Buyback Of Shares

Chapter 1

Introduction To The Indian Capital Market

Competitive forces with the unleashing of the liberalization policies

have made corporate restructuring a sine quo non for survival and

growth. Operational, financial and managerial strategies are employed

to maintain competitive edge and turnaround a sickened performance.

Financial restructuring involves either internal or external restructuring

(i.e. Mergers and Acquisitions). In the internal restructuring an existing

firm undergoes through a series of changes in terms of composition of

assets and liabilities.

Section 100-105 of The Company's Act 1956 governs the internal

restructuring of a corporate entity in the form of capital reduction.

Section 77A, 77B and 77AA now allow companies to buy back their

shares following the recommendations of committee on corporate

restructuring, which was set up by the government to propose various

strategies to strengthen the competitiveness of the banking and

finance sector, companies are now allowed to repurchase their own

shares.

This will enable the companies to catch up with other developed

markets as part of the government's moves to liberalize the local

market and hence emerged the concept of SHARE BUY BACK in the

Indian corporate scenario.

Over 300 companies, including the Tatas, the Birlas and Reliance, had passed resolutions -- taken shareholders permission -- at their AGMs during the year 1997-1998.

Buyback Of Shares

Sudden plethora…

Relative to the Indian context, the listing of various foreign players in

the earlier times on the Indian bourses was regulatory driven. They

had adequate funds in their kitty to pursue their own goals, both in

terms of funding their expansion and an inherent ability to outsource

and avail economic costs of production.

Why then did they still go in for an Indian listing?

In the 1970’s period, if MNC’s wanted to continue doing their business

in India, they could do so only by diluting their shareholding and

getting listed on the exchange. They were thus forced to go public.

Now that the norms have been altered and they are permitted to carry

on their business without any such compulsion, they would rather

operate as wholly owned subsidiaries without being listed on the

bourses.

Buyback Of Shares

Chapter 2

Buy back of shares

Buy back of equity shares is a capital restructuring process. It is a

financial strategy that allows a company to buy back its equity shares

and other securities. In a changing economic scenario corporate sector

demands more freedom in restructuring debt-equity mix in times of

favorable business environment.

So far it was possible to refund shareholders' money through capital

reduction process. A company could buy back own shares obtaining

permission of the Company Law Board under the old provisions of the

Companies Act, 1956. By virtue of the newly inserted section 77A to

the Companies Act, 1956 through the Companies (Amendment)

Ordinance, 1999, a new vista has been opened for flexible capital

structuring by companies as and when necessary without involvement

of any external regulatory mechanism.

Buy back is a financial strategy - it should be used accordingly. It is

not for improving controlling interest of the ruling shareholding group.

However, improvement of controlling interest occurs as a natural

consequence of buy back strategy.

In India, companies are lowly levered because of high incidence of

debt cost. But so long a company can earn above the effective debt

cost it is advantageous to create favorable leverage effect.

Share buy back is a financial tool for financial re-

engineering. It is described as a procedure that enables a

company to go back to its shareholders and offers to

purchase from them the shares they hold.

Buyback Of Shares

Creating shareholders' value should be the primary objective of

corporate management. It is difficult to service a large equity and add

shareholders' value. Slimming of capital structure should be an

objective of buying back of own shares by companies. Buy back offers

a straight route for swapping equity for debt. In a situation when

equity appears to be costlier to debt, this would help to reduce overall

cost of capital.

Prior to introduction of flexible buy back facility; once a particular

equity pattern is opted for it would become sacrosanct. To alter the

skewed equity a company has to build up the level of free reserves or

to infuse more borrowed funds. Infusion of more borrowed fund would

be possible in a growth situation.

In a no-growth situation changing the equity structure was very

difficult. Buy back option is expected to help to correct the positively

skewed equity share capital in the existing capital structure of a lowly

levered company that earns stable return.

If' a company cannot deploy the surplus cash in a growth process from

which it would be able to maintain average return on capital employed

(ROCE) and earnings per share (EPS), what should it do with the cash?

Inter corporate investments/loans although freed may not likely to

improve average ROCE of the company. Board of directors is the

custodian of shareholder’s money. If it cannot add better value or,

even maintain the current rate of value addition, it should refund the

money to the shareholders. This will at the same time create better

value to the leftovers. Good corporate governance demands proper

utilization of shareholder’s money.

Buyback Of Shares

Restriction that has been lifted

Section 77(l) of the Companies Act, 1956 prohibited (i) a company

limited by shares, and (ii) a company limited by guarantee and having

share capital to buy its share.

Section 77(2) of the Companies Act, 1956 disallowed a public company

or a private company, which is a subsidiary of a public company to give

any direct or indirect financial assistance to any person in the form of-

Loan

Guarantee

Provision for security or

In any other manner

for purchase of its own shares or of its holding company.

However, redemption of redeemable preference shares under section

80 of the Companies Act, 1956 were not subjected to this restriction.

Disadvantage of the capital reduction route

Capital reduction is possible for diminution of liability in respect of the

unpaid amount of share capital or payment to any shareholder of any

paid-up share capital. If repayment of a portion of share capital is the

purpose; that can be fulfilled through capital reduction.

Buyback Of Shares

However, it is not an easy route. It requires an order of court, which in

turn requires fulfillment of the following conditions-

The existing creditors should not object to the capital reduction;

All claims of the creditors who object to the capital reduction

should be settled; or their claims should be provided for;

Contingent or unascertained claims as fixed by the court should

be provided for.

This route involves court process and is not flexible. It cannot be

exercised as a financial strategy. To the contrary, buy back is a

flexible approach by which a company can safeguard payment of

outside liabilities before exercising buy back.

Buyback Of Shares

Chapter 3

SHARE BUY-BACK: OBJECTIVES

A company may decide to buy back its shares for one of the following

reasons:

To return surplus cash to shareholders as an alternative to a

higher dividend payment.

The management may also like to return surplus cash to the

shareholders in the form of buy back when there are no proper

investment opportunities to maintain the rate of return.

Adjust or change the company's capital structure quickly, say for

those companies seeking to increase its debt/equity ratio. Buyback

facilitates reduction of share capital without recourse to lengthy

capital reduction process.

To increase earnings per share and net asset value per share as

a possible signal to the market place that management is of the

view that the prospects of the company justify a market price

higher than that currently accorded by the market.

To improve the liquidity of the shares and other performance

parameters like EPS,DPS, operating cash flow per share,etc

The rationale behind buy back of shares is to boost demand by reducing the supply, which in theory should push the price up. The repurchase of shares reduces the number of shareholders, which in turn enhances the earnings per share (EPS), and thus improve investor sentiments.

Buyback Of Shares

Initially many companies may opt for equity financing to avoid

high financial risk. At a later stage when the company becomes

successful in stabilizing its income, it may prefer to have a levered

capital structure to ensure better return on equity.

Buyback can be used as a mechanism for maintaining

shareholder’s value in a situation of poor state of secondary market.

Buyback announcement may temporarily arrest the downtrend.

It is a mechanism to balance equity after the conversion of debt

or preference share capital.

To thwart the attempts of a hostile takeover. The maximum limit

of shares that a company can buy back in a financial year is 25% of

the total equity and the fund exposure is limited to 25% of the net

worth or 100% of the free reserves, whichever is more. Pricing for

buyback has been left to the discretion of the company.

A company may buy back equity shares through proportionate basis

(tender route) or from the open market. Buyback is reckoned as an

important tool to defeat buy-back of shares since the bought back

shares are cancelled and a promoter is in a position to consolidate

and strengthen his position. For example, a company X, which has

the following shareholding pattern is facing a hostile takeover bid :

Promoter

s

: 30

%

FIs : 25

%

Public : 45

%

Buyback Of Shares

If the company proposes to buyback 25% of the total equity, then the

post buyback holding of the promoters would be straight away

consolidating their position to 40%. With the support of financial

institutions the acquirer could be made to beat a hasty retreat.

What’s in it for the shareholders?

Dividend income received by the shareholders is liable for taxation at

the normal income tax rate, depending upon the category to which the

shareholder belongs. However, when buyback proceeds are received

by the shareholders, they are treated as Capital Gains and are liable

for Capital Gains Tax. As is common knowledge, the capital gains

taxation rate is much lower then the income tax rate.

The Law of Demand states that with an increase in demand, if supply

does not increase, the commodity can command a higher price. The

same will be true for shares too. With an increase in demand for the

stock and a corresponding decline in the available free float, the value

of the stock will tend to rise.

After the buyback has been effected, the proportional share of the

existing shareholders increases and thereby gives them a higher say

and holding in the company affairs.

What’s in it for the company?

