In three previous posts Repurchases: Part 1 Shareholders Beware and Repurchases Part 2: The Positive Side, and Repurchases, Part 3: Joe Responds, Joe and I have debated the merits of repurchases. Today's blog contains Part 4 where we continue the debate and try to summarize.
Thanks to all for your comments. You are also welcome to post them here.
Joe and Ralph
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Ralph:
Joe, your Repurchases Part 3 contains some great comments. Maybe I'm being picky but I still kinda disagree with two
points.
First, and this is technical, share repurchases can
alter the capital structure and as they increase leverage, the tax shield
increases. This can create value if it doesn't increase risk
excessively. For many repurchases, this
can be a minor effect. However, a company
can increase its leverage quickly by borrowing and using the proceeds to
repurchase stock.
Also, while I agree
you can replicate repurchases with special dividends, your shareholders will
suffer much higher taxes.
Joe:
Yes, but you can get
same leverage impact thru debt financed special dividend.
Regarding taxes - it
depends on the shareholder base-clientele.
Ralph:
OK, I agree you
can get the same leverage impact, good point, but still think either approach
can create value. It might be that we disagree whether leverage can
'create' value.
On taxes, yes, but
capital gains are taxed at a
substantially lower rate than ordinary income (dividends).
Joe:
Taxes are not an
issue for investors like untaxed pension funds
Microsoft’s
2004 32B special dividend is counterfactual.
If the tax
disadvantage is key,
then why didn't they use a repurchase?
Ralph:
I agree with your
comments about untaxed pension funds - and institutional ownership is quite
high in corporate America. To other
investors it would matter.
Regarding Microsoft,
I don't know the answer. I do note that in addition to the special
dividend, they also repurchased shares. So they actually did
both. As far as I know, Steve Ballmer and Bill Gates do pay taxes, so the mystery remains. (Bill Gates was reported to donate the
proceeds he received to his charity but I still think repurchases would have
saved taxes.)
I do think we can
agree that:
Share repurchases
can be controversial! And, while they
offer tax advantages over dividends, they can be abused. Two possibilities for this abuse are a) the
apparent, but misleading, increase of earnings through repurchases and b)
companies that overpay in repurchases harm existing shareholders.
Dividends don’t produce
the overpayment problem, but force shareholders to accept the distribution,
while repurchases give them the option to defer.
Also, since it is
difficult to precisely estimate the value of one’s shares, companies should
proceed cautiously with repurchases.
Finally, companies that cannot put cash to use
at rates higher than those demanded by shareholders should return it in some
form. If you increase regular dividends
make sure they can be sustained.
Otherwise, consider share repurchases and special dividends.
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