If a company issues debt to repurchase shares how does that Increase managerial flexibility? This was a question I missed on an exam. I figured with the added debt, managers would need to be more cautious so as to make interest payments - the only thing I can think of is maybe it lowers the WACC. any help would be appreciated. ty
Hi!
I think the intuition is that generally if we have less shareholders, there’d be less fund managers / scrutinizing investors who would limit how the company is run by casting their votes etc.
In the exaggerated case, take the case of leverage buyout (see page 261 vol 3 for details), where the company issues debt and buy all of its shares and converts to a privately held company. The management basically can now run the firm and make decisions like a private business. That’s the gist of it.
Yeap, I agree with you that the higher debt level would include more difficult convenants, and the management got to be careful about its various financial ratios.
It probably has to do with flexibility vis-a-vis the target capital structure, D/A. If you are away from the target, you could borrow, thus increase D, to purchase shares, which lowers E.
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While there may be multiple reasons for management to pusue issuing debt to buy back securities, I believe the main reason that is highlighted in our text is that this is a defense mechanism for a targeted firm of a buyout. (As KYH states). If a hostile investor/firm is trying to build up a controlling interest through purchasing outstanding stock, the management can regain control buy issueing debt and purchasing up more outstanding stock.
There are many benefits to increasing debt and buying back shares if you are moving towards the optimize capital structure allocations, but this specific question pertains to “Managerial Flexibility”. And management cannot be very flexible when there is an investor like Carl Ichan trying to take a controlling interest to remove the CEO and board of directors, Kinda like Chesapeake Energy at the moment.