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.
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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.
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SMART VIDEO
Source: Cengage Learning
Source: Cengage Learning