Question

Explain why, in the absence of personal taxes, there is an equivalence between dividends and share repurchases and why tax-paying investors prefer a share repurchase to a dividend payment.

Answer 1

Dividends and share buybacks both are done out of corporate profits of the company. Personal income tax is imposed on dividend received whereas share repurchases are not taxable to the shareholders. So in the absence of personal tax both will be equivalent as both will be taxed at a lower capital gain rate.

A tax paying investor prefers a share repurchase than dividend for the following reasons:

1. It is tax advantageousas as they are taxed at lower capital gains tax rate and dividends are also subject to income tax.

2. It improves their shareholder value because they are selling the shares at a price they are willing to.

3. Generally, buybacks are at higher prices. So increasing share prices is also an important reason.