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Distributions to Shareholders

A) List and briefly discuss two motivations that would lead a firm to engage in a stock repurchase versus a straight cash dividend.

B) Briefly describe the implications of the tradeoff between dividends and free cash flow retention.

C) Explain this statement: Even though both the Constant Dividend Payout theory of dividends and the residual theory of dividends result in erratic dividends over time, both theories arrive at the same conclusion differently. (Hint: Figure out what the conclusion is first.)

D) In what way is the Modigliani/Miller dividend irrelevance theory similar to the residual dividend theory?

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Distributions to shareholders


There are advantages that arise from a stock repurchase. The stockholders have the option of not selling or selling the stock and the stockholders must accept it and pay tax if a dividend is paid. The other advantage is that if a market price per share goes up as a result of the repurchase, then the stockholders can take advantage of the capital gain. This assumes that the stock is sold at a gain and that it is held for more than one year. The treasury stock can also be resold in the market if the additional funds are needed by the management (Kennon, n.d.).

If the management is holding tax, then the management would favor a stock repurchase rather than a dividend because of the favorable tax treatment. The treasury stock can also be used as a basis for stock options and can be used for future acquisitions. The management may also prefer to repurchase stock rather than to pay a higher dividend that they feel cannot be maintained if there is excess of the cash flow that is deemed temporary (Kennon, n.d.).

If one is interested in finding a company that has the ability to generate profits that are high by reinvesting in a business that can earn high return on investment then a firm that repurchases shares is preferable. If you are an investor that needs cash upon which you want to live or to ensure that the management has the ability to allocate excess profit, then one might prefer dividends (Kennon, n.d).

Implications of the tradeoff between dividends and free cash flow retention:

Dividends are guided by a life cycle theory and trade-off theory. The benefits of earnings retention includes having insufficient financial slack to finance positive NPV investments, avoidance of the subsequent floatation quotes for the external financing and avoidance of taxes on payouts of share repurchase and dividends. The negative effects of ...

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