finance

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Corporate payout policy in the UK: why are companies shifting away from dividends towards share repurchases .Testing for the substitution hypothesis in the UK for the period 1989-2004?

1. Introduction:

The market system in the UK and the US has emphasized the role of the stock market in the Anglo-American capitalist system.

Shares and bonds have become very common tools of investment in the capital system.

Investors buy shares and bonds in the hope of getting capital gains plus income from their investments.

Shares offer investors capital gains/losses and dividends, share are very attractive investment tools for people who are prepared to risk their principle and get less than the amount that they have invested.

Bonds offer limited return on investments, Bonds offer investors the same principle.

Financial managers usually pay off their shareholders using two methods:

  1. Dividends: dividends are share of the capital that investors receive in return for investing their money in the company. 
  2. Share repurchase/buyback: some financial managers choose to buyback the shares of the company if they feel that they company’s shares are undervalued, buying part of the shares will boost the remaining outstanding share prices.

Over the last twenty five years, companies have become less prone to distribute funds to shareholders.

This noticeable increase in dividends is accompanies by share repurchases in the US.

Since Margaret Thatcher came to the power in the UK, the United Kingdom has adapted a very similar economic path to the US.

These developments in the US have been followed by very similar developments in the UK.

British companies are trying to concentrate on share buyback rather than pay dividends.

In this assignment, we will try to find out why companies are heading towards share buyback.

2. What determines the payout policy of the company?:

Miller and Modigliani (1961) were the first two scientists to challenge that fact that high dividends payout leads to higher value of a company.

It is apparent that companies’ payout policy does not affect the value of the company.

The reason that made Miller and Modigliani think that the payout policy of the firm does not affect the value of the firm is that fact that in a frictionless economy investors could make their decisions rationally with no or minimum stochastic factors.

Investors will be able to see that distributing too much dividends means that the company is missing investment opportunities and that its future cash flows will be substantially less than now.

While if the company retained its earnings in order to invest into projects, investors will think that the company has over invested and so that the return on its capital will be substantially less than the market average.

Miller and Modigliani thought that companies could not create the impression that they are better than what they are in reality.

For several reasons, there are many people nowadays that do not believe in Miller and Modigliani, one of the possible reasons for that is the fact that financial markets are not frictionless and investors are not totally rational.

In the financial markets, there are many short-sighted investors that prefer to get profit as soon as possible without paying any real value to the future cash flow of the firm.

But the supporter of Miller and Modigliani argue that institutional investors watch the payout policy of the firm very carefully and analyze the activities of the firm in a very good way so institutional investors do know the value of the firm exactly.

Although Miller and Modigliani do not see any difference in the value of the firm no matter what payout policy the firm follows; there are many people who think that having high payout policy is much better than retaining funds because high payout policy attracts institutional investors who are able to monitor the company and give a more precise valuation to the value of the company and its credit quality.

Trojanowski, G(2004) thinks that the company is really in typical type I error and type II error dilemma, if the company adapted high payout policy towards so it became cash constraint the company might miss profitable investment opportunity( type II error), but if the company retained cash and invested in unprofitable projects this will be type I error.

Trojanowski, G(2004) thinks that this high payout policy is considered the price that should be paid to institutional investors in order to get things right and be able to give precise valuation to the company.

There are several factors that determine the payout policy of a firm; we can summarize these factors as: Valuation of the company’s value, taxes, information asymmetries and contract incompleteness.

2.1 Valuation of the Firm’s shares:

The value of the firm itself play a substantial role in the payout policy for any company, if the firm’s shares are undervalued, companies’ tend to buyback their share prices in order to make use of the undervalued share price, this will improve the share price and encourage investors to invest more in the shares of the particular company.

Share buyback play the merger& acquisition impact on share prices, in the case of merger and acquisition, a company comes forward to buy the shares of an undervalued company, this normally leads to a hike in the share prices of both companies.

In the case of share buyback, the company itself comes forward to buy its own shares, this leads as well to a hike in the share price. 

The rise in share prices resulting from share repurchases will make it more difficult to other companies to buy the shares of the undervalued company because buying the shares of the undervalued company will require additional premium.

The success of the share buyback process is directly related to the number of investors who come forward to sell their shares.

The number of investors who come forward to sell their shares is related to the price at which the shares were bought.

If the price of the bought shares was high and then fell dramatically, the buyback process will not be enough to compensate for the full loss of the invested money; Investors will rather prefer to change the management and hold it accountable for the poor results of the company.
 
If the fall in the price of the shares was modest and share buyback compensated the loss that investors have incurred and/or made capital gains, many investors will prefer to sell their shares and that is how the buyback process becomes successful.

2.2 Tax:

According to Miller and Modigliani (1961): dividends do not affect the value of the firm:

This result is based on many assumptions: taxes, 

The tax system of any country will affect the payout policy of most of the companies in the world.

The research that has been done on this issue refers to two facts:

The first one is that companies tend to change their payout policy if the tax law changed.

The second one is that: according to Kalay (1982) and Stiglitz, J, E (1983) individual investors do rebalance their portfolios quickly enough in response to tax law changes; this school of thought thinks that investors always try to follow tax avoidance strategies in order to maximize their wealth by “dividend laundering”

In other words, investors will try to put pressure on their company in order to pay them in the most tax efficient way that maximizes their wealth and the value of the company.

Share repurchases are very attractive way of distributing the profits of the company because they could happen at any time of the year; investors try to put pressure on the company to choose a suitable time for most of them.

Share repurchases give investors the flexibility and the choice in participations, investors might choose to participate in the share repurchase if they feel that their overall tax liabilities will become less.

