Proceedings of 4th European Business Research Conference
9 - 10 April 2015, Imperial College, London, UK, ISBN: 978-1-922069-72-6
Why Do Firms Repurchase Their Own Stocks? Theoretical
Frame Work and Conceptual Model
Ahmad Samir* and Ebtihag Abdurrahman**
This paper aims to investigate reasons for open market share repurchases,
as a result for the increasing use of open market share repurchase
announcement in the Egyptian stock market. The proposed methodology
will be event study methodology to measure the effect of this share
repurchase on the companies' financial performance and regression
model using panel data to know the reasons for share repurchases. This
paper is a conceptual framework throw reviewing the relevant literature and
needs to be applied. This paper original because it helps to understand the
motives for stock repurchase in the Egyptian context and the Egyptian
market reaction to this practice.
JEL Codes: G32, G35, and G38.
Key words: share repurchase, undervaluation, signaling, and pay out policy.
1. Introduction
Three major hypotheses in finance explain reasons for open market share repurchases;
undervaluation hypothesis happens when firms' stocks are undervalued, signaling
hypothesis takes place when companies want to signal some information about operating
performance improvements or profitability to the market about the future operation
performance improvements, and the third hypothesis concerns with the free cash flow
hypothesis that exists when excess cash flow remains under management control with bad
investment opportunities or when companies substitute share repurchase with cash
dividends (Nguyen et el., 2015; Wang et al ., 2103).
Other hypotheses are considered to motivate companies to repurchase their stocks; antitakeover hypothesis, optimal capital structure hypothesis and executive compensation
hypothesis, all these hypotheses mentioned represent the motivation for share
repurchase. Actually firms repurchase their own stocks for more than one reason
simultaneously what's called synergy effect of share repurchase.
*Mr. Ahmed Samir, Department of Business administration, Cairo University, Egypt.
Email: asa.empire@gmail.com
**Dr. Ebtihag Abdurrahman, Department of Business administration, Cairo University, Egypt.
Email: Dr_ebtihagmustafa@hotmail.com
2. Literature review:
Reviewing the literature including undervaluation hypothesis, free cash flow hypothesis,
investment opportunities (Agency theory), cash dividends (substitution hypothesis),
signaling hypothesis, capital structure hypothesis, takeover deterrence hypothesis, and
finally executive compensations hypothesis.
Undervaluation hypothesis
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Proceedings of 4th European Business Research Conference
9 - 10 April 2015, Imperial College, London, UK, ISBN: 978-1-922069-72-6
Firms with disvalued stocks announce buying their own stocks back in order to make
benefits of this undervaluation (Chen et al., 2011; Dittmar, 2000). Documented that the
undervaluation hypothesis is based on the information asymmetry between the
shareholders and the insiders. Through the repurchase announcement the management
send a signal to the market that the firm's stock is undervalued which may increase the
stock price as a positive reaction from the market to this announcement. Li and McNally,
(2007) suggest that Because of the information asymmetry the value firms (firms with high
B\M ratio) decide to repurchase their own stocks to increase the stocks prices in the
market.
The outstanding shareholders make wealth from repurchasing after the repurchase
program. That is because when the firm repurchases the stock less than their real value it
shifts this part of wealth (the difference between the intrinsic value of the stock and
purchasing price) from the shareholders who had sold their shares to the outstanding
shareholders. Repurchasing firms should offer a premium over the stock market price to
attract shareholders to sell their stock. This premium reduces the part transited to
outstanding shareholders (non-repurchasing practitioners) (Dixon et al., 2008).
Managers of repurchasing firms detect the time to repurchase when the stocks are
undervalued with negative (CARs) (Chen et al., 2011). Managers decide to repurchase at
the appropriate time not only to make benefit of the undervaluation or transit part of
intrinsic value to the outstanding shareholders, but also to stabilize the stock price in the
market (Bozniac, 2009). That is what was documented by Wranska and Skiodska,
(2013).Managers time the market, they decide to announce repurchase at a certain time
when is commonly met with favorably market reaction in prices increase at a short time as
a signal of undervaluation. Through this mechanism, they try to stabilize the price in the
short time horizon.
The price increase doesn't stay for a long time that is because the long run price
improvement needs real improvement in operating performance, earning and completion
of the purchasing ratio announced (Comment and Jarrell, 1991; Lie, 2005; Li and McNally,
2007).
Free cash flow hypothesis
Free cash flow is the most important motive for stocks repurchases. Guffy and Shneider
(2004) used growth and earnings ratios in a model to compare between repurchasing firms
and control firms in the same industry and with the same characteristics in US from 1994
to1996. Dittmar (2000) stated that when the cash flow excesses the investments
opportunities available for the firm, the management has two options; one is to keep that
excess cash flow without any use which in turn causes agency problems by increasing
money under the management control. The other is to distribute this excess cash to the
stockholders and that is the suitable solution. The firm is optionalized to distribute the
excess cash by repurchasing its own stocks or by cash dividends; it depends on the firms
pay out policy and regulations.
Free cash flow and investment opportunities (agency theory)
The agency theory implies that if there is excess cash flow under the management control,
the company will enter new negative NPV projects which destroy the company value. The
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Proceedings of 4th European Business Research Conference
9 - 10 April 2015, Imperial College, London, UK, ISBN: 978-1-922069-72-6
management should distribute this excess cash on the stock holders instead of entering a
new negative NPV projects (Gurllon and Michaelly, 2004).
Companies within growth level have a lot of investment opportunities which acquiring the
required rates of return. Companies in maturity have less investment opportunities and
negative NPV projects; this is because of the increase of assets size. Larger assets size
with low investment opportunities leads to decreasing ratios of earnings, return and capital
expenditure. In this case it is better for these companies to distributed cash to the stock
holders instead of entering new negative PNV projects destroying the companies' value
(Gurllon and Michaelly, 2004; Nixon et al., 2008; Nohel and Tarhan, 1998).
Nohel and Terhan (1998) discussed the repurchase- related gains as a result of
restructuring companies' assets, by shrinking the assets size and selling inoperative
assets. This reduces the assets turn over and helps to use optimally the remaining
productive assets. From their point of view the benefits of repurchase are related to
restructuring the company's assets and reducing the company's size but no operating
performance improvements and no increase in investment were found, contrary to Lie
(2005) results which support the improvements in operating performance after actual
repurchase.
Isagwa (2000) also supports free cash flow hypothesis, he documented that the market
reacts positively to repurchases of low (Q) firms which have law investment opportunities
because the investors perceive this cash distribution is better than letting the excess cash
flow under management control, this matches with Lag and Liztenburger (1989) and Li and
McNally (2007).
Free cash flow and cash dividend (substitution hypothesis).
The United States companies increase the use of stock repurchases as a tool for cash
payout from the middle of the eighties to 2000. The cash dividend paid by the US
companies had been decreased, in spite of that the cash paid out stayed the same. That
means that the US companies substitute cash dividend by share repurchases (Grullon and
Michaely, 2002). This consists with the results of Dixon et al., (2008); Li and McNally
(2007); Wronska and Skiodoska (2013) which supports the substitution hypothesis.
Moreover, companies prefer repurchase because of the tax gains. The gains of
repurchase are treated as capital gains which have lower tax rate than the tax rate of the
dividends.
BenHammouda and Watson (2009) did not support substitution hypothesis through their
study in England. They approved that the British companies don't substitute dividends by
repurchase and the investors perceive that the cash dividend is better than repurchases.
This also goes with Bierman (2008) who proved through a numerical instance that neither
cash dividends nor repurchase should affect the stock price in efficient markets, but
because of the investors' psychology, they prefer cash dividends.
Generally the free cash flow hypothesis predicts the following:1- Companies repurchase their own stocks when their profitability decline (Nohel
and Tarhan, 1998).
2- Companies with low investment opportunities, less capital expenditures and
excess cash flow should repurchase their own stocks.
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Proceedings of 4th European Business Research Conference
9 - 10 April 2015, Imperial College, London, UK, ISBN: 978-1-922069-72-6
3- Companies repurchase their own stocks experience a decline in their cost of
capital because of the decline in their systematic risk (Gurllon and Michaelly,
2004).
4- Market reacts positively with low (Q) firms (Q <1) when using Tobin's (Q) as a
measure for investment opportunities (Lag and Lizten Bruger, 1989; Nohel and
Tarhan, 1998).
5- Companies repurchase their own stocks instead of cash dividends experience
low M/B ratio (Li and McNally, 2007).
Signaling hypothesis
Signaling hypothesis implies that companies repurchase their own shares usually with
premium over market price to signal the market with operating performance improvements
in the future through entering new profitable projects or increasing profitability and growth
rates (Chen et al; 2010; Vermaelen, 1981). In case of an efficient market, companies can
signal information to the market through the payout tools (the way they distribute cash to
the stockholders) (Gurllon and Michaelly, 2004).
Like undervaluation hypothesis, signaling hypothesis is based on the information
asymmetric between the shareholders and investors from one side and the insiders from
the other side; hence the company signals to the market through repurchase that the
company's operating performance will be improved in the future or the company will held
new projects otherwise its stocks will be undervalued. (Dittmar, 2000; Wang L-H et al.,
2013).
Lie (2005) showed that companies do an actual repurchase (not announcement) in the
same fiscal quarter. They announced and this is followed by an improvement in its
operating performance. Then the market reacts positively for a long time, whereas the
market positive reaction appears only in the short time for the companies which do not
actually repurchase at the same fiscal quarter. These results imply that the long term price
drift relates to the real improvements in the companies' operating performance, where
shorter market positive reaction is caused by the perception of undervaluation (Gurllon and
Michaelly, 2004; Li and McNally, 2007).
The real signal about future improvement may be made by the price range announced by
the company, when the company offers high price range over the share market price, the
market acts favorably to repurchase (Hug and Chen, 2010; Kooli and L'Her, 2010). This
consists with the results found by Comment and Jarrall (1991). They proved that the
market reacts favorably to tender offer share repurchase more than the other two ways of
repurchase (Dutch auction open market share repurchase) that is because in tender offer
the company's obliged to buy the announced quantity of shares, usually higher than the
market price.
Signaling hypothesis predicts the following:1- Companies repurchase announcement followed by positive changes in their
stocks price.
2- Stock repurchase followed by performance improvement and increase
profitability and earnings.
3- The real operating performance improvements relates to the actual repurchases
not announcements.
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Proceedings of 4th European Business Research Conference
9 - 10 April 2015, Imperial College, London, UK, ISBN: 978-1-922069-72-6
Capital structural hypothesis
Companies use repurchase as a tool to change their capital structure when these
companies use debt to finance repurchases (Lie et al., 2010). Firms with additional debt
capacity repurchase their own stocks to change capital structure and go towards desirable
capital structure, especially when these repurchases were debt financed (Dittmar, 2000).
The most important motivation for undertaking share repurchases is to achieve an
optimum capital structure; particularly any reduction in the outstanding amount of shares
will affect capital structure even if the repurchases were not debt financed (Dixon et al.,
2008).
Li and McNally (2007) proposed that the optimal leverage is the industry average debt
ratio, so the optimal capital structure is industry average debt to total asset ratio. Firms
below optimal capital structure repurchase their shares to increase leverage and make
benefits of taxes and increase firms' value. That explains the abnormal returns around
repurchase announcements.
Managers determine the appropriate time to repurchase when they desire to modify the
company's capital structure to increase leverage or decrease the total taxes paid or reduce
the cost of capital by increasing debts (Fairchild, 2006).
Take over deterrence hypothesis
When firms' shares become undervalued, bidders want to acquire these firms because of
low price advantage. Value firms can defend take over because repurchase can increase
the price of undervalued stocks (Dittmar, 2000; lee et al., 2008).
The target companies do share repurchase for two main reasons (Dixon et al, 2008; Lin et
al., 2014).
1- The announcement of repurchase can increase the company's share prices, that
results in the increase of the cost of take over.
2- In case of actual repurchase the amount of shares under management control
will be increased, which strengthen the situation of the current management and
deter the take over.
Dixon et al., (2008) documented that repurchases transfer a part of value from the
participants in repurchase (stockholders who sell their stock( to non-participants (the
stockholders of the out-standing stocks) this value transfer concentrates the equity in lower
number of shareholders which makes the takeover more difficult in addition to that,
increasing the stocks' price makes the bidder unable to get the specified amount to
complete the take over( (Comment and Jarrel, 1991; Wronska and Skiodoska, 2013).
Companies which repurchase their stocks permanently, do not prefer to takeover other
companies, where companies concern in take over don’t repurchase their stocks (Bozanic,
2009).
Executive compensations hypothesis
Companies compensating their executives with large amount of stock options may prefer
to repurchase their stocks. The companies often provide their executives with stocks from
treasury stocks, so it is beneficial for these companies to repurchase their own stocks
when they were undervalued in the market and hold them to exercise these options
(Dittmer, 2000; Lee at al., 2008; li ad McNally, 2007).
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Proceedings of 4th European Business Research Conference
9 - 10 April 2015, Imperial College, London, UK, ISBN: 978-1-922069-72-6
Wronska and Skiodoska (2013) suppose that companies provide stock options to its
executive as an incentive to reduce agency problem, because when the (Insiders)
executives hold the company's stock they feel that they are owners which motivates them
to work more efficiently and effectively and reduces the conflict between shareholders and
management.
Proposed model
Figure (1)
H1
Undervaluation
H2
Free cash flow
H3
Abnormal
returns around
share
repurchase
announcement
Signaling
Research Hypotheses:
H1: there is a significant negative relationship between the undervaluation and the
abnormal returns around share repurchase announcement.
H2: there is a significant positive relationship between the free cash flow and the abnormal
returns around share repurchase announcement.
H3: there is a significant positive relationship between operating performance
improvement and the abnormal returns around share repurchase announcement.
3. Methodology:
 The expected model
To calculate the abnormal returns around share repurchase announcement we engage
with event study methodology.
Event study
This diagram illustrates how event study works:
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Proceedings of 4th European Business Research Conference
9 - 10 April 2015, Imperial College, London, UK, ISBN: 978-1-922069-72-6
Figure (2)
Event study term (Chi et al., 2010)
a. Calculating the expected return Ȓ
Using market model
Rit= αit + βi Rmt + εit
Ȓ = αi + βi Rmt
b. Calculate the abnormal returns:
ARit = Rit – E(Rit)
t (-n……….+n)
 Cumulative abnormal returns CAR:
∑
it
 Buy and hold abnormal returns:
t
t
BAHR =∏ {1+ Rit} + ∏ { (1+ E (Rit) }
t =1
t =1
Regression model
BHARit = αit + β1 Ln (size)it + β2 BMit + β3 ∆ RoAit + β4 ∆EPSit + β5 FCFit + β6 FCF.low TQit +
β7 ∆ Divit + β8 ∆ACit + εit.
CARit = αit + β1 Ln (size)it + β2 BMit + β3 ∆ RoAit + β4 ∆EPSit + β5 FCFit + β6 FCF.low TQit +
β7 ∆ Divit + β8 ∆ACit + εit .
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Proceedings of 4th European Business Research Conference
9 - 10 April 2015, Imperial College, London, UK, ISBN: 978-1-922069-72-6
BAHR
CAR
Buy and hold abnormal returns for firm (i) at time (t).
Cumulative abnormal returns for firm (i) at time (t).
Ln (Size) Natural logarithm for firm for firm size = firm's market value.
B/M
Firm's book value to market value
ROA
Net income before extraordinary items to total assets in average.
∆Eps
The changes in (Net income / Outstanding shares).
FcF
TQ
(Net income + Depreciation + abnormalization + incremental on working capital
– fixed asset purchasing) to book value of equity.
(total market value of equity + the book value of long term debt) / The book
value of total assets.
∆Div
Changing in cash dividends
∆Ac
Changes in agency cost – operating cost to total assets.
Divt1- Divt
4. Conclusion:
This paper presented reasons included in the finance literature for why companies
repurchase their own stocks. The most widely accepted reasons between researchers
depending on the results of their empirical result were undervaluation and free cash flow
especially in the United States and Canada.
5. References:
Calomiris, CW and Himmelberg, CP 1993, ‘Directed credit programs for agriculture and
industry : arguments from theory and fact’, In: Proceedings of the World Bank
Annual Conference on Economic Development, Supplemented to the World Bank
Review and the Third Word Research Observer, 1994, pp 113-13?.
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