Introduction to Corporate Finance

15: Payout Policy

15 -1d SHARE REPURCHASES

Companies can also pay out cash to shareholders by repurchasing some of their outstanding shares.

Comparing the dividend and share repurchase values in Figure 15.1, we can see that share repurchases

have grown in importance relative to dividends, and that in many recent years, aggregate repurchases

have exceeded aggregate dividends.

In addition to paying out cash to shareholders, the practical motives for share repurchases include

obtaining shares to be used in acquisitions, having shares available for employee share-option plans and

retiring shares. From a broader perspective, the rising importance of share repurchases suggests that

they may enhance shareholder value, perhaps because they have traditionally been a tax-advantaged

method of paying out cash. Although it is not clear exactly what managers are trying to achieve through

repurchases, one frequently mentioned rationale is to send a positive signal to investors in the marketplace

that management believes the shares are undervalued, thus reducing the number of shares outstanding

and raising earnings per share (EPS). Recall the discussions around capital budgeting decision criteria

from Chapter 10. In theory, if the managers of a company cannot find investment opportunities that

will produce a higher return on investment than their cost of capital, they should return this capital to

shareholders. This is another rationale for share repurchases.

A study by Weston and Siu suggested that share repurchases have grown rapidly since the early

1990s, largely to offset the dilution effects of the exercise of share options.^3 According to the study,

as the number and the value of options granted to (and exercised by) top executives have increased in

importance, companies have been buying back shares to keep the total number outstanding from rising

too sharply, thus reducing EPS.

Taxes

Today, both dividends and capital gains are taxed, but share repurchases still give investors the option

to participate or not (i.e. to sell or to retain their shares). Therefore, capital gains taxes can be deferred,

whereas taxes on cash dividends must be paid in the year the dividends are received.

Repurchase Methods

Companies can use several methods to repurchase shares. In the most common approach, an open-

market share repurchase, companies buy back their shares in the open market. In a tender offer, or

self-tender, companies offer to buy back a certain number of shares, usually at a premium above the

current market price. In a Dutch auction repurchase, companies ask investors to submit prices at

which they are willing to sell their shares. If the company wants to buy back two million shares, it

reviews the offers submitted  by shareholders and determines the lowest price at which shareholders

will tender a total of two million shares. In a Dutch auction, all investors receive the same price when

they sell back their shares, even if they expressed a willingness to sell at a lower price in their original

offer. When companies announce plans to repurchase shares, their share prices typically rise, and the

positive  reaction is much greater for tender offers and Dutch auctions than for open-market share

repurchases.

Having reviewed the basic mechanics and issues surrounding payout policy, we can now look more

closely at the factors affecting dividend and share repurchase decisions.

3 See J. Fred Weston and Juan A. Siu, ‘Changing Motives for Share Repurchases’, Finance, Paper 3 (2003), Anderson Graduate School of
Management, UCLA.

Source: Cengage Learning

Scott Lee, Texas A&M

University

‘Generally associated

with repurchase

announcements is a

fairly strong market

response.’

See the entire interview on

the CourseMate website.

COURSEMATE

SMART VIDEO

Andy Bryant, Executive

Vice President of Finance

and Enterprise Systems,

Chief Financial Officer,

Intel Corp.

‘Dividends are probably

not the most effective

way to return cash to

shareholders.’

See the entire interview on

the CourseMate website.

COURSEMATE

SMART VIDEO

Source: Cengage Learning

Source: Cengage Learning