Investors could defer their tax payments to make their own decision of when to sell in order to maximize their total wealth.

Of course, shareholders can sell their shares in the market if they want cash as a tax
Advantaged substitute for either share repurchases or cash dividends.

In the law, the tax paid on capital gains is deferred until the shares are sold whereas any income tax on dividends is paid annually. The deferral of the capital gains tax reduces its present value.

Broadly speaking dividends in the UK enjoy a less favourable tax regime than share repurchases which may give rise to something of a Dividend Policy Puzzle.

Although dividends do not enjoy the same tax treatment that share repurchases have, most of the companies in the UK are still paying dividends because most of the investors are tax-exempt and companies listen to their shareholders in the UK.

This point will be researched in more detail in the coming sections

2.3 Financial Structure:

When companies decide to buyback their shares, they change their financial structure.

Share buyback is accompanied with significant debt/equity ratio.

Share repurchase does not only reduce equity but also increases debt.

The leverage ratio will increase after the buyback period.

The financial structure of the company has a profound impact on the payout policy.

In order to understand how the financial structure affects the payout policy we need to understand the concept pf “block holders”.

Block Holders are few numbers of investors who own the majority of the shares of the company.

The economic literature is increasingly enforcing the fact that block holders could play a positive role in monitoring the performance of the companies that they invest in because they have a big interest in preserving and growing the capital that they have invested.
Unlike small investors, block holders power is very important in keeping the management of the company doing the best it can in order to maximize the wealth of the shareholders.

When companies use share buyback, it is expected that minority shareholders will sell their shares to the issuing company and not the block holders.
 
When that happens, small shareholders numbers will decrease and there power will be less.

This will open the door for bloke shareholders to use their power in imposing what they want without listening to the minority shareholders who have less power in the board room than bloke shareholder.

In that sense, we can say that changing the financial structure of the company can have a negative impact on the minority shareholders who choose to sell some of their shares to the issuing company.

In many countries such as Germany, France, Italy and Hong Kong, the volume of shares to be repurchased must not exceed 10% of total shares outstanding. Firms from such countries can therefore not use repurchase programs to increase their debt-to-capital ratio dramatically and to transfer value from debt holders to shareholders.

2.4 Cash Flow:

Public companies have shares that could be traded on the stock exchange, as illustrated above; investors expect return on their investments in the shape of dividends.

If the company did not meet investors’ expectations, share prices will go down.

Share buyback happens when the company has cash that is in excess of the company’s needs.

If the company cannot pay its investors good return on their investments, it is better to return the money to the investors in the shape of share buyback.

Jagannathan, Stephens and Weisbach (2000) showed that companies with excessive operating cash flows tend to distribute dividends while companies with limited operating cash flow tend to repurchase their shares.

Companies with temporary excessive cash flow tend to repurchase its shares in order to distribute the excess cash flow.

Companies with temporary excess cash flow tend to distribute its excess cash because the company wants to smooth its dividends policy, it is not in the company’s best interests to increase the volatility of its dividends because dividends are very important signaling tools that the market use in valuing the shares of the company, when dividends increase because of temporary excess cash and them decrease later one, share prices will become volatile and investors will try to avoid the shares of that particular company.

2.5 Agency Problem:

The industrial revolution has contributed significantly to the separation of management from ownership.

There is a constant crisis of trust between management and the shareholders of any public company.

Under perfect conditions, the management is supposed to be working for the best interests of the shareholders, but what happens in reality is something different, the management is constantly trying to maximize its own benefits and wealth on the expense of the shareholders.

The relationship between management and shareholders is not always a cooperative relationship; the relationship might well prove to be a competitive relationship. 

Managers and company directors might misuse the funds of the shareholders; directors might use the money of the shareholders in increasing their salaries, pensions and other allowances instead of paying this money to the shareholders in the form of dividends or share buyback.

When company directors choose to use the excess funds that they have in buying back the shares of the investors or in other words returning their money, the trust between the investors and the company directors increases significantly.

Share buyback proves that there is a wise management in that particular organization; investors will see this move as maintenance to the resources of the investors.

Company directors that choose to invest the excess cash that they have in non-profitable projects will be seen in the financial markets as not reliable; investors will know that the top management of that company is not sound.  

Some school of thoughts claim that share buybacks are bad for the minority shareholders if they are not accompanied with the selling of the shares of the directors.

The reason for that is the fact that company directors own shares and share options in the company and if the company made a share buyback, the share of directors and managers in the company will increase and this will open the door for possible misuses.

Many economists recommend that share buyback has to be accompanied by the selling of the shares of the directors in order to keep a sound management system in the corporation, Siu, J & Weston, F(2002).

Finally, Share repurchases can violate the interests of the last majority of uninformed shareholders when only inside shareholders have information about the exact timing of repurchase transactions and the amount that the issuing company will purchase.

Insiders could use that knowledge to dispose of their shares at a higher price than under normal market conditions, IKENBERRY/VERMAELEN 1996.

This illegal action would cause a wealth transfer from outside shareholders to inside shareholders and if anticipated by outside shareholders should lead to a negative announcement effect.

2.6 Signaling:

Share buyback are used a signaling tool, dividends convey information about the future cash flow of the company.

Motivations are normally in line with shareholders’ interests; this includes the attempt by management to convey to investors that the true value of their corporation’s equity exceeds its current market value.

Such a signal might be based on management’s believe that the true mean of the probability distribution of the firm’s future cash flows is actually higher than perceived by the market or alternatively, that the true variance of future returns is higher than expected, holding the distribution mean constant, DANN (1981)

We have two cases depending on the prices of the financial assets of the company:
 
In the first case, all of the firm’s risky securities appear to be undervalued. In the latter case, only equity claims appear to be undervalued, whereas claims in the form of risky debt might in fact be overvalued.

