# 7.7 Cash Dividend vs. Stock Repurchase

If a company earns net income, it may choose to either distribute a cash dividend or buy back its own stock. (A third choice would be to retain earnings and reinvest the funds in new assets or acquisitions; weâll ignore this possibility for now.)Â  Is there any difference, in effect, to the firm and its shareholders whether it pays a cash dividend as opposed to whether it buys back the equivalent dollar amount of stock? Let us examine this by way of example.

We are given:

The total firm equity value = \$1,000,000

100,000s. of stock in the company

The book â and market – values are \$10/s.

An investor owns 1,000s. or 1% of stock (1,000s. Ăˇ 100,000s.)

(We will ignore taxes.)

After \$1/s. or 10% Cash Dividend:

Dividend Cost: \$100,000

The new firm value = (\$1,000,000) â (\$1 Ă 100,000s.) = \$900,000

The dividend reduces the firmâs net worth by the amount of the dividend.

Here are the effects on the companyâs Balance Sheet, all else equal:

(\$000)

 Cash (Credit) = \$100 Equity0 = \$1,000 Cash Offset (Debit) = (100) Equity1 = \$900

Price (Book Value) = \$900,000 Ăˇ 100,000s. = \$9/s.

An investor still owns 1,000s., or 1%, of the stock â and s/he has the cash dividend of \$1/s. His/her total wealth is therefore \$9 + \$1 = \$10/s. Absent taxes, the investorâs wealth is unchanged.

• The new equity value (âVâ) of the firm = \$900.
• The new share value = \$900 / 100 s. = \$9 per share (i.e., \$9s.)
• The investor received \$1 in dividends.
• Therefore, the investor (absent taxes on the dividends received) has \$9s. + \$1 in dividends = \$10. This is the same as his original \$10 stock investment. His wealth is unchanged.

After Equivalent 10% Share Repurchase:

Instead of paying a \$100,00 cash dividend, the firm will use the same funds to buy back its own stock. The re-purchased shares will go into âTreasury Stock,â which is a debit to the Equity account, thus reducing Equity.

Share Repurchase Cost: (10% Ă \$1,000,000) = \$100,000

The new firm value = \$1,000,000 – \$100,000 = \$900,000

\$100,000 worth of stock will go into âTreasury Stock,â which reduces total equity.Â  (Treasury stock is a debit balance, contra-equity account.) There is now 10% less stock, that is, 10,000 fewer shares, leaving just 90,000s. outstanding. Here are the effects on the companyâs Balance Sheet, all else equal:

(\$000)

 Cash (Credit) = \$100 Equity0 = \$1,000 Treasury Stock (Debit) = (100) Equity1 = \$900

Price (Book Value) = \$900,000 Ăˇ 90,000s. = \$10/s. An investor now owns, as before, 1% of the companyâs stock.

• The new equity value (âVâ) of the firm = \$900,000.
• Outstanding shares have been reduced by 10%. Therefore, 100,000 s. (1 – 0.10) = 90,000 shares now outstanding.
• V = \$900 / 90 s. = \$10 per share. (Note that the numbers were rounded off.)
• The investorâs wealth has not changed. She now has 900 shares (rather than her original 1,000) at \$10 plus she received \$10 for 100 shares, which were bought back by the company.

In either case, the shareholder is equally well-off, all else equal. The truly relevant question is: who will deploy the \$1 in financial resources better â the corporation or the shareholder?

In the case of a cash dividend, the shareholder, of course, receives cash. If, alternatively, there is a cash buyback, the shareholder, once again, receives cash for his stock â in this case, for 10% of his/her shares. This question is relevant in the case where the corporation may have some other use for the cash, e.g., purchase of additional productive assets, a corporate acquisition, R & D or, perhaps other possibilities.

We must again note that, in this analysis, we have ignored taxes. The firm will choose whether to pay cash dividends or buy back shares depending on shareholder preferences. Of course, the foregoing alternatives affect the firmâs capital structure.

The firm will buy back shares in order to increase EPS. With the same prospective income as in prior years and fewer shares outstanding, EPS must rise.

Once the firm has repurchased a portion of its shares, this act may âsignalâ to shareholders that more buybacks are in the works, causing the share price to increase still more.