A company can make use of its surplus cash that it wants to return to the shareholders, either by paying cash dividends to the current shareholders of the company or by repurchasing their own shares.

A company can make use of its surplus cash that it wants to return to the shareholders, either by paying cash dividends to the current shareholders of the company or by repurchasing their own shares. Dividends are a share of the profits. Dividends are paid from the net income ( PAT) of a company. On the other hand a company can use its cash to repurchase its shares through share buyback schemes. A buyback will reduce the number of shares outstanding for a company and in the long run earnings per share (EPS) and cash flow per share improves significantly.

A company’s decision to pay dividends versus repurchase shares is important as it can use these decisions to balance the interest of the shareholders and the interest of the company. While payment of dividends offer more flexibility for the shareholders of a company, repurchase of shares offer a higher degree for the concerned company. Dividends give flexibility to the shareholders by enabling them to use the distributed profits in any manner in which they deem fit. Secondly the gain from dividends is certain for the shareholders. On the other hand repurchase of shares are often more favorable for tax purposes. Dividends are taxed while in case of buybacks no taxes are due until that point in time when the shares are eventually sold.

Managers acting in the interest of the shareholders, especially the long term shareholders, will most likely buy shares when they believe that the stock is undervalued i.e. is trading at a price that is lower than its intrinsic value. This is because when shares are repurchased the number of outstanding shares reduces and hence the earnings per share (EPS) and cash flows per share improve. These improvements propel the prices of the share in the secondary market. This ensures that the price of the share in the secondary market is no longer at a level that is lower than its intrinsic value. In the long run, this measure will ensure that stocks are no longer undervalued and so the interests of the long term shareholders are protected.

References:

Brigham, E. F., & Ehrhardt, M. C. (2017). Financial management: Theory & Practice, (15th ed.). Boston