Reading: The Pro’s and Con’s of Dividends and Repurchases
Advantages
of Repurchases
•The
advantages of repurchases can be listed as follows.
1. Repurchase announcements are viewed as positive signals by investors because the repurchase is often motivated by management’s belief that the firm’s shares are undervalued.
2. Stockholders have a choice when the firm distributes cash by repurchasing stock— they can sell or not sell. Those stockholders who need cash can sell back some of their shares while others can simply retain their stock. With a cash dividend, on the other hand, stockholders must accept a dividend payment.
3. Dividends are “sticky” in the short run because management is usually reluctant to raise the dividend if the increase cannot be maintained in the future, and cutting cash dividends is always avoided because of the negative signal it gives. Hence, if the excess cash flow is thought to be only temporary, management may prefer making the distribution in the form of a stock repurchase to declaring an increased cash dividend that cannot be maintained.
1. Repurchase announcements are viewed as positive signals by investors because the repurchase is often motivated by management’s belief that the firm’s shares are undervalued.
2. Stockholders have a choice when the firm distributes cash by repurchasing stock— they can sell or not sell. Those stockholders who need cash can sell back some of their shares while others can simply retain their stock. With a cash dividend, on the other hand, stockholders must accept a dividend payment.
3. Dividends are “sticky” in the short run because management is usually reluctant to raise the dividend if the increase cannot be maintained in the future, and cutting cash dividends is always avoided because of the negative signal it gives. Hence, if the excess cash flow is thought to be only temporary, management may prefer making the distribution in the form of a stock repurchase to declaring an increased cash dividend that cannot be maintained.
•4.
Companies can use the residual model to set a target cash distribution level
and then divide the distribution into a dividend component and a repurchase
component. The dividend payout ratio will be relatively low, but the dividend
itself will be relatively secure, and it will grow as a result of the declining
number of shares outstanding. The company has more flexibility in adjusting the
total distribution than it would if the entire distribution were in the form of
cash dividends, because repurchases can be varied from year to year without
giving off adverse signals.
5. Repurchases can be used to produce large-scale changes in capital structures. For example, several years ago Consolidated Edison decided to borrow $400 million and use the funds to repurchase some of its common stock. Thus, Con Ed was able to quickly change its capital structure.
6. Companies that use stock options as an important component of employee compensation usually repurchase shares in the secondary market and then use those shares when employees exercise their options. This technique allows companies to avoid issuing new shares and thus diluting earnings.
5. Repurchases can be used to produce large-scale changes in capital structures. For example, several years ago Consolidated Edison decided to borrow $400 million and use the funds to repurchase some of its common stock. Thus, Con Ed was able to quickly change its capital structure.
6. Companies that use stock options as an important component of employee compensation usually repurchase shares in the secondary market and then use those shares when employees exercise their options. This technique allows companies to avoid issuing new shares and thus diluting earnings.
Repurchase
Disadvantages
•Repurchases
have three principal disadvantages.
1. Stockholders may not be indifferent between dividends and capital gains, and the price of the stock might benefit more from cash dividends than from repurchases. Cash dividends are generally dependable, but repurchases are not.
2. The selling stockholders may not be fully aware of all the implications of a repurchase, or they may not have all the pertinent information about the corporation’s present and future activities. However, in order to avoid potential stockholder suits, firms generally announce repurchase programs before embarking on them.
3. The corporation may pay too much for the repurchased stock—to the disadvantage of remaining stockholders. If the firm seeks to acquire a relatively large amount of its stock, then the price may be bid above its equilibrium level and then fall after the firm ceases its repurchase operations.
1. Stockholders may not be indifferent between dividends and capital gains, and the price of the stock might benefit more from cash dividends than from repurchases. Cash dividends are generally dependable, but repurchases are not.
2. The selling stockholders may not be fully aware of all the implications of a repurchase, or they may not have all the pertinent information about the corporation’s present and future activities. However, in order to avoid potential stockholder suits, firms generally announce repurchase programs before embarking on them.
3. The corporation may pay too much for the repurchased stock—to the disadvantage of remaining stockholders. If the firm seeks to acquire a relatively large amount of its stock, then the price may be bid above its equilibrium level and then fall after the firm ceases its repurchase operations.
Dividends
vs Repurchases
•When
all the pros and cons on stock repurchases versus dividends have been totaled,
where do we stand? Our conclusions may be summarized as follows.
1. Because of the deferred tax on capital gains, repurchases have a tax advantage over dividends as a way to distribute income to stockholders. This advantage is reinforced by the fact that repurchases provide cash to stockholders who want cash while allowing those who do not need current cash to delay its receipt. On the other hand, dividends are more dependable and thus are better suited for those who need a steady source of income.
2. The danger of signaling effects requires that a company not have volatile dividend payments, which would lower investors’ confidence in the company and adversely affect its cost of equity and its stock price. However, cash flows vary over time, as do investment opportunities, so the “proper” dividend in the residual model sense varies. To get around this problem, a company can set its dividend low enough to keep dividend payments from constraining operations and then use repurchases on a more or less regular basis to distribute excess cash. Such a procedure will provide regular, dependable dividends plus additional cash flow to those stockholders who want it.
3. Repurchases are also useful when a firm wants to make a large shift in its capital structure, wants to distribute cash from a one-time event such as the sale of a division, or wants to obtain shares for use in an employee stock option plan.
1. Because of the deferred tax on capital gains, repurchases have a tax advantage over dividends as a way to distribute income to stockholders. This advantage is reinforced by the fact that repurchases provide cash to stockholders who want cash while allowing those who do not need current cash to delay its receipt. On the other hand, dividends are more dependable and thus are better suited for those who need a steady source of income.
2. The danger of signaling effects requires that a company not have volatile dividend payments, which would lower investors’ confidence in the company and adversely affect its cost of equity and its stock price. However, cash flows vary over time, as do investment opportunities, so the “proper” dividend in the residual model sense varies. To get around this problem, a company can set its dividend low enough to keep dividend payments from constraining operations and then use repurchases on a more or less regular basis to distribute excess cash. Such a procedure will provide regular, dependable dividends plus additional cash flow to those stockholders who want it.
3. Repurchases are also useful when a firm wants to make a large shift in its capital structure, wants to distribute cash from a one-time event such as the sale of a division, or wants to obtain shares for use in an employee stock option plan.
Last modified: Tuesday, August 14, 2018, 8:54 AM