The relationship between share repurchase announcement and share price behaviour

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1 The relationship between share repurchase announcement and share price behaviour Name: P.G.J. van Erp Submission date: 18/12/2014 Supervisor: B. Melenberg Second reader: F. Castiglionesi

2 Master Thesis Finance Tilburg University Tilburg School of Economics and Management Department of Finance Title: The relationship between share repurchase announcement and share price behaviour Name: P.G.J. van Erp ANR: Supervisor: B. Melenberg Submission date: 18/12/2014 Number of words:

3 Table of Contents Chapter 1. Introduction... 6 Chapter 2. Theory section Shares repurchase methods Open market repurchases Fixed price tender offers Dutch auction repurchases Hypotheses Mispricing hypothesis Free cash flows hypothesis Earnings per share dilution hypothesis Leverage hypothesis Tax benefits hypothesis Chapter 3. Data analysis Sample Variables Dependent variable Independent variables Control variables Method Chapter 4. Empirical analysis Empirical results The effect of the book to market ratio on the firm s CARs The effect of the logarithm of total assets on the firm s CARs The effect of the logarithm of market capitalization on the firm s CARs The effect of the total number of employees on the firm s CARs The effect of the free cash flow on the firm s CARs The effect of the return on assets ratio on the firm s CARs The effect of the options outstanding on the firm s CARs The effect of the options exercised on the firm s CARs The effect of the debt to asset ratio on the firm s CARs The effect of the percentage of dividend on the firm s CARs The effect of the dividend dummy on the firm s CARs Sensitivity analysis

4 Chapter 5. Conclusion and discussion Literature Appendix

5 Abstract In this thesis I investigate the relationship between share repurchase announcement and share price behaviour for the period , by assessing the cumulative abnormal returns (CARs) of share repurchases. The study includes 749 unique share repurchase announcements. I find a cumulative average abnormal return of 0.04, by investigating the window of one day before until one day after the share repurchase announcement. Moreover, this is statistically significant at the 1% significance level. Additionally, I find a statistically significant positive relation between the book to market ratio and the firm s CARs, at the 5% significance level. I also find a statistically significant negative relation between the logarithm of total assets and the firm s CARs, at the 1% significance level. Furthermore, I find a statistically significant negative relation between the logarithm of market capitalization and the firm s CARs, at the 1% significance level. All three of these results are consistent with the mispricing hypothesis. Additionally, I find a statistically significant negative relation between dividend paying firms and the firm s CARs, at the 10% significance level. This is consistent with the tax benefits hypothesis. Also the hypotheses: free cash flow hypothesis, earnings per share dilution hypothesis, and the leverage hypothesis, are tested. The free cash flow and the return on assets are used to test the free cash flow hypothesis. I find mixed results between the relations of these variables on the firm s CARs. But none of these results are significant. For the relation between the options outstanding and options exercised with the firm s CARs, a positive insignificant relation is found. So, no evidence is found to support the earnings per share dilution hypothesis. Finally, I find a positive relation between debt to asset ratio and the firm s CARs. This is consistent with the theory for the leverage hypothesis. However this result is not statistically significant. 5

6 Chapter 1. Introduction Share repurchase programs have been increasingly popular over the last years and are also gaining importance. One of the explanations for the increasing popularity of share repurchase behaviour is the change in governance over the last years. Brav et al. (2005) conclude that share repurchases are now a more important form of payout compared to the past. This upward trend of popularity for share repurchases already started in the 1980s. Since then there are multiple studies conducted about the short- and long-term effects of share repurchases. Most of the considered relevant papers, such as Vermaelen (1981), Ikenberry et al. (1995), Stephens and Weisbach (1998), and Lie (2005), find positive cumulative abnormal return (CAR) for the short- and long term horizon around the announcement date. But, this is not the case for all studies, for example Grullon and Michaely (2004) find that repurchase announcements are not followed by an increase in performance. Additionally, there is a debate about many of the explanations and consequences of the effect share repurchase announcements have on share price behaviour. Moreover, mixed results are found about these explanations in the literature. In this study I try to tackle this problem by investigating the possible effects share repurchase announcements have on share price behaviour. I do this by first investigating the relation between share repurchase announcements and share price behaviour. Next, to investigate the possible reasons for the effect share repurchase announcements have on share price behaviour, I come up with five hypothesis based on past literature. These hypotheses are the mispricing hypothesis, free cash flow hypothesis, earnings per share dilution hypothesis, leverage hypothesis, and tax benefits hypothesis. These hypotheses have already been tested collectively in the literature, or in some papers only one or more of these hypothesis are tested. In this study I explain the effects that multiple variables could have on the firm s CARs. Furthermore, this study is conducted over a relatively recent period of 2000 until 2012 The mispricing hypothesis is based upon signalling undervaluation of a company. Assuming the market is imperfect, because there is asymmetric information between insiders (typically the managers) and outside investors. The asymmetry could lead to mispricing of companies. Vermaelen (1981, 1984) concludes that firms offer premia for their shares, mainly in order to signal positive information. Also Dann (1981) concludes that firm values significantly increase within one day of a common stock repurchase announcement, principally due to the signalling of information. Stephens and Weisbach (1998) support the mispricing hypothesis 6

