Academic journal article Financial Management

Share Repurchases, the Clustering Problem, and the Free Cash Flow Hypothesis

Academic journal article Financial Management

Share Repurchases, the Clustering Problem, and the Free Cash Flow Hypothesis

Article excerpt

We examine the market reaction to announcements of actual share repurchases, events that cluster both within and across firms. Using a multivariate regression model, we find that the market reacts positively to the events, indicating that these announcements provide additional information to that contained in the initial repurchase intention announcements. Further, the market response is especially favorable for firms with overinvestment problems as measured by Tobin's q, and is not related to signaling costs as measured by the size of the repurchase. Our findings generally support the hypothesis that share repurchases reduce the agency costs of excessive free cash flow.

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Announcements of open market repurchase programs in the United States are popular and attract positive market reactions (Asquith and Mullins, 1986; Netter and Mitchell, 1989; Comment and Jarrell, 1991; Singh, Zaman, and Krishnamurti, 1994; Ikenberry, Lakonishok, and Vermaelen, 1995; McNally, 1999; Kahle, 2002). However, the reason that the market reacts favorably to these announcements remains in dispute because they do not represent firm commitments to buy back shares in the future. Bartov (1991), Comment and Jarrell (1991), and Lie (2005) argue that share repurchases increase firm value since potential cash payouts signal managerial confidence about future financial performance and cash flow. (1) This is consistent with the information-signaling (or undervaluation) hypothesis of Bhattacharya (1979) and Miller and Rock (1985). In contrast, Jagannathan and Stephens (2003), Grullon and Michaely (2004), and Li and McNally (2007) favor the free cash flow hypothesis, which states that share repurchases create firm value as potential repurchases reduce resources wasted on negative net present value (NPV) projects (Jensen, 1986). Both hypotheses predict a positive market reaction to repurchase intention announcements. Previous studies have used various data, methodologies, and proxies to shed light on these two hypotheses. However, these investigations have generally yielded mixed results.

Lie (2005), while investigating US firms, argues that these conflicting results probably occur because the announced repurchase programs reflect managerial intentions rather than legal obligations to actually repurchase shares from the market. He finds that both operating performance improvements and positive earnings announcement returns are limited to firms that actually repurchase shares during the same fiscal quarter. His findings suggest that the announcement of repurchase intention alone may not be a good indicator of superior future financial performance and cash flow. Similarly, Mitchell and Dharmawan (2007) find that Australian firms, which are required to disclose daily buyback transactions, have greater incentives to signal stock undervaluations or to return excess cash than do firms in countries like the United States that lack formal procedures for disclosing relevant information regarding repurchases. (2)

Previous studies in the United Kingdom by Rees (1996) and in Hong Kong by Zhang (2005) find that the market reacts positively to actual share repurchases, even after it has shown a positive response to initial announcements of intent to repurchase. These actual share repurchases appear to provide value-relevant information in addition to that conveyed by the initial repurchase program announcements. We examine this issue further by investigating how the market interprets the reasons for actual share repurchases after the initial repurchase intention announcements.

We use UK data for this study for the following reasons. Although US firms have been disclosing cash spending on capital transactions in their cash flow statements since 1984, Stephens and Weisbach (1998) and Jagannathan, Stephens, and Weisbach (2000) point out that this cash spending may include other capital transactions such as the conversion of other classes of stock into common stock, the retirement of common or preferred stock, or the redemption of redeemable preferred stock. …

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