## Three Tests for Determining Maximum Buy-back
Before executing a buy-back, a company must satisfy three independent tests. The actual buy-back cannot exceed the smallest limit produced by these three tests.
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### Test 1: Shares Outstanding Test
> Buy-back in any financial year ≤ 25% of total paid-up equity capital (by number of shares)
$$\text{Max shares} = 25\% \times \text{Total equity shares outstanding}$$
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### Test 2: Resource Test (Financial Resources Test)
> Total buy-back amount ≤ 25% of (Paid-up capital + Free reserves)
$$\text{Max shares} = \frac{25\% \times (\text{Paid-up capital} + \text{Free reserves})}{\text{Buy-back price per share}}$$
Free reserves include: General Reserve, Securities Premium, P&L credit balance.
Exclude: Capital Redemption Reserve, Capital Reserve (non-distributable).
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### Test 3: Debt-Equity Ratio Test
> Post-buy-back: Total Debt ≤ 2 × (Paid-up capital + Free reserves)
This is the most complex test because buying back shares reduces equity through two channels simultaneously:
- ESC reduces by face value (F) × shares
- Free reserves reduce by: premium on buy-back (P − F) × shares plus CRR transfer = F × shares
- Net equity reduction per share = F + (P − F) + F = P + F
#### Algebraic Setup
Let:
- $x$ = Amount to be transferred to CRR (= F × n)
- $y$ = Total buy-back amount (= P × n)
- Relationship: $x = \dfrac{F}{P} \cdot y$ (e.g., if F = ₹10, P = ₹30 → $3x = y$)
Post-buy-back equity = Present equity − x − y
Minimum required equity = Total Debt ÷ 2
Constraint: Present equity − x − y ≥ Min equity
Substitute $x = (F/P) \cdot y$:
$$y \leq (\text{Present equity} - \text{Min equity}) \times \frac{P}{P + F}$$
#### Shortcut Formula
$$\text{Equity headroom} = \text{Present equity} - \text{Min equity}$$
$$\text{Max BB amount} = \text{Headroom} \times \frac{P}{P + F}$$
$$\text{Amount to CRR} = \text{Headroom} \times \frac{F}{P + F}$$
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### Putting It Together
> Maximum permissible buy-back = min(Test 1 shares, Test 2 shares, Test 3 shares)
### Sequence When Buy-back Follows Preference Redemption
When preference shares are redeemed in the same period, recalculate free reserves after redemption before applying the three tests to the equity buy-back. The revised free reserves (reduced by CRR created for preference redemption) form the base for all three equity buy-back tests.