In a “perfect world” if a firm chooses to pay dividends instead of repurchasing shares based on the taxes that exist in a state where the company operates and the capital distribution strategy of a firm. Businesses choose to pay dividends in countries where the dividend penalty tax is relatively small. Alternatively, when the dividend tax penalty is more significant, companies are more inclined to repurchase their stock, which corresponds with the tax effect theory (Brigham & Ehrhardt, 2017; “Analysis of dividends and share repurchases,” 2020).
Higher dividend payouts are also associated with a higher rate of return. Repurchasing shares may be considered when the company has more cash as a result of operations or selling an asset when the amount of cash flow exceeds that necessary to service the debt (Picardo, 2019). Free cash flow (FCF) is another factor in determining the firm’s strategy. Hence, the strategy also depends on the FCF ratio and the strategic objectives of a firm.
In general, the desidion to repurchase shares or pay dividends depends on the type of growth an organization has – a fast-growing business choose to issue new shares instead of repurchasing stock or paying the debt. In terms of tax preferences, if a continually growing company aims to maintain its capital structure and retain tax deductions, it should choose to postpone repaying its debt and choose dividend payment over stock repurchasing.
Managers that consider the long-term interest of their shareholders would choose to repurchase stock, since Brigham and Ehrhardt (2017) state that “long-term capital gains are subject to lower taxes than dividends, investors prefer to have companies retain earnings rather than pay them out as dividends” (p. 565). Hence, it is better for these investors if the company chooses to withhold dividends and repurchase stock.
References
Analysis of dividends and share repurchases. (2020). Web.
Brigham, E. F., & Ehrhardt, M. C. (2017). Financial management: Theory and practice [with MindTap] (15th ed.). Mason, OH: South-Western.
Picardo, E. (2019). Dividends vs buyback: Understanding the difference. Web.