Finance Quiz: Stock Repurchases Vs Dividends
20 questions · exam conditions
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Stock Repurchases Vs DividendsQuestion 1 of 20

Apex Industries announces a plan to repurchase $200 million of its common stock. At the time of the announcement, the stock is trading at $50 per share. Shortly after, due to positive market sentiment, the stock price rises to $55 per share and stays there while the company executes the repurchase plan. What is the most likely consequence of this price increase?

The repurchase will have a greater accretive effect on EPS than originally anticipated.
The company will be able to repurchase fewer shares than originally anticipated.
Shareholders who do not sell their shares will experience a decrease in wealth.
The company will be required to increase the total dollar amount of the repurchase plan.
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Finance Quiz

Finance Quiz: Stock Repurchases Vs Dividends

Practice Stock Repurchases Vs Dividends in Finance with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Stock Repurchases Vs Dividends, giving you a quick way to practice the rules, question types, and explanations that matter most for Finance.

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Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

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Question 1

Apex Industries announces a plan to repurchase $200 million of its common stock. At the time of the announcement, the stock is trading at $50 per share. Shortly after, due to positive market sentiment, the stock price rises to $55 per share and stays there while the company executes the repurchase plan. What is the most likely consequence of this price increase?

  1. The repurchase will have a greater accretive effect on EPS than originally anticipated.
  2. The company will be able to repurchase fewer shares than originally anticipated. (correct answer)
  3. Shareholders who do not sell their shares will experience a decrease in wealth.
  4. The company will be required to increase the total dollar amount of the repurchase plan.
Explanation: A share repurchase program is typically defined by a total dollar amount. If the stock price increases, that fixed dollar amount will purchase fewer shares. For example, at $50/share, $200 million would buy 4 million shares. At $55/share, it would buy approximately 3.64 million shares. Distractor A is incorrect; since fewer shares are repurchased, the reduction in the denominator of the EPS calculation is smaller, leading to a less accretive effect on EPS. Distractor C is incorrect; non-selling shareholders are not harmed and may benefit from the price increase. Distractor D is incorrect; the company is not required to increase the size of the plan.

Question 2

Giga Corp. has a P/E ratio of 12.5 and is considering using excess cash to repurchase shares. The cash is currently invested in marketable securities yielding a 6% after-tax return. Based on the relationship between the company's earnings yield and the cost of funds, what will be the immediate impact of the repurchase on the company's EPS?

  1. EPS will increase. (correct answer)
  2. EPS will decrease.
  3. EPS will remain unchanged.
  4. The impact cannot be determined without knowing the dollar amount of the repurchase.
Explanation: A share repurchase increases EPS if the earnings yield of the repurchased shares is greater than the after-tax cost of the funds used.
  1. Calculate the earnings yield: The earnings yield is the inverse of the P/E ratio. Earnings Yield = 1 / P/E = 1 / 12.5 = 8.0%.
  2. Identify the cost of funds: The after-tax return on the cash being used is 6.0%.
  3. Compare: Since the earnings yield (8.0%) is greater than the cost of funds (6.0%), the repurchase will be accretive to EPS. The company is effectively trading a 6% earning asset (cash) for an 8% earning asset (its own stock).
Distractor B would be correct if the P/E were higher (e.g., > 16.67, where the earnings yield would be < 6%). Distractor C would be correct if the P/E were exactly 16.67 (1/0.06). Distractor D is incorrect because the directional impact can be determined without the specific dollar amount.

Question 3

An all-equity firm with stable net income uses cash to repurchase 15% of its outstanding shares. Assuming the cash was earning no return, what is the most likely immediate impact on the firm's Return on Equity (ROE) and debt-to-equity ratio?

