CP

532 CHAPTER 14 Distributions to Shareholders: Dividends and Repurchases

A Tale of Two Cash Distributions: Dividends

versus Stock Repurchases

Suppose a company’s current earnings are $400 million, it has 40 million shares of

stock, and it pays out 50 percent of its earnings as dividends. Earnings are expected to

grow at a constant rate of 5 percent, and the cost of equity is 10 percent. Its current

dividend per share is 0.50($400/40) 
$5. Using the dividend growth model, the cur-

rent stock price is:

.

As the year progresses, the stock should climb in price by 10 percent to $115.5, but

then fall by the amount of the dividend ($5.25) to $110.25 when the dividend is paid at

Year 1.^15 This process will be repeated each year, as shown in Figure 14-2. Notice that

the shareholders experience a 10 percent total return each year, with 5 percent as a

dividend yield and 5 percent as a capital gain. Also, the total expected market value of

equity after paying the dividend at the end of Year 1 is the price per share multiplied

by the number of shares:

S 1 
$110.25(40 million) 
$4,410 million.

Supposethecompanydecidestouse50percentofitsearningstorepurchasestock

eachyearinsteadofpayingdividends.Tofindthecurrentpricepershare,wediscount

the total payments to shareholders and divide that by the current number of shares.

These payments are exactly equal to the total dividend payments in the original sce-

nario, so the current price is the same for both dividend policies, ignoring any taxes

P 0 

D 1

rsg

D 0 (1g)

rsg

$5(10.05)

0.100.05

$5.25

0.05

$105

Stock Price

($)

0 12345

Year

160

140

120

100

Firm Pays

Dividends

Firm

Repurchases

Stock

FIGURE 14-2 Stock Repurchases versus Cash Dividends

(^15) This assumes no tax effects.

528 Distributions to Shareholders: Dividends and Repurchases