With stock repurchase, share value will increase, all other things remaining the same, and this will benefit the option holder.

To the extent a CEO and others in top management strongly influence the choice between dividends and share repurchase at the board level, personal compensation considerations may tilt the balance in favor of share repurchase. The greater the relative number of stock options owned by management, the more likely there is to be a share repurchase in lieu of an increase in cash dividends.13 Method of Repurchase There are three principal methods of repurchase: a fixed-price tender offer, a dutch-auction tender offer, and open-market repurchases. Brennan and Thakor advance a theory of corporate cash disbursement, suggesting that cash dividends are likely to be preferred for small distributions whereas tender offer repurchases dominate for large distributions.14 Open-market repurchases are suitable in the intermediate range. The authors formulate their theory based on less informed shareholders being vulnerable to expropriation by the better informed. With a fixed cost of information, it pays larger shareholders to become informed when a repurchase offer comes along. As a result, unless their tax rates are high, smaller stockholders are said to prefer dividends.

With a fixed-pricetender offer, the company makes a formal offer to stockholders to purchase so many shares, typically at a set price. This bid price is above

'Tor empirical support of this hypothesis, see Eli Bartov, Itzhak Krinsky, and Jason Lee, 'Evidence on How Companies Choose between Dividends and Open-Market Stock Repurchases," journal of Applied Corporate Finance, 11

(Spring 1998), 89-96.

"Michael J. Brennan and Anjan V. Raker, "Shareholder Preferences and Dividend Policy," Jourrrai of Finance, 45 (Septcmbcr 1990). 993-1018.

Chapter 11 Dividend Policy: Theory and Practice 321 the current market price; stockholders can elect either to sell their stock at the specified price or continue to hold it. Typically, the tender offer period is between 2 and 3 weeks. If stockholders tender more shares than originally sought by the company, the company may elect to purchase all or part of the excess. It is under no obligation to do so. In general, the transaction costs to the firm in making a tender offer are much higher than those incurred in the purchase of stock in the open market.

With a dutch-auction tender offer, each shareholder is given the opportunity to submit to the company the number of shares he or she is willing to sell at a particular price. In advance, the company specifies the number of shares it wishes to repurchase as well as a minimum and a maximum price it will entertain. Typically, the minimum price is slightly above the current market price. Upon receipt of all the self tenders, the company arrays them from low to high within the range. It then determines the lowest price that will result in the full repurchase of shares specified. This price is paid to all shareholders who tendered shares at that price or below. (The purchase of shares from those submitting the cutoff price is on a pro rata basis.) The fact that the price is the same may encourage certain shareholders to submit low ask prices, which may work to the advantage of the company.

Unlike a fixed-price tender offer, the company does not know the eventual repurchase price. In both cases, it is uncertain as to the number of shares that will be tendered, either at the fixed price or at or above the minimum price in the case of the dutch auction. The dutch-auction tender offer has increased dramatically in use and is now the dominant form of tender offer. Though smaller companies still use the fixed-price tender offer, larger ones tend to use the dutch auction.

In open-market repurchases, a company buys its stock as any other investor does-through a brokerage house but at a negotiated fee. If the repurchase program is gradual, its effect is to drive up the price of the stock. Also, certain Securities and Exchange Commission rules restrict the manner in which a company bids for its shares. As a result, it takes an extended period of time for a company to accumulate a relatively large block of stock. For these reasons, the tender offer is more suitable when the company seeks a large amount of stock.

Before the company repurchases stock, stockholders must be informed of the company's intentions. In a tender offer, these intentions are announced by the offer itself. Even here, the company must not withhold other information. It would be unethical for a mining company, for example, to withhold information of a substantial ore discovery while making a tender offer to repurchase shares.

In open-market purchases especially, it is necessary to disclose a company's repurchase intentions. Otherwise, stockholders may sell their stock not knowing about a repurchase program that will increase earnings per share. Given full information about the amount of repurchase and the objective of the company, the stockholders can sell their stock if thev choose. Without proper disclosure, the selling stockholder may be penalized. hen the amount o? stock repurchased is substantial, a tender offer is particularly suitable, for it gives all stockholders equal treatment.

Repurchasing as Part of a Dividend Decision If a firm has excess cash and insufficient profitable investment opportunities to justify the use of these funds, it is in the shareholders' interests to distribute the funds. The distribution can be accomplished either by the repurchase of stock or by paying the funds out in increased dividends. In the absence of personal income taxes and transaction costs, the two alternatives, theoretically, should make no difference to stock322 Part 111 Financing and Dividend Policies holders. With repurchase, fewer shares remain outstanding, and earnings per share and, ultimately, dividends per share rise. As a result, the market price per share should rise as well. In theory, the capital gain arising from repurchase should equal the dividend that otherwise would have been paid.

