Reading: Adjusting the Capital Structure

Instead of paying a dividend, the firm could also repurchase its own shares. There are various ways to do so and the module Payout Policy discusses them in detail (see here for a detailed overview of the various buyback mechanisms). Here, we consider the two most popular buyback forms, namely an open market buyback program and a fixed-price tender offer. 

Alternative 1: Open market share repurchase program

As the name already suggests, the first alternative is to repurchase shares like any other market participant in the "open market" at the prevailing stock price. 

From before, we know that the firm's stock price increases to 8.25 upon the announcement of the recapitalization (P'). With a total payout of 2'500, the firm will therefore repurchase a total of 303 shares in the open market. Let's denote the number of repurchased shares as \(N_R\) and the price at which the firm repurchases shares as \(P_R\). Consequently:

The number of shares outstanding therefore drops from 500 to 197 after the buyback program has been completed. We denote the post-recapitalization number of shares outstanding as \(N^*\), so that:

\( N^* = N - N_R = 500 - 303 = 197 \).

Remember from before that, after the levered recapitalization, the value of the firm (\(V_L^*\)) is 4'125 and the value of its equity is 1'625 (\(E_L^*\)):

\( E_L^* = V_L^* - D^* = 4'125 - 2'500 = 1'625 \).

With 197 shares remaining after the buyback (N*), the post-recapitalization share price (P*) therefore remains at 8.25:

Alternative 2: Fixed price tender offer

With a fixed price tender offer repurchase program, the company announces that it will repurchase a limited number of shares at a fixed price during a specific period of time. This offer to repurchase shares is an offer to all shareholders. If shareholders wish to participate in the repurchase opportunity, they notify the company as to how many shares they are willing to sell at the pre-specified price. Shareholders who wish to sell are said to have "tendered” their shares to the company. 

For the repurchase program to be successful, the firm must offer a price which corresponds at least to the share price after the announcement of the refinancing decision: P_R ≥ P'. Otherwise, nobody will tender their shares. Moreover, if the firm offers to repurchase shares at the post-announcement price (P_R = P'), the outcome is identical to that of the open market repurchase program discussed above.

Let us now consider a fixed-price tender offer program, in which the firm offers to repurchase shares at a price of 10:

\(P_R = 10\).

Since the total payout is limited to 2'500, the firm can only offer to repurchase 250 shares (\(N_R\)) at this price:

The repurchase price is significantly higher than the post-announcement price. Therefore, all shareholders will tender their shares and the firm will repurchase shares on a pro-rata basis (i.e., it will repurchase 50% of the tendered shares). Therefore, after the buyback program, there will be 250 shares outstanding (N*):

\(N^* = N - N_R = 500 - 250 = 250 \).

The overall value of the company (\(V_L^*\)) and the equity value (\(E_L^*\)) will be the same as in the case of the two preceeding alternatives, namely 4'125 and 1'625, respectively:

\( E_L^* = V_L^* - D^* = 4'125 - 2'500 = 1'625 \).

However, since there are still 250 shares remaining after the transaction (N*), the share price will drop to 6.50 (P*):

\( P* = \frac{E_L^*}{N^*} = \frac{1'625}{250} = 6.50 \).

Again, total shareholder wealth is not affected by the buyback itself. To see this, remember that the firm will only repurchase 250 shares at a price of \(P_R = 10\), whereas the remaining 250 shares will be valued at \(P^* = 6.50\) after the recapitalization. On aggregate, shareholders, therefore, still have a total wealth of 4'125.