Weigh up returning cash through dividends against buying back shares
The idea
With no taxes or information effects, a cash dividend and a repurchase of the same total amount leave shareholders equally well off. After a dividend the price falls by the dividend and holders keep the cash; after a repurchase at market price the price is unchanged and those who sell receive cash. In practice companies choose repurchases for flexibility (no implied commitment), to signal undervaluation, to offset dilution from employee share plans, to adjust leverage, and where capital gains are taxed more lightly. Dividends suit firms wanting to signal steady commitment. A weak argument is that a buyback creates value because it raises EPS, but the effect on EPS is not the same as value creation.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Explain the expected impact on shareholder wealth and on a company's financial ratios of cash dividends (regular, extra or liquidating), stock dividends, reverse stock splits and stock splits
- Contrast the main dividend policy theories and, for a described dividend decision by a company, explain what each theory implies for its share value
- Explain what signals a company may send by starting, raising, cutting or omitting its dividend
- Set out the ways agency costs can influence a firm's payout policy
- Set out what shapes the dividend policies companies actually adopt
- Work out and explain the effective tax rate borne by each currency unit a company earns, under double-taxation, imputation and split-rate tax regimes
- Contrast a stable dividend policy with a constant payout ratio policy and work out the dividend each would produce
- Outline how corporate payout policies have broadly changed over time
- Contrast the ways a firm can buy back shares
- Work out and contrast how a share buyback affects EPS when it is funded 1) from surplus cash and 2) with borrowed money
- Work out how buying back shares changes book value per share
- Work out and explain how well dividends are covered, measured against free cash flow and against net income
- Recognise the traits of firms whose cash dividend may prove unsustainable