Returning profits to shareholders

A look at dividend policy, stock repurchases, and signaling

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David J. Moore, Ph.D.
www.efficientminds.com

Dividends vs. Stock repurchases

! Acme Inc. has 1,000,000 shares outstanding with a current price of $100/share. The total market capitalization is $100,000,000. ! You have 1,000 shares ($100,000) of Acme Inc. ! Acme earns $8,000,000. The new market capitalization is $108,000,000 and market price per share is $108. ! Your holdings of 1,000 shares is now worth $108,000 ! Acme is trying to decide whether to distribute $8,000,000 in dividends or repurchasing $8,000,000 in stock. ! In either case, from Acmes perspective, it is an $8,000,000 cash outlay.

Shareholder perspective
! Dividend payment of $8/share
! ! ! ! You receive a check for $8 x 1,000 = $8,000 The value per-share drops back to $100. You still have 1,000 shares still worth $100,000 Total wealth in this state of the world: $108,000

! Repurchase $8,000,000/108 = 74,074 shares of stock

! Share price remains at $108 because the $100,000,000 market value is spread amongst fewer shares. ! You sell $8,000/108 = 74 shares of stock and receive a check for $8,000. ! You still have 926 x $108 = $100,000 in stock. ! Total wealth in this state of the world: $108,000

! Total wealth is the same in both cases. But wait

Shareholder perspective with taxes

! Taxable Income Clinton era taxes Tax bill (39.6% div/25% cap gains) Net income Bus era tax cuts Tax bill (15% Div/15%) Net income Obama era tax compromise Rich people (over $400k indiv/$450 Tax Bill (23.8% Div/23.8% Cap Gains) Net income Poor people Tax Bill (20% Div/20% cap gains) Net income Dividend of Check 8,000 ! 3,168 4,832 ! 1,200 6,800 ! couple) 1,904 6,096 ! 1,600 6,400 ! 118 7,882 Stock Repurchase 592 ! 148 7,852 ! 89 7,911 ! Notes 1 ! 2 !

! Taxes for the shareholder are far lower with stock repurchases. ! Neither dividends nor money spent repurchasing stock are tax deductions for the corporation.

141 7,859 !

! Given the same people who decide to repurchase are likely the to own shares, 3 they should prefer stock repurchases. ! More info here

1. $8 x 74 shares = $592 in capital gains 2. Dividends taxed as ordinary income 3. Dividends tax rate capped at 20% with a 3.8% Healthcare surcharged added to wealthy households.

Signaling
! So what message does dividend increases or stock repurchases signal to the market? ! Positive: Increases in dividends and stock repurchases indicate increased operational cash flows. ! Negative: Increases in dividends and stock purchases indicates the company has no investment opportunities. ! Dividends vs. repurchases:
! Repurchases funded via debt issuance increases leverage and may increase returns to stockholders. ! The firm is essentially swapping expensive equity financing for less expensive debt financing. ! This comes at the expense of greater default risk due to higher leverage.

What about stock dividends?

! In a stock dividend the number of shares outstanding is increased proportionally. ! If Acme Inc. announce a 10% stock dividend it would go from 1,000,000 shares @ $100/share shares to 1,100,000 shares at $90.91/share. ! This is different than a stock split because now your dividend payment just increased 10%. Instead of receiving $1/share on 1,000 shares you now receive $1/share on 1,100 shares. ! The net effect is higher dividends and you have the same problem with differential taxation when compared to stock repurchases.