7 by finding a negative relation between share repurchases and prior stock performance, suggesting that firms increase their purchasing depending on their degree of perceived undervaluation. In addition, also Dittmar (2000) finds evidence that supports the undervaluation hypothesis. However, in contrast to the studies discussed before, Chan et al. (2004) and Jagannathan and Stephens (2003) show only modest evidence for the mispricing hypothesis. Dittmar and Dittmar (2008) even show evidence against it, by analyzing waves in corporate finance events including stock repurchases. The free cash flow hypothesis is based on the separation of ownership and control in companies, because this separation could possibly lead to agency costs. By repurchasing shares, the managers could be more constrained, because it reduces the excess free cash flow. For example, by reducing the free cash flows there is less room for investing in negative net present value projects. The free cash flow hypothesis is supported by Stephens and Weisbach (1998). Also, Gangopadhyay et al. (2010), and Grullon and Michaely (2004) support the free cash flow hypothesis. They find that firms with free cash flows earn significantly higher abnormal returns than all other firms. Finally, Chan et al. (2004) find limited support for the free cash flow hypothesis. The earnings per share (EPS) dilution hypothesis is based on the tendency that managers often try to manage measurements such as the EPS. Moreover, one of the reasons to repurchase stocks could be to prevent EPS dilution, because of the simple principle that the reduction of common shares outstanding leads to an increase in the value per share, since the company s value is shared by less investors. Kahle (2002) provides evidence to support the earnings per share dilution hypothesis. Also Bens et al. (2003) show support for the prevention of the EPS dilution by firms, by repurchasing shares. Moreover, Brav et al. (2005) conclude that firms are likely to repurchase shares when their stock s float is adequate, and when Chief Financial Officers (CFOs) have the desire to offset option dilution. Additionally, they find that twothirds of their survey respondents feel that offsetting dilution is an important or very important factor affecting their repurchase decisions. The leverage hypothesis is based on the adjustment of the capital structure. By repurchasing shares, firms could adjust their capital structure to look for a more beneficial leverage ratio. Modigliani and Miller (1958, 1963) opened the discussion in scientific research about adjusting the capital structure in order to find a more optimal leverage ratio. This theory is mainly based on the effect of tax benefits of interest payments by adjusting the firm s capital 7

8 structure. Dittmar (2000) and Hovakimian et al. (2001) provide evidence to support the leverage hypothesis. On the other hand, Chan et al. (2004) do not find enough evidence to support the leverage hypothesis. Finally, the tax benefits hypothesis is based on the difference in tax burdens. For example, share repurchases could be more beneficial to shareholders than dividends. Black (1976) states that a corporation that pays no dividends will be more attractive to taxable individual investors than a similar corporation that pays dividends, when dividends are taxed more heavily than capital gains, and where capital gains are not taxed until realized. Grullon and Michaely (2002) state that it is more efficient to return capital to shareholders through a stock repurchase program instead of dividends after the reduction in long-term capital gains tax. However, Jagannathan et al (2000) do not find evidence to support this conclusion. Moreover, Brav et al. (2005) conducted a survey about the payout behaviour of managers. They find that managers at most firms do believe that taxes are not a dominant factor that affects the payout decision making. The method used in my master thesis to measure share price behaviour is an event study. First, the abnormal returns are calculated. This is used to measure the economic impact of share repurchases, over a relatively short period of time. By subtracting the firm s predicted normal returns from the firm s actual returns, the abnormal returns are calculated. The predicted normal returns are calculated by using an estimation window that is considered not to be affected by the announcement of share repurchases. The main event windows used in this study are: one day before until one day after the announcement of share repurchase [-1,1], and ten days before until 2 days before the announcement of share repurchase [-10,-2]. The estimation window is 200 days before until 31 days before the announcement of share repurchase [-200,-31]. Furthermore, to evaluate the effect of share repurchase announcements on share price behaviour, more event windows are used. In total nine event windows are used: [-1,1], [-3,3], [-1,1], [-5,1], [-5,5], [-10,-2], [-10,10], [-15,1], [-15,15], [-30,30], these indicate days around the announcement day of share repurchase at day 0. To calculate the abnormal returns, the market model is used, opposed to the related Capital Asset Pricing Model (CAPM), and the Arbitrage Pricing Theory (APT). This is further explained in chapter 3.3. As explained by MacKinlay (1997), the market model is a statistical model which relates the return of any given security to the return of the market portfolio. 8

