Corporations issue common and preferred stock to raise money. But occasionally, these corporations choose to reverse the process and reduce the number of outstanding shares. Corporations may redeem, or call, shares that permit calling, and/or can purchase preferred or common shares directly from shareholders. Both methods result in fewer shares available for trading, but the effects of each procedure on shareholders are different.
Redemption of Shares
Corporations can include a call feature in stock shares. This feature allows the company to forcibly redeem outstanding shares for a set price on or after either a specified call date or a change in management structure. When a company calls a share, it immediately cancels the share and pays the shareholder the call price or replacement shares. Shareholders also receive any accrued dividends. The call feature benefits the corporation by giving it flexibility to respond to future events, but that flexibility might come at the expense of shareholders -- for example, loss of dividends. Therefore, callable shares normally fetch less when issued than similar non-callable ones do.
Purchase of Shares
Corporations can announce buyback programs at any time. The company goes into the secondary market -- stock exchanges and broker/dealers -- to buy shares at the current price. Alternatively, they might choose to issue a tender offer, which invites shareholders to sell back their shares at a preset price. In either case, the buyback is voluntary and shareholders can choose to ignore it. Since buybacks reduce the number of trading shares, they tend to raise the stock’s price. A corporation is not obligated to follow through on a buyback announcement.
Redeem or Purchase?
Corporations can repurchase callable shares. In fact, the original stock contract may require it to do so rather than redeem the shares. The situation arises when the buyback price is lower than the call price. For example, if a preferred stock with a call price of $100 is trading at $85 a share, a corporation might be able to scoop up shares well below the call price and save a bundle. If that same stock sells for $102 a share, the corporation simply calls it and saves at least $2 per share. That $2 could have been a capital gain for shareholders had they sold their shares before the call; afterwards, it’s too late.
Some corporations buy back common stock rather than paying out dividends. A dividend creates taxable income for all shareholders, but a buyback creates a capital gain only for share sellers. Corporations might argue that because fewer shareholders incur a tax liability, buybacks are more tax-efficient than dividend hikes. Corporations normally redeem preferred shares when interest rates fall and replace them with shares bearing a lower dividend payout. In this way, the corporation reduces future dividend payments, but shareholders lose the higher dividend rate and any capital gains above the call price. When interest rates fall, shareholders might be unable to find a replacement investment with the same yield as that on the called shares -- this is reinvestment risk.
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