Equilibrium Formula What repurchase price per share should a company offer to achieve this balance, assuming a fixed-price tender offer? It depends on the current share price and the proportion of shares a company wishes to repurchase. The idea is to establish such a price that shareholders who do not tender will be no better or worse off than shareholders who tender, and vice versa. The equilibrium share repurchase price, P*, a company should offer is where S is the number of shares outstanding prior to the distribution, PC is the current market price per share prior to the distribution, and n is the number of shares to be repurchased.

Illustration To illustrate, suppose Apollo Products Inc. has 8 million shares outstanding whose current market price is $36 per share, and the company wishes to repurchase 1 million shares. The equilibrium share repurchase price offered should be If the offer price were $44, shareholders who tendered their shares would gain at the expense of those who continued to hold the stock. Contrarily, if the offer price were $38, selling stockholders would lose and continuing stockholders would gain. At $41.14, both parties are treated equally.

Recognize that this formula does not take account of the opportunity cost associated with using liquidity to repurchase shares. However, we assume that this liquidity is excess and should be distributed to stockholders. It is merely a question of dividends or share repurchase being the vehicle. With respect to monies realized, stockholders presumably would be indifferent. The equilibrium price established in Eq. (11-5), or by some other equilibrium formula, often is used as the maximum price specified in a dutch-auction tender offer.

Personal Tax Effect With a differential tax rate on dividends and capital gains, however, repurchase of stock offers a tax advantage over payment of dividends to the taxable investor. The market price increase resulting from a repurchase of stock is subject to the capital gains tax, whereas dividends are taxed at the ordinary income tax rate. With a share repurchase, the stockholder has a timing option. He or she can accept the share repurchase offer or reject it and continue to hold the stock.

With a cash dividend, there is no such option.

It is important to recognize that if an investor manufactures a homemade dividend by selling off sufficient stock to match the cash dividend that otherwise would have been paid, the proceeds realized are not entirely subject to the capital gains tax. Only the excess of the price realized over original cost is subject to taxaChapter I1 Dividend Policy: Theory and Practice 323 tion. Capital gains arising from the repurchase are not taxed on the remainder of the investor's holdings until the remaining stock is sold. In essence, the bulk of the capital gains tax is postponed. For tax reasons, then, most taxable investors are better off financially if the firm elects to distribute unused funds via the stock repurchase route rather than via cash dividends.

The repurchase of stock seems particularly appropriate when the firm has a large amount of unused funds to distribute. To pay the funds out through an extra dividend would result in a nonpostponable tax to stockholders. The tax effect could be alleviated somewhat by paying the funds out as extra dividends over a period of time, but this action might result in investors' counting on the extra dividend.

The firm must be careful not to undertake a steady program of repurchase in lieu of paying dividends. The Internal Revenue Service may regard such a program as dividend income and not allow stockholders redeeming their shares the capital gains tax advantage.15 Signaling EfSect Stock repurchases may have a signaling effect. For example, a positive signal might be sent to the market if management believed the stock were undervalued and they were constrained not to tender shares they owned individually. In this context, the premium in repurchase price over existing market price would reflect management's belief about the degree of undervaluation. The idea is that concrete actions, such as repurchase, stock dividends and splits, as well as capital structure changes and cash dividend changes, speak louder than words.

Empirical studies support the signaling effect in different ways.16 For fixedprice tender offers in particular, there is a significant positive share price effect around the time of the announcement. The evidence is less compelling for openmarket purchases. The last study cited in the footnote finds that stocks with low market values in relation to book values (known as "value" stocks) enjoy superior performance in the 4 years after the open-market repurchase announcement. This suggests undervaluation, which is recognized only slowly over time, that is, not completely at the time of the repurchase announcement. For most firms repurchasing their stock, there does not appear to be an improvement in operating performance following the repurchase. The exception is low-growth firms, which have been found to redeploy their existing assets more efficiently following repurchase.

17 Finally, dutch-auction tender offers appear to provide somewhat less in-

15The tax consequences involved in the repurchase of stock are complex and, in places, ambiguous. In most cases, the monies received by stockholders tendering their shares are subicct to the capital gains tax. Under certain circumstances, however, the distribution can be treated as ordinary income to the redeeming stockholder.

'6Larrv Y. Dam, "Common Stock Revurchases: An Analvsis of Returns to Bondholders and Stockholders."

