The buying back of shares by companies is a dangerous financial Essay

The buying back of shares by companies is a dangerous financial strategy as it increases the company's gearing ratio - Essay Example Besides increasing the gearing ratio of the company it impacts important ratios. The impact of leveraged buyback of shares on Vodafone Plc has been explained with the help of qualitative and numerical analysis. The EPS graph of the company has been shown for a five year period to highlight the rise in the earnings per share due to a stock repurchase program. The deterioration in the important financial ratios like interest coverage, return etc has also been shown with the help of suitable graphs. Introduction An announcement of a share repurchase by a company is valued highly by the market participants interpreting it as a ‘buy signal’ for its stock. So the company has good reasons to buy-back its stocks but sometimes these share buyback programs go awry. Despite the popularity of such programs as evident from the recent buyback deals there are concerns whether the firm or the shareholders derive any gains from it. One reason favouring the buyback deal is that at any poi nt of time the surplus cash lying with the management can be used for buyback of shares thereby returning the funds to the shareholders. It has been seen that idle cash makes the managers complacent so buying back of shares can be one way of instilling confidence among the investors. From the view-point of the company stock buyback results in increased Earnings per share (EPS), share price and increases the value of â€Å"executive stock options† (Ogilvie, 2006, p.51). However, the share buyback strategy can be dangerous if the company finances the buyback of equities using borrowed funds. Financing buyback using loan stock may look tempting in the short term but some years down the line the company has to pay back the loan. In the event of an economic recession the company will have to struggle with fund shortage. A rise in the share price, increase in company EPS are all good signs but not at the cost of endangering the position of the company in the future. The board of di rectors must keep the interests of the shareholders in mind while considering share buyback programs. Evidence behind share repurchases A significant research has been conducted especially in the area of share repurchases. The evidences from this research indicate that there is a strong market response on the announcement of share repurchase program. In the studies conducted by Asquith & Mullins (1983) and Damn et al (1981) it has been shown that the market responds positively to stock repurchase announcements, be it in the form of an â€Å"open market repurchase† or â€Å"a self tender offer†. There have been abnormal returns in the case of share repurchase offers. A study on long term market returns, by C.J. Loomis analysed the repurchase offers during the period 1974 to 1983. His studies revealed that the shareholders of the companies that undertook stock repurchase programs earned a compounded yearly return of 22.6% with the S&P 500 reporting a return of 14.1% duri ng the same period. Though the above evidences support a positive response to the share repurchase offers some papers some papers have highlighted the negativity associated with such programs. As per the papers against share repurchase, the stock repurchase decisions by the company manifest signs of poor financial and operating performance, in fact it signals that the