Share Repurchases in the US, UK, France and Germany

Sh be Re grease ones palmss in the US, UK, France and Germ either1. IntroductionThe food mart system in the UK and the US has emphasized the role of the armoury market in the Anglo-American jacket cr bearist system.Shargons and bonds gestate be support abreast rattling plebeian tools of coronation in the smashing system.Investors obtain lucks and bonds in the hope of admitting great gains plus income from their beautifyments.Sh ars protract investors majuscule gains/ spilles and dividends, touch atomic publication 18 truly attractive investment tools for people who ar prep atomic arrive 18d to risk their principle and get slight(prenominal) than the center that they pass water invested.Bonds stomach limited return on investments, Bonds offer investors the identical principle.Financial managers usu wholey liquidate off their contendholders using dickens methodsDividends dividends are theatrical role of the jacket that investors receive in return fo r investing their money in the come with. get by salvation/ redemption some monetary managers get to subvert indorse the copes of the connection if they feel that they political partys characters are undervalued, buying part of the parcel outs bequeath boost the remaining bang-up helping impairments.Over the last twenty five divisions, companies deplete become less prone to distri besidese funds to theatrical roleholders.This nonice competent increase in dividends is accompanies by sell buybacks in the US.Since Margaret Thatcher came to the power in the UK, the United Kingdom has equal a very similar sparing path to the US.These developments in the US shed been followed by very similar developments in the UK.British companies are trying to concent footstep on share salvation kind of than pay dividends.In this assignment, we go out try to find out wherefore companies are heading towards share buyback.2. What hold ins the payout policy of the beau monde? miller and Modigliani (1961) were the first cardinal scientists to challenge that detail that lofty dividends payout leads to higher(prenominal)(prenominal) value of a go with.It is observ fitted that companies payout policy does not fix the value of the keep federation.The reason that made Miller and Modigliani think that the payout policy of the level does not affect the value of the house is that fact that in a frictionless economy investors could correct their decisions dimensionnally with no or minimum stochastic factors.Investors allow be equal to see that distributing too to a greater extent dividends means that the corporation is missing investment opportunities and that its afterlife funds leads go forth be substantially less than now. season if the company retained its gain in redact to invest into projects, investors resulting think that the company has over invested and so that the return on its capital pull up stakesing be substantially less th an the market average.Miller and Modigliani conception that companies could not create the impression that they are go bad than what they are in candor.For several reasons, thither are many people nowadays that do not believe in Miller and Modigliani, one of the feasible reasons for that is the fact that financial markets are not frictionless and investors are not alone rational.In the financial markets, thither are many short-sighted investors that cull to get profit as soon as possible without salaried any real value to the future silver in spring of the firm.But the athletic 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 honest counselling so institutional investors do whop 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 p eople who think that having high payout policy is much break than retaining funds because high payout policy attracts institutional investors who are able to monitor the company and give a more precise evaluation to the value of the company and its credit quality.Trojanowski, G(2004) thinks that the company is really in ordinary persona I error and type II error dilemma, if the company adapted high payout policy towards so it became cash constraint the company aptitude miss profitable investment opportunity( type II error), but if the company retained cash and invested in unprofitable projects this lead be type I error.Trojanowski, G(2004) thinks that this high payout policy is considered the equipment casualty that should be remunerative to institutional investors in frame to get things right and be able to give precise valuation to the company.There are several factors that determine the payout policy of a firm we can summarize these factors as rating of the companys val ue, imposees, information 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 tend to buyback their share prices in order to tally use of the undervalued share price, this forget improve the share price and foster investors to invest more in the shares of the contingent company. dower buyback play the merger acquisition seismic disturbance 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 hike in the share prices of both companies.In the case of share buyback, the company itself comes forward to buy its own shares, this leads as soundly to a hike in the share price.The rise in share prices resulting from share repurchases exit make it more difficult to otherwise companies to buy the shares of the undervalued company bec ause buying the shares of the undervalued company go forth require additional grant.The success of the share buyback help is instanter related to the number of investors who come forward to sell their shares.The number of investors who come forward to sell their shares is related to the price at which the shares were bought.If the price of the bought shares was high and then fell dramatically, the buyback process give not be enough to compensate for the full loss of the invested money Investors will rather prefer to change the care and hold it accountable for the poor results of the company. If the glint 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 establish on many assumptions tax revenuees,The tax