LOS 50b Compare the impact on shareholder wealth of a share repurchase and a cash dividend of equal amount

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A share repurchase is a transaction in which a company buys back shares of its own common stock. Since shares are bought using a company's own cash, a share repurchase can be considered an alternative to a cash dividend.

Example: Impact of share repurchase and cash dividend of equal amounts

Spencer Pharmaceuticals Inc. (SPI) has 20,000,000 shares outstanding with a current market value of $50 per share. SPI made $100 million in profits tor the recent quarter, and since only 70% of these profits will be reinvested back into the company, SPI's Board ot Directors is considering two alternatives for distributing the remaining 30% to shareholders:

* Pay a cash dividend of $30,000,000 / 20,000,000 shares = $1.50 per share.

* Repurchase $30,000,000 worth ot common stock.

Assume that dividends are received when the shares go ex-dividend, the stock can be repurchased at the market price of $50 per share, and there are no differences in tax treatment between the two alternatives. How would the wealth of an SPI shareholder be affected by the board's decision on the method ot distribution?

Answer:

(1) Cash dividend

After the shares go ex-dividend, a shareholder ot a single share would have $1.50 in cash and a share worth $50- $1.50 = $48.50.

The ex-dividend value ot $48.50 can also be calculated as the market value of equity after the distribution ot the $30 million, divided by the number of shares outstanding after the dividend payment,

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