Share repurchases could actually lead to a re-distribution of debt holders’ wealth to the benefit of shareholders.

It is typically assumed that insiders which are the company’s management and directors know a lot more information about the company’s cash flow situation than insiders.

However, any straight public announcement by the board of directors that it considers its firm’s shares to be undervalued generally lacks credibility because there might be other hidden motives to the management.

Outside investors cannot distinguish between true and misleading announcements because they do not have all the information about the company.

They will perceive of all undervaluation announcements as try to hide the truth about share repurchases unless the company produces evidence that undervaluation is the real motivation for share repurchases.
 
Share repurchase announcements cause two types of costs to overvalued firms. Firstly, firms that repurchase overvalued shares must understand that the share price will decline to its true intrinsic value as soon as possible, so that the company would have paid too much for its shares.

Secondly, firms that announce to repurchase shares but then decide not to do so might see their general reputation for honest capital market communication deteriorate because the company’s public relations status with the company will be shaken.
Depending on the legal and regulatory restrictions for share repurchase programs, such firms also risk that authorities initiate investigations of price manipulation.

Given these potential costs, share repurchase announcements can be used as a clear signal to enhance the reputation and the credibility of an undervaluation signal.

Such credible signals should then lead to an appreciation in stock price and benefit the investors who are welling to sell their shares.

Share buyback will convey a message to investors that the company has few good projects (NPV<0) and in turn less cash flow and that is why the company is returning its money to investors.

Share buyback indicate that the financial situation of the company is not strong enough in order to meet the expectations of the investors.

When the company chooses to pay its investors by distributing dividends, it gives the signal that it has many good projects (NPV>0), and the company believes that it could create capital gains to investors without seeking refuge to share buyback.

2.7 Employee incentive plans:

The company might seek to purchase its own shares in order to finance its employee incentive plans.

In the current capitalist system, many companies realized that empowering employees is the best way to align the interests of the employees with the interest of the company.

Through the history, the management and the employees were always at odds and that caused many strikes and struggle within the company.

Many companies found out that the future organizations of the companies should depend on giving employees the initiative and turning them into an asset rather than looking at them as a liability or an expense.

This process has been triggered by the introduction of new technologies that enabled top managements to cut the middle management and give the authorities of the middle management to the employees that the technology will help them to perform their tasks in a more efficient way without the direct supervision of the middle management.

This process could not be achieved without giving employees shares in the company and make them real partners in the organizations.

When employees get share of the profit they will work harder than before and that will benefit the whole organization and the society.

Share repurchases are one of the best ways to turn the employees into an asset since share repurchases happen when the share price is relatively cheap, share repurchases provide a very cheap way to finance the employee share scheme and create a wholly new organization that depends on mutual trust between management and employees rather than struggle between them.

2.8 Convertible bonds execution:

Convertible bonds are defined as bonds that pay a regular coupon for their buyer, the price of bonds will depend on two main things: interest rates and credit quality of the issuer.

Convertible bonds combine the feature of bonds and shares at the same time.

We all know that companies give their investors the option to convert their bonds into common shares at any time they want in order to make their bonds more attractive to investors and give investors the flexibility in choosing the investment tools that they foresee suitable to their investment strategy.

We all know that shares and bonds are two different products that offer two different profit and loss opportunities.

Most of the times, shares and bonds markets work at odds. When interest rates are low share prices seem to be a better investment opportunity than bonds because they offer better return on investment.

When interest rates are high bonds seem to be a better investment opportunity than shares because they offer better return on capital.

Many companies encourage investors to invest with them by giving them the option( this option is called call option) to convert their bonds to shares.

When the company has a shortage of shares the company will have to buy them directly from the market in order to meet its investor’s requirements of converting bonds into shares.

2.9 Trade shares:

Trading shares might be the motive for share repurchases in the UK and elsewhere in the developed world.

When the market is depressed and the share prices reflect less than their fair value many companies will resort to buying their own shares in order to sell them later at a higher price.

When big companies believe that their shares are under-estimated, they invest the excess cash that they have in themselves in order to encourage more investors to buy their shares and when the market prices of the shares goes up the issuing companies will resell them at profit.

Investors will benefit from this share repurchase by two ways:

Investors will be able to sell some of their shares at higher price and make profit from that.

Investors will benefit from the higher dividends that their company will pay them as a result of re-selling the shares at higher price.     

Share repurchase might aim as well to reduce the volatility of the share and stabilize its price.

Share trading s not as easy as it might seem, there are regulations that govern the ability of the company to buy/sell its own stocks.

2.10 Destroy shares:

There are two reasons to destroying shares:

The first one is to change the ownership structure and the second one is to increase the wealth of the shareholders.

Change the ownership structure:

When the company buys its own shares in order to destroy them, it destroy with the shares the voting right, we all know that owning one share means owning one vote, this means that destroying one share means destroying one vote.

According to Pindur, D & Lucke, M (no date given) the management might find it very cost effective to have homogenous shareholders rather than heterogeneous shareholders, that’s why the company offers share repurchases and destroys shares.

In that case, the company will offer investors what is called a “controlled premium”, which is a premium that is paid above the market price in order to lure investors to sell their shares.

Wealth creation for investors:

The best measure to wealth creation is the Economic Value Added; Economic Value Added is defined as the operating after tax profit minus a charge for the opportunity cost of the invested capital.