With a dearth of investment opportunities and uncertainty looming

over the entire gamut of industries, most of the companies currently

Buyback Of Shares

have a very strong cash book position. If the company uses its cash to

repurchase its outstanding stock, it will enjoy a double credence:

The company effectively funnels in the ‘Accretion Effect’. It can

decrease its floating stock in the market and at the same time

increase the EPS. The growth in EPS will thus be compounded.

With the growth in EPS and a stable Price Earning (PE) multiple,

this will ultimately raise the Price of the stock in the market, since

Stock Price = EPS * PE

High cash balance reflecting in the balance sheet, will tend to drag

down a few return ratios, like the Return on Assets (ROA), Return on

Equity (ROE), and so on. Freeing up the cash reserves will push these

ratios to a higher level, thereby reflecting a sound financial

management practice.

Example 1

Let us now take a small example to understand the impact of

buyback:

A company XYZ Ltd has an issued share capital of 1,000 shares of Rs

100 each. XYZ Ltd is evaluating a buyback of 100 shares of Rs 150

each, which is priced at a slight premium to the current market price of

Rs 140 per share. ABC group of shareholders holds all the 1,000

shares.

Under such a scenario, XYZ Ltd uses its cash reserve of Rs

15,000 to buy back 100 shares. The likely impact on XYZ Ltd would

be:

Buyback Of Shares

The EPS should increase as the earnings stream remains

unaffected except for the loss of interest on Rs 15,000, but the

number of shares has reduced to 900.

Demand for XYZ Ltd's shares should increase with now only 900

shares in circulation, against 1000 shares before the buyback.

Net assets of XYZ Ltd will decrease by Rs 15,000, thus increasing

the gearing, but net assets per share should remain the same.

These factors should lead to an increase in the share price in one to

two years.

The successful implementation of buyback depends upon

two critical factors.

First, the cost of buyback, that is, the market price of XYZ Ltd's

shares. For example, HLL Ltd, with its cash reserves could do a

buyback but with the current market price hovering around Rs

1,700, this could be expensive.

Second, the impact of buyback on the company's average cost of

capital. Ideally, a buyback should drive down the average cost of

capital. This may be possible only for companies with high credit

rating, high cash flow interest cover and a reputed management

team, which could then counter the impact of higher gearing.

Contrary to common perception, buybacks may not be suitable for

excessively geared companies.

Buyback Of Shares

Chapter 4

Sources of buy back

A company can buy back its own shares or other specified securities

out of three sources:

Free reserves

Securities premium account

Proceeds of an earlier issue of shares or other specified

securities. [Section 77A(l)].

Buy back of any kind of shares is not allowed out of the proceeds of

any earlier issue of the same kinds of shares.

Free reserve

Meaning of Free Reserves

The term free reserve has been defined to carry same meaning as has

been assigned in clause (b) of Explanation to section 372A. For the

purpose of section 372A the term 'free reserve' has been defined as

those reserves which as per the latest audited balance sheet are free

for distribution as dividend and it includes balance of securities

premium account. Free reserve means the balance in the share

premium account, capital and debenture redemption reserves shown

or published in the balance sheet of the company and created by

appropriation out of the profits of the company.

Buyback Of Shares

Securities premium Account

Securities Premium Account is a broader term than Share Premium

Account. Share Premium account represents only premium on issue of

equity and preference shares, whereas securities premium account

represents premium on issue of debentures, bonds and other financial

instruments.

Proceeds of an earlier issue

Buy back of shares of any kind is not allowed out of fresh issue of

shares of the same kind. If it were so, it would frustrate the very

purpose of buy back. Fresh issue of equity shares for buying equity

makes no financial sense. However, financial logic of buy back could

very well be served if preference shares are issued and proceeds are

used for buying back equity shares.

Preference shares carry fixed rate of dividend. Also they are easy

to market.

Preference shares may give better yield to the investor than

after tax yield on loan or debentures. At the same time it is possible

to lever the capital structure by slimming the dividend paying

equity.

That apart buy back of shares is allowed utilizing proceeds of an earlier

issue. Proceeds of an earlier issue is an unqualified term. Any issue

means any issue of hybrid instruments, debentures, bonds, secured

and unsecured loans etc. Thus buy back of equity shares is allowed

byissue of any pure or hybrid debt instruments.

Buyback Of Shares

Then appropriate source of buy back should be the following if the

intention is to swap equity for debt or fixed income bearing

instruments:

Issue of debentures;

Issue of loans.

Buy Back sourcing caution

While approving the buy back resolution the following points should be

carefully scrutinized as regards cash flow linkage of free reserve and

securities premium account as they are not necessarily represented by

free cash:

How much of the free reserve and securities premium account

are readily available in the form of free cash?

Whether owned investments in current assets are released for

buy back? If so, its impact on current ratio?

Whether non-trade investments will be disposed to generate free

cash? If yes, what is the possible profit/loss?

If trade investments are proposed to be sold, what is the possible

adverse impact on operating activities?

If any fixed assets are sold, whether it has been intended to

reduce the scale of operation of the company

Buyback Of Shares

Buyback Conditions:

Section 77A(2) of the Companies Act,1956 requires that buy back

should be carried out if-

Authorized by its articles;

A special resolution has been passed in the general meeting of the

company authorizing the buy back;

The buy back does not exceed twenty-five per cent of the paid u

capital and free reserves of the company; also a company cannot

buy back more than twenty-five per cent of its paid-up equity

capital in any financial year;

The ratio of the debt owed by the company is not more than twice

the capital and its free reserves after such buy back;

All the shares or other specified securities are fully paid up;

Buy back of shares or other securities listed on any recognized

stock exchange should be carried out in accordance with the

Regulations made by the Securities and Exchange Board of India in

this behalf;

Buy back of shares or other securities other than those specified

in the clause above should be carried out in accordance with the

Guidelines as may be prescribed.

Buyback Of Shares

Chapter 5

Ways of Buyback

1) A company may buy-back its shares by any one of the following

methods -

From the existing shares on a proportionate basis through the

tender offer;

From open market.

From odd-lot holders.

2) A company shall not buy back its shares from any person through

negotiated deals, whether on or off the stock exchange or through spot

transactions or through any private arrangement.

Buy back is not allowed through negotiated deals on or off the stock

exchange. It is possible to negotiate the price and number of shares

and then to complete the deal in the stock exchange. This does not

give equal opportunity to other shareholders who could have also

preferred to tender their shares at the same price.

Negotiated deals although mean purchase of shares at negotiated

price outside the stock exchange, scope of the negotiated deals has

been increased to cover such transactions, which are negotiated off

market and then transacted in the stock exchange. Such transactions

cannot be classified as open market buyback.

This will help to check privately settled buy back deals. However, it is

equally difficult to trace the off market origin of a market settled

transactions.

Buyback Of Shares

Buy back is not allowed through spot transactions or through any

private arrangement.

3) Any person or an insider shall not deal in securities of the company

on the basis of unpublished information relating to buy-back of shares

of the company.

Insider trading in buyback, prohibited - Regulation 4(3) prohibits any

person or insider to deal in buy back transactions on the basis of

unpublished price sensitive information. There is no specific

prohibition for promoters to participate in buy back. Only insiders are

prohibited to participate in buy back transactions except in buy back

through stock exchange operation. So if a promoter is not an insider,

he can participate in buy back.

In case the company opts for tender offer route for buy back, all the

shareholders whose names appear in the Register of Shareholders on

the specified date should be offered to tender their shares.

Special Resolution:

(1) For the purposes of passing a special resolution under sub-

section (2) of section 77A of the Companies Act, the explanatory

statement to be annexed to the notice for the general meeting

pursuant to section 173 of the Companies Act shall contain

disclosures as specified in schedule I.

(2) A copy of the resolution passed at the general meeting under

sub-section (2) of section 77A of the Companies Act, shall be

filed with the Board and the stock exchanges where the shares of

Buyback Of Shares

the company are listed, within seven days from the date of

passing of the resolution.

Buyback Of Shares

BUY-BACK FROM THE OPEN MARKET

A company intending to buy-back its shares from the open market

shall do so in accordance with the provisions stated as under-

1) The buy-back of shares from the open market may be in any one of

the following methods:

Through stock exchange.

Book Building process.

Through stock exchange.

A company shall buy-back its shares through the stock exchange

as provided hereunder- Maximum price at which the buy-back shall

be made has to be specified by a special resolution.

The buy-back of the shares shall not be made from the

promoters or persons in control of the company.

The company shall appoint a merchant banker and make a public

announcement in respect of the same.

The public announcement shall be made at least seven days

prior to the commencement of buy-back.

A copy of the public announcement shall be filed with the Board

within two days of such announcement along with the fees as

specified in the provisions.

The public announcement shall also contain disclosures

regarding details of the brokers and stock exchanges through which

the buy-back of shares would be made.

