Monday, September 3, 2012

‘Fundamentals of Financial Instruments: An introduction to stock, bonds, foreign exchange, and derivatives’ by Sunil Parameswaran

Treasury stock

"The term treasury stock refers to shares that were at one point in time issued to the public but that have subsequently been reacquired by the firm.'

"These shares are held by the company and can subsequently be reissued, if and when employees were to exercise their stock options. Unlike the shares issued by the firm that are held by the shareholders, treasury shares have no voting rights, are ineligible for dividends, and are not included in the denominator used for computation of the earnings per share (EPS).'

"Why do companies repurchase shares? One motivation could be that the directors of the firm are of the opinion that the market is undervaluing the stock, and they would like to prop up the share price by creating greater demand. For a given level of profitability a buyback program will increase the earnings per share. And if the dividends per share (DPS) were to be kept constant, it will also reduce the total amount of dividends that the company needs to declare. Buyback is also a potent tool for fighting a potential takeover by corporate raiders. By reducing the shares in circulation, the current management can acquire greater control.'

"There are also situations in which a company is generating a lot of cash but is unable to identify profitable avenues for investment or is unable to identify projects with a positive net present value (NPV). One way to deal with such a situation is by declaring an extraordinary dividend. But in many countries cash dividends are taxed at the hands of the shareholder at the normal income tax rate, which could be significant for investors in higher tax brackets. On the other hand, if an investor were to sell her shares back to the firm at a price that is higher than what she paid to acquire them, the profits will be construed as capital gains, which in most countries are taxed at a lower rate."

(pp. 107-8, 'Fundamentals of Financial Instruments: An introduction to stock, bonds, foreign exchange, and derivatives' by Sunil Parameswaran – Wiley)

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