When the company wants to maximize its shareholders wealth by buying and destroying the shares directly from the market the company will resort to the following measures:

  1. Decrease the weighted average cost of capital (WACC): we all know that the weighted average cost of capital depends on two major elements which are shares and bonds: the average cost of bonds is the interest rate that is paid to the bondholder, the average cost of shares will depend on the risk premium that is required by shareholders to compensate them for the risk of losing their invested principle; when the company buys its own stock it reduces the weight of equity in the mix of capital, so the weighted average cost of capital will be less and that is how the wealth of the shareholders will increase if the company bought the shares from the market and destroyed them; reducing the weighted average cost of capital means that producing the same profits or more with less costs of capital, this is a real sign of improvement in the situation of the company, the issuing company has to be careful that reducing the number of outstanding shares might mean that share prices will go up in order to satisfy the demand on the shares of the company, especially when shares get less, the dividends get better, this might increase the demand on shares, that is why management is always advised to reduce the amount of shares and debt in the same percentage in order to leave prices of shares and bonds relatively stable, the opposition to share buyback comes from debt holders especially those with unsecured debt, the reason for that is the fact that when shares decreases this means that capital has decreased and this means that if the company went bankrupt there will be no enough capital to cover the value of the debt, while shareholders will be the least losers from bankruptcy, again that is another reason why companies are advised to buy shares and bonds at the same time and keep its leverage ratio stable during the time, A third and final reason for advising companies to buy shares and bonds at the same time is the reason that many companies offer convertible bonds which could be converted at any time to certain number of shares, if the company did not buy shares and bonds at the same time and share prices went up, convertible bond investors might find it more profitable to convert their bonds to shares and in this situation the company will find itself in front of two options the first one wither buying more shares to convertible bond investors from the market and that would mean paying high prices for them or issuing new shares again and that would make share repurchases pointless.
  2. Increase the return on invested capital (ROIC): this idea is very related to what we explained before about type I error and type II error, in other words the company will take decisions regarding the best investment opportunities that are available, it is assumed that the company will select the projects that maximize the return on invested capital and return the excess cash to the investors in the shape of share repurchases, this process will maximize the return on equity to the maximum, we all know that the marginal propensity to capital will increase rapidly at the beginning of the investment and after that the amount of increase will de-accelerate until it the marginal propensity to capital reaches zero and then it starts to decline.      
  3. Increase the growth rate: when the right amount of capital has been allocated to the most profitable projects the growth rate of the company should be maximum.

2.11 Legislative reasons:

Sometimes companies in a particular country find very difficult to repurchase their stocks even if there is tax benefit from repurchasing the stock rather than distributing dividends.

In the US for example, companies did not repurchase their shares until after the mid-eighties.

According to Grullon, G& Michaely, R(2000:PDF page 5), one of the possible reasons for that is “the risk of violating the anti-manipulative provisions of the Securities Exchange Act of 1934, Indeed, after the SEC adopted a safe–harbor rule (Rule 10b-18) in 1982 that guarantees that, under certain conditions, this agency will not file manipulation charges against companies repurchasing shares on the open market, repurchase activity experienced an upward structural shift”.

Grullon, G& Michaely, R(2000) says that one year after the change of the SEC rule the amount of earnings that have been distributed as share repurchases tripled.

In Germany for example, share repurchases are still very difficult because they need the approval of the shareholders that should be got in the Annual General Meeting.

We can see clearly that regulation is a very important too in encouraging and discouraging share repurchases.

2.12 Dilute earnings:

Many analysts think that share options have helped in aliening the directors’ interests with the interests of the shareholders but few people investigated how stock options change the behavior and choice of directors to distributing earnings.
 
There is increasing evidence that executive compensation that is usually granted in the form of stock option has a lot to do with share repurchases in the UK and the US.

Accounting rules make compulsory on companies to reflect the value of the stock options that are given to directors and managers.

We all know that writing an option on the shares of the company is equivalent to increasing the number of the outstanding shares.

When company directors want to exercise their options, there need to acquire actual shares of the company and that would make Earnings per Share less for everybody; that is called “diluting the earnings”.

Earnings per Share are the total earnings divided by the number of outstanding common shares and common shares equivalents.

When earnings per share become actually less; the company will try to repurchase the shares from the market.

Earnings per share will not only be less but also will cause a decline in share prices later on because EPS is used in valuing the shares.

The cash that is actually used to repurchase the shares will not be deducted from the total earnings and that the company will keep its total earnings unchanged after the repurchase of the shares from the market.

In order to illustrate this point further, there is a difference between EPS and diluted EPS.

Diluted EPS is the total earnings of the company subtracted from the cost of share options and warrants divided by the number of outstanding common shares and equivalents.

When analysts value shares they look at EPS but not diluted EPS.

After share repurchases, EPS will be the same as before share repurchase EPS.

So companies try to repurchase their own shares because they try to hideout the cost of share option costs.

If we look at the empirical studies that have been done in this area we find that most of the studies found a correlation between stock repurchases and executive’s share options.

According to Lambert, Lanen, and Larcker (1989), Option grants in general are associated with increased payouts and decreased earnings retention.

The larger is the executives’ holding of stock options, the more apt the firm is to retain more earnings and curtail cash distributions.

This finding is consistent with Fenn and Liang (2000) that  there is a well-documented finding of negative relationship between dividends and managerial stock options and.

The relationship does not appear to be explained by differences in investment opportunities across firms. This result supports the agency hypothesis, namely that the distribution decision of a firm is influenced by executive compensation. It also suggests that any option-induced dividend reductions to enhance the value of executives’ options have primarily been used to retain more earnings.

3. Share Buybacks vs. Dividends:

There is an argument for dividends and there is an argument against dividends.

