Real World Considerations in a Repurchase

The example we have just described shows that a repurchase and a cash dividend are the same thing in a world without taxes and transaction costs. In the real world, there are some accounting differences between a share repurchase and a cash dividend, but the most important difference is in the tax treatment.

Under current tax law, a repurchase has a significant tax advantage over a cash dividend. A dividend is fully taxed as ordinary income, and a shareholder has no choice about whether or not to receive the dividend. In a repurchase, a shareholder pays taxes only if (1) the shareholder actually chooses to sell and (2) the shareholder has a capital gain on the sale.

For example, a dividend of $1 per share is taxed at ordinary rates. Investors in the 28 percent tax bracket who own 100 shares of the security pay as much as $100 X .28 = $28 in taxes. Selling shareholders would pay far lower taxes if $100 worth of stock were repurchased. This is because taxes are paid only on the profit from a sale. Thus, the gain on a sale would be only $40 if shares sold at $100 were originally purchased at $60. The capital gains tax would be .28 X $40 = $11.20.

If this example strikes you as being too good to be true, you are quite likely right. The IRS does not allow a repurchase solely for the purpose of avoiding taxes. There must be some other business-related reason for repurchasing. Probably the most common reason is that "the stock is a good investment." The second most common is that "investing in the stock is a good use for the money" or that "the stock is undervalued," and so on.

However it is justified, some corporations have engaged in massive repurchases in recent years. For example, in the first six months of 2000, Coca-Cola repurchased 2.4 million shares, spending $117 million. Since it began buying back shares in 1984, Coke has repurchased more than a billion shares, or about a third of the shares outstanding in 1984. IBM is also well-known for its aggressive repurchasing policies. Between 1995 and 2000, IBM spent $40 billion to buy up 500 million shares. Because of the tax treatment, a repurchase is a very sensible alternative to an extra dividend, and executing a repurchase every once in a while provides a useful means of stabilizing cash dividends.

One thing to note is that not all announced stock repurchase plans are completed. It is difficult to get accurate information on how much is actually repurchased, but it has been estimated that only about one-third of all share repurchases are ever completed. In fact, according to one recent study of buyback programs announced between 1985 and 1991, 38 percent of the announcing firms didn't buy back any shares at all over the following five years, while two-thirds failed to buy back all of the shares authorized.

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