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1 Introduction
Share buy-backs are a way to distribute excess profits to shareholders. When capital markets are perfect and frictionless, dividends and share repurchases are perfect substitutes. In a perfect world the value of a company is only related to its investments. Therefore the way the company distributes excess profits to investors will not impact shareholders wealth. One possible answer to the question whether buy-backs are a sound strategy for creating shareholders wealth could be that buy-backs are not relevant for creating shareholders wealth.
However the capital markets are not perfect and frictionless. To answer the question more accurately we have to account for market imperfections such as taxes, agency costs, information asymmetry and transaction costs.
In an attempt to answer the question we have to take several points of view. From the company perspective share buy-backs and off market buy-backs in particular offer several advantages over other ways of distributing excess profits. Buy-backs are more flexible since they allow the company to use excess cash or even dept finance to buy their shares. This allows them to manage capital structure and cost of capital. For example; it allows them to replace expensive equity with less expensive dept.
In an off market buy-back a company is able to buy back shares at a discount to market due to the imputation tax system used in Australia. At the same time buy-backs signal under valuation of the company and can positively impact future share price. Buy-backs will also boost earnings per share since the number of shares on issue will be reduced.
On the negative side; if the buy-back is financed from excess cash thi ...