I~ldil.~L:) /ill:!l~lcI.lE.' ~.~,l.~n9ll !~Jiu, ~vI9 81 I, il5 38, T~~\c'curr t~ielen,' Common Srork I

n illing." F-t.rit.?ol f Fit~a:t~c.Fklr ot~nntr;i.9 (June 19Y1 I, 179-91, Pall Asqtllth and Dav~dI V Mull~njjr , 'S~fltdUinw~l ~h Uiridends. Stock I

Market Share Repurchases," Io~muzolf Finane, 46 (September 1991),1243-71; Laurie Simon Bagwell, "Dutch Auction Repurchases: An Analysis of Shareholder Heterogeneity," Journal of Finance, 47 (March 1992). 71-105; Erik Lie and John J. McConnell, "Earnings Signals in Fixed-Price and Dutch Auction Self-Tender Offers," Journal of Financial Economics, 49 (August 1998), 161-86; Bartov, Krinsky, and Lee, "Evidence on How Companies Choose Between Dividends and Open-Market Stock Repurchases"; and David Ikenbeq, Josef Lakonishok, and Theo Vermaelen, "Market Underrraction to Open Market Share Repurchases," Journal of Financial Economics, 39 (October-November 1995), 181-208.

17See Tom Nohel and Vefa Tarhan, "Share Repurchases and Firm Performance: New Evidence on the Agency Costs of F-e Cash Flow," Juurnal @Finanrial Economics, 49 (August 1998), 1x7-ZZZ.

324 Part 111 Financing and Dividend Policies formation content than do fixed-price tender offers but more than open-market repurchase programs. Thus, the credibility of the signal as to undervaluation differs with the method of repurchase.

STOCK DIVIDENDS AND STOCK SPLITS In an economic sense, stock dividends and stock splits are very similar, although typically used for different purposes. Only from an accounting standpoint is there a significant difference.

Stock Dividends A stock dividend is simply the payment of additional stock to stockholders. It represents nothing more than a recapitalization of the company; a stockholder's proportional ownership remains unchanged. Chen Industries had the following capital structure before issuing a stock dividend:

Stock splits and dividends are alike in principle, but not in accounting treatment.

Common stock ($5 par, 400,000 shares) $ 2,000,000 Additional paid-in capital 1,000,000 Shareholders' e Chen pays a 5 percent stock dividend, amounting to 20,000 additional shares of stock. The fair market value of the stock is $40 a share. For each 20 shares of stock owned, the stockholder receives an additional share. The balance sheet of the company after the stock dividend is With a stock dividend, $800,000 is transferred ($40 X 20,000 shares) from retained earnings to the common stock and paid-in capital accounts. Because the par value stays the same, the increase in number of shares is reflected in a $100,000 increase in the common stock account ($5 par x 20,000 shares). The residual of $700,000 goes into the paid-in capital account. Shareholders' equity of the company remains the same.

Because the number of shares outstanding is increased by 5 percent, earnings per share of the company are reduced proportionately. Total net profit after taxes is

$1 million. Before the stock dividend, earnings per share were $2.50 ($1 million/

400,000). After the stock dividend, earnings per share are $2.38 ($1 million/

420,000). Thus, stockholders have more shares of stock but lower earnings per share. The proportion of total earnings available to common stockholders remains unchanged.

Chapter 11 Dividend Policy: Theory and Practice 325 Accounting Treatment Differences The accounting treatment portrayed holds for what is known as small-percentage stock dividends, usually a distribution of 20 percent or less of the number of common shares already outstanding. Because larger stock dividends will materially reduce share price, the accounting authorities usually require that capitalization changes be in terms of the par value of the additional shares issued. (For small-percentage dividends, market value per share is employed.) Suppose in our example that Chen Industries declared a 50 percent stock dividend, amounting to 200,000 additional shares. The capitalization accounts after a large-percentage stock dividend of this sort are Thus, retained earnings are reduced by only the par value of new shares issued.

Stock Splits With a stock split, the number of shares is increased through a proportional reduction in the par value of the stock. The capital structure of a pharmaceutical company before a 2-to-1 stock split was Common stork ($5 par, 40i),000 shares) $ 2,000,000 After the split, the capital structure is With a stock dividend, the par value is not reduced, whereas with a split, it is. As a result, the common stock, paid-in capital, and retained earnings accounts remain unchanged. Shareholders' equity, of course, also stays the same; the only change is in the par value of the stock. Except in accounting treatment, the stock dividend and stock split are very similar. A stock split, however, is usually reserved for occasions when a company wishes to achieve a substantial reduction in the market price per share.

326 Part I11 Financing and Dividend Policies If the pie stays the same, stock dividends and splits are not a thing of value.

Value to Investors of Stock Dividends and Splits Theoretically, a stock dividend or stock split is not a thing of value to investors.

They receive additional stock certificates, but their proportionate ownership of the company is unchanged. The market price of the stock should decline proportionately, so that the total value of their holdings stays the same. To illustrate with a stock dividend, suppose you held 100 shares of stock worth $40 per share, or

$4,000 in total. After a 5 percent stock dividend, share price should drop by

$40(1 -