Dada Adefolami

Surplus funds

Where a business has no profitable opportunities in which to invest, returning any surplus funds may be the best option for investors. More mature, low-growth businesses are likely to find themselves in this position than younger, high-growth businesses. Various studies indicate that returning surplus funds is an important reason for undertaking buybacks. One UK study found that the returns of businesses that engaged in share buybacks were lower, when compared with a control group, for up to two years before and three years after the share buyback, but not during the buyback year . Lower returns before a buyback could be interpreted as the market punishing the business for not distributing surplus funds, whereas lower returns following a buyback may be due to relatively few investment opportunities.

Agency costs
There is always a risk that the managers, who act as agents for the investors, will use the resources of the business unwisely and, perhaps, in ways that benefit them rather than investors. To reduce this risk, managers may decide to distribute any temporary cash surplus to investors through a share buyback. As a consequence, managers will have to submit to the judgment of the market when fresh capital is required. Although this is less comfortable for managers, it may ultimately be in their own interests. By demonstrating a commitment to the interests of investors, managers may secure their confidence which, in turn, may lead to greater job security and or higher rewards.

Agency costs may also be reduced where a share buyback is used to alter the capital structure of the business. If debt capital is substituted for equity capital, the increase in interest payments that occurs will subject managers to much tighter financial discipline, as it will reduce the discretionary funds available.

NON-VALUE-ENHANCING REASONS
We have just seen that share buybacks can be used to help reduce agency costs; it is also possible for them to increase agency costs. In some cases, buybacks may be carried out for the benefit of managers rather than investors. The following two examples illustrate the problems that might arise:

Increasing earnings per share
Where a business has surplus funds, buying back shares will reduce the number of shares in issue but may have little or no effect on earnings. The result will be an increase in earnings per share. As this measure is often used in managers’ long-term incentive plans, there is a risk that managers will try to improve this measure through a share buyback in order to boost their rewards. Although suitable safeguards should be in place to ensure that increasing earnings per share in this way will not affect managerial rewards, this does not always occur.

Perhaps it is worth making the point that increasing earnings per share is not the same as increasing shareholder value.

This investment ratio is influenced by accounting policy choices and fails to take account of the cost of capital and future cash flows, which are the determinants of value. Thus, a change in this investment ratio may be of no real significance to investors. Although some appear to believe that analysts mechanically apply a multiple to the earnings per share figure in order to derive a value for share prices, this is not the case.

Management share options
Management share option schemes start from the premise that investors are concerned with share price increases and those managerial incentives should reflect this concern. Excessive focus on share price, however, may not be in the best interests of investors. Share price represents only one part of the investors’ total return: the other part is dividend income. There is a risk that undue concern for share price may lead managers to restrict dividend payments so that profits are retained to fuel share price growth. We saw earlier that, following a dividend payment, the share price will decrease and will be lower than the share price following a share buyback. Managers therefore have an incentive to employ buybacks rather than dividend payments, as they can increase the value of their options. For this reason, some share option schemes prohibit the restriction of dividends.

When management share options are exercised, the number of shares in issue will increase. Share buybacks may be used to offset the dilutive effects of share options, an action which does not necessarily benefit investors. One study has found that the market does not react as well to buyback announcements from businesses with significant management share option schemes.

INFORMING INVESTORS
As buybacks do not always enhance the wealth of investors, there have been calls for a much stronger light to be shone on this type of activity. To subject buyback decisions to closer scrutiny, however, greater disclosure is required.

The United Kingdom Shareholders’ Association (UKSA), which represents the interests of private investors, has argued that a buyback announcement should be accompanied by a clear explanation of the reasons for a buyback and its likely effect on future profits, capital structure and dividends. The particular method of buyback should also be justified. UKSA further argues that the annual report should set out a detailed account of any share buybacks, along with a report by the directors on the extent to which the buyback programme has achieved its objectives.

It is important to know how much money to allocate to new projects or equipment and still turn a profit. Capital budgeting calculations take into account initial cash outlays, the time value of money and estimated useful lives to help management make decisions. Knowing the expected rate of inflation and return on investment is critical for capital budgeting and profitability assessments. Management staff must be able to make capital purchases and be confident they are acting in the best interests of their organization.

Management accounting costs have a direct impact on profit margins and the viability of businesses. Whether you are looking at variable costs, fixed costs or a specific costing method used to track production, measurement of expenses is important for financial reporting and management decision-making. There are multiple types of costs in management accounting that business owners and their accountants evaluate on a regular basis.

Manufacturing costs include direct labor, direct materials and manufacturing overhead, which are important determinants in a company’s overall profitability. Direct labor consists of the line workers that physically manufacture products, despite whether they are hourly or salaried employees. Direct materials are processed into finished goods inventory and are essential for production. Manufacturing overhead includes indirect materials, indirect labor and factory operating costs such as utilities and real estate taxes.

Finally
In a world of perfect markets, it will not matter whether funds are returned to investors through a share buyback or through a dividend payment. In an imperfect world, however, financial flexibility and taxation considerations may favour a share buyback. While share buybacks may be used to enhance the value of an investor’s shares, they can also be used for non-value-enhancing purposes. Investors must be alert to this risk and should closely scrutinize share buyback proposals. To help them in this task, much fuller disclosure is required.

Stability versus investment: The key to staying in a good working capital position is to be careful to strike the right balance between stability and growth. If your company is making profit and you want to grow the business, it makes sense to reinvest the money you’re making.

Equally, you won’t want to have all of your business’s cash tied up in equipment, property or stock — then have to sell some of it to pay your bills and keep the business running. Most businesses will strike a balance between these two strategies — to allow some business growth without managing cash flow dangerously.

Share buybacks have become a very popular method of returning funds to investors. During 2007, it was estimated that nearly 15% of Europe’s large and mid-cap businesses carried out buybacks of more than 2% of their market capitalization. The changed economic climate, however, may make it impossible for businesses to fund buybacks on the same scale as in the recent past.

Prepared By: Dada SurajuAdefolami, Professor of Finance, School of Business Administration. UNEM University, Costa Rica, is a Finance / management Consultant and Certified Forensic Accountant. You can reach him via: [email protected]: 08052043855