Subject: Re: back to topic (was Re: a stocks and dividends question)
From: "Benjamin J. Tilly " <ben_tilly@operamail.com>
Date: Fri, 10 Jan 2003 23:11:46 +0500

"Stephen J. Turnbull" <stephen@xemacs.org> wrote:
> >>>>> "Larry" == Larry M Augustin <lma@lmaugustin.com> writes:
> 
>     Larry> Dividends are guaranteed to return money to shareholders.
>     Larry> Share buybacks are not.
> 
> I was assuming purchase at a premium.  If that's not the way it works,
> forgive me for being an expatriate theorist (Japanese companies don't
> do buybacks at all ;-).

It is purchase on the open market.

> If what Zimran meant was that the buyback would cause share
> appreciation in the future, so the shareholders would benefit, I think
> the theory behind this is extremely shaky.  Smoke and mirrors.  If
> it's just purchase on the open market, a buyback does nothing except
> increase leverage somewhat as the company's cash position
> deteriorates.  This should not change the company's value ex buyback,
> however (Modigliani-Miller theorem), and so the net effect should be
> constant share price as the value of the company is decreased by
> precisely the amount of the buyback.
>
> In other words, a shareholder who sells exactly the proportion of his
> shares as the company buys of shares outstanding should see no change
> in his financial situation whatsoever.[1]  The decreased risk of
> cash-in-hand is offset by the increased leverage (risk) of the stock.

Either you are missing something very basic, or I am.

What you just did is quoted deep results to conclude
that, when tax effects are disregarded, if a shareholder
sells off shares exactly as the company buys them, then
that shareholder winds up redistributing value to be at
an identical wealth, albeit with more of that wealth in
the form of cash at hand.

As is well-known from basic economic theory and observed
practice, if a company hands out a dividend, the value
of the company drops by the same amount as is handed out,
so the share price drops and the net result is that
shareholders wind up at an identical wealth to what they
were at, albeit with more of that wealth in the form of
cash at hand.

In other words in theory a stock buyback accomplishes
_the exact same thing_ as a handing out a dividend.  At
least if you don't look at tax effects.  Which makes
sense since both are direct reallocations of a portion
of the company's value (in the form of cash on hand)
back to the shareholders.  All that differs is the
mechanism of payback and distribution of shareholders
who directly receive that value.

However a significant number of shareholders actually
wish to remain fully invested in equities.  They have
no interest in receiving cash in the present.  How do
they perceive the two mechanisms, tax implications
included?

With traditional dividends they incur the value that
was redistributed as dividends, pay income tax on it,
then reinvest the remainder back into the company.
At the end of the investment period they then
experience changes in the company's projected fortunes
in the form of capital gains (or losses).

With a stock buyback they do nothing, incur no income,
and incur no taxes until they sell.  At which point
they realize both the value redistributed and the value
due to changes in the company's projected fortunes
combined in the form of capital gains (or losses).

Thus the theoretical difference for this common type of
investor is entirely whether they experience periodic
redistributions of wealth back to shareholders as
capital gains later or as personal income now.  Since
taxes are higher on personal income, many prefer to
take this in the form of capital gains.

Cheers,
Ben
-- 
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