1. The accounting transactions described here reflect only the effects of the dividend. Best Buy’s actual financial statements during this period obviously reflect many other transactions.
The mechanics of cash dividend payments are virtually the same for every dividend paid by every public company. With share repurchases, firms can use at least two different methods to get cash into the hands of shareholders. The most common method of executing a share repurchase program is called an open-market share repurchase. In an open-market share repurchase, as the name suggests, firms simply buy back some of their outstanding shares on the open market. Firms have a great deal of latitude regarding when and how they execute these open-market purchases. Some firms make purchases in fixed amounts at regular intervals, whereas other firms try to behave more opportunistically, buying back more shares when they think that the share price is relatively low and fewer shares when they think that the price is high.
open-market share repurchase
A share repurchase program in which firms simply buy back some of their outstanding shares on the open market.
In contrast, firms sometimes repurchase shares through a self-tender offer or simply a tender offer. In a tender offer share repurchase, a firm announces the price it is willing to pay to buy back shares and the quantity of shares it wishes to repurchase. The tender offer price is usually set at a significant premium above the current market price. Shareholders who want to participate let the firm know how many shares they would like to sell back to the firm at the stated price. If shareholders do not offer to sell back as many shares as the firm wants to repurchase, the firm may either cancel or extend the offer. If the offer is oversubscribed, meaning that shareholders want to sell more shares than the firms wants to repurchase, the firm typically repurchases shares on a pro rata basis. For example, if the firm wants to buy back 10 million shares, but 20 million shares are tendered by investors, the firm would repurchase exactly half of the shares tendered by each shareholder.
tender offer share repurchase
A repurchase program in which a firm offers to repurchase a fixed number of shares, usually at a premium relative to the market value, and shareholders decide whether or not they want to sell back their shares at that price.
A third method of buying back shares is called a Dutch auction share repurchase. In a Dutch auction, the firm specifies a range of prices at which it is willing to repurchase shares and the quantity of shares that it desires. Investors can tender their shares to the firm at any price in the specified range, which allows the firm to trace out a demand curve for their stock. That is, the demand curve specifies how many shares investors will sell back to the firm at each price in the offer range. This analysis allows the firm to determine the minimum price required to repurchase the desired quantity of shares, and every shareholder receives that price.
Dutch auction share repurchase
A repurchase method in which the firm specifies how many shares it wants to buy back and a range of prices at which it is willing to repurchase shares. Investors specify how many shares they will sell at each price in the range, and the firm determines the minimum price required to repurchase its target number of shares. All investors who tender receive the same price.
In July 2013, Fidelity National Information Services announced a Dutch auction repurchase for 86 million common shares at prices ranging from $29 to $31.50 per share. Fidelity shareholders were instructed to contact the company to indicate how many shares they would be willing to sell at different prices in this range. Suppose that after accumulating this information from investors, Fidelity constructed the following demand schedule:
|Offer price||Shares tendered||Cumulative total|
At a price of $31.25, shareholders are willing to tender a total of 86 million shares, exactly the amount that Fidelity wants to repurchase. Each shareholder who expressed a willingness to tender their shares at a price of $31.25 or less receives $31.25, and Fidelity repurchases all 86 million shares at a cost of roughly $2.7 billion.
For many years, dividends and share repurchases had very different tax consequences. The dividends that investors received were generally taxed at ordinary income tax rates. Therefore, if a firm paid $10 million in dividends, that payout would trigger significant tax liabilities for the firm’s shareholders (at least those subject to personal income taxes). On the other hand, when firms repurchased shares, the taxes triggered by that type of payout were generally much lower. There were several reasons for this difference. Only those shareholders who sold their shares as part of the repurchase program had any immediate tax liability. Shareholders who did not participate did not owe any taxes. Furthermore, some shareholders who did participate in the repurchase program might not owe any taxes on the funds they received if they were tax-exempt institutions or if they sold their shares at a loss. Finally, even those shareholders who participated in the repurchase program and sold their shares for a profit paid taxes only at the (usually lower) capital gains tax rate, (assuming the shares were held for at least one year), and even that tax only applied to the gain, not to the entire value of the shares repurchased. Consequently, investors could generally expect to pay far less in taxes on money that a firm distributed through a share repurchase compared to money paid out as dividends. That differential tax treatment in part explains the growing popularity of share repurchase programs in the 1980s and 1990s