Dividends Vs Buybacks

Q: Let's start with dividends.  The company distributes $70 of that cash as a dividend to
shareholders.  What happens to its assets? What happens to its liabilities and net worth?  And
what happens to the shareholders - how much do they now have?  This exercise might seem a
bit tricky, but don’t worry too much about getting it exactly right. Instead, try to work through
your intuitions, step by step.

Q: Now let’s consider a share buyback.  The company distributes $70 of that cash by buying back
$70 worth of shares.  What happens to its assets? What happens to its liabilities and net worth?
And what happens to the shareholders - how much do they now have?  Again, this exercise is a
bit tricky. Focus on your intuitions.
After the company issues $70 in equity, it will have $70 more in cash (for a total of $170)
and $210 in equity. How much are the shares worth?  To think this through, we need to
know how many shares are outstanding after the issuance. Shares are selling at $1.40
each, so raising $70 would require the company to issue 50 shares ($70 divided by
$1.40). That leaves 150 shares outstanding to split the $210 in equity.  Shares must
therefore be selling for $1.40 per share ($210 divided by 150), just as before.

Issuing equity has not diminished the price of the company's stock - it is exactly the
same as before.  In general, this is a manifestation of the lesson that value creation
comes from the asset side of the balance sheet, not from financing. What about the
concerns about “dilution”? Well, shareholders now have a smaller percentage share but
it is of a larger pie.

We should expect no changes to the market-value balance sheet because there have

Share Split

We should expect no changes to the market-value balance sheet because there have
been no changes in operations or to financing sources. What is each share worth?
There’s still $140 worth of equity, but now it’s now split over 200 shares, so each share
is now worth $0.70 ($140 divided by 200).

Have investors lost value?  No.  Each investor used to have one share worth $1.40. Now
he or she has two shares worth $0.70, for a total of $1.40. No value has been created or
destroyed by this stock split.