ACCA Advanced Financial Management (AFM) Practice Exam

Under what condition might firms choose to repurchase stock?

1. When they wish to issue more equity

2. When they have excess cash

3. When they wish to conduct a merger

4. When they are reducing debt levels

The correct answer is: When they have excess cash

Firms often choose to repurchase stock primarily when they have excess cash available. This situation arises when a company generates more cash flow than it needs for operational purposes, capital expenditures, or to maintain an adequate cash reserve for unforeseen circumstances. Instead of letting this excess cash sit idle or investing it in projects that may yield lower returns, a firm might decide to repurchase its shares. The decision to repurchase shares can signal to the market that the management believes the stock is undervalued, thus suggesting confidence in the company's future prospects. It can also improve financial ratios, such as earnings per share (EPS), since repurchasing reduces the number of shares outstanding. Additionally, returning cash to shareholders through buybacks can be more tax-efficient than paying dividends, making it an attractive option. In contrast, the other scenarios mentioned usually do not align with the rationale behind stock repurchases. Issuing more equity or conducting a merger typically requires a firm to raise cash rather than return it to shareholders, while reducing debt levels generally involves reallocating cash towards repayment obligations rather than investing in repurchases.