The buy-back shall be made only on stock exchanges with

electronic trading facility.

The buy-back of shares shall be made only through the order

matching mechanism except ‘all or none’ order matching system

Buyback Of Shares

The company and the merchant banker shall give the

information to the stock exchange on a daily basis regarding the

shares purchased for buy-back and the same shall be published in a

national daily;

The identity of the company as a purchaser shall appear on the

electronic screen when the order is placed.

The company shall complete the verification of acceptances

within fifteen days of the    pay-out.

Buy-back through book building 

A company may buy-back its shares through the book-building process

as provided here under-:

a. The maximum price at which the buy-back shall be made should

be specified by a special resolution as in the case of buy-back through

stock exchange.

b. The company shall appoint a merchant banker and make a public

announcement in reference to the same.

c. The public announcement shall be made at least seven days

prior to the commencement of buy-back.

d. The deposit in the escrow account shall be made before the date

of the public announcement. (ii) The amount to be deposited in the

escrow account shall be determined with reference to the maximum

price as specified in public announcement.

e. A copy of the public announcement shall be filed with the Board

within two days of such announcement along with the fees as specified

in the regulations.

f. The public announcement shall also contain the detailed

methodology of the book-building process, the manner of acceptance,

Buyback Of Shares

the format of acceptance to be sent by the shareholders pursuant to

the public announcement and the details of bidding centres.

g. The book building process shall be made through an

electronically linked transparent facility.

h. The number of bidding centres shall not be less than thirty and

there shall be at least one electronically linked computer terminal at all

the bidding centres.

i. The offer for buy back shall remain open to the shareholders for

a period not less than fifteen days and not exceeding thirty days.

j. The merchant banker and the company shall determine the buy-

back price based on the acceptances received.

k. The final buy-back price, which shall be the highest price

accepted should be paid to all holders whose shares have been

accepted for buy-back. 

Buyback Of Shares

Buyback through Tender Offer

A company can buy back its shares from the existing shareholders on

proportionate basis.

The explanatory statement annexed to the notice under section 173 of

the Companies Act, shall contain the disclosures mentioned in

regulation 5 and also the following disclosures;

a. The price at which the buy-back of shares shall be made;

b. If the promoter intends to offer their shares,

the quantum of shares proposed to be tendered, and

the details of their transactions and their holdings for the last six-

months prior to the passing of the special resolution for buy-back

including information of number of shares acquired, the price and

the date of acquisition.

Filing of offer document

(1) The company which has been authorized by a special resolution

shall before buy back of shares make a public announcement in at

least one English National Daily, one Hindi National Daily and a

Regional language daily all with wide circulation at the place where the

Registered office of the company is situated and shall contain all the

material information as specified in schedule II.

Buyback Of Shares

(2) The public announcement shall specify a date, which shall be the

`specified date’ for the purpose of determining the names of the

shareholders to whom the letter of offer shall be sent.

(3) The specified date shall not be earlier than thirty days and not later

than forty-two days from the date of the public announcement.

(4) The Company shall within seven working days of the public

announcement shall file with the Board a draft-letter of offer containing

disclosures as specified in schedule III through a merchant banker who

is not associated with the company.

(5) The draft letter of offer referred to in sub regulation (4) shall be

accompanied with fees specified in schedule IV.

(6) The letter of offer shall be dispatched not earlier than twenty-one

days from its submission to the Board under sub-regulation (4).

Provided that if, within twenty-one days from the date of submission of

the draft letter of offer, the Board specifies modifications, if any, in the

draft letter of offer, (without being under any obligation to do so) the

merchant banker and the company shall carry out such modifications

before the letter of offer is despatched to the shareholders.

(7) The company shall file along with the draft letter of offer, a

declaration of solvency in the prescribed form and in a manner

prescribed in sub-section (6) of section 77A of the Companies Act .

Offer procedure

Buyback Of Shares

(1). The offer for buy back shall remain open to the members for a

period not less than fifteen days and not exceeding thirty days.

(2) The date of the opening of the offer shall not be earlier than seven

days or later than thirty days after the specified date.

(3) The letter of offer shall be sent to the shareholders so as to reach

the shareholders before the opening of the offer.

(4) In case the number of shares offered by the shareholders is more

than the total number of shares to be bought back by the company,

the acceptances per shareholder shall be equal to the acceptances

tendered by the shareholders divided by the total acceptances

received and multiplied by the total number of shares to be bought

back.

(5) The company shall complete the verifications of the offers received

within fifteen days of the closure of the offer and the shares lodged

shall be deemed to be accepted unless a communication of rejection is

made within fifteen days from the closure of the offer.

Escrow account

(1). The company shall as and by way of security for performance of its

obligations under the regulations, on or before the opening of the offer

deposit in an escrow account such sum as specified in sub-regulation

(2).

(2). The escrow amount shall be payable in the following manner-

Buyback Of Shares

If the consideration payable does not exceed Rs.100 crores -

25% of the consideration payable;

If the consideration payable exceeds Rs. 100 crores – 25% upto

Rs. 100 crores and 10% thereafter.

(3) The escrow account referred in sub-regulation (1) shall consist of

Cash deposited with a scheduled commercial bank or;

Bank guarantee in favour of the merchant banker; or

Deposit of acceptable securities with appropriate margin, with

the

merchant banker,or

A combination of all of above.

(4) Where the escrow account consists of deposit with a scheduled

commercial bank, the company shall, while opening the account,

empower the merchant banker to instruct the bank to issue a banker’s

cheque or demand draft for the amount lying to the credit of the

escrow account, as provided in the regulations.

(5) Where the escrow account consists of bank guarantee, such bank

guarantee shall be in favour of the merchant banker and shall be valid

until thirty days after the closure of the offer.

(6) The company shall, in case the escrow account consists of

securities, empower the merchant banker to realise the value of such

escrow account by sale or otherwise and if there is any deficit on

realisation of the value of the securities, the merchant banker shall be

liable to make good any such deficit.

Buyback Of Shares

(7) In case the escrow account consists of bank guarantee or approved

securities, these shall not be returned by the merchant banker till

completion of all obligations under the regulations.

(8) Where the escrow account consists of bank guarantee or deposit of

approved securities, the company shall also deposit with the bank in

cash a sum of at least one-percent of the total consideration payable,

as and by way of security for fulfillment of the obligations under the

regulations by the company.

(9) On payment of consideration to all the shareholders who have

accepted the offer and after completion of all formalities of buy back,

the amount, guarantee and securities in the escrow, if any, shall be

released to the company.

(10) The Board in the interest of the shareholders may in case of non-

fulfillment of obligations under the regulations by the company forfeit

the escrow account either in full or in part.

(11) The amount forfeited under sub-regulation (10) may be distributed

pro rata amongst the shareholders who accepted the offer and

balance, if any, shall be utilised for investor protection.

Payment to shareholders

(1) The company shall immediately after the date of closure of the

offer open a special account with a Bankers to an Issue registered with

the Board and deposit therein, such sum as would, together with the

amount lying in the escrow account make-up the entire sum due and

payable as consideration for buy-back in terms of these regulations

and for this purpose, may transfer the funds from the escrow account.

Buyback Of Shares

(2) The company shall within seven days of the time specified in sub-

regulation (5) of regulation 9 make payment of consideration in cash to

those shareholders whose offer has been accepted or return the share

certificates to the shareholders.

Buyback Of Shares

Chapter 6

Public announcements

Public announcement is an important communication to the

shareholders detailing out the buy back. Although buy back is

approved by special resolution in the general meeting, it is expected

that shareholders are aware of the buy back proposal of the company

through explanatory statement attached to the notice of the meeting,

but there is no requirement to ensure that the resolution should be

informed to the shareholders.

Thus public announcement is the formal communication about the

approved buy back proposal of the company. It has been discussed in

Chapter Three that as per SEBI Regulations a company should not

withdraw from buy back offer once public announcement is made or

draft offer letter is filed with the SEBI.

In case of tender offer, public announcement precedes submission of

draft offer letter to the SEBI. Draft offer letter is required to be

submitted within seven days from date of public announcement. The

same course should be followed in case of buy back of odd lots. In case

of buy back through stock exchange operation, copy of the public

announcement is submitted to the SEBI and it should be made at least

seven days prior to the buy back.

The same process is to be followed for buy back through book building

process except that a copy of the public announcement should be

submitted to the SEBI within two days from the date of announcement.

Buyback Of Shares

The contents of the public announcement should cover the items

mentioned in Schedule H to the SEBI Buy Back Regulations, 1998. The

merchant banker appointed for buy back is responsible for ensuring

that contents of the public announcement are true, fair and not

misleading.

Information content of the public announcement provides advance

information to the shareholders about the buyback. This information is

also incorporated in the draft offer letter.

