Question

A shareholder has two choices, to have his shares repurchased or to receive cash dividends. The shareholder holds 100 shares and each share is worth £1. The shareholder bought the shares 3 years ago for £40. Assume that investors have to pay a personal tax rate of 32% and the same tax rate applies for both dividends and capital gains. The firm pays a dividend of £1 per share. Which is a better option for the investor, to have his shares repurchased or to receive cash dividends?

Answer 1

If the investor has his shares repurchased he will get an amount of $ 100 (100 shares * $ 1)

as he had held the shares for more than a year, ie . 3 yrs. , he will have to pay capital gains tax on the gains he makes,

and his capital gains tax will be Capital gains * Tax rate %

where, capital gains=Repurchase price-Original purchase price

so, Capital gains tax =(100-40)=60*32%=

19.2

so,residual income after CGT=100-19.2=

80.8

On the other hand,

If the investor opts for dividends,

still he may have to pay personal tax on the dividend income

so, his residual income will be 100-(100*32%)=

68

The investor will pay less tax under the repurchase option

ie.$ 19.2 < $ 32

& his income will be more

so from immediate cash in-flow point of view, he will have more cash under the repurchase option , than under dividend option--because of more tax incidence----given both capital gains & ordinary tax rates are the same 32%

But, he will retain the shares , if he opts for dividend option. Also the share has appreciated ($1-($40/100))/0.4= 1.5 times in value , in 3 yrs. & fetching dividend equal to market value.So there is much scope in holding the share , than going in for immediate cash.

as under repurchase option, he will, no more have the shares --under his asset category.

Bearing all these in mind,the investor may have to choose , depending upon his necessity , at this point of time.