  1. ROE increases; debt-to-equity ratio increases.
  2. ROE decreases; debt-to-equity ratio increases.
  3. ROE is unchanged; debt-to-equity ratio is unchanged.
  4. ROE increases; debt-to-equity ratio is unchanged. (correct answer)
Explanation: When analyzing share repurchases, you need to understand how they affect key financial ratios by changing both the numerator and denominator of those ratios. A share repurchase using cash reduces both assets (cash decreases) and equity (fewer shares outstanding means lower total equity). Since the firm is all-equity with no debt, let's trace the impact on each metric. For ROE, which equals Net Income ÷ Shareholders' Equity, the numerator (net income) stays the same since the cash was earning no return. However, the denominator decreases because shareholders' equity falls when shares are repurchased. When you divide the same numerator by a smaller denominator, ROE increases. For the debt-to-equity ratio, since this is an all-equity firm, there's no debt. The ratio remains zero regardless of changes to equity, so it's unchanged. This confirms answer D is correct: ROE increases while debt-to-equity ratio remains unchanged. Answer A is wrong because the debt-to-equity ratio cannot increase when there's no debt to begin with. Answer B incorrectly suggests ROE decreases—this would only happen if the cash were generating positive returns that exceeded the firm's ROE. Answer C is wrong because it assumes ROE stays constant, ignoring the mathematical impact of reducing the equity denominator while keeping net income stable. Study tip: Remember that share repurchases are "equity-neutral" from an accounting perspective but "equity-reducing" from a per-share perspective. Always ask yourself: does the transaction change the numerator, denominator, or both in the ratio you're analyzing?

Question 4

A firm wants to execute a large share repurchase quickly because management strongly believes the shares are undervalued. Which method of repurchase would be most suitable to achieve this objective?

  1. A fixed-price tender offer made to all shareholders at a premium to the current market price. (correct answer)
  2. A series of open-market repurchases spread over the course of a full fiscal year.
  3. A special cash dividend, which effectively functions as a mandatory repurchase from all shareholders.
  4. A private negotiation to buy back shares from a single large institutional holder.
Explanation: When management believes shares are significantly undervalued, they face a timing dilemma: act quickly to capture maximum value before the market corrects the mispricing, or risk the opportunity disappearing. This question tests your understanding of different repurchase mechanisms and their execution speeds. A fixed-price tender offer (A) is ideal for rapid execution because it invites all shareholders to sell a specific number of shares at a predetermined price above current market value. The premium incentivizes participation, and the tender process can be completed within weeks. Since management believes shares are undervalued, paying a premium still allows them to repurchase below intrinsic value. Option B fails because spreading purchases over a full year contradicts the urgency requirement. Open-market repurchases also face daily volume limitations and may drive up prices as buying pressure increases, making them inefficient for large, quick repurchases. Option C is conceptually flawed—a special dividend doesn't repurchase shares at all. It distributes cash to shareholders while leaving share count unchanged, making it irrelevant to the objective. Option D might seem fast, but buying from a single institutional holder creates several problems: it may not provide enough shares for a "large" repurchase, requires complex private negotiations that can be time-consuming, and may face regulatory scrutiny depending on the relationship between parties. Study tip: Remember that tender offers are management's tool for speed and certainty in repurchases, while open-market programs prioritize flexibility and cost control over time.

Question 5

A firm has a choice between distributing $50M via a special dividend or a share repurchase. Its current market capitalization is $1B, and it has 20M shares outstanding. Its P/E ratio is 25. Assuming no taxes or market imperfections, which of the following outcomes is most likely?

