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

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.
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.
 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

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.
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
 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 : 30
s %
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
have a very strong cash book position. If the company uses its cash to
repurchase its outstanding stock, it will enjoy a double credence:
 Buyback Of Shares

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
the company are listed, within seven days from the date of
passing of the resolution.
Buyback Of Shares
 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
 Buyback Of Shares

acceptance, 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.

(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.
 Buyback Of Shares

(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

(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.
 Buyback Of Shares

(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-

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.
 Buyback Of Shares

(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.

(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
 Buyback Of Shares

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.

(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;
 Buyback Of Shares

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;
 Buyback Of Shares

b. In forming their opinion for the above

purposes, the directors shall take into account the
liabilities as if the 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)
Buyback Of Shares
 Buyback Of Shares

Chapter 7
Extinguishment 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.
 Buyback Of Shares

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,.
 Buyback Of Shares

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—
 Buyback Of Shares

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.
 Buyback Of Shares

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?
Debt servicing coverage of the company should be good;
 Buyback Of Shares

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.
 Buyback Of Shares

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.
 Buyback Of Shares

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
 Buyback Of Shares

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
 Buyback Of Shares

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.
 Buyback Of Shares

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

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

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
 Buyback Of Shares

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.
 Buyback Of Shares

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
Pitfalls
Share 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
should be paid with dividends, larger distributions should take the
 Buyback Of Shares

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.

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
 Buyback Of Shares

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.

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.
 Buyback Of Shares

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
Max
Offer Offer
offe Targete Targete
size Offer size
r d d
Buybacks Rs Open offers price Rs
pric stake stake
crore Rs crore
e % %
s s
Rs
Reliance 303 1100 4 Castrol 350 865 20
Tata
60 163 15 Hitech Drilling 92 147 77
Chemicals
GE Shipping 42 100 N.A. Carrier Aircon 100 110 49
Siemens 250 81 25 Otis Elevator 280 109 31
Bombay German
60 62 25 650 107 20
Dyeing Remedies
Finolex Ind 40 60 N.A. Thomas Cook 352 104 20
Britannia
750 55 4 ITW Signode 80 90 49
Ind
Jayshree
75 8 10 Rhone Poulenc 875 79 20
Tea
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
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
 Buyback Of Shares

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,
will shift the spotlight to well-managed Indian companies, which might
begin to attract greater investment.
 Buyback Of Shares

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