9 In this study I obtained a sample that consists of companies from the United States. They are listed on the indices: NASDAQ, NYSE and AMEX. The sample includes 1087 share repurchase announcements with unique companies, and it only includes open market repurchases. In order to create a sample where all variables have the same number of observations, 749 firms from the full sample are selected. Firms from the divisions Finance, Real Estate, and Insurance are excluded from the study. Also, firms from the division Communications, Electric, Gas and Sanitary service, and Transportation, are excluded from the study. The reason for this is that it is more likely that these firms were regulated. To obtain my data, the Center for Research in Securities Pricing (CRSP) database, the Securities Data Corporation (SDC) database, and COMPUSTAT are used. In order to test the mispricing hypothesis, the free cash flow hypothesis, the earnings per share dilution hypothesis, the leverage hypothesis, and the tax benefits hypothesis, a time series ordinary least squares (OLS) regression is used. To test the five hypothesis further explained in chapter 2.2, several variables are used, further explained in chapter 3.2. Each of the independent variables is used to test for one of the five hypotheses. Most variables are based on past literature, such as Bens et al (2003), Ikenberry et al. (1995), Grullon and Michaely (2002, 2004) and Lie (2005). To test for the mispricing hypothesis, I added the number of employees as a proxy for size. In my study I investigate the effect share repurchase announcements have on share price behaviour. This study is conducted for several windows around the announcement day. Based on the window [-1,1] I find a cumulative average abnormal return (CAAR) of 0.04, this is statistically significant 1 at the 1% significance level. So, share repurchase has a significant positive effect on share price behaviour. Besides, the window [-10,-2] is used to test the relation between share repurchase and prior stock performance. The corresponding CAAR is and it is statistically significant, at the 5% significance level. This provides evidence for the mispricing hypothesis. Furthermore, I find a positive statistically significant relation between the book to market ratio and the firm s CARs, at the 5% significance level. I also find a negative statistically significant relation between the logarithm of market capitalization and the firm s CARs, and also for the relation between the logarithm of total assets and the firm s CARs, both at the 1% significant level. All these results show support for the 1 The default level for statistical significance throughout the rest of this study is set to a 10% statistical significance level. So, with statistical significance I mean the statistical significance at a 10% level. If the statistical significance level is different, this is mentioned explicitly. 9

10 mispricing hypothesis. Furthermore, I find a negative relation between the number of employees and the firm s CARs. However, this is not statistically significant. To investigate for the free cash flow hypothesis, I tested the effects of free cash flow and return on assets on the firm s CARs. For both variables I find mixed results about the relation with the firm s CARs. But none of these results are statistically significant. To investigate for the earnings per share dilution hypothesis, I tested the effects of options outstanding and the options exercised on the firm s CARs. I predicted it to have a negative relation with the firm s CARs. However, for both variables I find a positive relation between the independent variable and the firm s CARs. But these relations are not statistically significant. To investigate for the leverage hypothesis, I tested the effect of debt to assets ratio on the firm s CARs. I predicted it to have a positive relation between the debt to assets ratio and the firm s CARs. I indeed find a positive relation between these variables, but this relation is not statistically significant. Finally, to investigate the tax benefits hypothesis, I tested the effects of dividend dummy and percentage of dividend on the firm s CARs. For both of these relations I predicted it to have a negative relation with firm s CARs. I also find a negative statistically significant relation between dividend dummy and the firm s CARs. On the other hand, I find a positive statistically significant relation between percentage of dividend and the firm s CARs. However, this last result is based on a regression which has some levels of multicollinearity. This is explained in chapter 4.1. So, this last result is treated with caution. To conclude, my results show support for the mispricing hypothesis and the tax benefits hypothesis. Based on the other results, I do not provide enough evidence to support the free cash flow hypothesis, earnings per share dilution hypothesis, and the leverage hypothesis. I also provide evidence for different abnormal returns because of share repurchases among different industries. This might be interesting to investigate as part of future research. Another recommendation for future research is to try combining other data sources such as Zephyr, Orbis, or firm s financial reports, to obtain a full sample without performing a selection process. Besides, it would be interesting to also test for the long term effect of share repurchases. Furthermore, the agency costs theory, explained in chapter 2.1, could be investigated more specifically. I found evidence for the mispricing hypothesis, which is 10

11 related with agency costs, but it is for example interesting how this would relate to manager s compensation and ownership. The structure to explain the sample analysis, method, and empirical results shows similarities with my previous conducted master thesis, van Erp (2014). Moreover, the description of the dependent variable and the description of the variable industry dummy are also similar to the descriptions provided in this master thesis. The remainder of my master thesis is organized as follows: Chapter 2 presents the theory section. Chapter 3 presents the data analysis, it describes the sample, variables, and the method used in this study. Chapter 4 presents the empirical analysis, it consists of the empirical results and a sensitivity analysis. Chapter 5 presents the conclusion and discussion. 11

12 Chapter 2. Theory section 2.1 Shares repurchase methods Repurchasing Shares of its own company became increasingly popular over the last years and are also gaining importance When repurchasing its own shares, a company distribute a large amount of money to its shareholders. There are several methods to repurchase the shares, the most essential methods are: open-market, fixed price tender offer, and Dutch auction tender offer. These three methods are explained below Open market repurchases Among the three methods, the open market repurchase is the most popular. Chan et al. (2004) report a big increase in the number of firms announcing open market stock repurchases in the 1990s. In an open market repurchase, the firm announces to repurchase their stock on the open market. So, the repurchase price of the stock will be based on the market price, and is just the same as for any other investor Fixed price tender offers In fixed price tender offers the share price, number of shares, and duration of the offer is predefined. In contrast to open market repurchases these conditions are fixed. When issuing fixed price tender offers the firm gives shareholders the option to tender within the predefined condition. Additionally, the firm can set a target to the minimum number of tendered shares. If this condition is not met it still has the option to repeal the offers. Moreover, the firm is also allowed to adjust the duration of the period for repurchase and it could change the number of shares it want, to repurchase Dutch auction repurchases The Dutch auction was a specification of the fixed price tender method, introduced in Dutch auction repurchases are somewhat similar to fixed price tender offers, except for Dutch auction repurchases the firm offers a range of prices shareholders can sign up to. Shareholders can tender for the minimum price of a specified number of shares they are willing to accept. The firm can repeal the offers when there are fewer shares submitted for sale as the predefined amount, or it can repurchase the shares at the tendered prices. When there are more shares submitted for sale, the firm repurchases shares at a uniform lowest price possible that allows them to buy back the predetermined number of shares. So, this price is offered to shareholders who tendered at or below this price. 12

13 2.2 Hypotheses In this section I elaborate on the possible explanations why firms repurchase shares. Furthermore, I come up with different hypotheses about the relation between share repurchases and firm performance Mispricing hypothesis The mispricing hypothesis is based upon signalling for undervaluation of a company. Assuming the market is imperfect, because there is asymmetric information between insiders (typically the managers) and outside investors. The asymmetry could lead to mispricing of companies. Following the reasoning provided by Erken (2012), In most cases the managers are better informed about the current and future prospects of the company. For example, about the company s expectations, its opportunities, and prospects. When the corporation is undervalued, so the company is actually worth more than the current market value, managers could have the incentive to adjust this mispricing. To make the statement of undervaluation believable, the managers could repurchase their own stock to signal a positive view about the future of the corporation. Eventually, this could lead to a positive stock price reaction. Often in the literature a distinction is made between value stocks and growth stocks. Firms with a high book to market ratio are considered to have value stocks, and firms with a low book to market ratio are considered to have growth stocks. As concluded by Ikenberry, Lakonishok, and Vermaelen (1995), value stocks are more likely to have undervaluation as their primary motivation. Vermaelen (1981, 1984) concludes that firms offer premia for their shares, mainly in order to signal positive information. It also makes a distinction between small firms and large firms. Small firms are considered to have higher levels of information asymmetry. Also Dann (1981) concludes that firm values significantly increase within one day of a common stock repurchase announcement. These increases principally appear to be due to an information signal from the repurchasing firm. As stated by Dann (1981), these positive values are considered to be permanent in a way that the share prices do not return to their preannouncement date levels following expiration of the opportunity for stockholder to tender shares. However, the nature of the new information that results in a positive stock price change is still unidentified. Stephens and Weisbach (1998) support the mispricing hypothesis by finding a negative relation between share repurchases and prior stock performance, suggesting that firms increase their purchasing depending on their degree of perceived undervaluation. In addition, also Dittmar (2000) finds evidence that supports the undervaluation hypothesis. However, in contrast to the studies discussed before, Chan et al. 13

14 (2004) show only modest support for the mispricing hypothesis, when testing for the shorthorizon market reaction to the share repurchase announcement. Moreover, over a four-year window after the announcement, earnings surprises tend to be positive and significant. This result suggests that the market does not completely incorporate the information in share repurchase announcements. Also, the study of Jagannathan and Stephens (2003) causes doubts for the undervaluation hypothesis. They examine differences in firms that repurchase shares frequently versus firms that repurchase only occasionally or infrequently. They find that frequent repurchasers may be using it as a substitute for increasing dividends, but unlikely because of firm undervaluation. On the other hand, they find that infrequent repurchases may be motivated by undervaluation. Still, they find a positive market reaction for all repurchase announcements on average, but the infrequent repurchases have a much stronger positive reaction. Finally, Dittmar and Dittmar (2008) find evidence against the mispricing hypothesis, by analyzing waves in corporate finance events including stock repurchases, leading to a conclusion that equity issuance (and repurchases) predicts lower returns and likely reflects time-varying costs of capital rather than mispricing. So, to conclude, firms could use share repurchase to adjust for the undervaluation of their company Free cash flows hypothesis A general believe in finance is that the separation of ownership and control in companies can lead to agency costs. By repurchasing the shares of your own companies, the managers could be more constrained, because it reduces the excess free cash flow. As argued by Jensen (1986) followed upon Rozeff (1982) and Easterbrook (1984) Payouts to shareholders reduce the resources under managers' control, thereby reducing managers' power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital. Stephens and Weisbach (1998) conducted a study including the relation between cash flow and share repurchases. They find that both expected and unexpected cash flows are positively related to repurchases, therefore, suggesting that firms actively adjust their share repurchases behaviour to their cash position. Furthermore, Gangopadhyay et al. (2010) test the free cash flow hypothesis by examining the announcement-period abnormal returns of repurchasing firms sorted by their available investment opportunities, as measured by Tobin s q ratio and cash flows. They find that firms with free cash flows earn significantly higher abnormal returns than all other firms. By reducing the free cash flows there is less room for investing in negative net present value projects. By repurchasing stock, shareholders can invest in other 14

15 positive investment opportunities. In general, this could lead to a more optimal capital market allocation, because capital is moved from negative net present value investments, towards positive net present value investments, as argued by Grullon and Ikenberry (2000). Eventually, it would be more beneficial for firms with a high level of free cash flow to repurchase stock. This is supported by Grullon and Michaely (2004), who find that the market reaction to share repurchase announcements is more positive among those firms that have higher levels of free cash flows, and therefore were more likely to overinvest. So, by repurchasing stock, the corporation reduces the risk of investing disproportionally. This is one of the possible solutions to reduce empire building, because it prevents managers to focus too much on increasing the size of the corporation, rather than the size of its profits. Furthermore, reducing the free cash flow could reduce the fringe benefit consumption. It also could prevent managers for holding on to underperforming subordinates for too long. However, Chan et al. (2004) find limited support for the free cash flow hypothesis. They support the hypothesis by showing that repurchase firms tend to have above-average free cash flow compared to their industry peers. Moreover, the long-run drift is greater for high free cash flows firms compared to low free cash flow cases. But, on the other hand, they can t support the hypothesis that the gains from high free cash flow firms should be linked to cases where managers actually disgorge cash. So, to conclude, managers could use share repurchase to reduce agency costs Earnings per share dilution hypothesis Earnings per share (EPS) is an important measure to analyse firms in general. Often managers try to improve measurements such as the EPS. Moreover, one of the reasons to repurchase stocks could be to prevent EPS dilution, because of the simple principle that the reduction of common shares outstanding leads to an increase in the value per share, since the company s value is shared by less investors. Stock dilution could emerge from the issue of additional shares. This could occur from primary market offerings, preferred shares or warrants into stock, exercised stock options, or by conversed convertible bonds. According to Kahle (2002), firms announce for share repurchases when executives have large numbers of options outstanding and when employees have large numbers of options currently exercisable. Moreover, there is a positive relation between the amount repurchased and the total options exercisable by all employees, once the repurchase decision is made. However, the amount repurchased is independent of managerial options according to Kahle (2002). Also Bens et al. (2003) show support for the prevention of the EPS dilution by firms, because they find an increase in the level of stock repurchases when the dilutive effect of outstanding employee 15

16 stock options on diluted EPS increases. This increase also occurs when the firm s earnings are lower than required to achieve their EPS growth target. This increase is based on the incentive to manage EPS dilution, instead of also the incentive to adjust the basic EPS, according to Bens et al. (2003). Consistent with this theory, Brav et al. (2005) find that Chief Financial Officers (CFOs) are very conscious of the affect share repurchases have on the earnings per share. Furthermore, they conclude that firms are likely to repurchase when their stock s float is adequate, and when CFOs have the desire to offset option dilution. Additionally, they find that two-thirds of their survey respondents feel that offsetting dilution is an important or very important factor affecting their repurchase decisions. So, share repurchase could be used to adjust for possible share dilution Leverage hypothesis By repurchasing shares, the corporation could adjust their capital structure, especially if the amount of repurchases is high. This could lead to a more beneficial leverage ratio. Modigliani and Miller (1958, 1963) opened the discussion in scientific research about adjusting the capital structure in order to find a more optimal leverage ratio. This theory is mainly based on the effect of tax benefits of interest payments by adjusting the firm s capital structure. So, by repurchasing stocks, firms are able to adjust their leverage ratio. According to Dittmar (2000), this is one of the reasons why firms repurchase stocks during certain periods. Hovakimian et al. (2001) continue on the theory that firms adjust their capital structure, to move to a target debt ratio. They take a closer look at the impediments firms may face when moving toward their target ratio, and the possible change in the target ratio over time. To conclude, they find that capital structure considerations are more important for firms when they repurchase stock rather than raise capital. Moreover, Hovakimian et al. (2001) state The tendency of firms to make financial choices that move them toward a target debt ratio appears to be more important when they choose between equity repurchases and debt retirements than when they choose between equity and debt issuances. However, Chan et al. (2004) do not support the leverage hypothesis, although they find that repurchasing firms tend to have below average leverage, but these firms do not have any higher drift when compared to firms with a higher leverage. Also, there was no significant distinction in returns for firms that had sharp declines in leverage. Also, Brav et al. (2005) find little support for the leverage hypothesis by surveying financial executives and conducting in-depth interviews. So, to conclude, firms could repurchase share to adjust their capital structure to reach for a more optimal capital structure. 16

