Why buybacks are better

The current reporting season has created a nice problem for companies – what to do with excess money?

This is a different scenario from the worst of the GFC years, where the question for companies seemed to be, “how do we raise more money?”. This reporting season has seen different companies using a variety of strategies – Telstra is buying back shares using, in part, a fully franked dividend; Suncorp Metway has paid a special dividend; and Wesfarmers has flagged a capital return. The question is, which one is better for investors?

The case study for this comparison

Let us consider the hypothetical company AAA. AAA has 1 million shares outstanding, and has made a profit in the current year of $1 million. It has a policy of paying 100% of earnings as dividends, and will pay all of the $1 million out as a fully franked dividend. AAA also has a further $1 million in cash that it has decided to return to shareholders, as well $500,000 in franking credits (the franking credits being from the tax the company has previously paid). Let’s assume that the current share price of AAA is $10 per share.

The special dividend

The first option is that AAA can pay a special dividend. It could offer a fully franked dividend of $1 per share, which would cost it $1 million and use up $428,571 in franking credits. As an example from the current reporting season, Suncorp Metway has announced a fully franked special dividend of 30 cents per share. The benefit of a special dividend is that it flows directly to shareholders equally – all shareholders receive a fully franked dividend of $1 per share for every share that they own. This also ‘uses up’ the excess franking credits that the company has accumulated.

A slight downside is that a fully franked dividend does not have equal value for all shareholders – those with a 0% tax rate (a super fund paying a pension) receives the full value of the franking credits as a tax return. An individual on the highest income tax rate (45% plus Medicare and budget repair levy) will lose all of their franking credits in paying tax, as well as some of the cash value of their dividend.

A capital return

The second option is that AAA could offer a capital return. This is not treated as a dividend for tax purposes – instead the value of the capital return is subtracted from the cost base of the shares. This means that when a person comes to sell their shares, they will have a lower cost base and therefore a greater capital gain.

AAA would be in a position to offer all investors a $1 capital return. This will see the company use up all of the $1 million in cash, without touching any of the franking credits. If we compare this to the first option of a special dividend, in both cases investors receive $1 per share. However, it is the tax consequences that are very different. A pension fund (0% tax rate) and super fund (15% tax rate) investor will receive a bigger benefit from the fully franked special dividend, as they will benefit from the $1 cash plus a tax refund. However, once an investor’s tax rate gets above 30% their preference will be the capital return because the capital return itself is untaxed – albeit that it will generate increased capital gains tax if and when the shares are sold. In the current reporting season, Wesfarmers has indicated a $1 capital return – subject to a Tax Office ruling for the scheme.

A buyback with a fully franked dividend

The third option is that AAA could offer to buy back some of its shares using a fully franked dividend – paying less than the market price. This is a more complex situation, so let’s structure a hypothetical offer based on what has happened in previous buybacks. The price of the buyback will be at a discount to the market value of the shares (currently $10).

Let’s assume a 10% discount and a $9 buyback price. Let us also assume that this amount is made up of a capital return of $4.50 per share, and a fully franked dividend of $4.50 per share. This will be attractive enough to encourage 0% tax rate investors to participate, as the $4.50 fully franked dividend will have $1.93 in franking credits attached to it – a total benefit of $10.93 to an investor with a 0% tax rate.

Assuming these figures, AAA can afford to buy back 110,000 shares. This will cost it $990,000, and will see $212,300 in franking credits used up.

It is important to think about what happens for those investors who do not participate in the offer (because they are in too high a tax bracket to benefit from it). What do they get out of the buyback? After the buyback, AAA will only have 880,000 shares on offer, because 110,000 of the 1 million shares have been bought back.  In the current year the company has 1 million shares and $1 million in profit – effectively earnings of $1 per share. With a price of $10, the price-earnings ratio of the shares is 10.

This means that in the next year, if the company makes a profit of $1 million, the earnings per share will be higher because there are fewer shares on issue. Earnings per share will be 1 million ÷ 890,000 = $1.12. If we assume that the market continues to ascribe a PE ratio of 10 to the company, then the shares will have a price of $11.20 – a $1.20 capital growth with no assumed increase in earnings. So, for those investors who don’t participate there is the benefit of increased earnings per share, and you would assume an increased share price. Telstra has announced a share buyback structured in this way.

Conclusion

We return to the original question – which of these is better for investors?

Tax has a big influence on whether or not investors will prefer a fully franked special dividend, preferred by lower income tax rate investors, or a capital return, preferred by higher income rate investors. However, the buyback using a fully franked dividend has the interesting ‘twist’ that sets it apart for the first two – it has the benefit of offering something to everyone.

A low tax rate investor will benefit through participating in the buyback and receiving the franking credits and subsequent tax refund. A high income tax investor will choose not to participate in the buyback, yet will still benefit because the company will have fewer shares after the buyback, and earnings per share and the company share price will, all else being equal, be higher.

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.