JOIN USTata Consultancy Services (TCS) announced the biggest buyback of shares by any company in India amounting to a whopping Rs 16,000 crore in February this year.
TCS will buy back 5.60 crore shares at Rs 2,850 per share representing 2.85% of paid up capital. The share price rose 6% and closed at Rs 2,500 that day after the announcement. Other companies like SKF India, Mindtree and HCL Technologies are also mulling buyback of shares.
Many investors like you would have seen an arbitrage opportunity in the TCS offer as you could buy TCS shares at Rs 2,500 from the secondary market and sell them at Rs 2,850.
A back-of-the-envelope calculation will tell you that if you buy 100 shares at the closing price of Rs 2,500 and tender them to the company at Rs 2,850, you could make a neat profit of Rs 35,000 (i.e. Rs 350 X100 shares).
Is your understanding right? Most of us are guilty of this type of irrational behaviour without trying to understand the basics of buyback. What is share buyback? And why do companies resort to buybacks?
What is share buyback?
A buyback is the repurchase of its own outstanding shares by a company from the shareholders.
The buyback price is normally higher than the market price as there has to be an incentive for shareholders to participate in the buyback and help the company achieve the objectives. The shares which are bought back are extinguished and reduce the number of equity shares and the cash reserves.
Why does a company resort to buyback?
A company may resort to a buyback for the following reasons:
- To increase the stake of promoters in the company
- To prevent a hostile takeover bid
- To improve its earnings per share
- To improve return on equity and return on net worth
- To use its excess cash holdings to buy out/reward the shareholders
- Buybacks are more tax efficient compared to dividends in reducing cash from the balance sheet by distributing earnings to shareholders
- To bolster market price of its stock
- When the company is not sure of its business prospects
What is acceptance ratio?
Acceptance ratio tells you the number of shares accepted by the company out of all the shares tendered by you.
If you are holding 100 shares of a company, it doesn’t mean the company will buy back all 100 shares. The TCS offer says the total buyback represents 2.85% of the paid up capital and if promoters are also participating in the offer, the acceptance ratio will be 3:100.
This means for every 100 shares you tender the company will buyback three shares at the buyback price.
Hence if you had bought 100 shares of TCS after the announcement the company will buyback only 3 of the 100 shares at Rs 2,850. You would make a gain of Rs 1,050 only (i.e. Rs 350 X 3 shares) on purchase of 100 shares and not Rs 35,000 as you thought!
The real acceptance ratio may be higher as all shareholders may not participate in the buyback for various reasons. A company or the promoters may or may not participate in the buy back exercise. If the promoters do not participate then the acceptance ratio may be higher for other shareholders.
What about capital gains or retail investors?
The difference between buyback price and the purchase price is taxable as capital gains (whether short-term or long- term) under section 46A of the Income Tax Act.
So if you had bought the shares just before the record date to participate in the buyback, you have to pay short-term capital gains tax of 15% (excluding surcharge and cess). And for other investors who had held it for more than 12 months there would not be any tax on long-term gains.
To recap, while participating in the buyback programme of any company you should consider the buyback price, the acceptance ratio, tax on capital gains and the future prospects of the company before tendering the shares.
(The writer is a former banker, and currently teaches at Manipal Academy of Banking)