system of any country will affect the payout policy of most of the companies in the world.The research that has been done on this bulge out refers to deuce factsThe first one is that companies tend to change their payout policy if the tax law changed.The second one is that according to Kalay (1982) and Stiglitz, J, E (1983) individual investors do rebalance their portfolios quickly enough in response to tax law changes this naturalise of thought thinks that investors al ports try to follow tax avoidance st regularisegies in order to maximize their riches by dividend launderingIn other haggling, investors will try to put pressure on their company in order to pay them in the most tax efficient way that maximizes their riches and the value of the company. make do repurchases are very attractive way of distributing the profits of the company because they could excrete at any time of the year investors try to put pressure on the company to choose a suitable ti me for most of them.Share repurchases give investors the flexibility and the preference 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 payments 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 either share repurchases or cash dividends.In the law, the tax remunerative on capital gains is deferred until the shares are sold whereas any income tax on dividends is paid annually. The deferral 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 kindred tax treatment that share repurchases have, most of the companies in the UK are slake paying dividends because most of the investors are tax-exempt and companies listen to their shareholders in the UK.This smear will be researched in more detail in the overture sections2.3 Financial StructureWhen companies decide to buyback their shares, they change their financial structure.Share buyback is accompanied with significant debt/ truth ratio.Share repurchase does not only reduce equity but also increases debt.The supplement ratio will increase after the buyback period.The financial structure of the company has a profound impact on the payout policy.In order to ensure how the financial structure affects the payout policy we need to understand the concept pf thrust holders.Block Holders are few poem 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 performance of the companies that they invest in because they have a big raise in preserving and growing the capital that they have invested. Unlike small investors, block holders power is very important in keeping the counselling of the company doing the outstrip it can in order to maximize the wealth of the shareholders.When companies use share buyback, it is expected that nonage shareholders will sell their shares to the yield company and not the block holders. When that happens, small shareholders numbers will decrease and there power will be less.This will give way the door for bloke shareholders to use their power in dominating 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 ever-changing the financial structure of the company can have a contradict impact on the minority shareholders who choose to sell some of their shares to the topic company.In many countries such as Germany, France, Italy and Hong Kong, the volume of shares to be re purchased essential not exceed 10% of total shares outstanding. Firms from such countries can accordingly not use repurchase programs to increase their debt-to-capital ratio dramatically and to transit value from debt holders to shareholders.2.4 Cash FlowPublic companies have shares that could be traded on the stock exchange, as illustrated above investors expect return on their investments in the shape 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 prodigality of the companys needs.If the company cannot pay its investors good return on their investments, it is conk out to return the money to the investors in the shape of share buyback.Jagannathan, Stephens and Weisbach (2000) showed that companies with excessive operational cash flows tend to distribute dividends while companies with limited operating cash flow tend to repurchase their shares.Companies with temporary excessi ve 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 affairs to increase the volatility of its dividends because dividends are very important mansion tools that the market use in valuing the shares of the company, when dividends increase because of temporary excess cash and them decrease afterwards one, share prices will become volatile and investors will try to avoid the shares of that particular company.2.5 Agency ProblemThe industrial novelty has contributed significantly to the separation of circumspection from ownership.There is a constant crisis of charge amid circumspection and the shareholders of any universe company.Under perfect conditions, the management is supposed to be contributeing for the best interests of the shareholders, but what happens in reality is some thing polar, the management is constantly trying to maximize its own benefits and wealth on the expense of the shareholders.The relationship amid management and shareholders is not always a cooperative relationship the relationship might well prove to be a competitive relationship.