Question

In a "perfect world" capital market, how important is a firm's decision to pay dividends versus repurchase shares? Please explain in detail and provide an example. Under what conditions would you have a tax preference for share repurchase rather than dividends? Please explain with at least two examples. Would managers acting in the interests of long-term shareholders be more likely to repurchase shares if they believed the stock to be either undervalued or overvalued? Please explain how managers would come to that decision. Please keep in mind that inadequate answers already exist on the web.

Answer 1

There is a concept of irrelevance of dividend In a perfect World because investor will not be affected by decision of the company to pay the dividend and repurchase the share because the value of the companies will only be maximized by the cash flow generation abillity.

Shareholder will also not be affected by the decision of repurchase of the shares because repurchase is done out of the reserves of the company. only cash flow generation will be leading to maximization of the value of the company so it will make no difference.

When the firm will be paying dividend it will be paying out of the profit from the company so, it will make no difference to the overall value of the company.

I will be having a tax preference for share repurchase when the rate of the taxes are lower on capital gains then rate of tax on dividend so I would be prefering share repurchase, if capital gain taxes are very lower and dividend taxation is higher.

Like if rate of taxation for capital gain is 1%, and rate of taxation for dividend is 10%, I will be preferring repurchase of the share.

Managers will be purchasing the shares when they feel that the value of the share of the company is undervalued as it will help the manager in order to maximize the overall value of the company due to acquisition of shares at a lower price.

manager would be coming to make that decision after comparing of intrinsic value of the share with the market price of the share and if intrinsic value of the share is lower than the market value of the share then the share will be undervalued,and it will be purchased by the management.