Disclosures To Be Made In The Letter Of Offer

The letter of offer shall, inter-alia, contain the following:

1. Details of the offer including the total number and percentage of

the total paid up capital and free reserves proposed to be bought back

and price;

2. The proposed time table from opening of the offer till the

extinguishment of the certificates;

3. Authority for the offer of buy-back;

4. A full and complete disclosure of all material facts including the

contents of the explanatory statement annexed to the notice for the

general meeting at which the special resolution approving the buy

back was passed;

5. The necessity for the buy back;

6. The process to be adopted for the buy back;

Buyback Of Shares

7. The minimum and the maximum number of securities that the

company proposes to buy-back, sources of funds from which the buy-

back would be made and the cost of financing the buy-back;

8. Brief information about the company;

9. Audited Financial information for the last 3 years and the

company and its Directors shall ensure that the particulars (audited

statement and un-audited statement) contained therein shall not be

more than 6 months old from the date of the offer document together

with financial ratios as may be specified by the Central Government

( as per the amendment effective from March 2000 ) ;

10. Present capital structure (including the number of fully paid and

partly paid securities) and shareholding pattern;

11. The capital structure including details of outstanding convertible

instruments, if any, post buy-back;

12. The aggregate shareholding of the promoter group and of the

directors of the promoters, where the promoter is a company and of

persons who are in control of the company;

13. The aggregate number of equity shares purchased or sold by

persons mentioned in clause (xii) above during a period of twelve

months preceding the date of the public announcement and from the

date of public announcement to the date of the letter of offer; the

maximum and minimum price at which purchases and sales referred to

above were made alongwith the relevant date;

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14. Management discussion and analysis on the likely impact of buy

back on the company's earnings, public holdings, holdings of Non

Resident Indians/Foreign Institutional Investors, etc., promoters

holdings and any change in management structure;

15. The details of statutory approvals obtained;

16.

i. A declaration to be signed by at least two whole time directors

that there are no defaults subsisting in repayment of deposit.

Redemption of debentures or preference shares or repayment

of a term loans to any financial institutions or banks;

ii. A declaration to be signed by at least two whole time

directors, one of whom shall be the managing director stating

that the Board of Directors has made a full enquiry into the

affairs and prospectus of the company and that they have

formed the opinion-

a. As regards its prospects for the year immediately

following the date of the letter of offer that, having

regard to their intentions with respect to the

management of the company's business during the year

and to the amount and character of the financial

resources which will in their view be available to the

company during that year, the company will be able to

meet its liabilities and will not be rendered insolvent

within a period of one year from the date;

b. In forming their opinion for the above purposes, the

directors shall take into account the liabilities as if the

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company were being wound up under the provisions of

the Companies Act, 1956 (including prospective and

contingent liabilities)

17. The declaration must in addition have annexed to it a report

addressed to the directors by the company's auditors stating that-

a. They have inquired into the company's state of affairs, and

b. The amount of permissible capital payment for the securities in

question is in their view properly determined; and

c. They are not aware of anything to indicate that the opinion

expressed by the directors in the declaration as to any of the

matters mentioned in the declaration is unreasonable in all the

circumstances.

18. Such other disclosures as may be prescribed by the Central

Government from time to time.

19. The offer document shall be dated and signed by the Board of

Directors of the company.

20. The letter of offer shall contain pre and post buy-back debt

equity ratios (As per the amendment effective from March 2000 this

clause has been inserted)

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Chapter 7Extinguishment of Certificate

The company shall extinguish and physically destroy the share

certificates so bought back in the presence of a Registrar or the

Merchant Banker, and the Statutory Auditor within seven days from

the date of acceptance of the shares.

The shares offered for buy-back if already dematerialised shall be

extinguished and destroyed in the manner specified under

Securities and Exchange Board of India (Depositories and

Participants) Regulations,1996 and the bye-laws framed there

under.

The company shall furnish a certificate to the Board duly verified

by

The registrar and whenever there is no registrar through the

merchant banker;

Two whole-time Directors including the Managing Director

and,

The statutory auditor of the company, and certifying

compliance as specified in sub-regulation (1), within seven days

of extinguishment and destruction of the certificates.

The particulars of the share certificates extinguished and

destroyed under sub-regulation (1) shall be furnished to the stock

exchanges where the shares of the company are listed within seven

days of extinguishment and destruction of the certificates.

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The company shall maintain a record of share certificates which

have been cancelled and destroyed as prescribed in sub-section (9)

of section 77A of the Companies Act,.

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Chapter 8

LEVERAGED BUY BACK

Skewed Equity Structure

An important buy back objective is to swap equity for debt. Initially a

company may opt for high equity structure to avoid financial risk when

its capacity utilization is not very high. The next phase is stabilization

phase when it should try to rationalize its equity structure through

proper debt-equity mix.

The debt-equity ratio pattern of many Indian companies is lop-sided.

This situation prevails because of a wrong appreciation about the cost

of equity. If dividend is considered as cost of servicing shareholders'

funds, in many cases equity seems to be cheaper source of finance. In

fact this approach turns the shareholders away from the company.

In India, the debt equity ratio is greater than one for few companies

and is greater than two for even fewer companies. This is mostly

guided by the f act that cost of equity servicing is cheaper to cost of

debt.

Why to go for Leveraged Buy back

Many strategists like more debt in the capital structure. There are

many reasons for preferring levered capital structure—

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Debt has tax saving effect whereas in equity servicing

distribution tax has to be paid on dividend payment. If the target

is to achieve shareholders' value added (SVA) replacing equity at

its market price by debt does not matter. It is inappropriate to

consider that more money is pumped in to replace equity. Equity

should be looked into always at its market value. That will

facilitate equity servicing. When a company's equity is not even

cheaper taking dividend cost, it is better to replace it using debt.

Debt will bring tax benefit, reduce overall cost of capital and

increase economic value added (EVA) –

Debt cures reinvestment risk. The management of an equity

finance company is often faced with the reinvestment challenges.

They desperately search for reinvestment alternatives. The

management of many of the may face a problem of surplus cash.

Equity grew over the years. Where to park the money? Often the

money is locked in many unremunerative projects. For ensuring

increase in the share price to give commensurate return to the

shareholders, free cash flow should be reinvested judiciously. One

important advantage of having debt is its servicing pressure. The

level of free cash flow is reduced - repayment of debt becomes a

constraint. The management can source fund for growth which it

has to service at competitive market rate. This keeps the

management alert in the market front.

Debt creates motivational effect to earn competitive rate of

return. Managing a company with the so-called cheap equity fund

may not create adequate motivational effect to earn better.

Compulsion of debt servicing creates an urge to improve

performance and earn better.

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Debt compels spin off. The pressure of debt servicing

compels the management to rethink about the under performing

assets. The division which cannot generate adequate cash flow for

debt servicing may not be liked. Whereas if it was financed by free

reserve it might not be so alarming. Debt stops the management

from cross-subsidizing the under performing units. In the liberalized

environment of inter-corporate loans and investments, the persons

in control of the company may attempt to cross-subsidize the

inefficient units, which may eventually prove costly even for the

parent company.

Driving equity out by debt

The traditional attitude of borrowing to finance only new projects or

modemisation or working capital has its limitation. The company

should borrow to its full capacity of borrowing. If the target debt ratio

is set befitting with the debt servicing capacity of the company, it is

possible to reduce cost of capital using cheaper debt. Cash flow

generated through, debt if used for retiring equity, future free cash

flow can be used to retire debt at a cheaper rate. This will improve

value of equity of the non-tendering shareholders.

Conditions for Leveraged Buy Back

Since equity is costlier to debt, the management may think for buy

back equity through issue of debt instrument. What should be the

precondition of leveraged buy back?

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Debt servicing coverage of the company should be good;

Free cash flow to debt coverage is good;

Business risk is moderate.

Debt service coverage ratio is given by-

Cash flow available for debt servicing

Debt Installment + Interest

Cash flow available for debt servicing is determined by operating cash

flow net of tax payment plus income from investment and other

income included in the Cash Flow from Investment Activities. Cash

flow from operating activities is determined before charging

depreciation and other non-cash expenses and losses.

A successful leveraged buy back is dependent on

many factors-

Pre-buy back market price -If market price of equity

share is high, premium component will be high and dividend-paying

equity cannot be driven out cheaply. A higher premium could

reduce EPS.

Interest rate cut may bring opportunity for cheaper debt

financing. Even if old debt cannot be repaid because of high

premium claimed by Financial Institutions on premature

redemption, infusion of new debt would reduce the cost of capital.

Then a company may need to adopt leveraged buy back for

reduction of cost capital for capital restructuring.

Business risk is stable; acceptance of higher debt ratio

should not increase the total risk to a great extent.

