Question

Why do firms use their cash to buy back company shares vs. pay down dept? As an investor how do you feel about this practice? Who wins?

Ans: 500words

Answer 1

Firms use their cash to buy back company shares primarily for the following reasons – ownership consolidation, undervaluation and boosting its key financial ratios. First of all stock buybacks help companies to consolidate ownership. Secondly companies are able to use buyback as a tool to increase its equity value when market pessimism exists. Thirdly and lastly buybacks can make companies look more financially healthy. This attracts more investors.

It should be noted that unused cash is always costly for any company. A share of common stock of a company is representative of a small stake in ownership of that company and this also included a right to vote as well. The right to vote applies to the company’s policy decisions as well as financial decisions. It should be kept in mind that the purpose of issuing share capital particularly equity capital is to generate funds for expansion purposes. In the absence of any potential growth opportunity for the firm there is no economic and financial logic and rational for holding all the unused equity funding as it will mean sharing ownership of the company for no good reason at all.

For companies that have grown to dominate their business and industry the market usually matures and future legroom for growth is usually limited. With less legroom left for growth these companies does not find it sensible to hold on to large amounts of equity capital. Holding on to large amounts of equity capital becomes more of a burden for these companies and hence we can see that it is for this very reason that a company like Apple Inc. has used its excess cash balance to buy back its own shares. Shareholders of Apple, like shareholders of any other company, need returns on their investment. This is provided in the form of dividends which is the cost of equity. Buy backs are a simple way of paying off investors on one hand and reduce the overall cost of capital on the other hand.

A company uses its cash to pay down its debt in many situations as paring down debt is an overall good sign. When a company is generating enough cash flow then it need not depend on debt to finance its growth and expansion and in such cases companies use its excessive cash to reduce its debt. Reduction of debt allows the companies to clean up their balance sheet and to reduce their interest expenses as well.

As an investor I feel good about this practice. Whatever is the purpose of the company using cash either for buy back or for reducing debt will benefit me as an investor. Both will be a win-win situation for me. Buying back of stocks will increase my returns besides preserving the stock price and reduction of debt will increase the financial attractiveness of the company thus making the equity of the company more valuable. Both share buybacks and paring down of debt will lead to better growth prospects for the share price.

(Total word count = 500 words)