  1. The firm's P/E ratio will be higher after the repurchase than after the dividend.
  2. The firm's P/E ratio will be the same after either the repurchase or the dividend. (correct answer)
  3. The stock price will be $47.50 after the dividend and $50.00 after the repurchase.
  4. Total shareholder wealth will be greater with the repurchase due to the higher resulting EPS.
Explanation: In a perfect market, the firm's P/E ratio reflects its growth prospects and risk, which are not changed by the payout method. While the stock price (P) and EPS (E) change differently under each scenario, the ratio P/E should adjust to the same new level in both cases. Let's verify.
  • Initial State: Price = $1B / 20M = $50. NI = Mkt Cap / PE = $1B / 25 = $40M. EPS = $40M / 20M = $2.
  • Dividend: Dividend/share = $50M/20M = $2.50. New price = $50 - $2.50 = $47.50. EPS is still $2. New P/E = $47.50 / $2.00 = 23.75.
  • Repurchase: Shares bought = $50M / $50 = 1M. New shares = 19M. New EPS = $40M / 19M = $2.105. Price remains $50. New P/E = $50 / $2.105 = 23.75. The P/E ratio is the same in both scenarios.
Distractor A is incorrect. Distractor C has the correct prices but is not the most complete answer describing the outcome, as the key insight is the resulting valuation multiple. The question asks for the most likely outcome, and the equivalence of the P/E is a more robust conclusion. Distractor D is incorrect as shareholder wealth is unaffected by payout policy in perfect markets.

Question 6

A 'clientele effect' with respect to payout policy suggests that different groups of investors prefer different payout policies. If a company's shareholder base is dominated by tax-exempt institutional investors, such as pension funds and university endowments, what payout policy would the company most likely adopt to appeal to this clientele?

  1. A policy of low or no payouts, focusing on capital appreciation.
  2. A policy of irregular share repurchases timed to coincide with low stock prices.
  3. A policy of paying a high, stable, and predictable cash dividend. (correct answer)
  4. A flexible policy that alternates between dividends and repurchases each year.
Explanation: Tax-exempt institutions are indifferent to the form of the payout (dividend vs. capital gain) from a tax perspective. However, many of these institutions, particularly endowments and pension funds, rely on steady, predictable income to meet their own cash flow obligations. Therefore, they are often attracted to companies that pay high, stable, and predictable dividends. Distractor A appeals to investors seeking growth, but not necessarily those needing income. Distractor B provides capital return but lacks the predictability these institutions often desire. Distractor D is unpredictable and less desirable for income-focused investors.

Question 7

Nova Corp. has net income of $50 million and 20 million shares outstanding. The company's stock trades at a P/E ratio of 16. Nova's management decides to use $80 million of excess cash, which was earning no return, to repurchase shares on the open market. Assuming the repurchase is executed at the prevailing market price, what will be the company's approximate earnings per share (EPS) after the repurchase is completed?

  1. $2.50
  2. $2.63
  3. $2.78 (correct answer)
  4. $2.94
Explanation: This is a multi-step calculation.
  1. Calculate the initial EPS and stock price. Initial EPS = Net Income / Shares Outstanding = $50,000,000 / 20,000,000 = $2.50. Stock Price = Initial EPS × P/E Ratio = $2.50 × 16 = $40.00.
  2. Calculate the number of shares repurchased. Shares Repurchased = Cash Used / Stock Price = $80,000,000 / $40.00 = 2,000,000 shares.
  3. Calculate the new number of shares outstanding. New Shares = 20,000,000 - 2,000,000 = 18,000,000 shares.
  4. Calculate the new EPS. New EPS = Net Income / New Shares = $50,000,000 / 18,000,000 ≈ $2.78.
Distractor A is the initial EPS before the repurchase. Distractor B results from incorrectly reducing net income by the cash amount. Distractor D results from an error in calculating the number of shares repurchased, perhaps by using the initial EPS as the price.

Question 8

A company is considering using debt to finance a major share repurchase. The company's earnings before interest and taxes (EBIT) is $100 million, its tax rate is 25%, and it has 10 million shares outstanding. It plans to issue $120 million in new debt at an interest rate of 5% to buy back shares at the current market price of $30 per share. What is the expected EPS after this leveraged repurchase?

