Lesson 9 of 9
Both the cash dividends and share repurchase of same value have equivalent effect on the wealth of the shareholders. This assumes that all other factors such as the taxation are the same.
Let's take an example to understand this. Assume a company with the following information:
Shares outstanding: 1 million
Market value: $20 per share
Company profits: $5 million
Profits distributed: $1 million
The company has two alternatives:
Pay cash dividends at $1 per share
Repurchase stock equivalent to $1 million
Let's calculate the impact of wealth in both cases.
After the dividends are paid, the ex-dividend price would be: $20 - $1 = $19 per share
This can also be calculated as follows:
= ((1 million shares * $20 per share) - $1 million dividends)/1 million shares
= $19 per share
So, the shareholder has a stock worth $19 and $1 in cash that he receives in the form of cash.
Total wealth for each share = $19 + $1 = $20
For $1 million, the company will purchase 1,000,000/20 = 50,000 shares. The share price after repurchase can be calculated as follows:
= ((1 million shares * $20 per share) - $1 million dividends)/(1 million shares - 50,000 shares)
= $19,000,000/950,000
= $20
Total wealth for each share = $20
As you can see, in both cases the shareholder's wealth remains the same. So, practically, cash dividends have the same impact on shareholder's wealth as the share repurchase.