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ESOP - If it becomes necessary to buy shares held by ESOP to

provide it liquidity while discharging liability to a retiring employee

in cash rather than by way of proportionate shares, often the

management finds finance through borrowing.

Dividend pay out ratio When a company has reached a

very high level of dividend pay out ratio, which becomes

unsustainable, it can cut the dividend rate to reduce the market

price and then it may adopt leveraged buy back. A dividend cut will

bring down equity cost and in the process of leveraged buy back it

can find a favourable drive out premium. This will improve value of

the non-tendering shareholders.

Saving in dividend also reduces the cash flow matching

problem for debt servicing effectively.

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Chapter 9

PRICING BUY BACK

Relevance of pricing

Buy back pricing has many facets depending on the method

deployed for buy back. In tender offer, a company announces fixed

price at which shares to be tendered. There is no choice left to the

tendering shareholders. Of course, to be successful the buy back offer

price should be better than the comparative market price.

What constitutes comparable better price? What maximum price

should a company offer for buy back? In open market operation

through stock exchange operations, a company has to pay market

price. But the impact cost in stock exchange operation may push up

the company's cost ending up with lower buy back quantity.

So stock exchange operation may not necessarily produce finest result.

In book building process the company offers a price cap and the

current stock market price offers the automatic floor. Tendering

shareholders have to choose a price within that range. The company's

job is to appreciate the market price impact of buy back and value

impact before putting price cap.

Valuation approaches

Valuation of share is an important aspect of buy back pricing. A

company should have complete knowledge about the intrinsic value or

fair value of share. Intrinsic value of share is the weighted average of-

Buyback Of Shares

Asset backing value;

Profit Earning, Capacity Value

Market value.

Weights are chosen in accordance with financial position and profit-

ability of the company.

Although buy back essentially and implicitly emphasizes on going

concerned basis, so relevance of asset backing value may be

questioned. But there are circumstances when shares of many blue

chip companies are traded at less than their book values. One

important objective of back is to pay proper price to the shareholders

in the distressed market. It is not for buying back the shares cheaply.

Rather it offers premium exit route in the distressed market, which

makes stock market attractive.

A company that cares for its shareholders always comes out to protect

the market price. This is one of the purposes of allowing buy back in

India. So one cannot ignore the asset backing value while pricing buy

back.

Asset Backing Value

Asset backing value is given by net assets value available to the

shareholders divided by number of shares outstanding:

Net assets available to the equity shareholders

Number of outstanding equity shares

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Steps to be followed in determining net assets available to the equity

shareholders are-

Determination of the, value of the various assets - Tangible fixed

assets, Capital Work in progress, Investments, Current assets, Loans

and Advances, Miscellaneous expenditure and losses which are

fictitious assets should not be counted.

Valuation of goodwill - It includes valuation of all intangibles like

brand, patent right, franchise, know-how, etc. Whatever the

company has spent on intangibles that has value only if it can

generate additional operating profit.

For deriving Asset backing value the following steps are followed:

Current costs of assets are determined;

Value of goodwill is added to total current cost of tangible assets;

AU liabilities and provisions are deducted;

Preference share capital is deducted;

Adequate provision is made against contingent liabilities and

deducted from current cost of assets;

Net current cost of assets are worked out which represent

current cost of equity;

Net current cost of assets is divided by number of outstanding

equity shares.

The business is a going concern in the context of buy back. The

following valuation norm may be followed for valuation of assets:

Fixed assets are valued at lower of the current entry price and

current exit price.

Buyback Of Shares

Capital Work-in-progress are yet mature as revenue generating

assets, so they should be valued at cost.

Quoted investments are valued at market price.

Unquoted investments are valued at their asset backing value in

case asset-backing value is not available, book value can be used

for this purpose.

Current assets are valued at lower of the net realizable value and

cost. For comparing cost and market price of inventories item by

item comparison should be carried as required in Accounting

Standard-2. Similarly, for other items of current assets like debtors,

loans and advances item by item comparison should be made. This

will make automatic provisioning of current assets.

Miscellaneous expenditure and losses should be excluded.

All liabilities should be taken at the redemption value.

Price Earning Capacity Value

PECV is given by the discounted value of profit available to the equity

shareholders. A 1 0 - year time frame may be considered for the

future maintainable profit. Weighted Average Cost of Capital (WACC)

of the company is used as discounting factor. Underlying principle of

the PECV is that Future Maintainable Profit can be earned in the next

10 years. Thereafter the realisable value of the net asset is taken as

cash flow.

Steps to be followed are as follows:

Find out average maintainable profit. Depreciation is deducted

because it is an item of economic expense. I

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Find out weighted average cost of capital (WACC)

Deduct preference dividend including distribution of tax from

future maintainable profit to arrive at profit available to equity

shareholders;

Assume that profit for a period of ten years and discount it using

WACC;

Find out realizable value fixed assets - this is given by

depreciated value of fixed assets;

Take the realizable value of investments and current assets at

par.

Buyback Of Shares

Chapter 10

Tax Implications of Buy Back:

Buybacks are now imminent, but there seems to be lot of confusion as

to the tax implications and the buyback code and regulations. The

ministry of finance has not yet clarified the position, but the likely tax

consequences could be derived from first principles.

Lets take an example to understand this better.

A company XYZ Ltd has an issued share capital of 1,000 shares of Rs

100 each. XYZ Ltd is evaluating a buyback of 100 shares of Rs 150

each, which is priced at a slight premium to the current market price of

Rs 140 per share. ABC group of shareholders holds all the 1,000

shares.

We assume that XYZ Ltd's company rate of income tax is 35 per cent

and the capital-gains tax rate is 20 per cent.

As to the impact on XYZ Ltd, there are three alternatives - to treat it as

a revenue expense or capital expense or as a distribution. If XYZ Ltd is

able to deduct Rs 15,000 as revenue expense, it saves tax @ 35 per

cent of Rs 5,250, thus reducing the effective cost of buyback to Rs

9,250. This would make a buyback significantly cheaper with an

equivalent loss of revenue to the exchequer.

But this expense though wholly and exclusively for business would not

qualify as "necessarily" for business.

Buyback Of Shares

Secondly, in substance, it remains an equity transaction with owners of

the company, for example, the ABC group, and not an expense for

conducting the business of XYZ Ltd.

Alternatively, XYZ Ltd could treat it as capital loss of Rs 50 per share -

purchase price of Rs 150 less Rs 100 face value. XYZ Ltd could then

offset such losses against other gains. This is far-fetched as XYZ Ltd

has not sold any asset whether fixed or current nor extinguished any

liability. Again, it looks like an equity transaction with the owners,

which is distinct from buying or selling an asset.

The third option is to treat it as a special dividend. This amount of Rs

15,000 represents excess accumulated return on capital over the past

year, which has now been paid out in one installment. XYZ Ltd will then

have to pay tax of 10 per cent on Rs 15,000 as it would for any interim

or final dividend.

Therefore, XYZ Ltd bears the tax burden for distributing its net assets

of Rs 15,000 to its owners ABC. This is the treatment adopted

worldwide. Thus the special dividend treatment reflects the substance

of a buyback, which is distribution of excess profits. The buyback code

could then require a transfer of Rs 15,000 from distributable reserves

of XYZ Ltd to undistributable reserves to protect the creditor's buffer

and ensure consistency with dividend treatment.

As to the impact on XYZ Ltd's shareholders, there are two alternatives.

ABC can treat Rs 15,000as capital receipt or dividend receipt. Under

section 2 (47) (ii) of the Income Tax Act, shares are deemed to have

been sold if there has been a change in shareholders' right to vote or

right to receive dividend or right to receive excess capital on

liquidation.

Buyback Of Shares

In our example, though ABC now owns only 900 shares, ABC can still

exercise the same proportion of votes, that is, 100 per cent and has

the right to receive 100 per cent of XYZ Ltd's dividend.

Therefore, Rs 15,000 in such circumstances is likely to be treated as

dividend receipt. As dividends are tax-free, the net receipt to ABC is Rs

15,000, which is only fair if XYZ Ltd has already borne the tax burden.

This will be so when XYZ Ltd treats Rs 15,000 as dividend payment and

not as revenue or capital expense.

Thus shareholders should also treat most of the buybacks as dividend

receipts, assuming that the company makes a proportionate offer of

buyback to all shareholders in the same class. This would be a legal

necessity under the buyback of preference shares. Say XYZ Ltd wants

to buy back all its 100 15 per cent voting preference shares at Rs 150

each (face value of Rs 100).

Here the preference shareholders have lost the right to cast those 100

votes and the right to receive Rs 15 of annual dividend. Therefore,

they will be deemed to have sold the shares and the net gain of Rs

5,000 will become taxable (Rs 15,000 proceeds less Rs 10,000 cost).

