Question

7. Stock repurchases

There are a number of reasons why a firm might want to repurchase its own stock. Read the statement and then answer the corresponding question about the company’s motivation for the stock repurchase:

Smith and Martin Co.’s board of directors has decided to repurchase some of its stock on the open market because it wants to increase the company’s debt-to-equity ratio.

What is the company’s motivation for the stock repurchase?

To adjust the firm’s capital structure

To distribute excess funds to stockholders

To protect against a takeover attempt

To acquire shares needed for employee options or compensation

Which of the following statements would be considered advantages of a stock repurchase? Check all that apply.

The market generally perceives a stock repurchase as a sign that management believes that the firm’s stock is undervalued.

At times, the company will repurchase its stock at a price higher than the true value of the stock.

Stock repurchases are an effective way to change the firm’s capital structure when the amount of equity in the current capital structure is significantly greater than the firm’s target capital structure.

Answer 1

Q1:

To adjust firms capital structure. Since it is mentioned that they have to improve Debt to Equity ratio, the company is adjusting its capital structure such that the cost of capital is lowered.

Q2:

The market generally perceives a stock repurchase as a sign that management believes that the firm’s stock is undervalued.

At times, the company will repurchase its stock at a price higher than the true value of the stock.

---- Stock purchases are generally done when a company is having extra cash and have no other business plans. In such case, if they think the stock is undervalued, they will be doing buyback in an attempt to increase its value.