The Economist's Buttonwood blog takes some potshots at stock buybacks:
WHEN should a company choose to buy its own shares? You might think the right moment is when its share price was depressed; perhaps when the management believed the share price did not accurately reflect the company's prospects.
But as a recent column pointed out, companies are poor market-timers, using more of their cashflow to buy back shares when the stockmarket was high, not low.
Fair enough, although one would have to ask whether high stock valuations tend to correlate with firms having excess free cash flow that needs to be dispensed.
But then Buttonwood said something very odd:
... while many companies (including Apple) have lots of cash, it is not always the case that excess cash is sued to buy back shares; both Home Depot and Amgen have done so, for example. This is leveraging up the company and should make it no more valuable; as debt rises, the equity becomes more risky and thus less valuable.
It's not the most coherent statement, but Buttonwood seems to be arguing that leveraged stock repurchases are problematic. If so, that claim flies into the teeth of basic corporate finance as articulated by Michael Jensen in a classic piece on the benefits of debt in reducing agency costs of free cash flows:
Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organization inefficiencies. ...
Managers with substantial free cash flow can increase dividends or repurchase stock and thereby pay out current cash that would otherwise be invested in low-return projects or wasted. This leaves managers with control over the use of future free cash flows, but they can promise to pay out future cash flows by announcing a “permanent” increase in the dividend. Such promises are weak because dividends can be reduced in the future. The fact that capital markets punish dividend cuts with large stock price reductions is consistent with the agency costs of free cash flow.
Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows. Thus, debt can be an effective substitute for dividends, something not generally recognized in the corporate finance literature. By issuing debt in exchange for stock, managers are bonding their promise to pay out future cash flows in a way that cannot be accomplished by simple dividend increases. In doing so, they give shareholder recipients of the debt the right to take the firm into bankruptcy court if they do not maintain their promise to make the interest and principal payments. Thus debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. These control effects of debt are a potential determinant of capital structure.
Issuing large amounts of debt to buy back stock also sets up the required organizational incentives to motivate managers and to help them overcome normal organizational resistance to retrenchment which the payout of free cash flow often requires. The threat caused by failure to make debt service payments serves as an effective motivating force to make such organizations more efficient.
Leveraged stock repurchases thus should enhance firm value by credibly redirecting the stream of free cash flow to value-enhancing uses rather than into management perks, empire building, or what have you.
Jensen, Michael C., Agency Cost Of Free Cash Flow, Corporate Finance, and Takeovers. American Economic Review, Vol. 76, No. 2, May 1986. Available at SSRN: http://ssrn.com/abstract=99580 or http://dx.doi.org/10.2139/ssrn.99580