  1. $7.50
  2. $11.50
  3. $11.75 (correct answer)
  4. $12.50
Explanation: This is a multi-step calculation involving leverage and repurchase effects:
  1. Calculate shares repurchased: $120,000,000 ÷ $30 per share = 4,000,000 shares.
  2. Calculate new shares outstanding: 10,000,000 - 4,000,000 = 6,000,000 shares.
  3. Calculate new interest expense: $120,000,000 × 5% = $6,000,000.
  4. Calculate new earnings before taxes: $100,000,000 (EBIT) - $6,000,000 (Interest) = $94,000,000.
  5. Calculate new net income: $94,000,000 × (1 - 0.25) = $70,500,000.
  6. Calculate new EPS: $70,500,000 ÷ 6,000,000 shares = $11.75.
Distractor A is the initial EPS before the repurchase ($75M ÷ 10M = $7.50). Distractor B incorrectly deducts the full pre-tax interest from net income. Distractor D ignores the interest expense entirely.

Question 9

A firm has net income of $20 million and 5 million shares outstanding. The stock trades at $40 per share. The firm plans a $40 million payout, either as a $8.00 per share dividend or by repurchasing shares. An investor holds 500 shares. If the firm repurchases shares and the investor chooses to sell 100 shares back to the company, how does the investor's final cash position compare to what it would have been if the firm had paid the dividend?

  1. The investor has $4,000 more cash from the repurchase.
  2. The investor has $4,000 less cash from the repurchase.
  3. The investor's cash position is identical in both scenarios. (correct answer)
  4. The investor has $8,000 more cash from the repurchase.
Explanation: This question tests the concept of homemade dividends.
  1. Dividend Scenario: The investor receives a dividend on all 500 shares. Cash Received = 500 shares × $8.00/share = $4,000.
  2. Repurchase Scenario: The investor creates a 'homemade dividend' by selling shares. The repurchase is done at the market price of $40. Cash Received = 100 shares sold × $40/share = $4,000. The investor's cash position is identical ($4,000) in both scenarios. The key is that in a repurchase, investors can choose whether or not to receive cash by selling shares, thereby creating their own desired cash flow.
Distractors A, B, and D are incorrect as they fail to recognize that the investor can replicate the dividend cash flow through the repurchase.

Question 10

A 'clientele effect' with respect to payout policy suggests that different groups of investors prefer different payout policies. If a company's shareholder base is dominated by tax-exempt institutional investors, such as pension funds and university endowments, what payout policy would the company most likely adopt to appeal to this clientele?

  1. A policy of low or no payouts, focusing on capital appreciation.
  2. A policy of irregular share repurchases timed to coincide with low stock prices.
  3. A policy of paying a high, stable, and predictable cash dividend. (correct answer)
  4. A flexible policy that alternates between dividends and repurchases each year.
Explanation: Tax-exempt institutions are indifferent to the form of the payout (dividend vs. capital gain) from a tax perspective. However, many of these institutions, particularly endowments and pension funds, rely on steady, predictable income to meet their own cash flow obligations. Therefore, they are often attracted to companies that pay high, stable, and predictable dividends. Distractor A appeals to investors seeking growth, but not necessarily those needing income. Distractor B provides capital return but lacks the predictability these institutions often desire. Distractor D is unpredictable and less desirable for income-focused investors.

Question 11

A mature company with a long history of paying stable, quarterly dividends announces it will suspend its dividend for one quarter and instead conduct a large, one-time share repurchase. Management states the action is to 'return capital to shareholders.' What is the most likely signal this action sends to the market?

  1. The company is experiencing short-term financial distress and cannot afford the dividend payment.
  2. Management believes the company's shares are currently undervalued by the market. (correct answer)
  3. The company is permanently shifting its payout policy from dividends to repurchases.
  4. Management expects a significant and permanent increase in future earnings and cash flows.
Explanation: A large, non-recurring share repurchase is often interpreted as a signal that management believes the stock is a good investment at its current price, i.e., it is undervalued. By buying back shares, the company is investing in itself. Distractor A is unlikely, as a repurchase requires significant cash; if the company were in distress, it would likely conserve cash. Distractor C is a possibility, but a single event does not confirm a permanent shift. Distractor D is more strongly signaled by initiating or increasing a regular dividend, which implies a long-term commitment that repurchases do not.