17 2.2.5 Tax benefits hypothesis There are several ways of returning profits or an excess of capital to the shareholders. For example, share repurchases could be more beneficial to shareholders than dividends, because of tax benefits. So, the difference in tax burden could be a reason for companies to repurchase shares. Black (1976) states that a corporation that pays no dividends will be more attractive to taxable individual investors than a similar corporation that pays dividends, when dividends are taxed more heavily than capital gains, and where capital gains are not taxed until realized. The tax benefits of share repurchases in the US were especially beneficial before the For Jobs and Growth Tax Relief Reconciliation Act of 2003, because of the much lower taxation on capital gains versus dividend payments. After the Jobs and Growth Tax Relief Reconciliation Act of 2003, the taxes on qualified dividends 2 were lowered to the capital gains level. This was set to expire after However, in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 the dividends and capital gains rates were extended for another two years. Finally, in the American Taxpayer Relief Act of 2012, the tax rate levels on capital gains and dividends for 2013 remained the same as in 2012 for individuals with taxable income of $400,000 per year or less. For individuals with taxable income over $400,000, the top marginal tax rate on long-term capital gains was set to the level of 20% for under expiration of the Jobs and Growth Tax Relief Reconciliation Act of The top marginal tax rate on dividends remained at the similar level as capital gains, so also 20%, instead of the much higher 39,6% rate under expiration of the Jobs and Growth Tax Relief Reconciliation Act of But after these changes in tax rates, share repurchases are still considerate to be more beneficial than dividends, because investors have the option to defer capital gains or losses by holding on to their shares. On the other hand, dividends are taxed immediately when received. Blouin et al. (2007) tests for policy changes in dividends and repurchases following the Jobs and Growth Tax Relief Reconciliation Act of They find evidence consistent with dividends crowding out repurchases, as a result of reductions in dividends and capital gains tax rates. However, Grullon and Michaely (2002) state that it is more efficient to return capital to shareholders through a stock repurchase program instead of dividends after the reduction in long-term capital gains tax. Moreover, they show that there is a more positive market reaction to repurchases when the tax gains from repurchases relative to dividends are larger. On the other hand, Jagannathan et al (2000) do not find evidence to 2 For a description of qualified dividends, see 17

18 support this conclusion. Their work suggests that besides taxes much more is necessary to explain differences in motives to use dividends and repurchases. As discussed earlier, Brav et al. (2005) conducted a survey about the payout behaviour of managers. They find that managers at most firms do believe that taxes are not a dominant factor that affects the payout decision making. Moreover, they state that executives believe that repurchases and dividends are equally attractive to most institutional investors. So in general, share repurchase could be used to return profits or an excess of capital to shareholders in a more tax beneficial way for the shareholders. 18

19 Chapter 3. Data analysis In order to analyze my data I will first describe the sample. Next, the variables will be analyzed. Finally, the method I use in this study will be explained. This is the same order to analyze data as used in van Erp (2014). 3.1 Sample In this study I obtained a sample that consists of companies from the United States. They are listed on the indices: NASDAQ, NYSE and AMEX. 498 of the companies are listed in the NYSE index, 552 in the NASDAQ index, and 37 in the AMEX index. The sample includes share repurchase announcements for the period It only includes open market repurchases. Firms from the divisions Finance, Real Estate, and Insurance are excluded from the study. These are marked by the Standard Industrial Classification (SIC) codes 6000 until Also, firms from the division Communications, Electric, Gas and Sanitary service, Transportation, marked by the SIC codes 4000 until 4999, are excluded from the study. The reason for this is that it is more likely that these firms were regulated. In total 505 firms were removed from the sample because of this. Eventually, I end up with a sample consisting of 1087 share repurchase announcements with unique companies. The statistics about the variables used in this study are listed in table 1. To obtain my data, the Center for Research in Securities Pricing (CRSP) database, the Securities Data Corporation (SDC) database, and COMPUSTAT are used. As displayed in table 1 not all the variables have the same number of observations, this is because of missing data for some firms. In order to conduct my study, I created a sample where all variables have the same number of observations. This is displayed in table 2. Because of this selection, a selection bias might occur. Moreover, t-tests are conducted to test for differences in means among table 1 and 2. In the tables A13 and A14, the dependent variables CAR[-1,1] and CAR[-10,-2] are tested respectively. In these t-tests the H 0 hypothesis is that the mean CAR of table 1 and the mean CAR of table 2 are equal. So, the difference between the two variables is zero. The alternative hypothesis is: the difference between the mean CAR of table 1 and the mean CAR of table 2 is unequal to zero. Based on both tables the H 0 hypothesis: the mean CAR of table 1 and the mean CAR of table 2 are equal, cannot be rejected, because the corresponding p-values are and in tables A13 and A14 respectively. So, there is no evidence found that the two samples are different. 19

20 Furthermore, for each independent variable a similar t-test is conducted. For all of the variables except for the options outstanding, the H 0 hypothesis: the mean of the variable in table 1 and the mean of the variable in table 2 are equal, cannot be rejected. In table A15 the t- test for the options outstanding is displayed. Based on the p-value of , the H 0 hypothesis can be rejected, at the 10% significance level. But, based on all the t-tests I conclude that there does not seem to be any level of selection bias, and that the sample displayed in table 2 is still representative of the population that I intend to analyse. Moreover, by conducting a t-test for all the 17 variables separately, at the 10% significance level, I could expect that 10% of the test results will be rejected. 20

21 Table 1 Descriptive statistics of the full sample This table provides the descriptive statistics of the full sample over the period It provides the statistics about the number of observations, mean, standard deviation, and the minimum and maximum value of the variables. The currency in the descriptive statistics is the U.S. dollar. The MM behind some variables stands for measured in millions. The cumulative abnormal return (CAR) [-1,1] is based on the window 1 day before the announcement of share repurchase until 1 day after the announcement of share repurchase. The window [-10,-2], stands for 10 days before the announcement of share repurchase until 2 days before the announcement. The book to market ratio is calculated by dividing the book value of equity by the market value of equity. The market capitalization is calculated by multiplying the share price with the number of common shares outstanding. The free cash flow is calculated by dividing the variable Cash by the book value of equity. The capital expenditure is used as a percentage of the total assets. The return on assets is calculated by dividing net income by total assets. Options outstanding represent the stock options that are exchangeable for common stock of the firm. Options exercised represent the total number of stock options that were exercised for common stock. Debt to asset ratio is calculated by dividing long term debt by total assets. Total dividend ratio is calculated by dividing total dividend by total assets. Dividend dummy is a variable about the distinction between firms that pay dividends and firms that do not pay dividend. Firms that pay dividend are marked by 1 and firms that do not pay dividend are marked by 0. Finally, three industry dummies are displayed. Each of the dummies takes on the value 1 if the firm is from that particular industry. Variable Observations Mean Std. Dev. Min Max CAR [-1.1] CAR [-10.-2] Book to market ratio Logaritm of total assets Logaritm of market capitalization Number of employees Free cash flow Percentage of capital expenditures Return on Assets Options outstanding (MM) Options exercised (MM) Debt to asset ratio Percentage of dividend Dividend dummy Manufacturing industry dummy Service industry dummy Remaining industry dummy

22 Table 2 Descriptive statistics of the sample with equal amounts of observations for each variable This table provides the descriptive statistics of the sample with equal amounts of observations for each variable over the period It provides the statistics about the number of observations, mean, standard deviation, and the minimum and maximum value of the variables. The currency in the descriptive statistics is the U.S. dollar. The MM behind some variables stands for measured in millions. The cumulative abnormal return (CAR) [-1,1] is based on the window 1 day before the announcement of share repurchase until 1 day after the announcement of share repurchase. The window [-10,-2], stands for 10 days before the announcement of share repurchase until 2 days before the announcement. The book to market ratio is calculated by dividing the book value of equity by the market value of equity. The market capitalization is calculated by multiplying the share price with the number of common shares outstanding. The free cash flow is calculated by dividing the variable Cash by the book value of equity. The capital expenditure is used as a percentage of the total assets. The return on assets is calculated by dividing net income by total assets. Options outstanding represent the stock options that are exchangeable for common stock of the firm. Options exercised represent the total number of stock options that were exercised for common stock. Debt to asset ratio is calculated by dividing long term debt by total assets. Total dividend ratio is calculated by dividing total dividend by total assets. Dividend dummy is a variable about the distinction between firms that pay dividends and firms that do not pay dividend. Firms that pay dividend are marked by 1 and firms that do not pay dividend are marked by 0. Finally, three industry dummies are displayed. Each of the dummies takes on the value 1 if the firm is from that particular industry. Variable Observations Mean Std. Dev. Min Max CAR [-1.1] CAR [-10.-2] Book to market ratio Logaritm of total assets Logaritm of market capitalization Number of employees Free cash flow Percentage of capital expenditures Return on Assets Options outstanding (MM) Options exercised (MM) Debt to asset ratio Percentage of dividend Dividend dummy Manufacturing industry dummy Service industry dummy Remaining industry dummy

