Repurchase of Stock
• Define as stock buy back.
• Firm use excess cash to repurchase
shares of its own stock.
• By repurchasing stock firm reduce its
numbers of outstanding shares.
• Firm wants to purchase their own stock can be
done in one of three ways :
a) Open market purchase- firm does not reveal
itself as buyer thus seller does not know that the
shares were sold back to the firm or just to
another investor.
b) Tender offer – offer to existing stockholder to
buy up to a certain number of shares at a fixed
price.
C) Targeted repurchase - target to specific
stockholder. In some rare cases, a single large
stockholder can be bought at a lower price than
that in tender offer. Furthermore shares of large
stockholders are often repurchased in order to
avoid being take over.
0.25
0.2
0.15
Re pur chas e s
Divide nts
Total
0.1
0.05
20
04
20
00
19
96
19
92
19
88
19
84
0
Dividend versus Repurchase : conceptual example
for Telephone industries
For Entire Firm
Extra Dividend
Per Share
(100,000 shares
outstanding)
Proposed dividend
$300,000
$3.00
Forecast annual earnings
after dividend (expected
dividend)
$450,000
$4.50
Market value of stock after
dividend
$2,700,000.00
$27.00
Repurchase
(90,000 shares
outstanding)
Forecast annual earning
after repurchase
$450,000
$5.00
Market value of stock after
repurchase
$2,700,000
$30.00
Dividend versus repurchase: Real World consideration:
5 common reason why do some firms choose repurchase over
dividends:
1. Flexibility- Firm with permanent cash increase will issue dividends.
Firm with temporary cash increase will go for repurchase.
2. Executive Compensation – existing stock options have greater value
when firm repurchases. Stock price higher after repurchase, If
receive dividend, the prices stays. If repurchase, price will increase.
3. Offset dilution – Buy back shares avoid dilution therefore reduced nos
of shareholders and increase price
4. undervaluation- companies believe that repurchase is the best
investment especially price depressed. Stock price after buy back is
better than comparable companies that do not purchase.
5. Taxes- repurchase has a tax advantage over dividends payout.
Personal Taxes and Dividend.
The effect of taxes on both dividend and
repurchases:
Firms without sufficient cash to pay dividend.
When a company wishes to raise capital –
owner contribute cash and hence issue
stock to himself.
Figure 18.6 below firm issues stock to pay
dividend and we assume no tax and with
tax,
No Taxes
A Personal Tax Rate of 15%
Firm
Firm
Cash from
issue of stock ($100)
Dividend ($100)
Cash from issue
of stock ($100)
($85)
Dividend
($100)
($15)
IRS
Entrepreneur
Entrepreneur
In the no-tax case, the entrepreneur receives the $100 in dividends that he gave to the firm
when purchasing stock. The entire operation is called a wash; in other words, it has no
economic effect. With taxes, the entrepreneur still receives $100 dividends. However, he
must pay $15 in taxes to the IRS. The entrepreneur loses and the IRS wins when a firm
issues stock to pay a dividend.
- Thus, in general financial economist agree that
in a world of personal taxes, firm should not
issue stock to pay dividend.
- In the real world it is advisable not to finance
dividend through new stock issues.
- However, in particular stockholders appear to
prefer dividend stability.
- As for managers issue stock to indicate the
stability/performance of the company/firm,
knowing well verse of the tax consequences.
Firms with sufficient cash to pay dividend.
Firms normally consider the following alternative
to payout dividend:
I.
Select additional capital budgeting projects.
II. Acquire other companies.
III. Purchase financial asset.
IV. Repurchase shares.
Summary of Personal Taxes.
Firms reduce dividends due to personal taxes.
They would rather increase capital expenditures,
acquire other companies or purchase financial
asset.
The present trend of repurchasing shares instead
giving out dividends amongst are due to the tax
saving and also the benefits that can be gained
from repurchases