This net gain will be taxable at the rate of 20 per cent, reducing the

net receipt to Rs 14,000. This capital receipt treatment will be relevant

only in such exceptional circumstances of a buyback.

Thus the accounting principles dictate that companies and

shareholders treat buybacks as a special dividend payment. If

buybacks are treated as a revenue or capital expense, then this would

result in significant inconsistency between Indian business standards

and tax practices and those of rest of the world. More importantly, the

Buyback Of Shares

revenue or capital treatment would lead to government tax subsidies

on buyback payments made by profitable companies to their enriched

shareholders.

Even capitalist countries like the US and UK do not subsidize such

distributions and, therefore, to subsidize such transactions in a country

like India would lead to a unfair and unjust taxation system. Minority

shareholders also need to be protected and, therefore, the buyback

code should incorporate two safeguards: The buyback offer should be

made to all shareholders and it cannot be priced below the market

price.

Buyback Of Shares

Chapter 11

General obligations of a company

resorting to buy back

The following are the general obligations of company, which has

resorted to buy back:

Letter of offer, public information and other publicity material

should contain true and factual information. There should not be

any misleading information.

Company should not issue any shares including bonus shares till

the closure of the offer. It may be mentioned that a company will

not be entitled to issue shares on closure of the offer excepting

issue of bonus shares, in discharge of subsisting conversion liability,

sweat equity and issue of shares to ESOP.

The prohibition period should be earlier of the specified date or public

announcement. This is because although special resolution is passed,

a company may eventually put off the buy back decision.

Buy back consideration should be discharged only by way of

cash.

No withdrawal from the buy back is allowed after the draft letter

of offer is filed with the SEBI or public announcement is made. This

is to prevent creating market confusion through futile buy back

offer.

Buyback Of Shares

The promoters or persons in control of the company should not

deal in shares of the company in the stock exchange during the buy

back offer period. The promoters and persons having controlling

interest cannot participate in the buy back through stock exchange

operation.

However, they are allowed to participate in tender offer or buy back

through book building. This is targeted to prevent the possibility of

insider trading. However, this may not be able to prevent any

attempt to pull down the price by creating selling pressure during

the book building process.

Public announcement for buy back cannot be made during the

pendency of any scheme of amalgamation or compromise or

arrangement. No purpose can be served by this restriction, in normal

Course; a company has been prevented during the period of offer and

during cooling period to issue shares. So if buyback starts the company

will not be in a position to discharge equity swapped amalgamation.

As a means of investors' protection Regulation 19(3) requires

nomination of a Compliance officer by the company who will ensure

compliance with the legal aspects of the buy back. This could be the

responsibility of the merchant banker.

Buy back of shares which are in the lock-in period is not allowed till the

pendency of lock-in period and until the shares become transferable.

Publication of buy back information

Buyback Of Shares

The company is required to make public announcement by way of

advertisement in a national daily within two days from the date of

completion of the buyback inter alia disclosing:

Number of shares bought back;

Price at which shares are bought back;

Total amount invested in the buy back;

Details of the shareholders from whom more than 1% of the

shares are bought back;

Consequential changes in the capital structure and shareholding

pattern before and after buy back.

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Chapter 12

Buyback in India

In India the Buyback clause comes with certain

clauses.

The main objective of these clauses is to prevent Promoters from

malpractice. For example with Buyback a co. might be able to improve

its EPS & improve the Market value of the scrip (assuming at constant

P/E) & thereafter come up with an IPO at a higher premium to shore up

the Share Premium Account.

Or that a promoter might be able to corner a substantial number of

shares through open market purchases (not triggering the Takeover

code, however) & force the company to buy back these shares at a

higher price, making a clean profit in the process. To prevent such

malpractice the Working Group has recommended the following:

Any company that buy back its shares will not be allowed to issue fresh

capital, except bonus issue, for another 12 months if the shares are

bought back & extinguished, and for another 24 months if the shares

are held as Treasury Stocks. This will prevent manipulations of share

prices through Buyback.

Promoters have to specify the amount to be used for Buyback & get

prior approval of shareholders.

Only Free Reserves are allowed to be utilized for the purpose of

Buyback.

Buyback Of Shares

It has been argued hotly that a company will be rewarding the

shareholders through a Buyback route as well as it does through Bonus

& Rights issue, Dividends, etc. If a company buys back the shares and

extinguishes them, its Equity decreases to that extent, thereby

increasing its EPS.

And it is been assumed that the market price of the share increases to

match the pre-Buyback price to the Earnings ratio. Buyback also helps

a co. to maintain a target capital structure. When the RONW of a co. is

less than ROCE, it implies that the capital structure is lopsided with

excess Equity. The co. can buy back the Equity & replace it with Debt

to improve its RONW.

The key question that inevitably follows is that which is more beneficial

to the investors, a Dividend or a Buyback? This is a subjective question

that depends on the market price of the scrip & the price of

repurchase.

Buyback in India

In India though many specified group cos. qualify for Buyback, at

current prices, not many of them will be able to utilize their cash flow

to buy back their shares, as it will directly affect their cash

requirements for normal operations. Cash rich cos. like Reliance

Only multinational companies, which are keen to hike their

stakes in Indian ventures and promoters with low equity

holding will seriously think about buyback (as promoters are

not allowed to participate in buyback, their stake will

increase once the company buys back shares from other

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Industries, Bajaj Auto, TISCO, TELCO, HLL, etc. will have to shell out

huge amounts to buy back even a fraction of their Equity at prevailing

prices, which are obviously higher than the BV of the shares.

The other problem is that most of the Indian cos. have a Debt-Equity

ratio greater than one. Buyback would definitely increase this ratio &

reduce the leveraging capacity of the Co. This is specially applicable to

cos. having a high proportion of fixed assets, like TISCO & TELCO.

Coupled with the fact that the co. will not be able to issue new shares

for at least one year, this implies that the co. will not be able to go in

for any expansion for the next one year or so, this would be definitely a

big dampener to the whole concept of Buyback.

It has been argued that in India Buyback will be used predominantly to

ward-away hostile takeover bids. However the utility of Buyback as a

tool of defense In India is questionable under the existing regulations.

For example in the US, cos. are allowed to borrow to buy back their

shares in case of a takeover bid.

However in India a co. is not allowed to undertake fresh borrowings for

the purpose of Buyback. This means that weaker cos. which are

inevitably takeover targets cannot resort to Buyback as a defense

mechanism.

The lacunae in the buyback guidelines need to be addressed like the

applicability of SEBI’s takeover code. A company buying back to a

certain percentage, will it necessarily have to comply with the SEBI

Takeover Code regulations. For, on dilution, the proportion of shares

held by the promoters would increase and set off a trigger under

Regulation 10 of the SEBI Takeover Code.

Buyback Of Shares

Further, the takeover code gets triggered when shares beyond a

specified threshold limit are acquired. This entitles the acquirer to

exercise a certain percentage of voting power. In case of buybacks,

there is no increased entitlement to voting rights. For, under Section

77 A (7) of the Companies Act, 1956, a company buying back its

shares is not entitled to hold the same but has to statutorily cancel

them. Hence, a share buyback may not entail triggering of the

takeover code. Also as per the provisions of the Indian Stamp Act

1899, share transfers attract stamp duty and require the company to

register the shares bought back in its name. In case of buybacks, these

shares have to be statutorily extinguished. Hence, they do not get

registered in the acquirer’s name. The names of the shareholders have

to be struck off from the register of members too. Hence stamp duty

would not become payable in a share buyback.

Further, in the case of foreign JV, where the government has permitted

a fixed ratio of investment, the Indian company has to maintain the

same percentage in case of a buyback. Recently, there have been

reports that the government is proposing to exempt multinational joint

ventures from extinguishing shares bought back, provided the foreign

equity holding in the company is equal to sectoral caps post-buyback.

This has not been brought into effect as yet.

Given these pitfalls, Buyback as a concept & as a tool cannot make

much headway into the Indian corporate financial handbook. There

have to be modifications in the existing legal framework to make this

concept work in India.

 

Buyback Of Shares

Buyback Of Shares

Chapter 13

Recommendations & Findings

What should you look at before participating in buybacks?

Ever since the buyback of shares was allowed in India, there has been

a lot of confusion among shareholders; as whether to sell-off their

stake in the company or to retain it. To opt for a particular option is not

as easy as it appears. The perception of the shareholders about the

future of the company is the most important factor that influences

their decision.

However, that decision may not be accurate since they might not have

complete access to the internal and external strategies of the

company. A lot of careful thought has to be given before a final

decision is taken. Here’s a way on how to go about it.

Debt-equity ratio is an important criterion. The companies

having high debt burden are unlikely to have free cash. They should

prefer redeeming their debt first, to buying back equity. MNCs

having subsidiaries in India are unlikely to have any motive of

rigging up the share price and their buyback offer is likely to be

genuine.

