producing the same profits or more with less costs of capital, this is a real sign of improvement in the situation of the company, the issuing company has to be careful that reducing the number of outstanding shares might mean that share prices will go up in order to satisfy the demand on the shares of the company, especially when shares get less, the dividends get better, this might increase the demand on shares, that is why management is always advised to reduce the amount of shares and debt in the same percentage in order to leave prices of shares and bonds relatively stable, the opposition to share buyback comes from debt holders especially those with unsecured debt, the reason for that is the fact that when shares decreases this means that capital has decreased and this means that if the company went break there will be no enough capital to cover the value of the debt, while shareholders will be the least losers from bankruptcy, again that is another reason why companies are advised to buy shares and bonds at the same time and keep its leverage ratio stable during the time, A third and final reason for advising companies to buy shares and bonds at the same time is the reason that many companies offer convertible bonds which could be converted at any time to certain number of shares, if the company did not buy shares and bonds at the same time and share prices went up, convertible bond investors might find it more profitable to convert their bonds to shares and in this situation the company will find itself in front of two options the first one wither buying more shares to convertible bond investors from the market and that would mean paying high prices for them or issuing new shares again and that would make share repurchases pointless.Increase the return on invested capital (ROIC) this idea is very related to what we explained before about type I error and type II error, in other words the company will take decisions regarding the best investment opportunities that are available, it is assumed that the company will select the projects that maximize the return on invested capital and return the excess cash to the investors in the shape of share repurchases, this process will maximize the return on equity to the maximum, we all know that the marginal propensity to capital will increase promptly at the beginning of the investment and after that the amount of increase will de-accelerate until it the marginal propensity to capital reaches zero and then it starts to decline. Increa se the growth rate when the right amount of capital has been allocated to the most profitable projects the growth rate of the company should be maximum.2.11 Legislative reasonsSometimes companies in a particular country find very difficult to repurchase their stocks even if there is tax benefit from repurchasing the stock rather than distributing dividends.In the US for example, companies did not repurchase their shares until after the mid-eighties.According to Grullon, G Michaely, R(2000PDF page 5), one of the possible reasons for that is the risk of violating the anti-manipulative provisions of the Securities Exchange Act of 1934, Indeed, after the SEC adopted a safe give rule (Rule 10b-18) in 1982 that guarantees that, under certain conditions, this agency will not file manipulation charges against companies repurchasing shares on the open market, repurchase activity experienced an upward structural shift.Grullon, G Michaely, R(2000) says that one year after the change of the SE C rule the amount of sugar that have been distributed as share repurchases tripled.In Germany for example, share repurchases are still very difficult because they need the approval of the shareholders that should be got in the Annual General Meeting.We can see clearly that regulation is a very important too in encouraging and discouraging share repurchases.2.12 Dilute earningsMany analysts think that share options have helped in aliening the directors interests with the interests of the shareholders but few people investigated how stock options change the behavior and choice of directors to distributing earnings. There is increasing evidence that executive compensation that is usually granted in the form of stock option has a lot to do with share repurchases in the UK and the US.Accounting rules make compulsory on companies to reflect the value of the stock options that are given to directors and managers.We all know that writing an option on the shares of the company is equivalen t to increasing the number of the outstanding shares.When company directors want to influence their options, there need to acquire actual shares of the company and that would make Earnings per Share less for everybody that is called diluting the earnings.Earnings per Share are the total earnings divided by the number of outstanding common shares and common shares equivalents.When earnings per share become actually less the company will try to repurchase the shares from the market.Earnings per share will not only be less but also will cause a decline in share prices later on because EPS is used in valuing the shares.The cash that is actually used to repurchase the shares will not be deducted from the total earnings and that the company will keep its total earnings unchanged after the repurchase of the shares from the market.In order to illustrate this point further, there is a difference between EPS and reduce EPS.Diluted EPS is the total earnings of the company subtracted from the cost of share options and warrants divided by the number of outstanding common shares and equivalents.When analysts value shares they look at EPS but not diluted EPS.After share repurchases, EPS will be the same as before share repurchase EPS.So companies try to repurchase their own shares because they try to hideout the cost of share option costs.If we look at the empirical studies that have been done in this area we find that most of the studies found a correlation between stock repurchases and executives share options.According to Lambert, Lanen, and Larcker (1989), Option grants in general are associated with increased payouts and decreased earnings retention.The larger is the executives holding of stock options, the more apt the firm is to retain more earnings and curtail cash distributions.This finding is consistent with Fenn and Liang (2000) that there is a well-documented finding of negative relationship between dividends and managerial stock options and.The relationship do es not appear to be explained by differe