Question 12

Assume a perfect capital market where Modigliani-Miller propositions hold. A company pays out $2 million to its shareholders. An investor owns 1,000 shares, valued at $50 per share before the payout. If the company pays a dividend, the investor receives cash and the stock price falls. If the company repurchases shares, the investor does not sell any shares. What is the investor's total wealth immediately after the payout in each scenario?

  1. Higher with the dividend because the investor receives cash directly.
  2. Higher with the repurchase because the investor owns a larger percentage of the firm.
  3. The same in both scenarios, but higher than the initial wealth.
  4. The same in both scenarios, and equal to the initial wealth. (correct answer)
Explanation: In a perfect market (no taxes, no transaction costs), payout policy is irrelevant to shareholder wealth. The investor's total wealth remains unchanged.
  • Dividend: The investor receives a cash dividend, but the value of their shares falls by an equivalent amount. Wealth = (New Share Price + Dividend) × Shares. This equals the initial wealth.
  • Repurchase: The investor receives no cash but now owns a larger percentage of a smaller firm (whose value has decreased by the cash paid out). The value of their holding remains the same. Total wealth is unchanged. Therefore, the investor's wealth is the same in both scenarios and equal to their initial wealth of 1,000 shares × $50/share = $50,000.
Distractors A and B reflect common misconceptions that one method creates more wealth than the other. Distractor C incorrectly assumes that a payout increases total wealth.

Question 13

A company's stock has a book value per share of $20 and a market price of $50. The company repurchases shares on the open market at the prevailing market price. What is the effect of this repurchase on the book value per share (BVPS) for the remaining shareholders?

  1. BVPS will decrease because shares are repurchased at a price higher than book value. (correct answer)
  2. BVPS will increase because there are fewer shares outstanding.
  3. BVPS will remain the same because the transaction is a capital allocation decision.
  4. The effect on BVPS cannot be determined without knowing the P/E ratio.
Explanation: When you encounter share repurchase questions, focus on the mechanics of how the transaction affects the book value calculation. Book value per share equals total shareholders' equity divided by shares outstanding, so you need to analyze how both the numerator and denominator change. In this scenario, the company pays $50 per share while each share only represents $20 of book value. When the company repurchases shares at above book value, it removes $50 of cash (an asset) from shareholders' equity for each share bought back, but only eliminates $20 of book value per share from the calculation. This creates a net reduction in total shareholders' equity that's proportionally larger than the reduction in share count. Here's why each answer works or fails: Choice A correctly identifies that paying above book value reduces BVPS because the company depletes shareholders' equity faster than it reduces the share count. Choice B represents a common misconception—while fewer shares outstanding can increase BVPS, this only happens when shares are repurchased below book value. Choice C incorrectly suggests the premium paid doesn't matter, but the price relative to book value is crucial for determining the effect on remaining shareholders. Choice D is wrong because the P/E ratio is irrelevant to book value calculations, which are based on balance sheet equity, not earnings multiples. Study tip: Remember the golden rule for share repurchases: buying back shares above book value hurts remaining shareholders' BVPS, while buying below book value helps them. The market price versus book value comparison is your key indicator.

Question 14

Two identical companies, Firm A and Firm B, each have a market value of $500 million and 10 million shares outstanding, making their stock price $50 per share. Both firms decide to distribute $50 million in cash to shareholders. Firm A pays a cash dividend, while Firm B conducts a stock repurchase at the market price. In a perfect market with no taxes, what will be the stock price of Firm A and Firm B, respectively, immediately after the distributions are completed?

