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Chapter14: Dividends and dividend policy

14.4 Share repurchase: an alternative to cash dividends

When a firm wants to pay cash to its shareholders, it normally pays a cash dividend. Another way of paying cash to shareholders is to repurchaseA firm's purchase of its own shares. Also, share buyback. its own shares. Share repurchasing has been a new financial activity in recent years, and it appears that it will continue into the future.

CASH DIVIDENDS VERSUS REPURCHASE

Consider an all-equity company with excess cash of $300 000. The firm pays no dividends, and its net income for the year just ended is $49 000. The market value balance sheet at the end of the year is represented below.

   

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There are 100 000 shares outstanding. The total market value of the equity is $1 million, so the shares sell for $10 each. Earnings per share, EPS, are $49 000/100 000 = $0.49, and the price earnings ratio, PE, is $10/0.49 = 20.4.

   One option the company is considering is a $300 000/100 000 = $3 per share extra cash dividend. Alternatively, the company is thinking of using the money to repurchase $300 000/10 = 30 000 shares.

   If commissions, taxes, and other imperfections are ignored in our example, the shareholders should not care which option is chosen. Does this seem surprising? It should not, really. What is happening here is that the firm is paying out $300 000 in cash. The new balance sheet is represented here:

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If the cash is paid out as a dividend, there are still 100 000 shares outstanding, so each is worth $7.

   The fact that the per-share value fell from $10 to $7 is not a cause for concern. Consider a shareholder who owns 100 shares. At $10 per share before the dividend, the total value is $1000.

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   After the $3 dividend, this same shareholder has 100 shares worth $7 each, for a total of $700, plus 100 × 3 = $300 in cash, for a combined total of $1000. This just illustrates what we saw early on: a cash dividend does not affect a shareholder's wealth if there are no imperfections. In this case, the share price simply fell by $3 when the share went ex dividend.

   Also, since total earnings and the number of shares outstanding have not changed, EPS is still 49 cents. The price earnings ratio, however, falls to $7/0.49 = 14.3. Why we are looking at accounting earnings and PE ratios will become apparent just below.

   Alternatively, if the company repurchases 30 000 shares, there will be 70 000 left outstanding. The balance sheet looks the same.

   

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The company is worth $700 000 again, so each remaining share is worth $700 000/70 000 = $10. Our shareholder with 100 shares is obviously unaffected. For example, if they were so inclined, they could sell thirty shares and end up with $300 in cash and $700 in shares, just as they would if the firm paid the cash dividend.

   In this second case, EPS goes up, because total earnings stay the same while the number of shares goes down. The new EPS will be $49 000/70 000 = $0.70 per share. However, the important thing to notice is that the PE ratio is $10/0.70 = 14.3, just as it was following the dividend.

   This example illustrates the important point that, if there are no imperfections, a cash dividend and a share repurchase are essentially the same thing. This is just another illustration of dividend policy irrelevance when there are no taxes or other imperfections.

REAL-WORLD CONSIDERATIONS IN A REPURCHASE

The example we have just described shows that a repurchase and a cash dividend are the same thing in a world without taxes and transaction costs. In the real world there are some accounting differences between a share repurchase and a cash dividend, but the most important difference is in the tax treatment.

   Under current tax law, a repurchase (or buyback, as it is also called) has a significant tax effect that must be considered by the shareholder over a cash dividend. A dividend in a dividend imputation system can be tax free, depending on the shareholder's marginal tax rate, but the shareholder has no choice about whether or not to receive the dividend. In a repurchase, a shareholder pays taxes only if (1) the shareholder actually chooses to sell and (2) the company has structured the buyback to be tax effective for the shareholder. It is common today that part of the buyback will be treated as dividends with franking credits attached and part will be treated as capital gain on the sale.

