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Stock Repurchase

By Yuriy Smirnov Ph.D.

Definition

Stock repurchase or buyback is a way to return cash to investors, which is an alternative to dividend payout. In other words, a corporation offers to buy current stockholders’ shares.

There are several reasons why stock repurchase allows shareholder value to increase.

  1. It allows capital structure to be changed without an increase of debt.
  2. A corporation may pay out higher dividends without changing its dividend policy.
  3. The capital gains tax rate is lower than the dividend tax rate, which makes stock repurchase more profitable for investors.

Breaking down stock repurchase

A corporation may arrange stock repurchase in two ways.

  1. Buyback through an open market
  2. Tender offer

Buyback through an open market involves brokers who will buy shares at the current market price. The disadvantage of such a method is that it may take a long time to buy back the desired number of shares. It also leads to a decrease in the free float percentage, which will have a negative impact on liquidity of shares.

Making a tender offer to stockholders is an alternative to stock repurchase through an open market. In this case, a corporation itself sets a valid period of a tender offer and the price, which usually has a premium to the current market price. The key advantage of this method is that management controls timing and price, but there is no guarantee that management will buy back the declared number of shares since investors may find the tender offer to be unprofitable.

Journal entry

In accounting, a stock repurchase is recognized by debiting the “Treasury Stock” account and crediting the “Cash” account. The journal entry to be made is as follows:

Stock repurchase journal entry

As far as “Treasury Stock” is a contra equity account with a debit balance, its increase results in a decrease of total equity. For example,

Stock repurchase effect on balance sheet

Advantages and Disadvantages

Advantages

Many corporations initiate stock repurchase when management believes its stock is undervalued. Investors usually perceive it as a positive signal, so after such a declaration the stock price usually rises.

Unlike cash dividends, the decision to accept or refuse the tender offer is made by the shareholder. In addition, if the offer is accepted, shareholders receive tax savings because they pay the capital gains tax at a lower rate than the dividend tax.

If there is a possibility that one or more shareholders will enter the market with a large stake, the other investors will be concerned about a possible decline in the stock price. In this case, stock repurchase would be very useful.

If a corporation has an excess cash balance, management may use it to finance stock repurchase if this is considered the best investment opportunity.

It also has a positive effect on EPS (earnings per share). As the number of shares outstanding declines, the EPS decreases.

Disadvantages

Some investors believe that cash dividends are a more certain source of their cash flow than uncertain and irregular stock repurchase receipts. Thus, such investors may refuse to sell their shares to obtain cash dividends.

There is always a risk that management will choose the wrong time to enter the market. It may cause the opposite effect on stock price, i.e., it will decline.

If shareholders are not aware of all the details of the tender offer, this may be a reason for filing lawsuits demanding compensation.

Example

Total SE Inc. declared a net profit of $15,000,000 in the second quarter of 20X9. The number of shares outstanding at the end of this period was 5,000,000, and the stock price was $36. Management announced a 10% stock repurchase through a tender offer valid until 07/15/20X9 at a stock price of $40.

We should use price/earnings or the P/E ratio to estimate the effect of buyback on the stock price. The P/E ratio is the ratio of the current stock price to the earnings per share (EPS).

Before buyback, the EPS and P/E ratio are:

EPS =  $15,000,000  = $3
5,000,000
P/E =  $36  = 12
$3

After a 10% stock repurchase, the number of shares outstanding and the EPS will be:

Number of shares outstanding = 5,000,000 × 90% = 4,500,000

EPS =  $15,000,000  = $3.33
4,500,000

As far as the P/E ratio equals 12, the stock price after buyback should rise to $40 ($3.33 × 12).

The journal entry to be made on 07/15/20X9 is as follows:

Stock repurchase journal entry example

Cash flow to finance buyback = 500,000 × $40 = $20,000,000