The argument for dividends is that:

Dividends create discipline in the company: when the company issue shares, it becomes owned by the shareholders that monitor the work of the company and its managers.

The shareholders participate in the annual meetings of the company and put the managers and the directors accountable for their actions and ask the directors to set new targets that would achieve sufficient level of return to the stockholders.

Having shareholders means more discipline by the managers and the directors of that particular company.

If the company decided to buyback its shares this means that the company will have fewer shareholders monitoring the company’s actions.

Dividends attract long-term investors; investors who invest in share in order to get paid an income from dividends are long-term and committed investors.

It is important for every company to have long-term investors, committed investors stand by the company in the good and bad times.

If the company is in bad situations, investors will try to support the company in re-correcting its mistakes and re-drawing its strategy.

Uncommitted investors increase the volatility of the share price because they sell at high prices and buy at low prices, and they always try to push the company to pay them by stock buyback, so they are not committed to the long-term future of the company.

Dividends are preferred to share repurchases because share repurchases involve a large amount of expenses that have to be paid to investment bankers and brokers in order to make the share repurchase successful.

Many analysts argue that dividends are more efficient than share repurchases because they do not waste the money of the investors so they go directly to the investors.

Share repurchases are criticized because they often benefit short-term investors rather than long-term investors.

According to Barclay and Smith (1988), in their paper ‘Corporate Payout Policy: Cash Dividends versus Open Market Repurchases, the two researchersargued that there is a cost associated with open market repurchases which may outweigh any tax disadvantage of dividends.

Managers’ repurchase activity will be governed by managers’ superior information. Market makers, recognising that they are at a disadvantage in regard to information, will set the share’s bid-ask spread at such a level as will compensate them for the risk of dealing with the better informed. This raises the company’s cost of capital and reduces firm value.

Empirical support for the theory is mixed. However, Brockman and Chung, the two researchers find in Hong Kong the fact that bid-ask spreads usually widen during repurchase periods as market participants respond to the presence of informed managerial trading.

Hong Kong has a very similar economic system to Britain so what is true for Hong Kong is likely to be true for Britain.

Moreover,  Ginglinger and Hamon, in their article ‘Actual share repurchases and corporate liquidity’, (2003) find that for the French market share repurchases have an adverse effect on liquidity on the trading day concerned as measured by bid-ask spread and depth.

Moreover, In the current capitalist system, many investors buy and sell shares quite often, stock repurchases will benefit this type of short term investors who have not stood by the company long enough to deserve this money that easily.
Share repurchases are criticized that they might cause re-distribution of earnings between investors.

There are always investors who want to sell and get their money back but there are investors who want to hold to their shares, this means that these investors will get less earnings than the ones who accepted selling their shares to the issuing company.

While dividends create justice to the investors because every investor get the same amount of dividend for each share they hold.

The argument against dividends:

The tax on dividends is higher than the tax on share buyback, tax makes share less attractive to investors and push them to ask the company to pay them by share buybacks.

Dividends are criticized because they cause confusion in the market especially when the amount of profits goes down and the dividends that each share gets down as well.

In order to explain more about this point we have to look at what happens to the share price when dividends go down:

When dividends come out to be lower than expected the market will react negatively to the news, and share prices will go down.

Share repurchases are always interpreted positively, because investors do get rewarded and they do not feel negatively towards the company so share repurchase are always good news for the market.

3.1 Dividends, Share repurchases and Cash flow:

According to Jagannathan, Stephens and Weisbach found that, for US companies, repurchase and dividends are used at different times from one another by different kinds of firm.

Firms buy its shares when its share prices are undervalued and there is an excess cash that would be distributed.

While companies distribute dividends when there is a stable steady stream of earnings to the company.

In other words, shares are repurchased when the company wants to smooth dividends and share price, this usually sends the wrong message to small investors.

What is the alternative?

Some large UK companies found the alternatives to the share repurchasing problem by issuing redeemable ‘B’ shares on a pro-rata basis as an alternative to a repurchase or a one-off special dividend.

For example, in the year 2002 M&S announced that it will restructure its share capital, and that would involve the creation of a new holding company (www.marksandspencercom).

Existing shareholders were given a the choice of a mixture of new ordinary shares and redeemable 'B’ shares,

The redeemable shares can be claimed for cash at certain dates in the future.

The amount of money that the company pays out to investors is treated as a capital gain, so this method gives investors the freedom in choosing the tax brackets that they want to be into.

Offering more than one redemption date gives shareholders the ability to spread their capital gains over a certain time.

3.2 Payout policy and taxes in the UK:

The tax system in every country justifies the choice of the payout channel in the company.

The difference in the tax system between the US and the UK explains the discrepancies in the observed patterns of payout between the US and the UK.

3.3 Dividends and Taxes:

In the US, dividends are subject to two taxes:

Dividends are taxed before the company distributes them to investors via corporate tax; dividends are taxed again after the distribution of the dividends to investors via income tax.

This system of taxing dividends twice is the reason behind the rise in cash buyback in the US.

In the UK, it is a slightly different story:

The UK has an imputation tax system; the imputation tax system tries to avoid the drawbacks of the classical tax system.

The difference between the classical tax system and the imputation tax system is that the imputation tax system avoids the double taxation that the classical tax system has.

The imputation tax system repays part of the tax back to share investors in the shape of tax credit.

According to Renneboog, L & Trojanowski,G(2005: P 8): “The UK has used a partial imputation tax system since 1973, In that system, part of the firm’s payment of corporation tax is taken into account when calculating shareholder’s liability to income tax on company dividends. Hence, that tax treatment of dividends is more favorable than in a classical tax system”.

