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Are dividends and share repurchases substitutes?

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TABLE OF CONTENTS 1. Introduction 1 2. Theoretical base (MM) 2 3. Analysis of sub questions 3 3.1 Source of funds 3 3.2 Motives for payment 4 3.2.1 Free cash flow theory 4 3.2.2 Signaling theory 4 3.2.3 Other theories 5 3.3 Investors' reactions 6 3.4 Managers' perspective 7 4. Comparison of literature / Evaluation of sub questions 7 4.1 Source of funds 8 4.2 Motives for payment 8 4.3 Investors' reactions 9 4.4 Managers' perspective 9 5. Synthesis 9 5.1 Definition of subsitutes 9 5.2 Answering of problem statement 10 6. Conclusion 10 7. Reference list 12 Appendix A - Decision making trees 15 1. INTRODUCTION Traditionally, most companies used to make payments to their shareholders in the most direct form - dividends. In the last decades however, an alternative option to transfer wealth to shareholders has gained increasing importance. Firms repurchase their own shares, thereby diminishing the number of shares outstanding which in turn increases the stock price. However, there are widely differing views as to whether both payout methods can be as substitutes or whether there are significant differences between both. Even though dividend policy is the second big topic of research in the field of finance besides capital budgeting, there is still no commonly accepted framework and empirical evidence seems to leave open more questions than it answers. This paper aims at reviewing some of the more important contributions to the question: Are dividends and share repurchases substitutes? Furthermore, it will try to reconcile widely differing views and come to a conclusion in how far both methods are indeed substitutes or not. In order to examine this main question, it is broken down into some aspects. A first field of interest is the sources of the funds out of which either dividends or share repurchases are paid. If these sources were equal, that would mean strong evidence for firms viewing both as substitutes. ...read more.


3.3 Investors' reactions Given the large amount of hypotheses concerning the justification and source of funds of payout programs, a crucial issue is the actual outcome of decisions. Therefore, it is essential to monitor the reaction of the investors since they are the ones that define the success of any measure in business and even the success of companies as a whole. Rau et al. (2000) found positive abnormal returns in the long run for companies that announce share repurchases. While they interpret this as raising questions about efficiency, it could also be seen as supporting the good investment hypothesis which believes shares to be undervalued at the point of the repurchase announcement. Another interesting investor reaction is the one discovered by Howe et al. (1992), who finds that increases in share prices following a repurchase announcement are not significantly different for low-quality and high-quality firms. Howe et al. Interpret this as giving evidence for the free cash flow hypothesis but contradicting the signaling hypothesis. While many studies use a measure of stock market reactions to support or defend their theses, there emerges no clear picture as to which payout method investors prefer. 3.4 Managers' perspective One point that is often forgotten in the analysis of dividend policy is the perspective of the managers. Most study aim at finding elegant theoretical explanations for empirical patterns that are consistent with generally agreed upon principles such as market efficiency. However, the firms' managers are the ones that make the final decision, and therefore, their own interests must be taken into account, too. Managers care about dividend policy because it has the power to change the value of the firm's stock. As managers are often compensated, at least partly, with stock options, they have a genuine interest in maximizing share value. When a company pays a regular cash dividend, that company's stock price decreases on the ex-dividend date by up to as much as the dividend itself is. ...read more.


Agency cost of free cash flow, corporate finance and takeovers. American Economic Review 76, 323-329. John, K. & Williams, J. (1985). Dividends, dilution and taxes: A signalling equilibrium. Journal of Finance 40, 1053-1070. Retrieved June 20, from the World Wide Web: http://www.ub.unimaas.nl/fdewb Jong, A. de, Dijk, R. van & Veld, C. (2000). The Dividend and Share Repurchase Policies of Canadian Firms: Empirical Evidence Based on a New Research Design, Retrieved June 20, from the World Wide Web: http://papers.ssn.com Lang, L. & Litzenberger, R. (1989). Dividend announcements: cash flow signalling vs. free cash flow hypothesis?, Journal of Financial Economics 24, 181-191. Retrieved June 20, from the World Wide Web: http://www.ub.unimaas.nl/fdewb Liljeblom, E. & Pasternack, D. (2002). Share Repurchases, Dividends, and Executive Options: Empirical Evidence from Finland, Retrieved June 20, from the World Wide Web: http://papers.ssn.com Lintner, John (1956). Distribution of incomes of corporations among dividends, retained earnings and taxes. American Economic Review 46, 97-113. Megginson, Corporate Finance Theory, Addison-Wesley Persons, J.C. (1995). Heterogenous Shareholders and signaling with Share Repurchases, Retrieved June 20, from the World Wide Web: http://papers.ssn.com Raaballe, J. & Bechmann, K.L. (2002). Taxable Cash Dividends - A Useful Waste of Money, Retrieved June 20, from the World Wide Web: http://papers.ssn.com Rau, P.R. & Vermaelen T. (2002). Regulation, Taxes, and Share Repurchases in the United Kingdom. Journal of Business, v. 75, iss. 2, pp. 245-82. Retrieved June 20, from the World Wide Web: http://www.ub.unimaas.nl/fdewb Ross, S.A., Westerfield,R.W. & Jaffe, J.F. (2002). Corporate Finance (6th edition). New York: McGraw Hill, Sarig, O. (1999). A Longitudinal Analysis of Corporate Payout Policies. Retrieved June 20, from the World Wide Web: http://papers.ssn.com Stephen, C.P. & Wei´┐Żbach, M. (1998). Actual share reacquisitions in open market repurchase programs, Journal of Finance 53, 313-333. Retrieved June 22, from the World Wide Web: http://www.ub.unimaas.nl/fdewb University of Strathclyde (2003). Topics in corporate finance: Share repurchases. Retrieved June 25, from the World Wide Web:http://accfinweb.account.strath.ac.uk/tom/sharerep.doc APPENDIX A - DECISION MAKING TREES ARE SHARE REPURCHASES AND DIVIDENDS SUBSTITUTES? 1 ARE SHARE REPURCHASES AND DIVIDENDS SUBSTITUTES? ...read more.

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