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Understanding Stock Repurchases: Types, Reasons, and Planning

Explore the various types of stock repurchases, the reasons behind companies choosing this strategy, and the detailed planning involved in open market repurchases. Gain insights into the effects on stock price, earnings, cash flow, and agency costs.

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Understanding Stock Repurchases: Types, Reasons, and Planning

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  1. Topics • What do we know about stock repurchases? G. Grullon and D. L. Ikenberry Hu - Financing Decision I

  2. What do we know about stock repurchases?Types • Fixed-price tender offer • Large scale (15% shares), high premium 16% • Announcement effect: 15% • Dutch-auction tender offer • Open market repurchase program • 5% shares, lasting 2 to 3 years • Announcement effect: 4% Hu - Financing Decision I

  3. What do we know about stock repurchases?Types Hu - Financing Decision I

  4. What do we know about stock repurchases?Why? • Increase EPS • If the drop in earnings is less than the drop in the number of shares • Can it increase stock price? • Is it due to a better use of asset or stock repurchase? Hu - Financing Decision I

  5. What do we know about stock repurchases?Why? • Signal future cash flow • Information revealing needs to be credible • Stock repurchase is credible because lying is costly • Fixed price tender offer: • More credible, observe earnings improvement • Open market repurchase • Observe earnings decline Hu - Financing Decision I

  6. What do we know about stock repurchases?Why? • Exploit market undervaluation • Observe: Four year abnormal return is 12.14% • Concentrates on value stocks (high book-to-market value), four year return is 45.29% Hu - Financing Decision I

  7. What do we know about stock repurchases?Why? • Reduce agency costs of free cash flows • Managers can pursue their personal interests • Observation 1: • Tender offer firms have higher levels of cash • Announcement effect is higher when excess cash is higher • Observation 2: • Announcement effect is higher when operating return on investment is lower Hu - Financing Decision I

  8. What do we know about stock repurchases?Why? • Reallocate investment among companies • Shareholders can reallocate investment more efficiently • Observation • After repurchase, asset is less and capital expenditure is less Hu - Financing Decision I

  9. What do we know about stock repurchases?Why? • Substitute cash dividend • Personal dividend income tax or capital gains tax? • To maintain stock price (cash dividend will cause the stock price to drop) Hu - Financing Decision I

  10. What do we know about stock repurchases?Why? • Adjust capital structure • To offset share increase from stock options Hu - Financing Decision I

  11. What do we know about stock repurchases?Planning an open market repurchase • Repurchase and stock liquidity • Increase informed traders • Increase depth • Observation • Spread declines for less liquid stocks • Volatility drops • Price drops less with market Hu - Financing Decision I

  12. What do we know about stock repurchases?Planning an open market repurchase • Flexibility and completion rate • Will firms mislead the market and repurchase very few shares? • Disclosure • US does not disclose • Canada disclose • Observation • Price increases the most for companies that do not repurchase • Announcement effect is higher when flexibility is more valuable (stock is more volatile) Hu - Financing Decision I

  13. What do we know about stock repurchases?Planning an open market repurchase • Transaction limitations • SEC rule 10b-18 in 1982 • Made through only one broker • Not executed at the opening or during the last half hour of trading • Not done at a price exceeding the highest bid • Not exceed 25%of average daily volume • Black-out dates: prohibit insider trading Hu - Financing Decision I

  14. What do we know about stock repurchases?Planning an open market repurchase • Alternatives • Buy stocks • Buy call options • When price is higher, exercise call • When price is lower, buy stocks on open market • Sell put Hu - Financing Decision I

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