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Subject 6. Share Repurchases, Methods and Financial Statement Effects PDF Download
The Dividend versus Share Repurchase Decision

Under a stock repurchase plan, a firm buys back some of its outstanding stock, thereby decreasing the number of shares, which should increase both EPS and the stock price. Unlike stock dividends and stock splits, share repurchases use corporate cash. It is an alternative way of paying cash dividends.

A share repurchase should be equivalent to the payment of cash dividends of equal amount in their effect on shareholders' wealth, all other things equal (which means the taxation and information content of cash dividends and share repurchases do not differ).

There are different reasons for share repurchases:

  • Potential tax advantages. In some countries tax rate on capital gains is lower than the tax rate on cash dividends.
  • Share price support / signaling that the company considers its shares a good investment. 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. There is no question that the company has more information about itself than does any other entity, and is therefore the ultimate insider.
  • Added managerial flexibility. If the excess cash is thought to be only temporary, management may prefer to make the distribution in the form of a share repurchase rather than to declare an increased cash dividend which cannot be maintained.
  • Offsetting dilution from employee stock options. It can remove a large block of stock that is overhanging the market and keeping the price of per share down.
  • Increasing financial leverage. Repurchases can be used to produce large-scale changes in capital structures. For example, if a firm's capital structure is too heavily weighted with equity, it can sell debt and use the proceeds to buy back stocks, thus increase debt ratio.

Companies can pay regular cash dividends supplemented by share repurchases. In years of extraordinary increases in earnings, share repurchase can substitute for special cash dividends.

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