Stock Repurchases 533
or signaling effects. But what happens when the end of the year arrives? The stock
pricehasgrownto$115.50,justasforthecashdividendpolicy.Butunlikethecaseof
cash dividends in which the stock price falls by the amount of the dividend, the price
per share doesn’t change when a company repurchases stock, as shown earlier in
thissection(seeFigure14-2).Thismeansthatthetotalrateofreturnforashareholder
undertherepurchasepolicyis10percent,withazerodividendyieldanda10percent
capitalgain.
Year 1 earnings will be $400(1.05) $420 million, and the total amount of cash
used to repurchase stock is 0.50($420 million) $210 million. Using Equation 14-3,
we can solve for the number of shares remaining, n, after the repurchase at Year 1:
P(n 0 n) Cash purchase
$115.5(40 n) $210 million
n [$115.5(40) $210]/$115.5 38.182 million.
The total market value of equity at Year 1, S 1 , is the price per share multiplied by the
number of shares,
S 1 $115.5(38.182 million) $4,410 million,
which is identical to the market value of equity if the firm pays dividends instead of
repurchasing stock.
This example illustrates three key results: (1) Ignoring possible tax effects and sig-
nals, the total market value of equity will be the same whether a firm pays dividends or
repurchases stock. (2) The repurchase itself does not change the stock price, although
it does reduce the number of outstanding shares. (3) The stock price for a company
that repurchases its stock will climb faster than if it pays a dividend, but the total re-
turn to the shareholders will be the same.
Advantages of Repurchases
The advantages of repurchases are as follows:
- Repurchase announcements are viewed as positive signals by investors because
the repurchase is often motivated by management’s belief that the firm’s shares are
undervalued.
- The stockholders have a choice when the firm distributes cash by repurchasing
stock—they can sell or not sell. With a cash dividend, on the other hand, stock-
holders must accept a dividend payment and pay the tax. Thus, those stockholders
who need cash can sell back some of their shares, while those who do not want
additional cash can simply retain their stock. From a tax standpoint, a repurchase
permits both types of stockholders to get what they want.
- Dividends are “sticky” in the short run because managements are reluctant to raise
the dividend if the increase cannot be maintained in the future—managements dis-
like cutting cash dividends because of the negative signal a cut gives. Hence, if the
excess cash flow is thought to be only temporary, management may prefer to make
the distribution in the form of a share repurchase rather than to declare an in-
creased cash dividend that cannot be maintained.
- Companies can use the residual model to set atarget cas hdistributionlevel, then
divide the distribution into adividend componentand arepurchase component.The
dividend payout ratio will be relatively low, but the dividend itself will be
relatively secure, and it will grow as a result of the declining number of shares
outstanding. The company has more flexibility in adjusting the total distribution
than it would if the entire distribution were in the form of cash dividends,
Distributions to Shareholders: Dividends and Repurchases 529