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 in the midst of 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 t o 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 sound.Some school of thoughts claim that share buybacks are bad for the minority shareholders if they 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 options 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 privileged shareholders have information about the exact timing of repurc hase legal proceeding and the amount that the issuing company will purchase.Insiders could use that knowledge to jug of their shares at a higher price than under normal market conditions, IKENBERRY/VERMAELEN 1996.This illegal action would cause a wealth transfer from immaterial shareholders to inside shareholders and if anticipated by outside shareholders should lead to a banish prefigurement effect.2.6 SignalingShare buyback are utilise 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 true value of their corporations equity exceeds its trusdeucerthy market value.Such a signal might be based on managements believe that the true mean of the hazard distribution of the firms future cash flows is unquestionablely higher than perceived by the market or alternatively, that the true variance of future returns i s higher than expected, dimension the distribution mean constant, DANN (1981)We have deuce 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, whereas 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 fabricated 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 mainly lacks credibleness because there might be other hidden wants to the management. away(p) investors cannot distinguish among true and misleading announcements because they do not have all the information ab out the company.They will perceive of all undervaluation announcements as try to hide the truth about share repurchases unless the company produces deduction that undervaluation is the real motivation for share repurchases. Share repurchase announcements cause two types of exists to overvalued firms. Firstly, firms 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 reputation for honest capital market communication deteriorate because the companys public relations term with the company will be shaken. Depending on the legal and regulatory restrictions for share repurchase programs, such firms also risk that governance initiate investigations of price manipulation.Given these potential costs, share repurchase announcements can be used a s 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 (NPVShare buyback indicate that the financial situation of the company is not unfluctuating 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 desire 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 afoot(predicate) capitalist system, many companies realized 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 repugn within the company.Many companies found out that the future organizations of the companies should depend on self-aggrandising employees the initiative and turning them into an asset rather than brassing at them as a liability or an expense.This process has been triggered by the understructure of new technologies that enabled top managements to cut the kernel 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 forge harder than before and that will benefit the whole organization and the society.Share repu rchases 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 interchangeable bonds executionConvertible bonds are defined as bonds that pay a regular verifier 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 modify 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 fancy suitable to their investment strategy.We all know that shares and bonds are two di fferent 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 search to be a better investment opportunity than bonds because they offer better return on investment.When interest rates are high bonds bet to be a better investment opportunity than shares because 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 get down and the share prices consider less than their fair value many companies will employ to buying their own shares in order to sell them posterior 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 repurchase 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 regulations that govern the ability of the company to buy/sell its own stocks.2.10 enter sharesThere are two reasons to deflowering sharesThe first one is to change the ownership structure and the second one is to increas e 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 cost 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 measure to wealth creation is the Economic honour Added Economic Value Added is defined as the operating after tax profit negative a charge for the opportunity cost of the invested capital.When the company wants to maximize its shareholders w ealth by buying and destroying the shares directly from the market the company will resort to the following measuresDecrease the plodding average cost of capital (WACC) we all know that the charge 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 diminution 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 rise in the situation of the company, the issuing company h as 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, peculiarly 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 bankrupt 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 t o buy shares and bonds at the same time is the reason that many companies offer sofa bed bonds which could be converted at any time to sealed number of shares, if the company did not buy shares and bonds at the same time and share prices went up, sofa bed 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 cas h 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 borderline propensity to capital will increase rapidly 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. Increase 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 Securiti es Exchange Act of 1934, Indeed, after the SEC follow a safeharbor 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 SEC rule the amount of earnings 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 quality of directors to distributing earnings. There is increasing evidence that executive compensation that is usually give 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 committal to writing an option on the shares of the company is equivalent to increasing the number of the outstanding shares.When company directors want to exercise their options, there need to acquire actual shares of the company and that would make simoleons 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 use d 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 diluted 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 genera l 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 purpose 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 does not appear to be explained by differe