When do companies buy back shares using debt?

While companies would normally buy back shares using cash balances, which effectively recreates a dividend payment for investors, it is also possible for a company to use debt financing to improve its capital structure. However, because of the way in which such a transaction would impact the balance sheet much more aggressively, we need to be able to understand the full impacts of such a transaction before we can decide if the net impact will be beneficial to our investment positions.

The rationales behind repurchasing shares through debt financing are threefold: firstly, a company can write off the costs of debt, and therefore access it as an extremely cheap source of funds. Secondly, if the company operates in a highly fixed cost-environment, it would be appropriate to finance those fixed costs with debts so as to improve the scalability of the business. Lastly, the use of debt financing to purchase out equity positions can shift the total cost of capital over to a more favorable position in the event that a company’s equity has become too expensive as a source of funds.

As such, the cost of using debt to buy back shares will be evaluated against the earnings-per-share ratio of the company’s equity securities. If the company’s E/P is greater than the cost of borrowing additional funds (after adjusting for the tax benefits of debt), there is a benefit to the company’s capital structure to engage in the transaction, and therefore a benefit to the long-term profitability of the company. However, if the E/P is less than the cost of borrowing, then the transaction would actually reduce the efficiency of the company’s cost structuring, and potentially harm the long-term profitability of the company unless there is a specific reason as to why the transaction is taking place.

In looking at the potential outcomes of a debt-financed share buy-back, we need to remember that such a transaction will greatly increase the company’s leverage, and therefore it’s operating risk. Essentially, the company is trading out its variable financing costs (equity financing) in exchange for a fixed payment that will be made at a lower rate. That being said, the risks of missing a debt payment are much greater than those of missing an equity payment, because equity prices will simply adjust to reflect the risk of the operations themselves.

This is as opposed to the way in which a bondholder or bank will begin taking actions to foreclose on the business itself. As such, we need to make sure that a debt-financed share buy-back doesn't put the company in a position where they will not be able to maintain their operating margin. However, if the company is currently generating a great deal of reasonably assured returns through continuing operations, it is reasonable to assume that the company has improved its ability to generate returns for its equity base by improving its overall capital structure.

As with a cash-financed buy-back, an investor should start by evaluating the transaction as an investment into the company’s ability to make future investments. Even if the use of debt financing to buy out equity securities improves the company’s capital structure, it might cause the company to miss some investment opportunities today that would have been more valuable in the long run. As such, buy-back transactions should be evaluated by investors against the various opportunity costs available, and within the contexts of their overall portfolio itself.