According to the British imputation tax system, corporations pay their share investors dividends net of the imputed amount, companies pay to the Inland Revenue Advance Corporation Tax, Renneboog, L & Trojanowski,G(2005).

Normally, the shareholders receive his net cash dividends in addition to his tax credit.    
The tax credit is equivalent to the basic rate of income tax on dividends; these tax credits are normally used to offset income tax liabilities.

Tax laws gave full tax refund to charities and pension funds until 1997.

After 1997, tax authorities cancelled the full tax refund clause of the corporate tax law, this has made many institutional and personal investors indifferent between receiving tax in dividends or share repurchases.

This explains the difference between shares repurchases in the UK and the US, in the UK the motivation to be paid by share repurchases is much less than the US.

Compared to the US, the vast majority of UK firms pay dividends, Fama, E and French, K (2001).

3.4 Share repurchases tax treatment in the US:

Regarding the US tax treatment of share repurchases, as compared with cash dividends, which are subject to the tax rates for individuals.

Share repurchase profits in the US are subject to capital gains tax system.

Capital gains tax in the US have seen gradual decline in the recent year.

For example, in the year 2001, capital gains tax declined from 39.6% to 39.1%( http://www.kssmallbiz.com/articles/article_127.asp).

The tax law of the year 2001 makes clear that capital gains tax will be reduced gradually to 35% by the year 2006.

Capital gains tax can be charged at a rate of 20% if the gains qualify for long term capital gains tax, the long term capital gains tax save investors about 19%, which is 39%-20%(inland revenue website).

3.5 Share repurchases tax treatment in the UK:

The UK imputation system has its impact on share buybacks; in order to understand how we need to explain the following two ideas:

The first one is the off-market repurchase: this is the case when the share investor knowingly sells his shares to the same company that has issued them.

The second one is the open market repurchase: the second case when the investor sells his shares to other entities or bodies that are separate from the issuing firm.

In the open market repurchase case, investors get their realized profits taxed at the prevailing UK capital gains tax law.

In the Off-market repurchase case; investors get tax credit for the “distribution element”.

The “distribution element” is defined as the difference between market value of the share repurchase and the book value of corresponding paid-in capital.

According to Renneboog, L & Trojanowski,G(2005: P10) “the difference between the original subscription fee and the and the investor cost base which is the price at which he purchased the share plus inflation allowance is considered a capital loss”.
This capital loss can only be set off against capital gains.

It is natural to conclude that small investors would prefer share buybacks should they make capital gains from selling to the issuing company.

3.6 Ways of Share Repurchase Activities:
 
Companies usually use three methods in share repurchasing:

Fixed price tender offers (FPT) give shareholders an in- the-money put option.

Fixed price tender could be defined as well as a one-time offer announced for a specific period of time to purchase a stated number of shares at a price above the stock’s current market price, say at a tender premium.

Put option is the right but not the obligation to sell an underlying at a pre-agreed price; investors will exercise their put option if they could make profit from exercising their put option.

If the company wanted its fixed price tender offer to be successful the strike price should be high enough in order to lure as many investors as possible to sell their shares to the issuing company.

If the strike price was not high enough some investors might not find it profitable to sell their shares and that is how the Fixed Price Tender Offer fails.

When setting the exercise price, the issuing company should take into its consideration the price that investors have bought the share for.

The issuing company should make investors make profits when setting the exercise price.

That is what we mean by in-the-money put option, an in-the-money put option makes profit to its owners.

The reason for using put option is to give the investors the right to realize their profits in a way that suit their tax liabilities (as mentioned above).

Normally, companies will extend their repurchase offer if it did not find a satisfactory response from investors to the tender.

The fixed price tender offer might be done either by deciding in advance the number of shares that the company wants to buy or the amount of money that they company is prepared to spend.

If the company decides to buy a certain number of shares and that the tender did not look appealing to too many investors, the company might try to increase the tender price in order to buy the number of shares that it wants to buy.

Dutch auctions (DA) is designed to give shareholders a put at a range of prices, some of them are in-the-money.

Dutch auctions are a very flexible way of luring investors into selling their shares to the issuing company.

The difference between Dutch auctions and Fixed Price Tender is the fact that Dutch auctions give investors a range of exercise prices.

The reason for giving investors a range of exercise prices is again suit the investors’ varying tax needs.
 
As we have already shown that investors differ from each other in terms of their tax liabilities and the price that they purchased their shares at, so having different exercise prices will lure more investors to selling their shares to the issuing company.

Open market share repurchase (OMR) announcements create a valuable exchange option which permits a firm to exchange cash for the market value of its shares at times selected by management.

3.7 More recent motives for stock repurchase:

In the above paragraphs, we have explained the traditional reasons for stock repurchases, in this section I will try to explain more recent trends that stand behind stock repurchase, most of these reasons are immoral and I tried to sum most of them up here in this section:

According to a study done by Comment and Jarrell (1991), share repurchase are significantly lower when companies’ directors and managers are not at risk of being ousted by share holders.

This is a very significant finding; I think that the opposite is true as well which means that when companies’ directors and managers are at risk of being ousted by shareholders they try to buy the company’s stocks in order to create an exit for the unsatisfied shareholders.

In that sense, share repurchases are a very good way to get rid of the responsibility of the decline of many companies.

This might cause a crisis and prejudice against small shareholders that are unaware of the real purpose of share buyback.

In this case, share buybacks are immoral way of lifting share prices because they might create a false sense of improvement in the financial position of the company to many small and unprofessional investors.
 
3.8 Increase stock options values:

Most company directors are offered massive salaries every year and most of them are offered share options.

