What it means
A normal share buyback uses spare cash to buy back shares. A leveraged one uses borrowed money instead, either from bank loans or from newly issued bonds.
The company replaces some of its equity (owners' money) with debt, which changes its capital structure. The appeal comes from simple arithmetic.
If the company earns a steady profit and the number of shares falls, each remaining share claims a bigger piece of those profits, so earnings per share (EPS) rises. Interest on debt is also usually tax-deductible, which makes borrowing cheaper than its headline rate after tax.
However, whether the buyback helps depends on a comparison. If the earnings yield on the shares, which is earnings per share divided by the share price, is higher than the after-tax cost of the debt, EPS goes up.
If it is lower, EPS goes down, even though fewer shares are in issue. The risks are considerable.
More debt means fixed interest payments that must be met even in a downturn, and credit rating agencies may downgrade the company. Buying back shares at a high price destroys value if the stock later falls, and the cash could have gone into growth, research or paying down existing debt.
A useful rule of thumb is to ask what else the money could do. The same borrowing could fund a new product line, an acquisition or the repayment of more expensive debt, so the buyback must beat those alternatives on risk-adjusted return.
Investors tend to reward buybacks funded from surplus cash more than those funded by stretching the balance sheet. Leveraged buybacks are sometimes used to defend against a hostile takeover or to signal management's confidence.
Boards need to consider legal limits on buybacks, the company's solvency and the conditions in its existing loan agreements.
In practice
Real-world examples.
Example
A consumer goods company with stable cash flows issues $500,000,000 of bonds and uses the proceeds to repurchase shares. Management says that the company's strong earnings can comfortably cover the new interest payments.
Example
A technology firm facing an activist investor borrows from its bank to buy back 8% of its shares. The move returns cash to shareholders and raises EPS, but credit analysts note the rise in the company's debt levels.
Example
A family-controlled manufacturer borrows to buy out a group of minority shareholders. The remaining shares are cancelled, and the family's ownership percentage rises without any extra investment from them.
Formula
Calculation
New EPS = (Net income - After-tax interest on new debt) / (Shares outstanding - Shares repurchased)
Worked example: a company has net income of $50,000,000 and 25,000,000 shares, so EPS is $50,000,000 / 25,000,000 = $2.00. The share price is $40, and the company borrows $100,000,000 at 6% to buy back shares. The tax rate is 25%.
Shares repurchased = $100,000,000 / $40 = 2,500,000. Shares remaining = 25,000,000 - 2,500,000 = 22,500,000.
Interest = $100,000,000 x 6% = $6,000,000. After-tax interest = $6,000,000 x (1 - 0.25) = $4,500,000.
New net income = $50,000,000 - $4,500,000 = $45,500,000. New EPS = $45,500,000 / 22,500,000 = $2.0222.
EPS rises from $2.00 to about $2.02, because the earnings yield of $2.00 / $40 = 5% is higher than the after-tax cost of debt of 4.5%.Case study
Seen in the real world.
Kingsford Beverages is a fictional drinks company with stable profits and low debt. Its finance director proposed borrowing $60,000,000 at 5% to repurchase shares priced at $30, believing it would lift EPS.
Net income was $90,000,000 on 45,000,000 shares, so EPS was $2.00. The calculation showed 2,000,000 shares bought back and after-tax interest of $2,250,000 at a 25% tax rate, so EPS would rise to $87,750,000 / 43,000,000 = about $2.04, a gain of roughly 2%, because the earnings yield of 6.7% beat the after-tax debt cost of 3.75%.
The board approved a smaller programme of $40,000,000 after the credit committee flagged that a recession could squeeze interest cover. This is an illustrative story, but it shows how the maths and the risk both enter the decision.
Watch out
Common mistakes.
- Assuming a buyback always raises EPS. If the earnings yield on the shares is lower than the after-tax cost of the debt, EPS can fall.
- Ignoring the added financial risk. More debt means higher fixed interest costs, and a downturn can strain the company's ability to pay.
- Paying too high a price for the shares. Buying back stock when it is expensive can destroy value for the remaining shareholders.
Questions
People also ask.
Is a leveraged buyback the same as a leveraged buyout?
No. A leveraged buyback is a company repurchasing its own shares with debt, while a leveraged buyout is when an investor acquires a company using borrowed money.
Why not just pay a dividend?
A buyback returns cash more flexibly and can raise EPS, whereas a dividend is paid to all shareholders and sets an expectation of future payments. Tax treatment may also differ.
Where do the repurchased shares go?
They are either cancelled or held as treasury shares. Either way, they no longer count in the shares outstanding used for EPS.
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