Repurchase of Stock Define as stock buy back. Firm use excess cash to repurchase shares of its own stock. By repurchasing stock firm reduce its numbers of outstanding shares.
Firm wants to purchase their own stock can be done in one of three ways : a) Open market purchase- firm does not reveal itself as buyer thus seller does not know that the shares were sold back to the firm or just to another investor. b) Tender offer – offer to existing stockholder to buy up to a certain number of shares at a fixed price. C) Targeted repurchase - target to specific stockholder. In some rare cases, a single large stockholder can be bought at a lower price than that in tender offer. Furthermore shares of large stockholders are often repurchased in order to avoid being take over.
Dividend versus Repurchase : conceptual example for Telephone industries For Entire FirmPer Share Extra Dividend(100,000 shares outstanding) Proposed dividend$300,000$3.00 Forecast annual earnings after dividend (expected dividend) $450,000$4.50 Market value of stock after dividend $2,700,000.00$27.00 Repurchase(90,000 shares outstanding) Forecast annual earning after repurchase $450,000$5.00 Market value of stock after repurchase $2,700,000$30.00
Dividend versus repurchase: Real World consideration: 5 common reason why do some firms choose repurchase over dividends: 1. Flexibility- Firm with permanent cash increase will issue dividends. Firm with temporary cash increase will go for repurchase. 2. Executive Compensation – existing stock options have greater value when firm repurchases. Stock price higher after repurchase, If receive dividend, the prices stays. If repurchase, price will increase. 3. Offset dilution – Buy back shares avoid dilution therefore reduced nos of shareholders and increase price 4. undervaluation- companies believe that repurchase is the best investment especially price depressed. Stock price after buy back is better than comparable companies that do not purchase. 5. Taxes- repurchase has a tax advantage over dividends payout.
Personal Taxes and Dividend. The effect of taxes on both dividend and repurchases: Firms without sufficient cash to pay dividend. When a company wishes to raise capital – owner contribute cash and hence issue stock to himself. Figure 18.6 below firm issues stock to pay dividend and we assume no tax and with tax,
No Taxes A Personal Tax Rate of 15% Firm Firm Cash from issue of stock ($100) Dividend ($100) Cash from issue of stock ($100) Dividend ($100) Entrepreneur Entrepreneur In the no-tax case, the entrepreneur receives the $100 in dividends that he gave to the firm when purchasing stock. The entire operation is called a wash; in other words, it has no economic effect. With taxes, the entrepreneur still receives $100 dividends. However, he must pay $15 in taxes to the IRS. The entrepreneur loses and the IRS wins when a firm issues stock to pay a dividend. ($85) ($15) IRS
-Thus, in general financial economist agree that in a world of personal taxes, firm should not issue stock to pay dividend. - In the real world it is advisable not to finance dividend through new stock issues. -However, in particular stockholders appear to prefer dividend stability. - As for managers issue stock to indicate the stability/performance of the company/firm, knowing well verse of the tax consequences.
Firms with sufficient cash to pay dividend. Firms normally consider the following alternative to payout dividend: I.Select additional capital budgeting projects. II.Acquire other companies. III.Purchase financial asset. IV.Repurchase shares.
Summary of Personal Taxes. Firms reduce dividends due to personal taxes. They would rather increase capital expenditures, acquire other companies or purchase financial asset. The present trend of repurchasing shares instead giving out dividends amongst are due to the tax saving and also the benefits that can be gained from repurchases