CFA Level II ExamCorporate IssuersMedium
A publicly traded company is considering a significant share repurchase program. The company's management believes its stock is undervalued. Which of the following is the most likely motivation for the company to choose a share repurchase over an equivalent cash dividend?
- ATo increase the company's total assets and market capitalization.
- BTo reduce the company's financial leverage and improve its credit rating.
- CTo send a positive signal to the market that management believes the stock is undervalued.
- DTo provide a guaranteed return to all shareholders.
Show answer & explanationAnswer & explanation
Correct answer: C. To send a positive signal to the market that management believes the stock is undervalued.
Share repurchases, especially when management believes the stock is undervalued, send a strong signal to the market about management's confidence in the company's future prospects and that the stock is a good investment. This can positively influence investor perception and stock price.
Why the other options are wrong
- A. Share repurchases reduce treasury stock, which reduces equity, and also reduce cash, thus decreasing total assets. Market capitalization might increase due to a positive signal, but it's not a direct effect of the repurchase itself.
- B. Share repurchases reduce equity and cash, which can increase the debt-to-equity ratio, thus increasing financial leverage, not reducing it.
- D. Dividends provide a guaranteed return (if declared), but repurchases do not guarantee a return for all shareholders, only those who sell.
Share Repurchase Motivation (Signaling)
Companies may repurchase shares to signal to the market that management believes the stock is undervalued, conveying confidence in future performance.
- Signals management's confidence.
- Can be more tax-efficient for shareholders than dividends (capital gains vs. ordinary income).
- Increases EPS and ROE due to fewer outstanding shares.
Memory trick: Dividends Delight, Repurchases Reflect.