Reading: Dividends vs. Share Repurchases

With alternatives 3 and 4 listed at the beginning of this example, the firm returns the excess cash today (as a dividend in alternative 3 and via buyback in alternative 4) and then the shareholders invest the proceeds on their own at the assumed reinvestment return ROIC_P of 10%. 

Payout Today

From before, we already know the tax implications of dividends and repurchases:

• With a dividend payment, shareholders receive \(\text{Cash}_0 \times (1- \tau_D) = 100'000 \times (1 - 0.15) = 85'000 \).
• In contrast, with a buyback, shareholders only pay taxes on the capital gain.
  • Let us assume that a buyback today occurs at a buyback price (P_R,0) of 18, which is approximately 10% lower than the expected buyback price in 1 year (P_R,1, see before).
  • Consequently, the taxable portion of the buyback price is 16.67% and the factual buyback tax rate is 2.5%:
     
    Taxable portion of P_R,0 = \( 1- \frac{P_B}{P_{R,0}} = 1 - \frac{15}{18} = 0.1667 \)
     
    Factual buyback tax rate = Taxable portion of P_R,0 × τ_G = \( \tau_G \times (1- \frac{P_B}{P_{R,0}}) \)  \( = 0.15 \times 0.1667 = 0.025 \) 

Therefore, the two forms of distribution imply the following after-tax payout to shareholders today:

\( \text{After-tax Payout}_{Dividend,0} = \text{Cash}_0 \times (1 - \tau_D) = 100'000 \times (1-0.15) = 85'000 \)

 
\( \text{After-tax Payout}_{Buyback,0} = \text{Cash}_0 \times ( 1 - \tau_G \times (1- \frac{P_B}{P_{R,0}})) \) \( = 100'000 \times (1 - 0.025) = 97'500 \)

Obviously, the management implications are the same as before; share buybacks receive favorable tax treatment regardless of the timing of the buyback.

In our example, the difference is in fact even more pronounced, as we have assumed that the buyback today occurs at a lower price, namely 18, than the buyback in the future (20). As a consequence, only 16.7% instead of 25% of the buyback price are subject to capital gains taxes. Note that, in most instances, the assumption that a buyback today occurs at a lower price than a buyback in the future would seem to be realistic. After all shareholders expect to earn a positive return, namely their cost of capital.

Reinvestment by Shareholders

As per our assumptions, shareholders reinvest the proceeds of today's payout at a reinvestment return ROIC_P of 10% (as opposed to a reinvestment return ROIC_C of 11% by the company). Assuming that this return constitutes a taxable income for the investors, personal income taxes of 30% (τ_P) will be due in one year, according to our assumptions.

For the shareholders, the after-tax return on the investment, therefore, is 7%:

 \( \text{After-tax ROIC}_P = ROIC_P \times (1-\tau_P ) \) \( = 0.1 \times (1-0.3) = 0.07 \)

Consequently, shareholders will have a total payout of 90'950 in one year if the firm pays a dividend today and shareholders invest at an after-tax rate of return of 7%, whereas the total payout will be 104'325 in one year if today's payout is via buyback:

\( \text{Total Payout}_{Dividend, Invest} = \text{After-tax Payout}_{Dividend, 0} \times (1 + \text{After-tax ROIC}_P)\) \(=85'000 \times 1.07 = 90'950 \)

\( \text{Total Payout}_{Buyback, Invest} = \text{After-tax Payout}_{Buyback, 0} \times ( 1 + \text{After-tax ROIC}_P)\) \(=97'500 \times 1.07 = 104'325 \)