Question

Explain how cash dividends affect individual shareholders differently than an equal amount of funds spent on a repurchase. Worth 16 marks so I would like a wealth of information. Thanking you in advance

Answer 1

Both the cash dividends and buybacks increase the overall rate of return for the investors by owning shares in a company. The decision on cash dividend or share is based on several factors such as the company’s stock price, tax structure applicable to the company and its shareholders, the intention of building image by the company etc.

Dividend payment offers a definite return, whereas a buyback represents an uncertain future return. The cash dividend provides a regular flow of cash for investors. The payment of dividend allows the company to have a conservative capitalization structure.

Rather, as per ‘'bird in hand” theory, investors value the amount of dividends today more than uncertain capital gains in the future. More than that a dividend or increasing a dividend payment sends a positive signal to the investors. It is a measure of investment quality. Payment of dividends also helps to reduce the agency problem between managers and shareholders. But the dividends once received, the shareholders must also pay taxes on dividends.

Shares repurchase bring higher capital gains. But these profits will not be taxed until the shareholder sells the shares. Another benefit of a share repurchase is that it reduces the number of shares outstanding for a company and thereby increase earnings per-share and also improve return on equity.