Cash Dividends and Share Repurchases

Under the assumption of “all else being equal”, i.e. the information content and taxation for a share repurchase and cash dividend are the same, a share repurchase is considered to be equivalent to a cash dividend payment of the same amount with respect to the effect of the share repurchase on shareholders’ wealth.

In this regard, a company is not able to impact shareholders’ wealth regardless of the method it uses to distribute profit to its shareholders.

Equivalence of Cash Dividends and Share Repurchases

All else being equal, if a company pays cash dividends, then each shareholder’s wealth would consist of the dividend received and the market value of the shares owned. This would be equivalent to the market value of the shares owned by each shareholder if the company had distributed profits by a share repurchase instead.

An example will help to explain this concept of equivalence.

Example

Company XYZ has 20 million outstanding shares with a current market value of $8 per share. The company wishes to distribute $40 million of profit to shareholders either by (i) paying a special cash dividend or (ii) repurchasing shares of this amount. All else being equal, and assuming that the company can buy shares ex-dividend at the market price, demonstrate that shareholders’ wealth will be the same regardless of the selected option.

Solution

Cash Dividend method

If the company pays a total cash dividend of $40 million, then each shareholder will get $40 million/20 million = $2 per share.

Since the shares have gone ex-dividend, the market value of equity after the cash dividend payment = (20,000,000 x $8) – $40,000,000 = $120,000,000. Therefore, market value per share = $120,000,000/20,000,000 = $6 per share.

Each shareholder would get $2 in cash, while each share would now be worth $6.

The total shareholders’ wealth from the ownership of one share would, therefore, be $2 + $6 = $8.

Share repurchases method

The company uses the $40 million to repurchase $40,000,000/$8 = 5,000,000 shares.

After the repurchase, there are therefore only 20,000,000 – 5,000,000 = 15,000,000 outstanding shares.

The market value of equity = (20,000,000 x $8) – $40,000,000 = $120,000,000.

Market value per share = $120,000,000/15,000,000 = $8 per share

In conclusion, shareholders’ wealth of $8 per share is, therefore, the same under either method i.e. cash dividends and share repurchases.

Question

If a company wishes to make a distribution to its shareholders and in its jurisdiction, neither dividends nor capital gains are taxed, which of the following statements is accurate?

A. Shareholder wealth would increase if the company repurchases shares

B. Shareholder wealth would remain the same whether the company repurchases shares or pays a special cash dividend

C. Shareholder wealth would increase if the company pays a special cash dividend

Solution

The correct answer is B.

Since there are no applicable taxes, all else being equal, shareholders’ wealth would be the same under either a cash dividend payment or share repurchase.

Reading 38 LOS 38f:

Explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders’ wealth, all else being equal