Stock Repurchase as a Tax-Saving Distribution
Journal of Financial Research, Vol. 4, No. 1, pp. 69-79, Spring 1981
11 Pages Posted: 14 Feb 2008 Last revised: 8 Oct 2013
Abstract
The personal tax impact on share prices of a permanent distribution via stock repurchase was first modeled by Bierman and West (JF 1966, #4) who argued that the tax impact is minimized under permanent ownership by the same shareholders. Elton and Gruber (JF 1968, #1) faulted the original model for lack of time consistency and argued that market forces would lead to an annual turnover of ownership. One-year ownership would be the dominate behavior since tax saving is at a maximum in the first year. This study develops a time-consistent theoretical model which demonstrates that Bierman and West's intuition was correct: Indefinite holding by the original shareholders would minimize the impact of capital gains tax thereby maximizing the current share price both in absolute terms and relative to a pure distribution by cash dividends. In contrast, an annual turnover of owners would decrease the tax saving and its impact to a minimum as measured by the ratio of the two tax rates, erasing the tax shield of stock repurchase. The corrected valuation model under an indefinite holding period reveals that the annual tax shield and post-tax distribution constitute decreasing non-geometric series.
Keywords: stock repurchase, stock buyback, tax-saving distribution
JEL Classification: G35, G38, H21, H24, H32
Suggested Citation: Suggested Citation