Evaluating Impact of Disbursement Methods on Wealth and EPS

This assignment analyzes the impact of three different methods of disbursing free cash to shareholders—cash dividend, stock repurchase, and stock dividend—on shareholder wealth and the company's earnings per share (EPS). It calculates EPS under each method, demonstrating how cash dividends do not affect EPS, stock repurchases increase EPS due to a reduction in outstanding shares, and stock dividends decrease EPS by increasing the number of shares. The analysis further explores investor preferences, considering factors like tax implications, specifically comparing capital gains tax versus dividend tax. It concludes that investors might prefer stock repurchases over cash dividends if capital gains tax is lower than dividend tax, providing a detailed calculation to support this preference. Desklib offers a platform to explore more solved assignments and past papers.

FINANCE

The effect on wealth and the EPS of the company affected by the methods mentioned above are
as follows:
Method 1- There are two areas in the balance sheet of the company that are affected on paying
cash dividend. The first area that is affected is the shareholder’s equity and the other is the fall in
the cash.
EPS = Net income- Preferred dividend / Total number of shares outstanding
EPS= 150000/100000 = 1.5 per share
So, the cash dividend does not affect the EPS of the company.
Method 2- The number of shares outstanding is reduced when a company repurchases shares
from the open market, which increases the EPS of the company. A company that has a higher
EPS is usually considered favorable because investors have high expectations of growth from
such companies so the wealth of the shareholders seems to be increasing.
EPS = Net income- Preferred dividend / Total number of shares outstanding
EPS =150000 / 90000 = 1.66 per share
The EPS of the company increases when the company buybacks share as the number of shares
outstanding decreases.
Method 3 - When a company decides to give stock dividend, the number of shares outstanding
increases, which ultimately affects the EPS negatively. A decrease in EPS shows that the
management of the company is not very confident about its future growth. So, the investors
wealth is expected to fall.
EPS = Net income- Preferred dividend / Total number of shares outstanding
EPS = 150000/ 110000 = 1.36 per share.
The investor would always prefer method 1 over method 2. The reason behind this is that when a
company uses its cash to repurchase shares in the open market it selects only handful of
shareholders randomly and repurchase shares from them. But in cash dividend all the investors
holding the stock would receive it (Atkinson, 2012) . Investors usually prefer cash dividend and

not stock dividend because they tend to invest the cash dividend in other profitable companies,
which they cannot if they receive stock dividend.
If the capital gain tax is less than the dividend tax rate then the investors would prefer retained
earnings resulting in capital gains as compared to high cash dividend. However, the investor
would prefer method 2 when compared to method 1. The following calculation is the explanation
for the same (Berry, 2009).
Earnings per share = (150000/100000) = 1.5 per share
Cash dividend for 10000 shares = 10000*1.5 = 15000
Tax if cash dividend is paid to investors = 25% * 15000 = 3750
Capital gain tax = 20% * 15000 =3000.
Therefore, we can say that investors would prefer paying capital gain tax when compared to
dividend tax.

References:
Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.
Berry, L. E. (2009). Management accounting demystified. New York: McGraw-Hill.