Academic journal article Academy of Accounting and Financial Studies Journal

Determinants of Firms Managing EPS through Share Repurchases

Academic journal article Academy of Accounting and Financial Studies Journal

Determinants of Firms Managing EPS through Share Repurchases

Article excerpt


The motives behind share repurchase programs have changed over the years. Dittmar (2000) presents some motives behind share repurchase announcements. Dittmar states that excess capital as one of these motives by saying that when firms' capital exceeds their investment opportunities, the firms either distribute excess cash to the investors or retain the cash. Cash distribution to investors can be categorized into two forms: as dividends or as share repurchases. Share repurchases have advantages over dividend payouts as a method of cash distribution. In fact, firms that carry out share repurchase programs are not committed to announce future share repurchases.

Also, the market does not expect cash distribution in the form of share repurchases in a regular basis as appose to dividends and, hence, stock of repurchasing firms will not be affected negatively by not announcing future share repurchases. Signaling stock undervaluation is cited by prior research as another motive of share repurchases (Dittmar 2000). Firms repurchase their shares because they believe that their shares are undervalued. The premise is based on the information asymmetry between insiders and investors. By repurchasing their shares, firms signal the market that they have inside information that their shares worth more than their present value.

Optimizing leverage ratio is the third motive behind share repurchases. Firms repurchase their shares so they can reach the desired leverage ratio by reducing number of shares outstanding in the denominator calculation (Dittmar 2000). To dilute the effect of stock options, firms repurchase their shares so options exercised have no effect on shares' value. In the merger market, an outside party tries to takeover the target firm. As a defense, the target firm repurchases its shares to raise the lowest share price to make it more expensive for the outside party to takeover the firm. Dittmar argues that the motive for share repurchases changes over the time due to the increase in certain activities. To illustrate, she argues that stock options dilution as a motive behind share repurchases increased in the early 1990's due to the large amount of options granted to the employees and management.

However, recent research has focused on share repurchases as a self-serving behavior tool (Khaledi and Balsam, 2003; Bens et al, 2003). Khaledi and Balsam (2003) and Bens et al. (2003) report that firms are able to manage EPS through share repurchases when the cost of debt capital is less than the cost of equity. Earlier research on share repurchases reports positive abnormal return on and post share repurchase announcements (Comment and Jarrel, 1991). This implies that managers not only manage EPS through reducing number of shares outstanding, but also increase the price of the stock. This paper extends our understanding on determinants of firms that use share repurchases as a tool to manage EPS. The study's contribution is that it uses current interest rate to proxy for the cost of debt capital not prior interest expenses as in Khaledi and Balsam (2003) because historical data (interest expenses) are not relevant in share repurchase decisions.


To differentiate between firms that are able to manage EPS through share repurchases (managing firms) and firms that are not able to manage EPS through share repurchases (non-managing firms), I partition the sample based on the relation between cost of debt capital (CODC) and earnings-price (E/P) ratio, the proxy for cost of equity. When CODC for a firm is lower than its cost of equity, the firm is better off to repurchase its shares by borrowing cash or using available cash on hand. To run the test, I use Univariate analysis to see how the firms behave according to their cost of debt capital in relation to their E/P ratio.


Prior research has generally ignored share repurchases as a way of managing EPS (Khaledi and Balsam, 2003). …

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