CF 13-3A – Dividends vs Share Repurchases – Corporate Finance

Let's take a look at problem 13-3a. We just did 13-2a. If you've just come from 13-2, and I hope you have, you've seen that dividends and share repurchases are very similar things for companies, but there might be tax reasons or other reasons to choose one over the other. Here we look at a few more differences and similarities between dividends and share repurchases. Let's jump into it. Smith Company has $40,000 in excess cash and is debating between a cash dividend and a share repurchase. They're choosing between the two. The company has 20,000 shares outstanding and its stock price is $32. I wanted to set up a before and after here. Before the dividend or share repurchase, we had 20,000 shares outstanding. The stock price is $32. 20,000 times 32, I think that's 640, but let's just, whoa, right-clicked. An errant right-click got in my way there. 20,000 times 32 is indeed $640,000, but anyway, we'll get to that later. It has 75 cents in earnings per share. It says, ignore the effect of taxes and other real-world irregularities in your analysis. Compare the two options, dividend or share repurchase, in terms of the effect on stock price and overall shareholder wealth. Let's see how a dividend changes the share price. We're going to pay $40,000 in dividends. We have 20,000 shares, so what does a dividend look like? It looks like every share, 20,000 shares, get a $2 dividend for a $40,000 dividend. After that, the value of our equity is $600,000. We still have 20,000 shares, but because in a vacuum, you've reduced your assets by 40 grand, your stock value is going to fall. The value of your company has fallen by $40,000, so the value of our company has gone down to 600. We still have 20,000 shares. What's our share price? $30. Okay, so that's one of our data points here. The effect of the stock price of a dividend is the dividend made the stock price go from $32 to $30, which is, of course, down by $2 per share. Let's compare that to our buyback and let's see what that looks like. Before the buyback, I have 20,000 shares outstanding, $32 a share, $640,000. Now how many shares am I going to buy back? The stock price is $32 and I have $40,000 in excess cash, so $40,000 divided by $32 means I can buy back how many shares? I can buy back 1,250 shares, so that's how many I'll buy back. The buyback will be of 1,250 shares and I'll buy them back for their price, $32 a share. I did the math. That is $40,000. Leaving me, let's see the math here, I think it's 1,8750 and the total amount of shares is 600,000 shares. Well, 600,000 divided by 1,8750, so my company value's dropped, right, because I've paid out $40,000. I have $40,000 left in my bank account. I have less assets, therefore I have less equity. The company value has dropped by $40,000, but the amount of shares has also dropped, so $600,000 is my company value divided by 1,8750, the number of shares outstanding. It's still a $32 share. In terms of the stock price with buybacks, it was 32, it is 32, oops, not 22. There is no change. In terms of stock price, dividends drop the share price by $2, buybacks leave the share price the same. That's that piece. What about overall shareholder wealth? We explored this in the previous question. You know that the shareholders are equally well off. What does that mean? With a dividend, the shareholders had a $32 stock, now they have a $30 stock, but they also have $2 cash, so they have $32 in value. With a buyback, shareholders had a $32 stock, now they either have a $32 stock because they didn't participate in the buyback, or they have $32 cash. They have either a $32 stock or $32 cash. In the dividend example, all shareholders have a $30 stock and $2 of cash. They're in the same spot, they have $32 worth of value, I suppose. In terms of shareholder wealth, they're in the exact same position. That is our answer to part A. Stock price for dividends drops, buyback stays the same. Shareholder wealth, buyback, and dividend, there's no difference. Compare the two options in terms of earnings per share and price to earnings ratio. To figure out our earnings per share, let's actually scroll up. We kind of want to know our earnings. It says we had a $0.75 before considering it, a $0.75 in earnings per share, and we had 20,000 shares. How much did we earn, $0.75 times 20,000, our earnings must have been $15,000. Okay, well now it's earnings per share. After our dividend, we have 20,000 shares, so we go, our earnings is 15,000, after dividends we have 20,000 shares, our earnings per share is 0.75, it's unaffected by a dividend. I think you'll be able to put this together, it is going to be affected by a buyback because our denominator changes, our per share, that piece of it got smaller. We have still 15,000 earnings, these types of things do not affect the day-to-day business, the profits of the company, so we just divide by 18,750, a smaller denominator, 15,000 times 18,750 equals, that is not right, 15,000, what a goof, 15,000 divided by 18,750, that was a slip-up, equals 0.8. I like when my answers are very wrong. You go, okay, I know what something's on, sometimes the answer is just slightly wrong, you don't catch it, but that was easy to catch. Yes, our earnings per share is 0.8, so your earnings per share is 5 cents higher under a buyback situation. What about the P-E ratio, the price-to-earnings ratio? Well, price divided by earnings is the math here, it's price divided by earnings per share, P-E ratio equals price divided by EPS. Well, what is our share price? After a dividend, so for dividends, our share price, we said after all this would be $30 divided by 0.75. For buybacks, it's going to be $32 divided by 0.8, and let's see what the P-E ratio is. 30 divided by 0.75 equals 40, so people are paying 40 times earnings for the pleasure of owning our share. That seems high to me, but what do I know, 32 divided by 0.8, also 40. So how does it affect earnings per share? Well, a buyback will increase the earnings per share. How does it affect P-E ratio? Doesn't affect P-E ratio. There you go. So that's part A and B. Now, the key here is part C. It says, if we consider taxes and real-world irregularities, which option do you think is better? Why? The general thinking as of this recording is that buybacks are preferred by most shareholders in most circumstances, and the reason is pretty simple. In most places, dividends are taxed in a pretty disadvantageous way, and again, these videos go out to people in various places. It might be different where you live, but in general, dividends are taxed in a way that's disadvantageous, that's negative for shareholders, and the other key thing is, dividends, everybody gets a $2 dividend. It's a taxable event that gets triggered for everybody. Buybacks, only the people that want the buyback will take the buyback, and therefore, you're not triggering a tax event. You have control of when your tax event gets triggered in the event of a buyback, so that's why buybacks tend to be in favor or in vogue these days, so buybacks would generally be thought to have preference as my answer to part C. All right, well, shareholders prefer a buyback. I don't care, buyback, dividend. I just prefer a thumbs-up, so hit me with a thumbs-up, and I'll see you in the next video. Thanks for watching.