Stock repurchase effect with loan or idle fund

Abstract

Purpose – The purpose of this paper is to integrate Modigliani-Miller (MM) theory and stock repurchases strategy to procure a practical concept for capital decision. Design/methodology/approach – No-arbitrage proof model deduction was used in this study. The authors consider corporate tax and funding sources as two crucial factors drawn in the model. The paper derives some propositions by trichotomy property and keeps the key assumptions of MM Capital Structure Theory. Findings – There are two different effects on firm's value through stock repurchases. The positive effect occurs on firm's value through stock repurchases with loan fund. And the negative impact exists on firm's value through stock repurchases with idle fund. Research limitations/implications – Notably, in the real world there are three limitations with such an arbitrage transaction (Stulz, 2000). The first one is the default risk, and the second one is transaction costs and the last one is the perfect credit market assumption. In the near future, the authors suggest it would be interesting to involve the interest rate factor and contingent tax variable into our model. Originality/value – On the basis of no arbitrage opportunity, this paper considers both trichotomy property and MM theory. It proves the share repurchase strategy should be financed by borrowing fund. In contrast, share repurchase should not be executed with idle fund because of opportunity cost.