The Decision to Repurchase Shares: A Cash Flow Story*
Evans, John P., Evans, Robert T., Gentry, James A., Journal of Business and Management
Utilizing classification systems developed by Helfert (1982), and Gentry, Newbold, and Whitford (1985, 1990), this paper presents a summary of changes in the cash flow position of companies embarking on a share repurchase strategy. The results from the adoption of a repurchasing strategy show that subsequent to the repurchase, net working capital flow components and net operating flow get smaller while net investment flow increases. There also exists a clear cashflow effect leading up to the announcement period as well as reduced reliance on external funds. The findings are of interest to corporate executives, credit analysts, investors and other outside parties in evaluating the strategic and operational change occurring in firms who choose to repurchase shares. The results are also consistent with firms using share repurchase programs as a way of adjusting payouts.
In recent years, the growth of share repurchase programs indicates they are an important tool in implementing a firm's overall business strategy. For example, in 1996, a record 1,475 American companies announced plans to buy back equity worth US$177 billion (Fortune, 1997, p. 24). Yet the link between share repurchase programs and corporate strategy remains a confounding issue for corporate management, boards of directors, investment bankers, financial analysts and investors. What should a company do with its surplus cash? Should it reduce debt levels, increase dividend payouts, make additional capital investments, or utilize the cash in buying back a percentage of the firm 's stock. Because management cannot observe the future affect of share repurchase on its financial performance, the dilemma facing decision makers is choosing a course of action that will maximize future firm value. An objective of this study is to explore the relationships between strategic share repurchases and changes in cash flow components. Because share repurchases are connected to the availability of net cash flow (NCH), a further objective is to highlight the contribution of the three free cash flow (PCP) components-net operating flows (NOP), net investment flows (NIP) and net working capital flows (NWC).
The success of any business organization is dependent upon the ability of management to generate future cash flows from investing, financing and operating activities. Recently, it has been shown that the performance of cash flows can be directly linked to growth in firm value (Kaplan & Ruback, 1995).
This paper adds to our understanding of the cash flow implications of share repurchases. The results show that subsequent to the repurchase, net working capital flow components get smaller, net operating flow components get smaller and investment flows component remain unchanged. There also exists a clear cash flow effect leading up to the announcement period.
Reasons for Initiating a Share Repurchase Program
A number of strategic reasons are cited in the financial literature as to why a company would repurchase its own stock. The survey work of Young (1969) and Wanslcy, Lane, and Sarkar (1989) identifies up to 29 different reasons for a company justifying the repurchase of its shares. Most however can be classified under the following headings:
A signal by management of future confidence. Management is constantly making observable information-revealing decisions or signals to corporate stakeholders. Share repurchase decisions may be an attempt to send a message to information users.
An increase in the firm's leverage. The leverage theory states that investors will respond positively to a share repurchase program due to the presence of tax savings associated with increased use of debt.
Excess cash. A company with excess cash available after funding all value creating investments will enhance value by paying out the excess cash to repurchase shares. The signal will be perceived positively since the release of free cash to stockholders eliminates the possibility of management investing those funds sub-optimally. …