Buybacks and Dividends Stock Buy-Backs Term Paper

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3.0 Dividends

According to the Miller-Modigliani Hypothesis, dividends do not affect value. This theory reasons that if a firm's investment policy doesn't change, the value of the firm cannot change with dividend policy. Therefore, investors should be indifferent to receiving either dividends or capital gains. but, the Miller-Modigliani Hypothesis has underlying assumptions that don't hold in the real work. It assumes there are no tax differences between dividends and capital gains and that companies do not use the excess cash they have as result of not paying the dividends for bad projects or acquisitions (Dividend policy). As these situations occur, there are distinct advantages and disadvantages of dividends

3.1 Advantages of Dividends

Stockholders may value regular cash payments that dividends offer and many may not face the tax disadvantages of dividends (discussed in the next session of this paper). and, unlike volatile stock prices firms generally do not change their dollar dividends frequently; dividends are said to be "stick."

Dividends tend to follow a much smoother path than earning do. (Returning cash to owners: the firm's payout policy).

Dividends now are more certain than capital gains later and this is often considered an advantage of dividends. but, this does not mean that dividends are more valuable than capital gains because the appropriate comparison should be between dividends today and price appreciation today. Unfortunately, this is a common fallacy known as "the bird in the hand fallacy" and it should be avoided when comparing dividends to capital gains (Dividend policy).

A firm's change in dividend policy sends a strong market signal about their future cash flows; a dividend increase indicates that the firm expects to have higher future cash flows which translate into higher share prices.

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Further, making a commitment to pay dividends imposes financial discipline on managers who are under greater pressure to make sure that free flow cash flows are not wasted (Returning cash to owners: the firm's payout policy).

3.2 Disadvantages of Dividends

In cases where dividends are taxed differently than capital gains (dividends are taxed as ordinary income) and the marginal tax rate of dividends is higher than that of capital gains, there is a tax disadvantage for stockholders who receive dividends. and, even if ordinary income and capital gains are taxed the same, dividends still have a tax disadvantage because investors do not have the choice of when to report the dividend as it is the case with capital gains (Returning cash to owners: the firm's payout policy).

4.0 Recommendations

In summary, it's difficult to say whether a stockholder is better off with dividends or stock buybacks. Stockholders should explore underlying reasons behind either policy choice made by a company and they should focus on quarterly net income fundamentals in analyzing earning reports rather than just types of metrics that are easily influenced by stock buybacks. Further, stockholders need to explore their own preferences for regular cash payments vs. stock price appreciation and asses their individual tax situations to decide which type of policy will truly benefit them the most......

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