Page 32 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 22.k: Explain the choice between paying cash READING 22: DIVIDENDS AND SHARE REPURCHASES: ANALYSIS
dividends and repurchasing shares – 5 rationales!

1. Potential tax advantages. When the tax rate on capital gains < on tax rate on MODULE 22.2: STOCK BUYBACKS
dividend income, share repurchases have a tax advantage over cash dividends.

2. Share price support/signaling. Companies may purchase their own stock, to signal that company views its own stock as a good investment. Tactics
often used when share price is declining and confidence boost is needed!
3. Added flexibility. Unlike dividends, share repurchases are not a long-term commitment. Additionally, managers have discretion with respect to “market
timing” their repurchases.
4. Offsetting dilution from employee stock options. Repurchases offset EPS dilution that results from the exercise of employee stock options.
5. Increasing financial leverage. When funded by new debt, share repurchases increase leverage. Management can change the company’s capital
structure (and perhaps move toward the company’s optimal capital structure) by decreasing the percentage of equity.

EXAMPLE: Impact of share repurchase and cash dividend of equal amounts: Spencer Pharmaceuticals, Inc. (SPI) has 20,000,000 shares outstanding
with a current market value of $50 per share. SPI made $100 million in profits for the recent quarter, and since only 70% of these profits will be reinvested
back into the company, SPI’s Board of Directors is considering two alternatives for distributing the remaining 30% to shareholders:
• Pay a cash dividend of $30,000,000 / 20,000,000 shares = $1.50 per share.
• Repurchase $30,000,000 worth of common stock.
Suppose that dividends are received when the shares go ex-dividend, the stock can be repurchased at the market price of $50 per share, and there are no
differences in tax treatment between the two alternatives. How would the wealth of an SPI shareholder be affected by the board’s chosen method of
distribution?

Answer:
(1) Cash dividend: After the shares go ex-dividend, (2) Share repurchase: With $30,000,000, SPI could
a shareholder of a single share would have $1.50 in repurchase $30,000,000 / $50 = 600,000 shares of
cash and a share worth $50 − $1.50 = $48.50. common stock. The share price after the repurchase is
calculated as the market value of equity after the
The ex-dividend value of $48.50 can also be Total wealth from the ownership of $30,000,000 repurchase divided by the shares
calculated as the market value of equity after the outstanding after the repurchase:
distribution of the $30 million, divided by the number one share = $48.50 + $1.50 = $50.
of shares outstanding after the dividend payment.

Assuming the tax treatment of the two alternatives is the same, a share repurchase has the
same impact on shareholder wealth as a cash dividend payment of an equal amount.