Relevance of Dividends and Share Repurchases

Relevance of Dividends and Share Repurchases

Transaction Cost

Most investors sell their shares to raise liquid cash especially if they withhold non-dividend stocks, thus making the transactions costly to cover. However, it is a common phenomenon for corporations to conduct share repurchase automatically if shareholders are unsatisfied with the costs incurred during transactions (Ye, 2011).

Transaction costs refer to the expenses incurred when selling or buying securities. They include commissions paid to brokers, closing costs, government fees, spreads, and appraisal fees (Memil et al., 2011).  They are important to business investors because they determine net returns. Over a lengthy period of time, transaction costs can diminish returns as they reduce the available capital for investment.

Tax

The tax burden on share repurchases and dividends is highly dependent on personal and corporate income tax systems. Gains taxes are exceeded by the tax on dividends thus the conception of incentives to minimize dividends (Memili et al., 2012). Incentives to increase dividends are also created especially if there is a large minimization of tax on dividends n capital gains. Many countries tax dividends at a higher rate as compared to capital gains, but in the US, the taxation of both are equalized at 15%.  In theory, the aim of taxation is to prevent business entities from paying dividends to shareholders. It is true that dividends have a tax disadvantage, but studies indicate that shareholders and investors react negatively when dividends are decreased and positively when increased.  Besides, if capital gains are taxed at a lower rate than dividends, business entities should prefer to conduct share repurchases or to retain earnings.

In the United States, investors that sell shares held for more than a year can only be taxed on the profit they make using the rate of long-term capital gains. The rate is significantly lower than that of personal tax on dividends. More than two decades ago, dividends were surpassed by share repurchases to become the largest corporate payout forms in the United States. When capital gains are exceeded by dividend tax rates, the optimal dividend policy does not allow for dividend payments (Grullon et al., 2012). Taxing dividends at a higher rate when compared to capital gains leads to shareholder dissatisfaction because the income is lower than their investment expenses. On the other hand, shareholders pay less tax if dividend tax rate is more than the tax rate on capital gains. Tax savings such as this raise the company's value if it uses share repurchases.

Business corporations operational in countries that have adopted a system of double taxation have less dividend payout than states that avoid the double taxation system (Grullon 2014). Therefore, tax effect measurable by the nature of the treatment of dividend taxes impacts strongly on the size of dividend payout.

Clientele Effect

Clientele effect states that the company's stock price changes according to investor's goals and demands in reaction to dividends, taxes or other changes in policies that affect the organization. Its assumption is that distinct company policies attract investors, thus, their alteration will lead to stock adjustments as per their needs (Rubinstein, 2013). Consequently, adjustment in stock results in their price movement. 

Tax rates are variable according to investment horizons, jurisdiction, and income. In light of this, it is possible for a business entity to attract varied groups of investors as per the policies of investment. The clientele is not perfect because high tax investors are eligible for dividends, thus implying that taxes on dividends are not the sole determinants of investment portfolios (Kania et al., 2010). Despite clientele effect on business transactions, it cannot eliminate relative tax disadvantage.

SR individual investors have no preferences and are taxed the same on gains and dividends. They rely on dividend as the main income source (Boardman, 2013). On the other hand, LR individual investors prefer share repurchases to dividends. It is worth noting that stocks held in pension funds or a retirement account cannot be taxed on capital gains or dividends. Business organizations can exclude more than 70% of their overall dividend income but cannot exclude capital gains because they prefer stocks that pay high dividends. In most organizations, managers pay dividends to investors if they place a stock price on the payers. Investors cannot be catered for if their preference and loyalty are towards non-payers (Ekholm, 2015). Hence, the organization cannot attract new investors for as long as high-dividend companies are available to serve investors that prefer high dividends.

Signaling

Signaling refers to the notification from the organization to investors that it can afford to pay higher dividend rates for the foreseeable future by increasing dividends. On the other hand, its decrease signals less optimism on market conditions. Managers that have god investment opportunities signals more often than those that do not, given that it is in their best interest to do so to increase the viability of the firm (Das et al., 2011). However, surveys indicate that most investors and shareholders prefer table dividends if there are market uncertainties and volatilities. Therefore, the majority of organizations are mandated to raise dividend rates only if there is a perception of long-term and sustainable growth. According to the bird-in-the-hand argument, investors go for cash dividends instead of uncertain capital gains. Therefore, the value of companies that pay dividends will be higher in comparison to those that do not.

Organizations can comfortably maintain any level of dividends in the short-run via constant adjustments to the number of shares issued or repurchased and the amount of cash retained. Still managers cannot commit to dividends that the organization is unable to pay out of regular earnings because of transaction costs and taxes.

Antitakeover Device

            Corporations have multiple options of barring takeovers by hostile firms. They can set rules and regulations that deter attempted hostile takeovers, but such statutes can be detrimental to investors and shareholders as they can prevent the companies from engaging in justified or profitable takeovers (Coffee et al., 2011). Accumulation of cash on balance sheets renders organization vulnerable to takeovers because cash is usable in settling debt incurred to enable acquisition. Some anti-takeover strategies include maintenance of lean cash, share repurchases, and raising the cost of the takeover.

Bibliography

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