Track record of raising capital in the past. Companies that

have frequented the capital markets to raise money are unlikely to

be good candidates for buyback.

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Look at ROCE/RONW-The companies with consistently high

ROCE/RONW are more likely to have free cash than others.

Checkout the previous price pattern of the share

Companies generally tend to buyback shares at a higher premium

over the market price if they feel that their shares are under-priced.

This decision to buyback often leads to an increase in share price.

At this stage, you have to analyse the fluctuation in the price of the

scrip for a specific time period (say one year) and if you find that

the scrip moved a band lower than the offer price, selling of the

scrip would be a better option.

Take note of Irrationality A buyback offer with a huge

premium may appear very attractive. Investigate and ensure that

any temporary negatives do not affect the share price. If you feel

that the share prices of the company are presently undervalued,

refrain from selling, since a company buying back its shares is

indirectly conveying that its shares are undervalued.

Take a long-term perspective It would be difficult to

envisage whether a company would issue bonus or split shares or

make an acquisition. But these factors can be sidelined if the

fundamentals of the company are strong and you expect the

company to perform well in the future. Therefore, in the long-term

perspective, the scripts of such companies should not be sold.

Dispose off volatile shares Despite strong fundamentals,

the shares of a few companies are highly volatile and exhibit wild

oscillation in prices. If you want to play it safe and avoid volatility,

selling out would be a better option.

Buyback Of Shares

Selling off for profit The first question that comes to mind

once you decide to sell your scrip is whether to opt for a buyback or

to sell it in the market. Even after buyback is announced, the

purchase price need not necessarily be the highest if a price band is

given. Further, there is no guarantee that all the shares offered for

buyback would be bought. Companies mostly buy about 10% of the

equity in buybacks. In such cases it would be wiser to sell your

stake in the market at a time when prices of your scrip are trading

at a price equivalent to the highest in the offer band.

Finally, one should keep one thing in mind, that buyback has no impact

on the fundamentals of the company or on the economy. The only

thing is that one should be cautious of unscrupulous promoters' traps

and do not fall prey to them.

The provision to allow buyback can be a booty for long-term investors

who want to stick on in good companies, but it can be a terrible bait in

many others.

Caution is advised in the following types of

companies:

Where the management talks about buyback, as market has

not valued their shares fully. To my mind, a good management will

never bother about its share price and valuation as done by the

market. It would know that if it continues to perform well, the

market has to take notice in the long term.

Buyback Of Shares

Where the management has passed, with a lot of publicity,

special resolutions empowering the Board to buy back whenever

allowed. Anybody with the genuine intention of buying back to

enhance shareholders' wealth would try to do so with minimum

publicity so that the share price does not flare up.

Buyback has no impact on the fundamentals of the economy or

companies. Investors should be cautious of unscrupulous promoters'

traps.

To sell or not to sell?

When confronted with a buyback offer, one shouldn’t just be guided by

the offer price in relation to the prevailing market price. Yes, if you

were looking to exit the stock anyway, that’s perhaps all you need to

look at. However, if you are a medium- to long-term investor in the

company, you also need to weigh the implications of the buyback on

the company and its stock–and, therefore, your investment.

Earnings per share (EPS).

Post-buyback, the EPS of a company is bound to increase due to a

reduction in equity. However, going forward, the EPS could fall if the

performance of the company deteriorates, or if the funds used for

the buyback earned significant additional income for the company.

Hence, future prospects of the company ought to be your biggest

consideration while evaluating its buyback offer. If the company is

expected to record healthy growth, it pays to stay invested in it.

However, if it is expected to founder, exiting might be a better

option. This fact is borne out by the contrasting post-buyback

Buyback Of Shares

numbers of two companies that have bought back stock in recent

times, Bajaj Auto and GE Shipping .

Adjusted for the buyback, Bajaj Auto’s EPS increased from Rs 51.4

to Rs 60.7. However, soon after, for the financial year ended March

2001, its EPS fell to Rs 25.9 due to a decline in two-wheeler sales

from 1.43 million units to 1.2 million units.

Book value.

This is the per-share value of the company’s assets as valued in its

books. Other things remaining constant, you stand to gain by

exiting if the buyback price paid by the company is above its book

value. However, if the price paid by the company to buy back its

stock is less than its book value, you gain by staying on.

Bajaj Auto made its tender offer at Rs 400 per share, a premium of

almost 50 per cent to its pre-buyback book value of Rs 268 per

share. As a result, post-buyback, the company’s book value dropped

3 per cent to Rs 260 per share. Since the premium came from its

existing reserves, residual shareholders actually ended up sharing

the cost of the premium paid.

Return on equity (RoE).

Post-buyback, the net worth the company must service decreases.

Even if the company does not expand its bottom line considerably,

this would result in an improved RoE for residual shareholders.

But an increase in RoE that results from a reduction in the net

worth, as opposed to an increase in earnings, may just end up being

a one-time improvement. Hence, look at the company’s track record

Buyback Of Shares

on RoE and also assess its future earnings potential before choosing

to stay on as a residual shareholder in it.

Promoter’s stake. A buyback increases the promoter’s

stake in his company. When a buyback is announced, look at the

stake of the promoter and his associates in the company, before

and after the buyback (assuming the offer is fully subscribed).

Cash-rich companies where the promoters have a low holding and

are keen to increase their stake could well make further buyback

offers at a later date–often, at a higher price. There are many old

economy companies that fit this profile. A good example is GE

Shipping. In January this year, the company announced a Rs 150

crore buyback from the market at a maximum price of Rs 42 per

share. It completed the buyback at an average price of Rs 35 per

share, and the Sheths hiked their stake from 17 per cent to 21 per

cent.

GE Shipping is currently in the midst of its second buyback exercise. It

has earmarked Rs 100 crore to buy back equity at a maximum price of

Rs 42 per share. At that price, the Sheths’ holding in the company will

rise to 25.8 per cent.

However, given the weak stock market and the recent downturn in the

shipping industry, the stock is languishing near Rs 23, and the

company might well complete the buyback paying less than Rs 100

crore. In better times, though, the same buyback could have been

closer to the offer price.

However, when a company makes a buyback with the prime intention

to increase its promoters’ stake, it’s dipping into its net worth without

Buyback Of Shares

necessarily meaning to increase shareholder wealth. Therefore, you

need to evaluate the impact the outflow of funds would have on the

company’s operations and whether this could be detrimental to future

growth.

Price and liquidity.

A buyback rouses interest in a scrip. When done through open

market purchases, it creates a cap or floor for the stock. In a bullish

market, the buyback price creates a floor for the scrip in the

secondary market. When Reliance offered to buy back its shares in

June 2000 at Rs 303 per share, this effectively became the floor

price for the stock. The stock traded below that level for just 11

days over the next 264 trading days, as market players anticipated

that Reliance would step in and make purchases if it dipped below

Rs 303.

In a bearish market, though, this is reversed–the maximum buyback

price becomes a ceiling price for the scrip. Reliance never did pick

any stock till June 2001 (when the initial buyback approval lapsed).

It took fresh approval, on the same terms. Post-September 11, the

scrip hasn’t breached Rs 303. In this bearish market, investors are

not inclined to pay more than what the management perceives to

be a fair value for the stock.

A buyback has greater implications for investors in illiquid stocks, as it

offers them a much-needed exit route. However, post-buyback,

liquidity in such stocks is likely to decline further due to a drop in their

free float. It’s not a good idea to hold an illiquid stock–low liquidity

results in poor price determination. In extreme cases, where a

Buyback Of Shares

promoter’s holding crosses 90 per cent, the company has to delist. So,

always keep in mind the promoter’s stake and the stock’s free float in

the market.

Buyback Of Shares

The bottomline.

Buybacks should be used as an opportunity to exit only when there is

concern over a company’s prospects or when the post-buyback free

float is expected to shrink considerably. In most other cases, buybacks

do offer the lure of an immediate benefit–but you might be better off

as a residual shareholder, and gain from a hike in the share of assets

and profits of the business.

Buyback Of Shares

Chapter 14

PitfallsShare buybacks, if handled badly or in an imprudent manner can

exacerbate a sinister situation. The recent spates of buybacks at a

torrid pace are leading to a flight of capital from the stock markets.

Buybacks coupled with mergers and acquisitions are gnawing at the

free float available to the investors.

The utilization of a company’s cash reserve to fund it’s re purchase

plans, if viewed in entirety also leads to reduced ploughing back of

funds for fuelling operations and a higher debt perspective on the

balance sheet.

Many companies have in fact initiated borrowing to finance their

buyback programs. This might bestow upon the company various tax

advantages but at the same time it amounts to replacing equity with

debt.

Dividend yield may eventually lose importance as more and more

companies substitute their dividend plans with buyback plans. The

company gets highly leveraged and changes the shareholders

perception of the company from being an income stock to a growth

stock.

Conclusion

While scrutinizing a buyback offer, attention must be paid to the size of

the buyback relative to the company’s free float and with the newly

granted stock options. The buyback announcements are a mere

statement of the company’s intentions and need not necessarily be

Buyback Of Shares

effected in actuality. However, if the announcement is backed by a

tender offer, the possibility of the fulfillment of buyback promise does

exist.

Will Buybacks Backfire??

Finance theory suggests three main motives for a firm to use a

share buyback:

Tax motives

A signaling motive or

A takeover deterrent motive.

It is through these lenses that the framing of buyback norms should be

viewed. There has been some theoretical research on the use of share

repurchases as a signaling device. Some of the conclusions worth

restating are:

The offer premium, the target percentage of shares sought and

the percentage of insider holdings have been perceived as signal

devices – the higher each of these parameters, the more positive is

the signal

When there is a small disparity between intrinsic worth of a firm

and its market price, dividends are the preferred distribution

mechanism. If the price disparity is large, a smaller cash outlay on

share buyback can convey the same information as a relatively

larger dividend

Information asymmetry between managers, investors with larger

holdings and small investors means that the smallest distributions

Buyback Of Shares

should be paid with dividends, larger distributions should take the

form of open market repurchases and tender offers should be used

for the largest distributions.

The yardstick for deciding the size of a signaling buyback is its

materiality level, a number that measures how much impact the

buyback will have on the wealth of shareholders who keep their

shares. The materiality level for any given number of shares the

company may buyback depends on the degree to which the market

undervalues the company. But all too many companies routinely

underestimate how many shares they need to buy to send a credible

signal to the markets. While buybacks are typically sized in the 5-10

percent range, they typically need to be closer to 20 percent to have a

material signal.

Buybacks are a more tax efficient form of cash distribution to the firm

than dividends (the firm saves on dividend tax). Furthermore, they

create value through changes in capital structure (the tax shield of

debt increases firm value). However, there are some concerns that

need to be addressed in the currently uncertain economic climate in

India. Taxable income in India can be highly cyclical if the economy

continues to nosedive.

Given the current short cooling off period (period in which no fresh

issue of shares is permitted after the buyback) of 6 months, will the

change in capital structure be perceived by the market to be

permanent? In the absence of clear answers, a case for increased

valuation due to changes in capital structure on account of buybacks

remain tenuous.

Buyback Of Shares

It is suggested that managers repurchase shares to prevent takeovers,

but only if the cost of doing so is not too high. The recent success of

attempts at "greenmail" in India and UTI’s disastrous finances and

attempts to increase value of under performers in its portfolio through

change in management is causing many mid-cap companies to

consider buybacks. It is also causing many multinational subsidiaries to

indirectly increase their parent companies stakes using corporate cash

with an eventual objective to delist.

This is probably not in the interest of financial institutions like UTI.

Delisting by multinationals is not in the interest of India’s capital

markets. Thus one can say that buybacks increasingly look less of a

boon.

Some of the leading merchant bankers have prepared lists of

potential companies with good reserves, but inquiries reveal

that only less than a dozen of out of 300 companies will really

pursue the buyback move in right earnest.

Buyback Of Shares

Chapter 15

Buy Back of PSU's Shares

The Central Government is reportedly planning to adopt buy back

route for mopping up Rs. 10,000 crore. Reportedly buy back route

may be adopted by big PSUs including Indian Oil Corporation, Bharat

Heavy Electricals Ltd., Oil and Natural Gas Corporation, Bharat

Petroleum Corporation Ltd., Gas Authority of India Ltd. and NALCO.

In view of the prolonged bearish spell in the capital market the Central

Government has failed to achieve targeted disinvestments in the PSU

shares. Buy back route seems to be better than disinvestments

because in this the Central Government can fix the price as per

prudential valuation. Reportedly the core group of secretaries has

identified four cash rich oil PSUs, namely, IOC, BPCL, ONGC and GAIL,

for the first trench of buy back. The PSUs have huge accumulated

reserves to satisfy the upper ceiling of buy back. A few other cash rich

PSUS, namely, BHEL and NALCO, might be considered as a buy back

candidate in the second trench.

Under the buy back route the PSUs may launch buy back applying

book building process. In case the quote of the Central Government is

lowest it may be able to sell the desired shares, which it targeted in

the disinvestments route. However, in the buy back route the PSUs

have to buy back shares of ordinary shareholders also on the basis of

competitive quote.

Buyback Of Shares

In case tender offer route is opted for fixing up a fixed price, the

likelihood of other shareholders participating in the buy back cannot be

eliminated.

Reportedly, the buy back may be financed by the financial institutions.

This means IOC, ONGC, BHEL, etc. should swap equity for debt.

Reportedly, the basic telecom service provides MTNL plans to buy back

its share. Present Government holding in MTNL 57.16% is expected to

come down to 54.94 % because of the proposed issue of equity shares

to the employees to the extent of 2.22%. So to maintain Government

holding at 51%, the MTNL can buy back about 16.75% of its present

equity share capital.

Buyback Of Shares

Annexure: What you can’t buy back...

Buybacks and open offers bring a much needed infusion into a

market gasping for liquidity. But what are their real effects on

the market?

Buybacks and open offers gather steam in corporate India in 2001

 Buybacks

Max

offe

r

pric

e

Rs

Offer

size

Rs

crore

s

Targete

d

stake

%

 Open offers

Offer

price

Rs

Offer

size

Rs

crore

s

Targete

d

stake

%

 Reliance 303 1100 4    Castrol 350 865 20

 Tata

Chemicals 60 163 15    Hitech Drilling 92 147 77

 GE Shipping 42 100 N.A.    Carrier Aircon 100 110 49

 Siemens 250 81 25    Otis Elevator 280 109 31

 Bombay

Dyeing 60 62 25  

 German

Remedies650 107 20

 Finolex Ind 40 60 N.A.    Thomas Cook 352 104 20

 Britannia

Ind750 55 4    ITW Signode 80 90 49

 Jayshree

Tea 75 8 10    Rhone Poulenc 875 79 20

In the current dismal market conditions, the only stocks that are

showing any signs of resilience are those that have open offers or

buybacks in progress. At a time when FII inflows seem to be slowing

down, these offers are the lone hope of fresh liquidity coming into the

equity markets.

Of late, quite a few companies have taken to the buyback route as a

means to pay out excess cash to shareholders. Promoters with low

Buyback Of Shares

stakes are also turning to buybacks to hike their holdings, using the

company’s money rather than their own funds.

As restrictions on foreign ownership become less stringent, many

multinational companies have hiked stakes in their Indian subsidiaries

via open offers. These usually follow disappointing financial results,

making one wonder whether it’s coincidence or a strategy to buy the

stock cheaper. With greater global M&A activity, mandatory open

offers by new parent companies have also gained in pace.

Our table lists the major buybacks and open offers to hit the market in

2001. Our estimates show that the total amount earmarked for these

offers is a substantial Rs3600 crores. That’s in addition to the Rs4000

crores that came in during 2000.

It should be noted that a number of open offers have been made at low

prices, leading to poor response from shareholders. In the case of

buybacks, the Rs1100 crores ear-marked by Reliance Industries may

actually never materialise due to the fact that market price is till date

above the maximum buyback price. Thus, while the payout to

investors may be well short of the estimated Rs3600 crores, it’s still a

figure to reckon with.

Whatever the amount, it’s hard to see investors ploughing back this

money into equities, at least for now. It’s more likely that these funds

would find their way into the debt markets. But as equities win favour

again, undoubtedly these funds will shift back to where they came

from, injecting much needed liquidity in the short term.

But what do these offers mean for the Indian markets over the long

haul? Most open offers from MNCs are made in order to increase their

stake to 100%. This will lead to the eventual delisting of their well-run,

profit-making Indian subsidiaries. Domestic investors would thus be

deprived of being a part of the future growth of these ventures.

The delisting of these well-known, investment worthy companies will

mean less choice in Indian equities for the global investor. This, in turn,

Buyback Of Shares

will shift the spotlight to well-managed Indian companies, which might

begin to attract greater investment.

Bibliography

Websites:

www.blonnet.com

www.vckgroup.com

www.advanishares.com

www.indiainfoline.com

www.google.com

www.rediff.com

www.indiaheadlines.com

www.indiainfo.com

Newspapers:

The Times of India

Business Standard

Financial Express

Business Line

Books:

Buyback of Shares – Ghosh

Inter – CA module

Financial Management- Prasanna Chandra

Buyback Of Shares

Acknowledgements