Company’s capital structure
Explain why Share buy-backs are seen as an attractive way of altering a company’s capital structure and examine the circumstances in which they can ‘ensure appropriate share prices’. For one to own a company’s shares is to stake claim to the firm’s earnings. Any enterprise that possesses capital in excess of its requirements (or earns profits) must necessitate one or more of a combination of possible ‘Capital Management Policies.’ Primarily, it may choose to retain and plough back these funds internally in order to expand potential operations such as the purchasing of other businesses, buying capital assets, improving existing operating conditions within the firm etc.; secondly, it could return them to shareholders on a proportional basis in the form of dividends; and/or finally, by share ‘buy-back’ where the company can return capital to those owners who prefer to exchange their shares for cash.
If the company does choose to drive the share buyback highway, UK companies for instance could repurchase shares via: (a) Purchasing shares from the stock market; (b) Arrangements with individual shareholders; (c) Tender offers to all shareholders. Changes in corporation laws in recent years2 in many different countries, especially in the last 6-7 years has made the process of companies
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Many investors believe that Board executives deciding to undertake a share buyback subsequently shrink the company’s capital base in essence relinquishing its responsibility to stakeholders to increase the business’s size and profits. This is done when the amount of overall shares in circulation decreases from the buyback strategy adopted by the enterprise concerned. It is a common misconception that the Directors’ duty is to enhance a company’s profits but rather it is to maximise its fundamental profitability. Directors are therefore expected not to just enlarge the resources at their disposal but put those resources to the most efficient and effective possible use.
Hence if earnings cannot be retained to purposeful and adequate effect within a company and particularly when its shareholders could achieve superior returns by re-investing these earnings elsewhere, a conscientious Board will return capital to shareholders. In my opinion, a share repurchase strategy shouldn’t be undertaken in reasons for the remedial purpose in stock prices. In 1988 the Bank of England suggested five main reasons for share buy-backs buy firms. They were: (1) To return surplus cash to shareholders; (2) Increase the underlying chare value; (3) Support share price in periods of provisional weakness; (4) To achieve or maintain target capital structure (5) To prevent unwelcome takeover bids.
In small capitalisation firms there are reasons as to why buy back shares are attractive; one is to generate more proceeds for those shareholders that are ‘left standing’ when an eventual “value recognition event” occurs when markets realise that the subsequent increase in share price is just a temporary over inflated period, but if the objective is to cause a lasting increase in the share price, the project is destined to fail.5 The fundamental problem with these stocks is they are extremely liquid low and demand is inelastic. History has shown as valuations fall to rather poorly low levels, no new investor interest is generated (Vermilion 1981). Depressed total market capitalisation have cast these firms deeper into obscurity just by decreasing the supply of stock (Fig.1) so it cannot be expected to create any sustainable improvement in the share price.
The capital structure of a company is essentially the way the company is composed in terms of the permanent long-term financing of the firm, including long-term debt, common stock and preferred stock (weighted assets of debt and/or equity) and retained earnings. It differs from financial structure, (which includes short-term debt and accounts payable). The capital structure will change when costs are more internalised after the buy-back. To illustrate6 how share repurchasing by firms can alter the company’s capital structure, we can imagine a company where: