In principle, a company is supposed to pay cash dividends but under financial constraints or otherwise, it can pay stock dividends.
A stock dividend is paid in additional shares of stock instead of cash and simply involve a bookkeeping transfer from retained earnings to ordinary share capital.
Payment of stock dividend has already been considered in Section 7.2.5.
The company can buy back some of its outstanding shares instead of paying cash dividend. This is known as stock repurchase and shares that have been bought back are referred to as treasury stock. If some outstanding share are repurchased, few shares will remain outstanding and assuming the repurchase does not adversely affect the firm's earnings, the earning per share of the remaining shares will increase. This increase may result in a higher market price per share, so capital gains will be substituted for dividends.
Stock repurchase has the following advantages:
(a) It may be seen as a positive signal because the repurchase may be motivated by management's belief that the firm's shares are undervalued.
(b) The shareholders has a choice to sell or not to sell. On the other hand, one must accept a dividend payment and pay tax.
(c) The repurchase reduces the number of outstanding shares and thus increases the market price per share.
(d) The firm can use repurchased stock when stock options are exercised.
(e) A company may use repurchased stocks to undertake a major restructuring such as changing its capital structure.
(f) A company can repurchase its shares to make it impossible for the company to be acquired.
However, stock repurchase has the following disadvantages:
(a) The selling shareholders may not have all the information about the firm and thus may sell their shares at a lower price.
(b) If the shares are not actively traded in the market, the company may offer a price which is above equilibrium. This reduces the wealth of remaining shareholders.