In a "perfect world" capital market, how important is a firm's decision to pay dividends versus repurchase shares? Under what conditions would you have a tax preference for share repurchase rather than dividends? Would managers acting in the interests of long-term shareholders be more likely to repurchase shares if they believed the stock to be either undervalued or overvalued?
You would have a tax preference for share repurchase rather than dividends under the following conditions:
| Condition | Tax Impact |
|---|---|
| Capital Gains Tax < Dividend Tax | Repurchases result in a capital gain only for the shareholders who sell their stock, which is typically taxed at a lower rate than dividends (which are often taxed as ordinary income or at a higher qualified dividend rate). |
| Tax Deferral | With a repurchase, the capital gain is only realized and taxed when the shareholder chooses to sell the shares. This allows investors to defer paying taxes indefinitely, which is a major advantage over cash dividends, where the tax is due in the year the dividend is received. |
| Recovery of Basis | When a shareholder sells stock in a repurchase, they only pay tax on the gain (selling price minus the original cost basis). A dividend, however, is generally taxed in its entirety (the full cash amount received). |
| Foreign Shareholders | In some jurisdictions (like the U.S.), foreign shareholders are often subject to a withholding tax on dividends but may not be taxed on capital gains from the sale of shares, strongly favoring repurchases. |
Managers acting in the interests of long-term shareholders would be more likely to repurchase shares if they believed the stock to be undervalued.
Action: Managers repurchase shares.
Rationale: The manager believes the market price is temporarily below the true intrinsic value of the company. Buying an undervalued asset is an excellent investment for all remaining long-term shareholders. Repurchasing shares in this scenario maximizes long-term shareholder wealth because it effectively locks in a superior rate of return on the firm's cash.
Signal: A repurchase sends a strong positive signal to the market that management, which possesses superior information, believes the stock is cheap.
Action: Managers would not repurchase shares.
Rationale: Buying an overvalued asset destroys shareholder value because the firm is using valuable cash to acquire something worth less. The cash would be better returned to shareholders as a dividend (so they can invest it elsewhere) or retained for new projects.
Alternative: When a stock is considered overvalued, management that needs to raise capital for projects is more likely to issue new shares to capitalize on the inflated price.
The manager's job is to deploy capital where the return is highest. If the firm's own stock is the best available investment (because it's undervalued), then a repurchase is the correct capital allocation decision.
In a "perfect world" capital market, the firm's decision to pay dividends versus repurchase shares is irrelevant to the total value of the firm and, consequently, to shareholder wealth. This is the conclusion of the Modigliani and Miller (MM) Dividend Irrelevance Theory (in a world without taxes, transaction costs, or information asymmetry).
The key concept is that shareholders can create their own preferred cash flow stream through "homemade dividends."
If the company pays a dividend: The shareholder receives cash directly.
If the company repurchases shares: The shareholder who needs cash can simply sell a portion of their shares equal to the cash they would have received from the dividend. The total value of the shareholder's investment (remaining shares plus cash from the sale) is the same as it would have been under a dividend payment.
In the perfect world, both methods are simply two different ways for the company to return excess cash to its owners, and neither method changes the fundamental value of the firm's assets or its future operating cash flows.
In the real world, the tax treatment for shareholders is the primary reason for preferring one distribution method over the other.