The results are also consistent with the positive information, and that he market uses the premium, the target fraction and the fraction of insider holdings as signals in order to price securities around the announcement date. The observation that repurchases tender offer are followed by abnormal increases in earnings per share and that mainly small firms engage in repurchase tender offers, provides further support for the signaling hypothesis. 1.
Introduction The purpose of this study is to examine the price behavior of securities of firms which buy back their own shares in the open market or via a tender offer and announce the repurchase decision in the Wall Street Journal. The U. S. Is one of the few countries in the world which allows firms to make tender offers for their own shares at a price above the market price. The rather negative attitude of legislators of other countries is generally motivated by a stated desire to protect non-insider investors.
The argument is that insiders could manipulate prices by giving false ‘signals’ to the market or they could expropriate bondholders by reducing the size of their claims on the assets of the firm. In spite of some outcries for legislation,’ repurchases in the U. S. Have been left largely untouched by the S. E. C. This paper is adapted from my dissertation at the University of Chicago. I would like to thank my committee -? Eugene Fame.
Jon Engineers, Roger Cordoned, Morton Miller, Myron and especially my chairman Robert Yamaha for their support and encouragement. Helpful comments on earlier versions were received from Giovanni Barron Ideas, Michael Bradley (referee), Rob Hinkle, Ron Missals, an anonymous referee for this Journal especially, Michael Jensen. The generous financial support of the Interpretative College Poor Doctorate Studies in Managementwetenschappen is gratefully acknowledged.
The author takes accessibility for all remaining errors. ‘For example, to quote Gather (1965, p. 53): ‘At the present time, the SEC has no specific requirements concerning share repurchases, and the body of corporate law concerning this particular activity is not clear regarding the potential conflict of interest that may exist. Conclusive detonations of responsibility in this area are urgently needed,’ 0304-405)3/81 /000-0000/$02. 0 O North-Holland 7: Permeable, 140 Stock repurchases and market signaling One of the objectives of this study is to investigate whether an argument could be made for increased regulation purchase on the wealth of the different classes of security holders. Previous research is inconclusive and contradictory with respect to the motivation and effects of common stock repurchases. Several studies [e. G. Young (1967) Stewart (1976), Marks (1976) and Lane (1976)] suggest Weak-form’ market inefficiencies and/or suffer from methodological weaknesses.
Two more recent studies are those of Danna (1981) and Missals (AAA). They both report abnormal price increases after a repurchase announcement but they provide different explanations for the observed returns. With regard to the explanation or any observed changes in stock prices, we test the following most often mentioned reasons for repurchasing: Information or signaling hypothesis When a company purchases its stock, management gives an information signal to investors.
The direction of this signal is ambiguous. It may be that the company perceives no profitable use for internally generated funds because of a lack of growth opportunities. On the other hand, especially when a company offers to buy its shares at a substantial market price, management may believe that their company is undervalued. The tender offer then represents n attempt to pass on the value of this inside information to the current shareholders.
Dividend or personal taxation hypothesis Firms repurchase stock in order to let the shareholders benefit from the preferential tax treatment of repurchases relative to dividends; the tax advantage may be weakened to a certain extent by the provisions of Section 302 of the Internal Revenue Code, which treats redemption of stock as a capital gain only if one of the following cases applies: (I) the redemption is ‘substantially disproportionate’ to the extent that after the repurchase, the percentage ownership of the shareholder just be less than 80 7; of the percentage ownership he had, before the repurchase; by railroad companies in certain (it) the stock is issued reorganizations, Act; not equivalent’ to paying (iii) the distribution is ‘essentially dividend.
It is not clear whether ‘For an extensive discussion prices should reflect personal tax effects, of the various degrees of market efficiency, see Fame (1976). 7: Permeable, Stock repurchases and market signaling 141 Black and Schools (1974) do not find evidence that the expected returns on high-yield securities are significantly different from the expected returns on owe yield securities, other things being equal, and Miller and Schools (1978) illustrate various ways to offset personal tax liabilities on dividends. More recently, however, Litterbug and Ramsey (1979) have obtained results which are consistent with the existence of a statistically significant tax effect.
Leverage The repurchase may be financed by a subsequent (or previous) issue of debt. Because of the tax-subsidy connected with the deductibility of interest payments and to the extent that this subsidy is passed on to the shareholders, the price of the stock will increase. The existence of a tax-subsidy o debt as originally proposed Modeling and Miller (1958,’1963) is still a highly controversial issue; Miller (1977) who assumes that common stock returns are tax free but interest are taxable, argues that issuing more debt necessitates attracting investors in the higher personal tax brackets up to the point where the corporate tax rate equals the personal income tax rate of the marginal bondholder.
As a consequence, it is shown that there exists no optimal debility ratio for an individual firm. Considering the theoretical controversy, mainly an empirical issue. Michelson (1980) reports negative abnormal stock turns when a firm calls its convertible bonds, which is consistent with a tax shield . Effect. The most extensive methodologically sophisticated empirical study to date is the one by Missals (1978, Bibb), who investigates nitrating debt-equity exchanges and finds evidence on the existence of a tax effect. When stock repurchases are financed with debt, they are practically identical to debt-equity exchanges. But because repurchases can also be financed with cash, it becomes possible to separate tax effects from other effects.
Bondholder expropriation Repurchasing stock reduces the assets of the company and therefore the alee of the claims of the bondholders. To the extent that this expropriation has not been anticipated in pricing the bond issues, wealth will be transferred to stockholders from bondholders. [The effect is similar to a spin-off, analyses in Gala and Missals (1976). ] The plausibility of this hypothesis is weakened by the existence of laws in many states which restrict repurchases to those made out of surplus or earned surplus accounts. Moreover, most bond covenants put limits on 142 Two final comments should be noted: first, some of these alternative hypotheses are not mutually exclusive.
Therefore, we argue that our investigation can only be conclusive with respect to the predominant effects behind common stock repurchases among a sample of repurchasing companies. Finding that one of the effects seems to dominate the others does not imply that this effect (and dominance) is relevant for every individual firm in our,. Sample; second, our sample includes only repurchases which are announced in the Wall Street Journal and the conclusions of this paper do not necessarily apply to other repurchases. Every year hundreds of firms repurchase shares for a variety of reasons and the annual dollar volume of has been fluctuating between 3. And 13 billion dollars in the last seven years. Only a small percentage of these are announced in the Wall Street Journal, however.
In section 2, below, we describe the institutional environment and the data base used in our empirical section 3 a theoretical framework similar to the one developed (1979) is presented. Analysis. In by Bradley In section 4 we analyses the pricing behavior of tender offers and open market purchases. It is found that repurchase announcements are followed by permanent increases in stock price. The results are consistent with the joint hypothesis that the market is efficient (in the semi-strong form sense) ND that the pricing model (developed in section 3) is correct. In section 5, we try to find an explanation, consistent with our working hypotheses, for the abnormal returns observed around the announcement date. The results suggest that the signaling hypothesis is the most plausible predominant explanation returns.
