Rationales for Share Repurchases

Potential tax advantages

When the tax rate on capital gains is lower than the tax rate on dividend income, share repurchases have a clear tax advantage over cash dividends.

Share price support/signaling

Companies may purchase their own stock, thereby signaling to the market that the company views its own stock as undervalued. Signaling is important in the presence of asymmetric information (where company insiders have access to better information about the company’s prospects than external investors). Management can send a signal to investors that the future outlook for the company is good. This tactic is often used when a share price is declining and management wants to signal that they are confident in the company’s future.

Add flexibility

A company can declare a regular cash dividend and periodically repurchase shares as a supplement to the dividend. Unlike dividends, share repurchases are not considered a long-term commitment. Since paying a cash dividend and repurchasing shares are economically equivalent, a company could declare a small stable dividend and then repurchase shares with the company’s leftover earnings. That way, the company effectively implements a residual dividend policy without the negative impact that fluctuating cash dividends may have on the share price. Additionally, managers have discretion with respect to “market timing” their purchases.