Some companies’ directors might be reluctant to repurchase the shares of the company in order to increase the price of shares of their companies so they can exercise their options and make profits.

In fact, this is difficult to happen in the actual world because most of the companies are monitored by institutional investors and analysts from all over the world but of course, there are some exceptions from time to time and illegal things do happen in big and small companies.

This could only happen if the institutional investors are engaged in the same way as the issuing company that is when analysts collaborate with some companies in order to cover these facts

Moreover, some companies’ directors who have shares in the companies that they manage might use share repurchases in order to dilute the control rights of other shareholder groups.

Even if these other shareholders are not willing to sell their shares to the firm the transaction costs associated with such an attempt might have a negative value impact.

3.9 The response of the market to share repurchases:

Market response to share repurchases news is always mixed and depends on the understanding of the market to the reason or the motivation of the management to share repurchases:

If the market thinks that share repurchases intend to improve the overall position of the company and it is in the best interests of the shareholders, the stock prices will go up.

What happened if the company repurchased its shares in the intension of increasing its EPS (Earnings per Share)?

If the market is aware of the fact that the company’s shares are undervalued and that the company intends to increase its EPS, the market will buy the shares of that company so the price of the shares will go up and the move will lose its effectiveness.

In this case, that total earnings will decline by the same percentage value as the number of shares outstanding because the company will use the earnings in order to buy the shares.

Earnings per share (EPS) will therefore remain unchanged. As a consequence, firms that solely buy back shares to increase their EPS ratio should not be able to achieve this goal.

This means that the company will use its assets (earnings) to buy its liabilities and that the relative position of the assets and liabilities will remain the same.

In the second case, when the market is not aware of the fact that the company want to buy its shares to increase its EPS, market participants will not rush to buy the shares of the company and that means that share prices will remain unchanged and that the company will buy them undervalued and that will increase EPS for all the remaining outstanding shares.

The second case is an ideal case in perfect financial markets where there are no insiders and there is no leak of information to outsiders.

4. The difference between share repurchases in the US, UK, France and Germany:

I have chosen to compare between the US and German laws regarding stock repurchases; the US represents the Anglo-American system and Germany stands for the Franco-Germanic system.

This comparison will allow us to understand the differences between the two competing systems and will help us expect and/or speculate on the new motivations of stock repurchases in the UK because the UK model is very much like the US model:

The German laws regarding share repurchase plans differ significantly from the laws and regulations that govern share repurchase transactions in the US For example, managers of German firms are required first under the law to obtain approval for a specified share repurchase program on their annual shareholder meeting and must then publicly announce any coming share repurchase, the company has to announce the number of shares that it wants to buy, the annual general meeting has to decide the duration of the repurchase and the way of the repurchase and the repurchasing duration that should be a maximum of eighteen months, Hackethal, A & Zdantchouk,A(2005).

After the share repurchase and exactly on the shareholder meeting that is after the share repurchase, management should justify to its shareholders the reason of the share repurchase, its volume and the price paid per share.

In contrast, US firms need only obtain an approval from their company board and are only required to publicly announce the establishment of a repurchase program.

Under the US laws and regulations, US firms are not required to announce the details of the proposed or actual share repurchase transactions to the financial authorities or to shareholders, Hackethal, A & Zdantchouk,A(2005).

This means that the door is open for the board of directors to decide for itself the reasons for the share repurchase; this means that share repurchases are subject as illustrated above to the way that the directors are rewarded.

Most of the few studies that have been made before about the motivations of US open market share repurchases reveals strong evidence that many US firms announce repurchasing programs to convey a message to investors that the share are undervalued and that it is the right time to buy them for cheaper than their real value.

Most of the analysts used to think that tax issues are the most important driver for share repurchases; now its is widely believed that share repurchases are increasing because of director rewards issues; the next generation of the studies is coming to shed the light about directors rewards issues.

In the UK, the purchase of shares means that the shares will be cancelled automatically and that these shares will not be banked or be put in the treasury.

France has very similar laws to Germany the French do not give freedom to the directors of the company to decide on the duration and the amount of the share repurchase in France.

Like Germany, French shareholders have to agree on the share repurchase in the general meeting.

The French law n° 98-546 of July 2, 1998,” authorized open market stock repurchases for public firms. Shares can be sold, bought or kept within the limit of 10% of the capital of the firm for a maximum period of 18 months. With the authorization given at the special meeting of shareholders, shares may be cancelled within a 10 % limit of existing capital for a 24-month period”, Reference number 20

In France, the motivation of the share repurchase is known because the issue will be discussed with the share holders before the share holders approve it and that what makes the classification of the share repurchases motivations easier than in the Anglo-American System.

5. Propensity to pay in the UK:

I have talked about the work of Renneboog, L & Trojanowski,G because they have tested the substitution hypothesis and rejected.

According to Renneboog, L & Trojanowski,G( 2005: PDF page 23) : “The overwhelming majority of UK firms (85%) do pay dividends over the 1990s Moreover, the proportion of dividend payers in the UK does not decrease over 1992-1998 (if anything, a modestly increasing trend can be observed). In any of the sample years, approximately five out of every six firms pay cash dividends. This result contrasts with the existing US evidence for the same period: only less than 24% of the American firms paid dividends”

Again according to Renneboog, L & Trojanowski,G( 2005) companies in the UK pay their earnings in the form of dividends rather than share repurchases because that is consistent with the wish of the shareholders that the fast majority of them are tax-exempt. On average less than 6 % of the analyzed firms repurchase their shares.

