Academic journal article Quarterly Journal of Finance and Accounting

Free Cash Flow and the Wealth Effects of Stock Repurchase Announcements

Academic journal article Quarterly Journal of Finance and Accounting

Free Cash Flow and the Wealth Effects of Stock Repurchase Announcements

Article excerpt

Introduction

There is ample evidence in the literature that stock repurchases generate significantly positive announcement-period abnormal returns. Studies report average abnormal announcement-period returns of 3 percent to 5 percent for open market repurchases (Dann, 1981; Vermaelen, 1981; Comment and Jarrell, 1991; Ikenberry, Lakonishok, Vermaelen, 1995; Grullon and Michaely, 2002; Chan, Ikenberry, and Lee, 2004) and 8 percent to 15 percent for fixed-price or Dutch-auction tender offers (Comment and Jarrell, 1991; Louis and White, 2007).

Several hypotheses have been proposed in the literature to explain the positive announcement-period abnormal returns. Among these, the signaling (undervaluation) hypothesis and the free cash flow hypothesis have received the most attention. The signaling hypothesis suggests that repurchase announcements are interpreted as managerial signals that the shares are currently undervalued (Vermaelen, 1981; Lakonishok and Vermaelen, 1990; Ikenberry, Lakonishok and Vermaelen, 1995; Stephens and Weisbach, 1998; Dittmar, 2000; D'Mello and Shroff, 2000; Chan, Ikenberry and Lee, 2004; Peyer and Vermaelen, 2005).

The results of a few recent industry surveys cast doubts about the validity of the signaling (undervaluation) hypothesis (Baker, Powell, and Veit, 2003; Grullon and Michaely, 2004; Brav, Graham, Harvey, and Michaely, 2005). The surveys provide evidence suggesting that firms repurchase shares primarily to distribute free cash flows to shareholders, not necessarily to signal undervalued share prices.

Stock repurchases are reported in recent literature as being increasingly used as a method to enhance shareholder wealth by distributing free cash flows to shareholders. Dittmar (2000) finds that stock repurchases are positively related to the level of cash flow, holding investment opportunities constant. Guay and Harford (2000) and Jagannathan, Stephens, and Weisbach (2000) report that stock repurchases are used by firms with primarily temporary cash flows whereas dividends are financed by permanent cash flows. Along a similar vein, Grullon and Michaely (2002) and Skinner (2008) provide evidence that corporations have been substituting share repurchases for dividends, resulting in repurchases becoming the dominant form of payout, probably because of tax advantages and inherent flexibility of repurchases over dividends. In another study, Grullon and Michaely (2004) find that the market reaction to open-market repurchase announcements is more positive among those firms that are more likely to overinvest, which is consistent with the free cash-flow hypothesis. (1)

Several other studies also have tested the free cash flow hypothesis using the Tobin's q ratio, which is defined as the ratio of a firm's market value to the replacement cost of assets. Howe, He, and Kao (1992) examine 55 tender offer repurchase announcements between 1979 and 1989 and find that there is no significant difference in the announcement-period abnormal returns between firms with high Tobin's q ratios (value-maximizing firms) and those with low q ratios (over-investing firms). Furthermore, low q firms with high free cash flows do not have larger announcement-period returns than other firms. They conclude that the observed positive announcement-period returns for repurchasing firms cannot be attributed to the reduction of agency costs of free cash flows for repurchasers. The positive returns are probably due to the signaling aspects of the repurchase announcements. The Tobin's q ratio in Howe, He, and Kao's (1992) study is based on average values calculated over a three-year period before the announcement.

Perfect, Peterson, and Peterson (1995) also examine 101 tender offer repurchases made during 1978 to 1990 and find that the empirical results are sensitive to how the Tobin's q ratios are calculated. While the evidence does not support the free cash flow hypothesis when long-run measures of Tobin's q are used (as in the Howe et al. …

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