When companies decide to distribute capital to shareholders, they have two main options, dividends or share repurchases. Though both methods achieve the same goal, they have different implications and are preferred under varying circumstances. Dividends are payments made by a company to its shareholders out of its profits or reserves. These payments are often preferred by investors seeking regular income and can demonstrate that the company is financially stable and confident about its prospects.

On the other hand, share repurchases entail a company buying back its shares from the open market. This can be an effective way to distribute capital to shareholders, as it reduces the number of outstanding shares, thereby increasing earnings per share (EPS) and potentially boosting stock prices. In certain tax regimes, share repurchases may be more advantageous than dividends due to tax considerations. For instance, in the United States, capital gains tax rates are generally lower than ordinary income tax rates on dividends. Share repurchases allow shareholders to defer taxation until they sell their shares, potentially resulting in tax savings.

Managers may opt to repurchase shares in different scenarios. If managers believe that the company's stock is undervalued relative to its intrinsic value, they may view share repurchases as an opportunity to invest in the company's own shares at a discount, thereby benefiting long-term shareholders. Conversely, if managers believe that the company's stock is overvalued, they may still opt for share repurchases to return excess capital to shareholders rather than making potentially value-destructive acquisitions or investments.

References:

Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.

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