Loewen Case

There are aspects that have not been taken in account in the prior example.

1- In order to repurchase the company needs to use cash. From the accounting point of view cash will be reduced and "Treasury stock" will increase. Treasury stock is an equity account. In this transaction the company incurred either in a loss or in a gain, depending of the price at which the stock were sold before. This loss or gain is posted to equity account called "Paid in capital from treasury stock" and it is not recognized in the Income Statement. The EPS increases because the Net Income of the company remains the same, but the loss or gain incurred in this transaction is not taken in account for this calculation. This transaction affects the equity of the company and not the Income Statement. We need to remember that valuable dollars are spent buying back shares, so companies should be doing so only when the shares are deemed undervalued. If management is buying at bargain prices and retiring shares, it's creating good value for shareholders. If it's buying at inflated prices, that money would be better spent paying out a dividend, paying down debt, being reinvested in the business, or in a number of more profitable ways.

2- Many executives believe that since a repurchase reduces the number of outstanding shares, thus increasing EPS, it also raises a company's share price. At first glance, this argument seems to make sense: the same earnings divided by fewer shares results in a higher EPS and so a higher share price. But this belief is wrong. The reasons behind the repurchase are important too. Companies should repurchase stock when there is an excess of cash or when the stocks are undervalued in the market.

The net income of this company is 10 million while the repurchase will cost 40 million (200 000 shares x 200 dollar per share). If the company has excess of cash it is because the company has either high retained earnings from prior years or high debt.

If the company is using retained earnings from prior year's profits, this means that repurchase will not be based on this year's performance. In other words this repurchase is not based on increase of operation or on improvements of company's performance. Since the value of operations remain the same and the cash goes down the value of the company goes down. The share price will remain the same; however, as the total