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Chapter 18
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Share Repurchases
©2001 Prentice Hall
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Introduction
• Share repurchases are cash offers for
outstanding shares of common stock
• Share repurchases change the book
capital structure of the firm by reducing
the amount of common stock
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• Effects on leverage ratio
– Leverage ratio increases because the
amount of common stock is reduced
– Leverage ratio is magnified if excess cash,
which is used to extinguish common stock,
is no longer deducted from debt to
measure leverage ratio
– If additional debt is used to buy common
stock, similar magnification of leverage
ratio
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The Use of Share
Repurchases
• Share repurchases have increased in
absolute terms
– Repurchases increased from $0.3 billion in
1980 to $236.2 billion in 1998
– Repurchases have grown at a compound
annual rate of 29.9% per year
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• Share repurchases have increased
relative to the use of dividends
– Repurchases were a 0.5% percentage of
cash dividend payouts in 1980. By 1998, it
was 84.6%
– Between 1980 and 1998, cash dividends
grew at a rate of 8.7% per year compared to
29.9% for share repurchases
– For the S&P 500 companies, share
repurchases have exceeded cash dividends
beginning in 1997
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• Some factors in the growth of share
repurchases
– Tax savings
• Cash dividends subject to maximum individual
tax rate of 39.6%
• Returns of cash from share repurchases may
qualify for long-term capital gains rate of 20%
– Timing of taxes
• Shareholders can choose whether or not to
participate in a buyback program
• Shareholders can choose to defer tax payments
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– Management incentives
• Share repurchases increase the percentage
ownership of the firm for nonparticipants such as
officers and directors
• Incentives of officers and directors to think as
owners will be strengthened
• Reduce agency problems
– Management responsibility
• Returning excess cash to shareholders may
demonstrate that officers and directors acted in
the best interest of shareholders
• Shareholders' trust in their officers and directors is
strengthened because excess funds were not
used for negative NPV investments
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– Undervaluation signal
• Non-participation of officers and directors in
buyback programs may signal that stock price is
undervalued
• Cash flows are likely to increase in the future
– Sharp price declines
• After sharp decline in the stock market in
October 1987, many firms initiated substantial
share repurchase programs
• Share repurchases represent a statement by
management that overall market decline did not
justify the sharp drop in their firm's share price
• Special case of undervaluation scenario
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– Greater flexibility
• Market rewards a history of consistent increases
in dividends and punishes company that fails to
do so
– Patterns of dividend behavior by individual firms are
established over time
– Earnings rise with fluctuations while dividends
increase in a stair step fashion with a lag behind
growth in cash flows
• In share repurchases, the expectation is that
cash will be returned to shareholders when
funds are available in excess of needs to finance
sound investment programs
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– Accounting treatment
• Accounting for shares repurchases
– Reduce (debit) shareholders' equity account
• Accounting principles permit charge at cost or market
• Common practice is to charge the actual amount paid for
shares (at market)
– Reduce (credit) cash by the required outlay
• Accounting effect after share repurchase
– If net income remains at the same level, EPS increases
– If P/E ratio remains at the same level, market price per
share will rise and market capitalization will remain the
same
– Book value per share will decrease since book
shareholders' equity decreases by more than book value
of shares when market to book ratio is greater than 1
– Return on book equity will increase
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– Debt to equity ratio
• Share repurchases increase leverage ratio
• Share repurchases could be used to move the
firm toward its target debt leverage ratio
– Offset stock options
• Stock options increasingly used in executive
compensation programs and in employee
incentive plans
• Exercise of stock options increases firm's
shares outstanding creating downward
pressure on the firm's stock price
• Share repurchases can be used to offset the
potential dilutive effect of stock options
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– Takeover defenses
• Share repurchase price may be viewed more
favorably than takeover price
• Share repurchase may cause takeover bidders
to offer a higher premium
– When a firm tenders for 10% or 20% of its shares,
shareholders who offer their shares are those with the
lowest reservation prices
– Shareholders who did not tender have the highest
reservation prices
– In order for takeover bidder to succeed, he must offer
a higher premium to the remaining higher reservation
price shareholders
– Required higher premium may deter potential bidders
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– Restructuring factors
• Share repurchases may be part of general
restructuring programs
• Influence on share prices is likely to be
positive, but it is the restructuring that is the
stronger casual force
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Fixed Price Tender Offers
• Tender offer
– Company sets number of shares it is offering
to purchase
– Company sets price at which it will
repurchase shares
– Company sets period of time offer will be
open
– Officers and directors of repurchasing firm
do not participate in tender offer
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• Tender price
– Average 20% over prevailing market price
– Tendering shareholders receive full tender
offer price
• Tendering shareholders pay no brokerage fees
• Company pays any transfer taxes levied
• Number of shares
– Offer specifies maximum number of shares
the firm will buy
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– If oversubscription
• Company may buy pro rata basis from all
tendering shareholders up to a maximum
• Company may buy all tendered shares
– If undersubscription
• Company buys all shares tendered
• Company may cancel offer if it includes a
minimum acceptance clause
• Company may extend offer period
• Company purchases shares offered during
extension period either pro rata or on basis of
order in which shares are offered
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• Stock repurchase model
– Assumptions
• Efficient markets — prices reflect all publicly
available information
• Informationally efficient market — information is
costless and is received simultaneously by all
• Perfectly competitive securities markets —
individuals are price takers
• Wealth-maximizing investors
• Homogeneous expectations
• Maximum limit offers
• Price changes are net of market-wide effects
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– Model variables
•
•
•
•
•
•
•
•
Po
PT
PE
No
=
=
=
=
preannouncement stock price
tender price
postexpiration share price
preannouncement number of shares
outstanding
NE = postexpiration number of shares outstanding
W = shareholder wealth effect
FP = fraction of shares repurchased = (No - NE)/No
1 - FP = fraction of untendered shares = NE/No
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– Model
PE NE = Po No - PT (No - NE ) + W
(18.1)
• Total share value postexpiration (PE NE) is equal to:
– total share value preannouncement (Po No)
– minus the total value of shares repurchased [PT (No - NE)]
– plus the change in shareholder wealth associated with the
repurchase offer (W )
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• In rate of return form
W/(No Po) = FP [(PT - Po)/Po]
+ (1 - FP)[(PE - Po)/Po]
(18.2)
• Total return associated with repurchase,
W/(No Po) is made up of two components
– Return received by tendering shareholders, weighted by
percent of shares purchased, FP[(PT - Po)/Po]
– Return received by nontendering shareholders,
weighted by percent of nontendering shares,
(1 - FP)[(PE - Po)/Po]
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• Empirical studies
– General patterns
•
•
•
•
Initial premium = (PT - Po)/Po = 15-25%
Fraction of shares repurchased = FP = 15-20%
Wealth effect = W/(No Po) = 10-16%
Premium of postexpiration price = (PE - Po)/Po =
11-15%
• Percent wealth effect to tendering shareholders
= FP[(PT - Po)/Po] = 3-5%
• Percent wealth effect to nontendering
shareholders = (1-FP)[(PE - Po)/Po] = 10-13%
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– Premium of postexpiration price = (PE - Po)/Po
(Assume FP = 20%)
• If (PT - Po)/Po = 20% and W% = 15%
15% = 0.20(20%) + 0.80(X)
X = 13.75% = (PE - Po)/Po
– Of 15% wealth effect associated with share repurchase
offers,
• 0.20(20%) = 4% went to tendering shareholders
• 0.80(13.75%) = 11% went to nontendering
shareholders
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• If (PT - Po)/Po = 15% and W% = 10%
10% = 0.20(15%) + 0.80(X)
X = 8.75% = (PE - Po)/Po
– Of 10% wealth effect associated with share repurchase
offers,
• 0.20(15%) = 3% went to tendering shareholders
• 0.80(8.75%) = 7% went to nontendering shareholders
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• Rationale for postexpiration price
changes
– Introduction
• Size of premium offered to shareholders to
tender about 15-20% over prevailing stock price
• At expiration of tender offer period, price of stock
remains 8-10% above pretender offer
announcement price
• What is the source of the postexpiration stock
price increases associated with share
repurchase programs?
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– Masulis (1980) emphasized benefits of
increased leverage
– Vermaelen (1981)
• Argued for positive signaling hypothesis
• Repurchase tender offers associated with future
cash flow levels above what would have been
predicted by a time-series model using
preannouncement data
• Concludes information/signaling effect carries
more weight than leverage — although the two
are related
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– Nohel and Tarhan (1998)
• Sample of 290 share repurchase companies for
period 1978 to 1991
• Companies divided into low q-ratio firms and
high q-ratio firms
• Sample compared to a control group of
nonshare repurchase firms
• Share repurchase firms, net of control group,
have significantly positive event returns
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• Improvement comes entirely from low q-ratio
firms
– Low-q firms have higher asset turnover ratios relative
to control group, both before and after the
repurchase
– Difference widens after repurchase
– Improvement associated with asset sales by low-q
firms — successful repurchasing firms dispose of
poorly performing assets as part of a restructuring
program
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Dutch Auction Repurchases
(DARs)
• Implementation
– Firm specifies number of shares and range
of prices for share repurchase
– Shareholders can tender shares at any
price within stated range
– Firm puts together shareholder responses
into supply schedule curve for the stock
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– Firm repurchases shares at lowest price
(purchase price) that allows it to buy
number of shares it sought in offer
– Purchase price is paid to all shareholders
who tendered at or below purchase price
– If oversubscribed — firm purchases shares
tendered on pro rata basis
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• Upward sloping supply schedule curve
– Shows evidence of shareholder
heterogeneity
• Different expectations and valuations
• Different tax basis for low and high reservation
shareholders
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– Equation for upward sloping supply
schedule is of the form:
V(r) = a + br
• Each share is assumed to be held by an
individual shareholder
• V(r) indicates reservation price of the rth
shareholder
• Intercept term a represents the prevailing market
price of the stock
• More steeply sloped (slope b) schedule, higher
reservation price schedule
• Premium paid in Dutch auction share
repurchases lower than fixed price tender offers
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• Comment and Jarrell (1991)
– Influences on share repurchase wealth
effects
• Pro rata transaction — if reservation prices of
shareholders are so low that tender offer
stimulates flood of tenders, wealth effects not
very high
• Officers and directors (OD) at risk of personal
wealth loss if
– OD collective proportional ownership interest in
company's stock must increase as result of tender offer
and
– Premium in tender offer more than 2% above market
price of stock four days before offer is announced
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– Results
• Average wealth effects
– Fixed price tender offers = 12-13%
– Dutch auctions = 8%
• With prorationing
– Wealth effects virtually zero
• Fixed price tender offers = 0-5%
• Dutch auctions = 0%
– Shareholder reservation prices are low — signaling of
future value increase is less credible
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• No prorationing
– Large wealth effects
• Fixed price tender offers = 15%
• Dutch auctions = 8%
– Shareholder reservation prices are high — premia
offered in share repurchases is credible signal of
future value increases
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• Officers and directors at risk
– Signaling credible
– Large wealth effects
• Fixed price tender offers = 16%
• Dutch auctions = 8%
• Officers and directors not at risk
– Signaling not credible
– Small or negligible wealth effects
• Fixed price tender offers = 4%
• Dutch auctions = 0%
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• Conclusions
– Dutch auctions favored by firms that are
• Relatively large and widely followed by security
analysts and other informed investors
• Management owns low percentage of stock
– These firms do not need to send strong credible
signals in premium repurchase offers
– For these firms, Dutch auctions likely to be a
substitute for open market repurchases
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• Lie and McConnell (1998)
– Compares fixed price (FP) versus Dutch
auctions (DA) self tender offers
– Sample
• 130 FP and 102 DA between 1981 and 1994
• DA started in 1981 and accounted for less than 10
transactions per year through 1987
• Period 1988-1989, DA accounted for slightly above 20
per year
• In 1991, 1 FP and 2 DA; in 1993, 6 DA; in 1994, 4 DA
• Most FP are pre-1990
• Sharp decline in self tender sample after 1989
suggests that open market share repurchases were
substituting for both FP and DA repurchases
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– Event returns
• Three-day window centered on announcement
date
• FP abnormal returns were mean of 7.9% and
median of 6.8%
• DA abnormal returns were mean of 7.7% and
median of 6.4%
• Excluding offers with coincident confounding
news
– FP abnormal returns were mean of 10.2% and median
of 8.6%
– DA abnormal returns were mean of 7.6% and median
of 6.2%
– Difference is significant at the 5% level
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– Comparison of earnings pattern
• Both FA and DA firms exhibit superior
performance during year of self-tender offer
• Both FA and DA firms exhibit slower mean
reversion in their operating performance than
firms not undertaking tender offers
• FA and DA firms continued to exhibit superior
performance longer than what otherwise would
have been expected
• There was no significance difference in the
measured subsequent performance between FA
and DA firms
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Transferable Put Rights
(TPRs)
• Implementation
– Firm issues put options to shareholders in
proportion to number of shares owned
– If firm wishes to repurchase 10% of
outstanding shares, it gives shareholders 1
TPR per 10 shares owned
– Each TPR gives shareholder right to sell
one share back to firm at fixed price within
specified period
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– All shares put back to firm are repurchased
— no prorationing occurs
– Shareholders that do not wish to sell shares
back to firm can sell their TPRs in open
market
– If significant premium of put price over
prevailing market price
• TPRs have value
• Trading in TPRs will take place
• TPR trading can discover market
clearing price of shares company seeks
to repurchase
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• TPRs vs. fixed-price offer
– In fixed-price offers, shareholders avoid
risk of prorationing by selling shares to
arbitragers
– Arbitragers can accumulate shares and
achieve strong bargaining position
– TPRs prevent arbitrager from driving up
prices in fixed-price offers
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• TPRs can be used to consolidate control
position of a group
– TPRs are issued with put price at a
substantial premium
– Dissident group happy to accept the
substantial premium
– Noncontrolling group purchases TPRs from
control group
– After TPRs plus stocks are put, control
group ends up with increased ownership
percentage of firm
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• Use in takeover defense; trading in
TPRs result in
– Low reservation price shareholders put
their shares for repurchase
– Remaining shareholders will be high
reservation price shareholders
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Open Market Share
Repurchases (OMRs)
• Firm repurchases its common stock in
open market transactions
• OMRs outnumber other three methods by
at least 10 to 1
• OMRs involve a smaller percentage of
total shares outstanding than other
methods — average 5% vs. 16% for fixed
price tender offers
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• Ikenberry, Lakonishok and Vermaelen
(1995)
– Aggregate value of stock repurchases
• 1980-1990, one-third of dollar amount of cash
dividends
• Later years of 1980s, one-half of dollar amount
of cash dividends
– 1,239 open market share repurchases
between 1980-1990
– Announced repurchases for 6.6% of
outstanding shares on average —
percentage rising over sample time period
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– Market response to announcement of OMR
• Average of positive 3.5%
• For event window [-2 days,+2 days]
– Period 1980-1986 = 4.2%
– Period 1987-1990 = 2.3%
• Based on size of repurchase program
– 10% or more of outstanding shares = 4.51%
– Less than 2.5% of outstanding shares = 2.58%
• Based on firm size
– Firm in two smallest size deciles, highest abnormal
returns = 8.19%
– Firm in largest size decile, abnormal returns = 2.09%
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– Market underreacts to OMR
• Buy and hold strategy, four-year abnormal
performance following announcement = over 12%
• Combined with announcement effect, total
undervaluation about 15%
• Firms ranked by book to market
– Firms in top quintile, four-year abnormal performance
following announcement = 45.3%
– Firms in bottom two quintiles, four-year abnormal
performance following announcement close to zero
– Abnormal performance measure is net of a benchmark
that explicitly controls for size and book-to-market
effects
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– Conclusions
• Stronger market response to larger share
repurchase consistent with signaling hypothesis
• If firm size is proxy for informational asymmetries,
inverse relationship between size and abnormal
return consistent with signaling hypothesis
• Based on four-year abnormal performance
results, market reaction to new information is not
completed over short time periods
• Companies with high book to market ratios that
engage in share repurchases show higher returns
in future compared with high book to market ratio
stocks in general
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Weston - 49
• If market underreacts to first OMR
announcement, managers may make a series of
OMRs
• If major reason for repurchase is that shares are
underpriced, as share price increases with
announcement and initiation of repurchase
program, managers have less incentive to
complete OMR
• Evidence consistent with market timing ability of
managers
• In recent years, firms with depressed stock
prices have announced OMRs. But if future cash
flow outlook is unfavorable, market prices will not
rise — no wealth effect
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• Accounting manipulation
– Reduction in book value of shareholders'
equity as a result of share repurchase may
be substantial for high market to book firms
— debit to record repurchase can be made
at market value
– For a given level of net income, accounting
return on equity (ROE) would increase
substantially
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Weston - 51
• OMR model (Rappaport, 1998)
Cost of Equity
1  Percent Un dervaluati on
ks
0.10


1  (V  P) V 1  [( 20) /(100)]
k
0.10
 s 
PV
0.8
R
Cost of Equity

 12.5%
Ratio of Actual Market to Intrinsic Value
where
©2001 Prentice Hall
R
Ks
V
P
=
=
=
=
rate of return in share repurchase
market required cost of equity = 10%
intrinsic value = $100
market price = $80
Takeovers, Restructuring, and Corporate Governance, 3/e
Weston - 52
– Non-selling shareholders will earn a rate of
return greater than the market required cost
of equity
• if a company's shares are undervalued and
• if stock is repurchased in OMRs at an
undervalued price.
– Share repurchase financed by foregoing
value-creating investments makes sense
only if the investment would have yielded a
rate of return less than the rate of return on
a share repurchase.
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– Returns on OMRs can be increased by the
use of puts
• Company sells put warrants — income from put
is net since tax code allows corporations to sell
options on their stock tax-free
• Buyer of put warrant hedges his position by
buying company's shares in the open market
– If stock goes up:
• Warrants are worthless
• Owner of put can sell stocks in the open market for
profit — needs fewer shares to hedge position
– If stock falls below exercise price:
• Warrants are valuable
• Owner of puts can exercise
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