Academic journal article Journal of Comparative International Management

An Examination of the Current Value Impact of a Leveraged Buyback Announcement

Academic journal article Journal of Comparative International Management

An Examination of the Current Value Impact of a Leveraged Buyback Announcement

Article excerpt

This research is aimed at studying the impact of a substantial share repurchase financed through debt (known as a Leveraged Buyback) on the value of the stock of a company. Prior research shows evidence of a positive average effect, but factors determining the magnitude of response for an individual company are not well understood. This study focuses on explaining variations in response to a leveraged buyback. The study suggested that shareholders like a LBB when the size of the LBB is small and the principle behind it is to supplement their dividend income. However, in cases when the company announces a substantial LBB the shareholders perceive it as bad news. This is because the shareholders feel that such a major restructuring of the capital structure at the hands of an untrustworthy management would put at risk not only their dividend income, but also their original investment.

Introduction

The relationship between capital structure and value was one of the first problems in finance to be addressed using scientific methods. However, there is still much that is not known about how capital structure affects value. Numerous studies have focused on the value impact of changes in capital structure, including repurchase of common stock. Previous research (Loomis, 1985; Wansley and Fayez, 1986; Davidson and Garrison, 1989) has found that positive abnormal gains accrue to shareholders of firms, which enter into share repurchase deals. Their research does not, however, allow us to identify reasons for this abnormal increase.

This research is aimed at studying the impact of a Leveraged Buyback (LBB) announcement on the market price of the stock of a company. The research will further try to isolate variables, which may be responsible for this increase and can be used in the future to predict the market price performance of the stock of a company after all LBB announcement.

Previous research has identified several possible reasons for a share buyback, among the reasons cited include: to correct price-value divergences, to distribute excess capital, to line tune the capital structure, to send signals to the market, to provide a tax benefit to shareholders, to avoid takeovers, to counter dilution effects of stock options, to provide for agency problem solution etc.

This research initiative has two main objectives. The first focuses on determining whether abnormal positive returns accrue as a result of an LBB announcement. The second part of the research will focus on identifying some of the possible variables which theory dictates may be responsible for this increase.

Theory suggests several possible reasons for these positive abnormal returns, these include: reduction of free cash flow or debt capacity, signaling of management's optimism, distribution of tax preferred income, and dividend clientele effect. Variables representing these reasons will be used as independent variables and regressed against the excess returns occurring at the announcement time.

The variables used to test for each possible explanation are as follows:

1. Reduction of Free Cash Flow or Debt Capacity:

Free Cash Flow

Debt Ratio

Return on Assets

Market to Book Value

Earnings to Price Ratio

2. Signaling of Managements Optimism:

Percentage of Management Ownership

3. Distribution as Tax Preferred Income:

Holding Period Return

4. Dividend Clientele Effect:

Retention Ratio

Dividend Yield to Total Returns Ratio

This research effort will provide new evidence for students of capital structure by identifying some of the important variables that are responsible for the excess returns. Corporate managers will benefit from this research through identification of variables, which are perceived to be important to the shareholders. This information will benefit them in their strategies to maximize the wealth of the shareholders. …

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