In a theoretically perfect world capital market, Modigliani and Miller's Proposition I deem the choice between dividends and share repurchases irrelevant. This proposition, under the assumptions of perfect capital markets, no taxes, and no information asymmetry, asserts that a firm's value is solely determined by its investment decisions, unaffected by its financing decisions like dividends or share repurchases. However, in the real world, where capital markets are imperfect and taxes are a reality, this decision can significantly impact both the firm and its shareholders.

However, in the real world, where capital markets are not perfect, and taxes exist, the decision between dividends and share repurchases can have implications for investors and the firm. Share repurchases may be preferred over dividends under certain tax conditions. For example, in the United States, capital gains tax rates are typically lower than ordinary income tax rates on dividends. Therefore, shareholders may prefer share repurchases, as they can defer taxation until they sell their shares, potentially benefiting from lower capital gains tax rates. This tax preference for share repurchases may incentivize firms to favor buybacks over dividends.Managers acting in the interests of long-term shareholders may choose to repurchase shares if they believe the stock to be either undervalued or overvalued, depending on their assessment of the firm's future prospects and market conditions. If managers believe the stock is undervalued, they may view share repurchases as an opportunity to invest in the company at a discount, thereby enhancing shareholder value in the long run. Conversely, if managers believe the stock is overvalued, they may repurchase shares to return excess cash to shareholders and prevent value destruction from investing in overpriced securities.

References:

Brigham, E. F., and Ehrhardt, M. C. (2020).Financial management: Theory and practice[withMindTap] (16th ed.). Cengage Learning. ISBN-13: 9780357252680

Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares.the Journal of Business,34(4), 411-433

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