Equivalence of Cash Dividends and Share Repurchases

Share repurchase announcements are followed by positive returns from the announcement date and for the next two years. This is because management tends to buy back their shares when undervalued and sell them when they are overvalued. All other things being equal, cash dividends are equivalent to share repurchases of equal amount on their effect on shareholders’ wealth.

Some of the reasons why a company may choose share repurchases are:

• Potential tax advantages: Share repurchases have a tax advantage over cash dividends in countries with higher tax rates than capital gains.
• Share price signaling that the company considers its shares a good investment: Investors often interpret the announcement of share repurchase as a positive signal about the company’s prospects and attractiveness of investing in the company.
• Added managerial flexibility: Share purchases via open market purchases allow management to time share repurchases when the market prices are favorable. Share repurchases are also flexible for shareholders because their participation is optional.
• Increasing financial leverage: Share buybacks are used to finance newly issued debt, expanding the company’s financial leverage.
• Offsetting dilution from employee stock options: Many companies will opt to repurchase as many shares as possible from employee stock options to avoid dilution.

A company is at liberty to use both share repurchases and special cash dividends as an alternative to cash dividends. This occurs when there is an extraordinarily large increase that will not continue in the future. The volume of share repurchases increases when companies have more cash and the economy is strong.

Question

A company with free cash flow considers whether it should pay cash dividends or repurchase shares at the prevailing market price.

Which one of the following is the most likely reason a company will opt to repurchase shares?

1. Share repurchases are faster to execute.
2. Share repurchases afford management and shareholders more flexibility.
3. Share repurchases reduce financial leverage.

Solution

The correct answer is B.

Share repurchases give more time to manage to wait and repurchase the shares when undervalued and sell the shares when they are overvalued.

A is incorrect. Cash dividends are faster to execute than share repurchases.

C is incorrect. Repurchase of shares increases financial leverage when the cash from the repurchase is used to fund newly issued debt.

Reading 18: Analysis of Dividends and Share Repurchases

LOS 18 (k) Explain the choice between paying cash dividends and repurchasing shares.