A board can hand shareholders the same $40 million as a special dividend or as a buyback and leave aggregate wealth identical. What changes is earnings per share, book value per share, the tax bill, and the signal the market reads.
A dividend is a distribution declared by the board. On the ex-dividend date, the first date shares trade without the right to the declared payment, the share price can be expected to drop by roughly the dividend amount. Payout policy is broader than dividend policy because it covers cash dividends and share repurchases.
- Regular cash dividend: a recurring payment on a set schedule (quarterly in the United States and Canada, semiannual in Japan and much of Europe, annual in parts of Asia).
- Extra or special dividend: a supplemental or one-off payment, common in cyclical firms that want to distribute strong-year earnings without raising the regular rate.
- Liquidating dividend: a return of capital, paid when a firm winds up, sells a business segment and passes the proceeds through, or pays out more than accumulated retained earnings (impairing...
Common mistakes
- Assigning ratio effects to stock dividends. Only cash out the door moves the cash ratio, current ratio, debt-to-equity, or debt-to-assets. A 3% stock dividend leaves all four exactly where they were, and a 1-for-10 reverse split leaves market capitalization unchanged.
- Comparing the borrowing rate to the wrong hurdle. The debt-funded EPS test is after-tax cost of debt versus earnings yield (E/P), not versus return on equity, cost of equity, or the dividend yield.
- Reversing the BVPS rule. Buying back above book value dilutes BVPS (here $15.00 down to $14.13). Candidates often assume any buyback raises per share book value because the share count fell.
Bottom line
- Forms: regular, extra/special, liquidating (a return of capital), stock dividend, split, reverse split; only cash distributions change wealth, assets, liquidity ratios, or leverage ratios
- Theories: MM irrelevance under perfect markets (homemade dividends), bird in the hand (dividends valued as less risky), tax preference (favor retention or buybacks when dividends are taxed higher)
- Signals: initiations and increases are positive and precede earnings growth; cuts and omissions are negative; credible because costly to mimic
- Agency: payout curbs manager overinvestment (Jensen free cash flow) but worsens the shareholder versus bondholder conflict, hence covenants capping distributions
Exam shortcut
Two numbers decide most buyback questions. Write the earnings yield (EPS / price) first, then the after-tax financing cost. Cost below yield means EPS up, cost above means EPS down, equal means unchanged. The classic trap answer compares the pre-tax coupon and flips the sign. Separately, remember that BVPS has its own comparison: repurchase price versus BVPS, nothing to do with earnings.
The full lesson (about 3,721 words, 25 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- dividends and repurchases
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