Choosing between Dividends and Equity Repurchases

Firms that plan to return cash to their stockholders can either pay them dividends or buy back stock. How do they choose? The choice will depend upon the following factors:

• Sustainability and Stability of Excess Cash Flow: Both equity repurchases and increased dividends are triggered by a firm's excess cash flows. If the excess cash flows are temporary or unstable, firms should repurchase stock; if they are stable and predictable, paying dividends provides a stronger signal of future project quality.

• Stockholder Tax Preferences: If stockholders are taxed at much higher rates on dividends than capital gains, they will be better off if the firm repurchases stock. If, on the other hand, stockholders prefer dividends, they will gain if the firm pays a special dividend.

• Predictability of Future Investment Needs: Firms that are uncertain about the magnitude of future investment opportunities should use equity repurchases as a way of returning cash to stockholders. The flexibility that is gained will be useful, if they need cash flows in a future period to accept an attractive new investment.

• Undervaluation of the Stock: For two reasons, an equity repurchase makes even more sense when managers believe their stock to be undervalued. First, if the stock remains undervalued, the remaining stockholders will benefit if managers buy back stock at less than true value. The difference between the true value and the market price paid on the buyback will be accrue to those stockholders who do not sell their stock back. Second, the stock buyback may send a signal to financial markets that the stock is undervalued, and the market may react accordingly, by pushing up the price.

• Management Compensation: Managers often receive options on the stock of the companies that they manage. The prevalence and magnitude of such option-based compensation can affect whether firms use dividends or buy back stock. The payment of dividends reduces stock prices, while leaving the number of shares unchanged. The buying back of stock reduces the number of shares, and the share price usually increases on the buyback. Since options become less valuable as the stock price decreases, and more valuable as the stock price increases, managers with significant option positions may be more likely to buy back stock than pay dividends.

Bartov, Krinsky and Lee examined three of these determinants - undervaluation, management compensation and institutional investor holdings (as a proxy for stockholder tax preferences) - of whether firms buy back stock or pay dividends.4 They looked at 150 firms announcing stock buyback programs between 1986 and 1992 and compared these firms to other firms in their industries that chose to increase dividends instead. Table 11.3 reports on the characteristics of the two groups.

Table 11.3: Characteristics of Firms Buying Back Stock versus those Increasing

Dividends

Dividends

Table 11.3: Characteristics of Firms Buying Back Stock versus those Increasing

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