  1. Firm A: $45.00; Firm B: $45.00
  2. Firm A: $45.00; Firm B: $50.00 (correct answer)
  3. Firm A: $50.00; Firm B: $45.00
  4. Firm A: $50.00; Firm B: $50.00
Explanation: In a perfect market:
  • Firm A (Dividend): The company pays a dividend of $50 million / 10 million shares = $5.00 per share. On the ex-dividend date, the stock price drops by the amount of the dividend. New Price = $50.00 - $5.00 = $45.00.
  • Firm B (Repurchase): The company uses $50 million to buy back shares at $50/share, repurchasing 50M/50M/50 = 1 million shares. The new company value is $500M - $50M = $450M. The new shares outstanding are 10M - 1M = 9M. The new stock price is $450M / 9M shares = $50.00. The stock price does not change.
Distractor A incorrectly assumes the price drops for both firms. Distractor C reverses the effects. Distractor D incorrectly assumes neither action affects the price.

Question 15

Which of the following statements comparing a cash dividend and a share repurchase of equivalent size is LEAST accurate in a real-world context (i.e., with taxes, information asymmetries, and transaction costs)?

  1. A repurchase offers tax timing options to investors, while a dividend triggers an immediate tax liability for all recipients.
  2. A regular dividend is often perceived as a stronger commitment to sustained operational performance than a repurchase plan.
  3. Both policies reduce a firm's cash and total equity, thus increasing financial leverage if debt is held constant.
  4. A repurchase mechanically increases EPS, which directly causes a proportional increase in the firm's intrinsic value per share. (correct answer)
Explanation: Statement D is the least accurate. While a share repurchase does mechanically increase EPS by reducing the number of shares, this is an accounting effect. It does not necessarily increase the intrinsic value of the firm or its shares. Intrinsic value is based on the present value of future cash flows. A repurchase simply returns capital to shareholders and reduces the size of the firm; it doesn't inherently make the underlying business more valuable on a per-share basis, aside from potential tax benefits or signals. To claim it directly causes a proportional increase is a common misconception. Statements A, B, and C are all generally accepted and accurate descriptions of the differences and effects of the two policies in the real world.

Question 16

An investor is in the highest marginal tax bracket, where dividends are taxed as ordinary income at 37% and long-term capital gains are taxed at 20%. The investor plans to hold the stock for the long term. From a tax perspective only, which corporate payout method would this investor prefer, and why?

  1. A cash dividend, because the tax liability is realized immediately and is certain.
  2. A share repurchase, because it allows the deferral of taxes until the shares are sold. (correct answer)
  3. Indifferent, because the after-tax proceeds are identical under both methods in an efficient market.
  4. A cash dividend, because repurchases can be taxed as dividends if not structured correctly.
Explanation: The investor prefers a share repurchase for two main tax reasons: 1) The tax rate on long-term capital gains (20%) is lower than the tax rate on dividends (37%). 2) A repurchase does not create a taxable event for shareholders who do not sell. They benefit from the price appreciation (if any), and the tax on this capital gain is deferred until they choose to sell their shares. This tax deferral is valuable. Distractor A incorrectly identifies an immediate tax liability as a benefit. Distractor C ignores the significant impact of differential tax rates and tax timing. Distractor D mentions a valid but less central regulatory point and ignores the primary benefits of deferral and lower rates.

Question 17

A company with 10 million shares outstanding and a stock price of $60 decides to repurchase $30 million worth of shares. Immediately after the repurchase is announced but before it is executed, positive news unrelated to the repurchase causes the stock price to jump to $75. Assuming the company proceeds with the $30 million repurchase at this new price, what is the effect on shares outstanding compared to the number of shares that would have been repurchased at the pre-announcement price?