   However it is justified, some corporations have engaged in large repurchases in recent years, but this was prior to the global financial crisis (GFC). After the events of 2008, many companies have decided to build equity rather than buy it back. However, in February 2010 Woolworths Ltd announced a $400 million share buyback after increasing first-half profit by 11%. Early in 2008 both Boral and Coca-Cola Amatil announced share buybacks. Boral announced a $100 million share buyback: shares would be bought off-market, the off-market price being at a 14% discount to the current market price. In January 2008, Coca-Cola Amatil announced plans to repurchase $170 million worth of its ordinary shares as part of its capital management program. One cautionary note is in order concerning share repurchases, or buybacks. A company announcing plans to buy back some of its shares has no legal obligation to actually do it. As the accompanying Reality Bytes box indicates, share buybacks are big business, and they seem to be growing again after the GFC.

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SHARE BUYBACKS: NO END IN SIGHT

Share repurchases have continued to grow in recent years, but the recession that began in 2008 affected share repurchases. During 2008, Australian companies announced $270 million in share buybacks, which is 97% lower than the $10.9 billion announced in 2007. However share repurchases have again started to gather momentum in Australia.

   A notable feature of Australian share buybacks, compared with those in other countries like the United States, is the way Australian firms structure the buyback offering. Many share buybacks have, with the approval of the Australian Taxation Office, had part of the offer price deemed as a franked dividend. For this reason the capital component is lower than an equivalent on-market sale, which may lead to substantial tax advantages for shareholders. For example, in February 2008 Coca-Cola Amatil Ltd announced a structured share buyback. Coca-Cola Amatil offered to buy back shares at $7.84, with $5.17 of the $7.84 being treated as a fully franked dividend. In February Coca-Cola Amatil shares were trading at around $8.80. Although Coca-Cola Amatil was offering to repurchase the shares below the then current market price of $8.80, the buyback was attractive to many shareholders because of the large franked dividend component. If shareholders sold their shares on-market, the sale price would be $8.80, which could also result in a large capital gain being realised. If the same shareholders took advantage of the buyback, the sale price would be $2.67 (7.84 − 5.17). This would reduce or even eliminate any capital gain and, in addition, the shareholders would also receive a large fully franked dividend. Other companies have made similar arrangements, for example Boral's 2008 share buyback price was $5.65, with $2.81 being treated as a fully franked dividend.

   Share buybacks are used by firms in many countries. For example: in the United States, Microsoft announced a $40 billion share buyback in September 2008; in August 2009, industrial robot maker Fanuc Ltd announced a share buyback of up to 5% of its shares; in April 2010, the French lingerie group Etam announced a share buyback of 26.5% of its shares; and in March 2010 PepsiCo Inc., the world's biggest maker of snack food, said it plans to buy back as much as $15 billion shares over three years. In April 2010, Millicom International Cellular SA, a leading international operator of mobile telephony services in 13 countries in Latin America and Africa, announced a $300 million share buyback.

   The total benefits of share buybacks are hard to pin down. One thing is clear, however: investors and companies both seem to like share repurchases, and their widespread use is probably going to continue.

   
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SHARE REPURCHASE AND EPS

You may read in the popular financial press that a share repurchase is beneficial because earnings per share increase. As we have seen, this will happen. The reason is simply that a share repurchase reduces the number of outstanding shares, but it has no effect on total earnings. As a result, EPS rises.

   However, the financial press may place undue emphasis on EPS figures in a repurchase agreement. In our example above, we saw that the value of the share was not affected by the EPS change. In fact, the price earnings ratio was exactly the same when we compared a cash dividend with a repurchase.

   Since the increase in earnings per share is exactly tracked by the increase in the price per share, there is no net effect. Put another way, the increase in EPS is just an accounting adjustment that reflects (correctly) the change in the number of shares outstanding.

   

CONCEPT QUESTIONS

14.4a  

Why might a share repurchase make more sense than an extra cash dividend?

14.4b  

Why do not all firms use share repurchases instead of cash dividends?

     
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