Rationales for Share Repurchases
There are at least five common rationales for share repurchases instead of distributing dividends. These include potential tax advantages, share price support/signaling, added flexibility, offsetting dilution from employee stock options and increasing financial leverage. On this page, we discuss each of these reasons for share repurchases in more detail.
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.
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.
Offsetting dilution from employee stock options
Repurchases can offset EPS dilution that results from the exercise of employee stock options.
Increasing financial leverage
When funded by new debt, share repurchases increase leverage. Management can change the company’s capital structure (and perhaps move toward the company’s optimal capital structure) by decreasing the percentage of equity.
We discussed five rationales for share repurchases.