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Dividend Cash or Repurchase Shares?

This discussion concerns general issues of dividend policy that must be addressed in developing a long term company strategy for dividend payments and share repurchases.

    Dividend policy simply put involves the decision to pay out earnings versus retaining them for reinvestment in the firm [Brigham, Financial Management, 1985]. These two opposing options require a balance between investors desire for current dividends and for future growth. A number of factors influence dividend policy, including the differential tax rates on dividends and capital gains, the investment opportunities available to the firm, alternative sources of capital, and of course stockholders’ preferences for current or future income.

 Finance scholars identify three theories of dividend policy, briefly as follows:

    Dividend Irrelevance, (Miller & Modigliani, 1961) which asserts that dividend policy has no effect on either the price of the firm or its cost of capital. However the inherent assumptions here exclude personal and corporate taxes as well as any linkage to capital investment policy as well as other factors which limit its application to real world situations.

    Bird in the Hand, (Gorden & Lintner, 1962) addresses the investor preference for receiving dividends without selling stock, arguing that a capital gain "in the bush" is perceived as riskier than a dividend "in the hand." Miller & Modigliani refer to this theory as the "bird in the hand fallacy," suggesting that most investors will reinvest their dividends in the same or similar firms anyway and that in the long run riskiness is determined by asset cash flows not dividend policy.

    Tax Differential, simply concludes that since dividends are taxed at higher rates than capital gains, investors require higher rates of return as dividend yields increase. This theory suggests that a low dividend payout ratio will maximize firm value. Results of empirical tests of these theories are mixed and have not led to definitive conclusions. In the less than theoretical "real world", companies budget future dividend payments the same way that they budget any other cash outflow such as debt service requirements, capital expenditures, or any foreseeable demand for cash. As a result, when a board of directors sets a general dividend policy, it is often in terms of and always in consideration of projected cash flows - not earnings. Thus, the internal policy might well be described as a certain percentage of cash flow, even for companies that express their policy publicly in terms of payout ratios or a percent of earnings [Graham & Dodd, Security Analysis, 1988].

    In practice, therefore, firms generally adopt a residual dividend payment policy where dividends are paid only if more cash is available than is needed to support the optimal capital budget. It has been advised that firms look to "free cash flow" (after tax profits plus depreciation, less working capital requirements and capital expenditures) and debt levels (often benchmarked as years of free cash flow to pay off debt) to estimate their dividend options [Hackel & Livnat, Cash Flow and Security Analysis, 1992]. Here a percentage of free cash flow not needed to support the growth of the firms business represents the dividend payment. Usually, cyclical companies with less consistent levels of cash flow may maintain lower levels of cash dividends versus levels for companies which are more consistent generators of cash flow.

    We recommended that dividend policy and share purchase alternatives be addressed in conjunction with historic and forecast free cash flow and debt levels, and the effective tax consequences.

    For example, given available cash, if your share basis is very low, you may be indifferent towards share repurchase versus dividend if your goal is diversification and you are willing to suffer double taxation. The best of all possible worlds would be a pre-tax share repurchase with no gain recognition, as regularly experienced in ESOP 1042 rollover situations.


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