In a "perfect world" capital market, how important is a firm's decision to pay dividends versus repurchase shares? Under what conditions would you have a tax preference for share repurchase rather than dividends? Would managers acting in the interests of long-term shareholders be more likely to repurchase shares if they believed the stock to be either undervalued or overvalued?

Answer and Explanation:

A business may use its extra funds to return it to the shareholders, by either paying cash dividends to the company's existing shareholders or by buying back its own shares. Dividends are a profit-share. Dividends are paid out of an enterprise's net profit (PAT).

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On the other way, by way of equity buyback plans, a company can use its money to repurchase its assets. A buyback would decrease a company's a number of shares outstanding and significantly increase the long-term earnings per share ( EPS), and cash flow per share.

The decision of a corporation to pay a dividend and repurchase shares is significant as it can use such actions to manage the investors' interests and the corporation's interest.

Although dividend payment provides greater stability for a company's shareholders, the buy back of shares presents a greater level for the company concerned.

Dividends offer the shareholders flexibility by allowing them to make use of the allocated income in whatever way they see fit. Secondly, the dividend benefit for the shareholders is assured.

The buy back of shares from the other hand is also more desirable for taxation purposes. Dividends are taxable although no taxes are required in case of share repurchases till the moment in time when the securities will finally be sold.

Managers serving the interests of shareholders, particularly long-term shareholders, are more likely to purchase shares if they think the shares are undervalued, i.e. trading at a price below its intrinsic value.

It is due to the number of shares outstanding decreases as the securities are bought back and therefore the earnings per share ( EPS) and cash flows per share increase.

These enhancements help push share prices in the second hand market. This implies that the stock price in the secondary market is no longer at a point below its intrinsic value.

This initiative would mean that securities are no longer underpriced in the long term, thereby protecting the interests of long-term investors.