3. Dividends versus stock repurchases Aa Aa Ignoring possible tax effects and si

Question

3. Dividends versus stock repurchases Aa Aa Ignoring possible tax effects and signaling costs, the total value of a firm's equity remains the same irrespective of how the firm distributes its residual earnings-dividends or stock repurchases. Each distribution method has certain advantages and disadvantages. Based on your understanding of dividends and stock repurchases, select the best terms to go with the statements Select the best term to complete the sentence Repurchase stock Distribute dividends Excess cash or a desire to recapitalize usually leads management to ????. False True Repurchases allow a firm to buy back as much stock as it wants, at whatever price it wants, without affecting shareholders. This statement is ???? True False Dividends provide signals about a firm's future prospects, whereas some investors might misinterpret why a firm is repurchasing stock. This statement is ???? Cash Additional stock Repurchases allow investors who need cash to convert their investment in the company into ????.

Explanation / Answer

Repurchase stock – A company that has excess cash or desiring to recapitalize would usually go for repurchasing stock. If the company believes that the returns it will generate on the additional cash would be lower than the shareholder’s expectation then also it is prudent to redistribute that income to the shareholders via buyback. Also payment of dividend does not alter the capital structure of the company, whereas stock repurchase would reduce the number of outstanding shares that the public holds.

False – The share buyback happens at a predetermined price which is usually higher than the prevailing market price of the stock. However, shareholders have an option to tender shares for buyback. Therefore, cannot buyback as much shares as it wants, it can only buyback as much shares as the shareholders have put up for buyback.

False – Stable dividends are signs of stability in the company which builds the shareholders trust. Share buyback also helps to provide a floor price since the shareholders see it as management’s belief of the minimum price for the shares. Both dividend payment and stock repurchase are means to distribute excess cash after retained earnings back to the shareholders.

Cash – Repurchase allows existing investors to sell their shares in the company for cash. This would generate additional cash for the shareholders and is also desirable for those shareholders who prefer dividend who value cash payment more than potential future growth in value.

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