23 3.2 Variables Dependent variable In this master thesis I test for the relation between share repurchase announcement and share price behaviour. To explain share price behaviour I use the cumulative abnormal return (CAR), based on the share prices of firms around the announcement of share repurchase. As described in van Erp (2014), to calculate the abnormal returns the differences between the stock prices and the expected returns are taken. In chapter 3.3 about the method, this is further explained. In this study multiple event windows are used, as displayed in table 4. To test for the relation of different variables with the firm s CARs for share repurchase, I focus on the event window of one day before the announcement of share repurchase until one day after the announcement of share repurchase, resulting in the window [-1,+1]. Furthermore, to test for the mispricing hypothesis a window of 10 days before the announcement until 2 days before the announcement [-10,-2] is used. This window is used to test the relation between share repurchases and prior stock performance. As argued by Stephens and Weisbach (1998), firms adjust their share repurchase behaviour based on the perceived undervaluation. Finally, how the CARs are obtained is described in chapter Independent variables In order to explain the possible relation between share repurchase announcement and share price behaviour, I test for five hypotheses, as explained in chapter 2.2. To test these hypotheses I use several different variables. In this chapter these are further explained. Book to market ratio is calculated by dividing the book value of equity by the market value of equity. This variable is a proxy for firm size. It is used to test for the mispricing hypothesis. Firms with a high book to market ratio are considered to have value stocks, and firms with a low book to market ratio are considered to have growth stocks. As concluded by Ikenberry, Lakonishok and Vermaelen (1995), value stocks are more likely to have undervaluation as their primary motivation. The natural logarithm of total Assets is another proxy for firm size. After calculating the natural logarithm of total assets, it is also used to test for the mispricing hypothesis. According to Vermaelen (1981), small firms have higher levels of information asymmetry. This affects the share repurchase behavior of managers. The natural logarithm of Market capitalization is also a proxy for firm size. Therefore, it is also used to test for the mispricing hypothesis. The market capitalization is the total value 23

24 of shares outstanding. It is calculated by multiplying the share price with the total common shares outstanding. The total number of employees is the last proxy for firm size used in this study. Also this variable is used to test for the mispricing hypothesis. Free cash flow is calculated by dividing the variable Cash by the book value of equity. The free cash flow is used to test for the free cash flow hypothesis. A general believe in finance is that the separation of ownership and control in companies can lead to agency costs. By repurchasing shares the free cash flow will decrease. This could reduce agency costs because managers are more constraint, because there is for example less room for investing in negative net present value project, or using cash flows for empire building or fringe benefit consumption. It also could prevent managers for holding on to underperforming subordinates for too long. Return on assets is calculated by dividing net income by total assets. It may also provide information about the free cash flow hypothesis, because the return on assets is related to the free cash flow. Therefore, having higher returns on assets could lead to higher agency costs. On the other hand, having higher levels of return on assets could signal financial strength when financially healthy firms repurchase shares. Options outstanding represent the stock options that are exchangeable for common stock of the firm, that have not been exercised or cancelled. It includes, shares outstanding at year-end, including employee plans and non-employee plans (i.e. director plans), Options exchangeable for all classes of common stock, and "Stand alone" Stock Appreciation Rights (SARs) that are not associated with options or "Additive" Stock Appreciation Rights (SARs) that pay a cash amount when the option is exercised. This variable is used to test the earnings per share dilution hypothesis. As stated by Kahle (2002), Firms announce repurchases when executives have large numbers of options outstanding. A reason for this is to prevent share dilution. Options exercised represent the total number of stock options that were exercised for common stock. Also this variable is used to test for the earnings per share dilution hypothesis. According to Kahle (2002), there is also a positive relation between options exercised and the announcement of share repurchase. 24

25 Debt to asset ratio is calculated by dividing long term debt by total assets. This ratio is used to test the leverage hypothesis, because by repurchasing shares the capital structure could be adjusted. As stated by Dittmar (2000), this is one of the reasons why firms repurchase stocks during certain periods. Moreover the debt to asset ratio could be a driver for agency cost, because having higher levels of debt could make manager more constraint. Total dividend ratio is calculated by dividing total dividend by total assets. This variable is used to test for the tax benefits hypothesis. There are several ways of returning profits or an excess of capital to the shareholders. The difference in tax burden between paying dividend versus repurchasing shares could be a reason for companies to repurchase shares. This trade-off is addressed by Black (1976). Dividend dummy is created to make a distinction between firms that pay dividends and firms that do not pay dividend. Firms that pay dividend are marked by 1 and firms that do not pay dividend are marked by 0. Again, this is also used to test for the tax benefits hypothesis Control variables In order to improve the model control variables are added to the test. Capital expenditure represents the funds used for additions to property, plant, and equipment. The capital expenditure is used as a percentage of the total assets. Industry dummy is a dummy variable to test for differences between industries. This variable is also used in van Erp (2014). To make a distinction between industries, the Standard Industrial Classification (SIC) codes are used. Moreover, it makes a distinction between the service, manufacturing, and remaining industries. The firms from the manufacturing industry are indicated by the SIC codes The firms from the Service industry are indicated by the SIC codes The industries and their corresponding SIC codes for the group of the remaining industries are division Agriculture, Forestry and Fishing ( ), division Mining ( ), division Construction ( ), division Wholesale Trade ( ), division Retail Trade ( ), and finally division Public Administration ( ). 3 3 The website of United States Department of Labor ( provides an overview of the divisions using the SIC codes 25

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