In simple terms when a company repurchases shares, they may either be canceled or held for reissue. If not canceled, such shares are referred to as treasury shares. Technically, a repurchased share is a company's own share that has been bought back after having been issued and fully paid OR in another context it can also be said that a treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market (common shares).
Stock repurchases are often used as a tax-efficient method to put cash into shareholders' hands, rather than paying dividends. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Other times, companies do this to provide a "bonus" to incentive compensation plans for employees. Rather than receive cash, recipients receive an asset that might appreciate in value faster than cash saved in a bank account. Another motive for stock repurchase is to protect the company against a takeover threat.
Limitations of Treasury Stock:
· Treasury stock does not pay a dividend
· Treasury stock has no voting rights
· Total treasury stock cannot exceed the maximum proportion of total capitalization specified by law in the relevant country
The possession of treasury shares does not give the company the right to vote, to exercise pre-emptive rights as a shareholder, to receive cash dividends, or to receive assets on company liquidation. Treasury shares are essentially the same as unissued capital and no one advocates classifying unissued share capital as an asset on the balance sheet, as an asset should have probable future economic benefits. Treasury shares simply reduce ordinary share capital.
Importance of the Treasury Method:
This method comes into picture when we need to deal with the reduction in earnings (EPS) of common stock that occurs through the issuance of additional shares at the exercise of stock options or warrants or the conversion of convertible securities. An investor should carefully consider the fully diluted share amount because it can cause a company’s share price to plummet significantly if a large number of option holders or convertible bond holders decide to claim their stock.
Thus method is one of the most commonly used methods to value the options/warrants for the calculation of enterprise value. The purpose of this method is to account for the cash generated by the exercise of options/ or warrants. It assumes that the proceeds that a company receives from an in-the-money (options are in the money if its exercise price is less than the share prices) option exercises are used to repurchase common shares in the market. The net new shares that are potentially created is calculated by taking the number of shares that are in-the-money options purchase, then subtracting the number of common shares that the company can purchase from the market with the option proceeds. The net new shares are added to the basic shares outstanding to get the fully diluted shares outstanding which are used to calculate the diluted equity value. An example has been illustrated for better understanding the Treasury Method concept.
Example:
Current share price: $50
Share outstanding: 400mm
Options/warrants outstanding: 10mm
Exercise price: $25
Proceeds from conversion: 10*$25 = $250mm
Stock buyback (at premium): $250/$50 = 5mm
Diluted shares: 400 + 10 – 5 = 405mm
Check out space for effects of convertibles on EPS……..
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