530 CHAPTER 14 Distributions to Shareholders: Dividends and RepurchasesStock Repurchases
A stock repurchaseoccurs when a company buys back some of its own outstanding
stock.^10 Up until the 1980s most stock repurchases were fairly small, but Phillips Pe-
troleum set a record in 1985 when it announced plans to repurchase 81 million of its
shares with a market value of $4.1 billion. Texaco, IBM, CBS, Coca-Cola, and dozens
of others soon made large repurchases. Indeed, since 1985 large companies have
repurchased more shares that they have issued. During the last two decades the
amount of cash paid in dividends has steadily declined, while the amount used for
repurchases has steadily increased. In fact, since 1995 more cash has been returned to
shareholders in repurchases than as dividend payments.^11 Interestingly, total distribu-
tions have remained relatively stable over the last two decades.
Three principal situations lead to stock repurchases. First, a company may de-
cide to increase its leverage by issuing debt and using the proceeds to repurchase
stock, as we described in Chapter 13. Second, many firms have given their employ-
ees stock options, and they repurchase stock for use when employees exercise the
options. In this case, the number of outstanding shares reverts to its pre-repurchase
level after the options are exercised. Third, a company may have excess cash. This
may be due to a one-time cash inflow, such as the sale of a division, or it may sim-
ply be that the company is generating more free cash flow than it needs to service
itsdebt.
Stock repurchases are usually made in one of three ways: (1) A publicly owned firm
can buy back its own stock through a broker on the open market. (2) The firm can
make a tender offer, under which it permits stockholders to send in (that is, “tender”)
shares in exchange for a specified price per share. In this case, the firm generally indi-
cates that it will buy up to a specified number of shares within a stated time period
(usually about two weeks). If more shares are tendered than the company wants to buy,
purchases are made on a pro rata basis. (3) The firm can purchase a block of shares
from one large holder on a negotiated basis. This is a targeted stock repurchase as was
discussed in Chapter 12.The Effects of Stock Repurchases
Suppose a company has some extra cash, perhaps due to the sale of a division, and it
plans to use that cash to repurchase stock.^12 To keep the example simple, we assume
the company has no debt. The current stock price, P 0 , is $20 and the company has
2 million outstanding shares, n 0 , for a total market capitalization of $40 million. The
company has $5 million in marketable securities (that is, extra cash) from the recent
sale of a division.
AsdescribedinthecorporatevaluationmodelofChapter12,thecompany’svalueof
operations,Vop,isthepresentvalueofitsexpectedfuturefreecashflows,discountedat
theWACC.^13 NoticethattherepurchasewillnotaffecttheFCFsortheWACC,sothe
repurchasedoesn’taffectthevalueofoperations.Thetotalvalueofthecompanyisthe(^10) The repurchased stock is called “treasury stock,” and is shown as a negative value on the company’s bal-
ance sheets.
(^11) See Gustavo Grullon and David Ikenberry, “What Do We Know about Stock Repurchases?” Journal of
Applied Corporate Finance,Spring 2000, 31–51.
(^12) See Chapter 13 for a description of a stock repurchase as part of a recapitalization.
(^13) The WACC is based on the company’s capital used in operations and does not include any effects due to
the extra cash.