The Profitability of a Firm’s Purchase of Its Own Common Stock

by Eugene Brigham



Funds are generated internally as depreciation and profits after taxes, and externally by the sale of debt and equity securities. The true growth company, by definition, has attractive internal investment opportunities; it can invest its available funds in projects that promise a relatively high internal rate of return, while just the reverse is true for the nongrowth firm. Each company must decide how to best use its internally generated funds and whether, given its investment opportunities, these funds are insufficient, just right, or excessive. Many acquisition-minded firms find that companies can frequently be bought more easily on an exchange of stock basis than for cash. The acquiring firm could issue new shares to effect the merger, but sometimes it is apparently expedient to buy out standing stock and use it for this purpose. The second reason for a firm's purchase of its own shares is simply as an investment. Thompson Ramo Wooldridge, for instance, stated that the company now has funds in excess of its operating requirements for the foreseeable future. The U.S. economy as a whole has grown rapidly in the postwar era, but not all sectors have shared in this expansion. This has caused serious investment problems for some of the firms operating in the more or less stagnant industries where demand is increasing too slowly to permit all available internal funds to be invested profitably.

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