  1. 100,000 fewer shares will be repurchased. (correct answer)
  2. 100,000 more shares will be repurchased.
  3. 400,000 shares will be repurchased.
  4. 500,000 shares will be repurchased.
Explanation: This requires a two-step calculation and comparison.
  1. Calculate shares repurchased at the initial price ($60): Shares = Total Amount / Price = $30,000,000 / $60 = 500,000 shares.
  2. Calculate shares repurchased at the new price ($75): Shares = Total Amount / Price = $30,000,000 / $75 = 400,000 shares.
  3. Compare the two outcomes: Difference = 500,000 - 400,000 = 100,000. The company will repurchase 100,000 fewer shares due to the price increase.
Distractor B has the wrong sign. Distractor C is the number of shares repurchased at the new price, not the difference. Distractor D is the number of shares that would have been repurchased at the old price, not the difference.

Question 18

A firm is initiating a policy to return cash to shareholders but is uncertain about the stability of its future cash flows. Management wants to avoid the negative market reaction that often accompanies a dividend cut. Which of the following payout strategies would be most appropriate for this firm?

  1. Initiate a small, regular quarterly dividend and commit to increasing it annually.
  2. Declare a large special dividend that is explicitly labeled as a one-time event.
  3. Announce a formal, fixed-dollar-amount open-market repurchase program. (correct answer)
  4. Use the excess cash to pay down long-term debt to increase financial stability.
Explanation: An open-market repurchase program provides the most flexibility. Management is not obligated to complete the program, and there is no negative stigma if the pace of repurchases slows or stops due to cash flow uncertainty. The market understands that repurchases are flexible. Distractor A is the least appropriate choice, as it creates a strong market expectation that is difficult to reverse without a negative stock price reaction. Distractor B is a possibility, but repurchase programs are generally viewed as even more flexible than special dividends. Distractor D is a use of cash, but it is not a payout to shareholders.

Question 19

A technology company has a significant number of outstanding employee stock options, many of which are currently 'at-the-money'. The company generates substantial excess cash. How would this outstanding options position likely influence the board's preference between a large special dividend versus a share repurchase program?

  1. Favor a special dividend, as it rewards all shareholders, including employees who hold stock.
  2. Favor a share repurchase, as it helps offset the dilutive effect of the options when exercised. (correct answer)
  3. Remain neutral, as both payout methods have an equivalent economic impact on option holders.
  4. Favor a special dividend, as it forces the stock price down, making it cheaper for employees to exercise options.
Explanation: Companies with large employee stock option overhang often favor share repurchases. A repurchase reduces the number of shares outstanding, which helps to counteract the dilution that occurs when employees exercise their options. Furthermore, a large dividend payment causes a drop in the stock price, which could put the options 'out-of-the-money' and reduce their value as an incentive for employees. Distractor A is incorrect because the dividend harms the value of the options. Distractor C is incorrect because the impact is not equivalent; dividends explicitly reduce the stock price. Distractor D contains flawed logic; employees do not want the stock price to fall.

Question 20

Which of the following statements comparing a cash dividend and a share repurchase of equivalent size is LEAST accurate in a real-world context (i.e., with taxes, information asymmetries, and transaction costs)?

  1. A repurchase offers tax timing options to investors, while a dividend triggers an immediate tax liability for all recipients.
  2. A regular dividend is often perceived as a stronger commitment to sustained operational performance than a repurchase plan.
  3. Both policies reduce a firm's cash and total equity, thus increasing financial leverage if debt is held constant.
  4. A repurchase mechanically increases EPS, which directly causes a proportional increase in the firm's intrinsic value per share. (correct answer)
Explanation: Statement D is the least accurate. While a share repurchase does mechanically increase EPS by reducing the number of shares, this is an accounting effect. It does not necessarily increase the intrinsic value of the firm or its shares. Intrinsic value is based on the present value of future cash flows. A repurchase simply returns capital to shareholders and reduces the size of the firm; it doesn't inherently make the underlying business more valuable on a per-share basis, aside from potential tax benefits or signals. To claim it directly causes a proportional increase is a common misconception. Statements A, B, and C are all generally accepted and accurate descriptions of the differences and effects of the two policies in the real world.