Chapter 16 Payout Policy 417
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But the price per share depends on whether the surplus cash is paid out as a dividend or by
repurchases. If a dividend of $1 per share is paid, one million shares are still outstanding,
and stock price is $10. Shareholders’ wealth, including the cash dividends, is $10 + 1 = $11
per share.
Suppose Rational pays no cash dividend, but repurchases shares instead. It spends $1 mil-
lion to repurchase 90,909 shares at $11 each, leaving 909,091 shares outstanding. Stock price
remains at $11 ($10 million divided by 909,091 shares).^14 Shareholders’ wealth is $11 per
share. It doesn’t matter whether a particular shareholder decides to sell shares back to the
firm. If she sells, she gets $11 per share in cash. If she doesn’t want to sell, she retains shares
worth $11 each.
Thus shareholder wealth is the same with dividends as with repurchases. If Rational pays a
cash dividend, wealth is $10 + 1 = $11, including the dividend. If Rational repurchases, there
is no dividend but each share is worth $11.
You may hear a claim that share repurchases should increase the stock price. That’s not
quite right, as our example illustrates. A repurchase does not increase the stock price, but it
avoids the fall in stock price that would occur on the ex-dividend day if the amount spent on
repurchases were paid out as cash dividends. Repurchases do not guarantee a higher stock
price, but only a stock price higher than if a dividend were paid instead. Repurchases also
reduce the number of shares outstanding, so future earnings per share are higher than if the
same amount were paid out as dividends.
If MM and the middle-of-the-roaders are correct and payout policy does not affect value,
then the choice between dividends and repurchases is merely tactical. A company will decide
to repurchase if it wants to retain the flexibility to cut back payout if valuable investment
opportunities arise. Another company may decide to pay dividends to assure stockholders
that it will run a tight ship, paying out free cash flow to limit the temptation for careless
spending.
(^14) The original market price of $11 per share is the only price at which repurchase works. Shareholders will not sell their shares for less
than $11, because then $1 million would purchase more than 90,909 shares, leaving less than 909,091 shares outstanding and a price
above $11 when the repurchase is completed. The firm should not offer more than $11, because that would repurchase fewer than
90,909 shares and hand a “free gift” to selling stockholders.
Rational Demiconductor Balance Sheet (Market Values, $ millions)
Surplus cash $ 1.0 $ 0 Debt
Fixed assets and
net working capital
10.0 11.0 Equity market capitalization
(1 million shares at $11 per share)
$11.0 $11.0
Rational Demiconductor Balance Sheet (Market Values after Payout, $ millions)
Surplus cash $ 0 $ 0 Debt
Fixed assets and
net working capital
10.0 10.0 Equity market capitalization
$10.0 $10.0
For simplicity we assume it has no debt. All of its fixed assets are paid for. We assume that its
working capital includes enough cash to support its operations, so the $1 million cash entered
at the top left of its balance sheet is surplus.
Rational’s market capitalization is $11 million, so each of its one million shares is worth
$11. If it now pays out the surplus cash, market capitalization must fall to $10 million: