The company can also buy back some of its outstanding shares instead of paying cash dividends. This is known as stock repurchase and shares repurchased, (bought back) are called treasury Stock. If some outstanding shares are repurchased, fewer shares would remain outstanding.
Assuming repurchase does not adversely affect firm’s earnings, E.P.S. of share would increase. This would result in an increase in M.P.S. so that capital gain is substituted for dividends.
Advantages of Stock Repurchase
1. It may be seen as a true signal as repurchase may be motivated by management belief that firm’s shares are undervalued. This is true in inefficient markets.
2. Utilization of idle funds
Companies, which have accumulated cash balances in excess of future investments, might find share reinvestment scheme a fair method of returning cash to shareholders.
Continuing to carry excess cash may prompt management to invest unwisely as a means of using excess cash.
A firm may invest surplus cash in an expensive acquisition, transferring value to another group of shareholders entirely. There is a tendency for more mature firms to continue with investment plan even when E (K) is lower than cost of capital.