According to Renneboog, L & Trojanowski,G( 2005) “In the US the proportion of share repurchasing companies has increased from 70% to 90% over the 1990s”.
According to Renneboog, L & Trojanowski,G( 2005), In the first half of the 1990s, If we look at the frequency of the share repurchases in the UK market, we find the frequency to be very low for those companies which chose to repurchase their shares before.

According to Renneboog, L & Trojanowski,G( 2005), In the second half of the 1990s, we witnessed an increase in the number of share repurchases but the number of companies who repurchase shares is really small compared to the number of shares that distribute dividends.

The two economists, Renneboog, L & Trojanowski,G, rejected the substitute hypothesis.

6. Payout policy and Investment policy:

I would like to show the relationship between the payout policies of the firm with its investment decisions.

In the Anglo-American system companies tend to payout more earnings to its investors; this could affect the level of investment in the company because investors want their money in the quickest possible way with no consideration to the long-term future of the company.

From what we have seen above, company directors and managers of the Anglo-American system want to protect themselves by buying their companies’ shares in a defensive move to prevent any M&A.

This means that company directors in the Anglo-American system are more likely to waist the money of their share-holders on fruitless issues rather than spend the money in the right place.

The overall result of this way in distributing earnings would be less investment in the whole economy in the long-run if that trend persisted.

If we look at the Franco-Germanic model we see easily that the share repurchase issue is well regulated and the directors of any company cannot take the decision of buying its own shares without discussing the issue with most of its shareholders in order to get their approval.

When a company takes a decision in this way, it uses its funds in the best way because it gives equal opportunity to all the shareholders to participate and reach a compromise about the share repurchase.

The shareholders of the company, in the Franco-Germanic model, will not approve a share buyback if the purpose of the share buyback is to save the bad-performing directors or to dilute earnings.

In turn, this makes investment in the whole economy healthier because the funds of the shareholders are not wasted.

7. Conclusion:

From the above research, we can easily find that stock repurchases happen because of a variety of reasons such as signaling, cash flow, stock options, taxes, diluting, when company’s directors are at risk of being ousted.

The most important factors that contribute to the movement of stock repurchases are taxation, stock options, diluting and taxes.

8. Reference:

  • Barclay and Smith, ‘Corporate Payout Policy: Cash Dividends versus Open Market Repurchases, Journal of Financial Economics, (1988) pp61-82
  • Brockman and Chung, Journal of Financial Economics, 61(3)2001 pp417-448
  • Comment, Robert, and Gregg A. Jarrell, 1991 “The Relative Signaling Power of Dutch- Auction and Fixed-Price Self-Tender Offers and Open-Market Share Repurchases Journal of Finance, 46, (No. 4, September), PP 1243-1272.
  • DANN, L. (1981): Common stock repurchases: an analysis of return to bondholders and stockholders, Journal of Financial Economics, VOL 9, pp. 113-138.
  • Fama, E and French, K(2001): Disappearing dividends: Changing firm Characteristics or Lower propensity to pay?, Journal of Financial Economics VOL.60, PP. 3-43.
  • Fenn, G and Liang, N (2000):” corporate payout policy and managerial stock incentives” Journal of Financial Economics, Vol 60, PP 45-72.
  • Ginglinger and Hamon, ‘Actual share repurchases and corporate liquidity’, ssrn.com (2003)
  • Grullon, G& Michaely, R(2000): “ Dividends Share Repurchases and the Substitution Hypothesis”, journal of finance, August 2002 
  • Hackethal, A & Zdantchouk,A(2005): “signaling power of open market share repurchases in Germany” URL: www.ebs.de/fileadmin/redakteur/funkt.dept.finance/ hackethal/WP/Signaling_Power_of_OMR_Germany_Feb_2005.pdf
  • IKENBERRY, D. & VERMAELEN, T. (1996) “ the option to repurchase stock, Financial management, Vol. 25, pp. 9-24
  • Jagannathan, S and Weisbach (2000): ‘Financial flexibility and the choice between dividends and stock repurchases’ Journal of Financial Economics, pp335-384.
  • Lambert, Richard A, William N. Lanen and David F. Lacker (1989) “Executive Stock Option Plans and Corporate Dividend Policy” Journal of Financial Quantitative Analysis VOL 24, PP 409-425.
  • Miller and Modigliani (1961) : ‘Dividend Policy, Growth, and the Valuation of Shares’, Journal of Business,Vol. 34, pp. 411-433.
  • Pindur, D & Lucke, M (no date given): Riding the Hat Curve-why shareholders should tender their shares in fixed price tender repurchase programs, URL Link: http://www.fmpm.ch/docs/6th/Papers_6/Papers_Netz/SGF615.pdf
  • Kalay, A.(1980): ‘Signaling Information Content and Reluctance to Cut Dividends’ Journal of Financial and Quantitative Analysis VOL.15, pp, 1053-1070.
  • Renneboog, L & Trojanowski,G(2005:p8 & p10): patterns in payout policy and payout channel choice of UK firms in the 1990s, finance Working Paper number 70/2005: publisher: European Corporate Governance Institute.    
  • Siu, J & Weston, F(2002): Changing motives for share repurchases, http://www.anderson.ucla.edu/documents/areas/fac/finance/3-03.pdf
  • Stiglitz, J, E (1983): ‘some aspects of the taxation of capital gains’ journal of public Economics, Vol.21, PP.257-296.
  • Trojanowski, G(2004): ownership structure and payout policy in the UK, department of finance and center graduate school, Tilburg University, Netherland URL: papers.ssrn.com/sol3/papers.cfm?abstract_id=498023 - 20k
  • No author name(2003): the use of Open-Market Repurchase Programs in France, internet document URL: http://207.36.165.114/Zurich/Papers/160013.pdf

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