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Buy-Back of Shares.

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What are Shares?

Shares are the shareholder’s interest in the corporate or financial entity’s assets  These can be understood as the proportion of the money paid to the company’s capital. People who own these shares are known as Shareholders. Profits are given in the form of dividends. The rights and obligations of Shareholders are mentioned in the Article and Memorandum of Association. According to Section 44 of Companies Act, shares, debentures or any other interest owned by shareholders are considered as movable property. Method and process of transferring these are mentioned in the Companies Act,2013. 

What are the different types of Shares?

  1. Preferential Share Capital:

These shares are issued from the Issued share capital of the financial entity. These shares have preferential rights:

  • Dividend paid to Preferential Shareholders is a fixed amount or the dividend amount is calculated at a fixed rate. 
  • When the company is liquidated, they have a preferential right to get their share capital back first. 
  • These Rights can be purchased or sold in the stock exchange at the price desired. 
  • Preferential shareholders do not have voting powers. 

Preferential Shares are further classified into:

  1. Cumulative
  2. Non-Cumulative
  3. Participating
  4. Non-Participating
  5. Convertible
  6. Non-convertible
  7. Redeemable
  8. Irredeemable
  1. Equity Shares:

Shares which are not preferential shares are called Equity shares.1 These are also known as ordinary shares. Rate of dividend is not the same year after year. Dividend completely depends upon the profits of the company thus resulting in fluctuations. If the profits of the company for a particular year are not sufficient it may so happen that equity shareholders may not get any dividend that particular year. 

  • These can be purchased or sold in the stock exchange
  • Equity shareholders have a right to vote in the financial and management matters.
  • They have a share in the assets upon liquidation
  • Post completion of all the obligations of the company, equity shareholders will receive surplus. 2

What is Buy-Back of Shares?

When the company which issued shares buys them back at market value to conquer its share that was sold to shareholders in the capital back, it is known as share buy-back. For share buyback, a company can either purchase those shares from shareholders directly or from the stock exchange. Compared to smaller companies, blue-chip companies tend to buy back the shares more because of the cost involved. 

What are the reasons for the Buyback of Shares?

Companies raise their equity capital by selling equity and preferential shares. Hence, buying them back may seem illogical. However, there are a number of reasons through which buying back of shares can benefit the company:

  1. Unused cash is Costly:

Every equity share capital has a small share in the ownership of the company and the equity shareholder has a right to vote in the meetings. Total number owners of a company are considered to be number of shareholders including the M.D. With the sale of shares, equity capital increases but, in situations where there is no potential for growth, holding on to the equity share capital while distributing the ownership to many people is not considered to be wise.  A business which has grown up to its potential or almost to its potential has no much use with a large equity share capital. In that case, large equity share capital is seen as a burden for the company. Moreover, at the end of every year dividends are paid to these shareholders. With buying back the unwanted shares this cost can be cut-down. 

  1. Stock Price is preserved:

Shareholders expect an increase in dividends year after year. Company executors in order to make the shareholders happy try to allot a lot of money to them. This backfires in times of crises. For example, Bank of America has hardly recovered from the loss suffered at the time of great depression. The Bank’s Executive Manager has shifted the focus from allocating large sums of money as dividends to providing the same to the share repurchases. The main reason behind this is that when there is an economic crisis, dividends paid to the shareholders gradually decrease which would result in sell-off in the stocks. At the time of recession, share buybacks reduce much more than the dividends showing a negative impact on the stocks. 3

  1. Undervaluation of Stocks:

If the value of a company’s shares is constantly low, the company can repurchase them at this lowered price and re-issue them at a higher price later. By this process of re-issuing the shares, companies can increase their equity share capital without the need of generating new shares. However, this is a risky move.

  1. Quick way to adjust the financial Statement:

Buying back of unwanted shares increases the company’s earnings per share ratio. This is because the annual shares of a company are divided with a lesser number. Short-time investors look for better buy-backs. Thus resulting in an increase in both Prices to earnings ratio and Returns on equity ratio. Buying back of shares can also be viewed as the confidence management has on its own company. Further, it portrays an image that the company does not need outsiders to purchase its shares. Share buybacks are usually seen as a sign of improvement. 

What are the disadvantages of buying back of shares?

If a company has to borrow funds to buy back its shares, it can affect its credit ratings. Many companies aim for tax-deductions while buying back their own company shares through loans. In times of economic crises, cash reserves are required which are drained through the debt obligations. 

Conclusion

Share is the shareholder’s interest in the corporate or financial entity’s assets  This can be understood as the proportion of the money paid to the company’s capital. People who own these shares are known as Shareholders. There are two types of shares: Preferential shares and Equity shares. When a company buys back its own shares either directly through the shareholder or through the market exchange it is known as shares buyback. This is done by the companies for numerous reasons: to reduce the cost of the unused cash, to preserve the stock price, to save the stocks from undervaluation, to sell the stocks when their prices are raised, to adjust their financial statements. However, buying back of shares through finance is very dangerous. Many companies do this with a view to deduct their tax but, this can result in an increase in debt obligations. These debt obligations in the time of economic crisis drain all the cash reserves and leave the companies in a few cases bankrupt.

Endnotes

  1. Types of Shares, TOPPR, (20 May, 2020), https://www.toppr.com/guides/business-laws/companies-act-2013/types-of-shares/
  2. Nilima M., Types of Shares: Preference and Equity, ACCOUNTINGNOTES, (20 May, 2020), https://www.accountingnotes.net/shares/types-of-shares-preference-and-equity-accounting/12042
  3. Troy Segal, Why would a company buy back its own shares?, INVESTOPEDIA, (16 March, 2020), https://www.investopedia.com/ask/answers/042015/why-would-company-buyback-its-own-shares.asp
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Anusha Nookala

Student, Symbiosis Law School Hyderabad

Anusha Nookala is a student at Symbiosis Law School, Hyderabad currently pursuing BBA LLB. She is a corporate law enthusiast.  She is an effective and attentive speaker and listener, highly organized and detail-oriented individual. For any Clarifications, feedback, and suggestion, you can reach her at l.anusha@student.slsh.edu.in

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