Share repurchases and firm performance: new evidence on the agency costs of free cash flow Nohel and Tarhan (1998, JFE)

Contents Abstract Introduction Information signaling and free cash flow Data and variables Empirical finding and interpretation Conclusion

abstract Information signaling hypothesis Free cash flow hypothesis Using changes in operating performance (this paper) rather than stock abnormal returns or long run return (previous studies) Low q firms—operating performance improve cause of efficient utilization of assets and asset sales. The result support free cash flow hypothesis

Information signaling hypothesis Repurchasing sends a strong signal to lesser-informed outside investors that firm performance will be improved in the future.

Free cash flow hypothesis Firm with excess cash and a poor portfolio of investment opportunities will face sizable agency costs if the excess cash is not distributed to shareholders. Excess cash  managers might perquisites, empire building (entrenchment), and invest other negative NPV projects.

Dividend payout issue Supported free cash flow hypothesis Lang and Litzenberger (1989) Market reacts more to dividend changes of low q firms than those of high q firms (why supports free cash flow hypothesis?) Low q do not have more positive NPV projects, as a result, using dividend payout to mitigate excess cash problem. Perfect et al. (1995) Support LL(1989)’s results. Disputed free cash flow hypothesis Howel et al. (1992) Denis et al. (1994)

Rationale of hypotheses Signal Repurchasing announcement => tangible improvement in operating performance Free cash flow Repurchasing announcement => may or may not exhibit improved performance. Note: signaling implies an improvement in performance, but a performance improvement need not imply signaling. Note: Assets sale (poor performance assets) => execute share repurchase => operating performance improvement => spirit of the free cash flow

Purpose of this paper Distinguish between the information signal hypothesis and free cash flow hypothesis by using operating performance changes rather than “earning changes”. Decompose firm operating performance Performance improvement: repurchasing, efficient mgr, or cost down,…etc. Understanding the motive behind the repurchase.

Purpose of this paper Examine the relationship between performance and risk. How these variables related to announcement period returns. Long term return to realize the anticipated performance and risk. Subsample: low q and high q

Information signaling Repurchasing sends a strong signal to lesser-informed outside investors that firm performance will be improved in the future. Literatures (skip)

Free cash flow Firm with excess cash and a poor portfolio of investment opportunities will face sizable agency costs if the excess cash is not distributed to shareholders. Excess cash  managers might perquisites, empire building (entrenchment), and invest other negative NPV projects. Literatures (skip)

How to discriminate between the two hypotheses? Three measurements: Operating performance Abnormal stock return Long run returns In this paper, three measurements are implemented.

Data Tender offer stock repurchase ( why not open market repurchase?) 1978-1981 COMPUSTAT, NYSE, AMEX, and NASDAQ Data processing Matching firms selection Criterion

Data Using firm performance rather than abnormal stock return. (why?) Healy et al. (1992), Cornett and Tehranian (1992), and Tarhan et al. (1998) Measurement of firm performance The ratio of an upstream measure of cash flow, defined as EBITDA / market value of the assets (why market value of assets?)

Variables

Decomposition of cash flow return on asset Du Pont analysis ROA= cash flow margin + asset turnover Cash flow margin = Net income / sales Asset turnover = sales / total assets Deep discussion on firm performance

Empirical findings—univariate statistics

Empirical findings—univariate statistics Low q firms’ operating performance improve after repurchasing announcement. Low q firms are undervalued. Low q firms’ asset turnover rate are significantly positive not only before repurchasing but also after repurchasing.

Regression analysis for each variable

The results of regression analysis

The results of regression analysis

The results of regression analysis Why check each variable? But not regression on all variables. Why test for a zero intercept terms (Healy et al., 1992) Low q firms performance improvement cause of better utilization of assets or reduce unproductive assets?

Which one drives performance improvement Information signal hypothesis Managers repurchase shares to signal their improved growth prospects. Free cash flow hypothesis Managers return cash to shareholder in lieu of investing in unproductive assets. Two way to improve the efficiency of the assets: Acquire highly productive assets Liquidating unproductive assets

Which one drives performance improvement

Which one drives performance improvement Asset sale is positive significant (firms sale their assets) => firms reduce unproductive assets and distribute cash to shareholder => support free cash flow hypothesis This result implies that share repurchase is used as part of a corporate restructuring package.

Robustness check

Robustness check

Robustness check Asset sales positively related to the firms’ performance improvement The results are robust to reduce unproductively assets => support free cash flow hypothesis again.

Market reaction to repurchase

Market reaction to repurchase Short run abnormal return are significantly positive. (including AR and AER) These results are consistent to Lakonishok and Vermaelen (1990) Denis (1990) and Comment and Jarrell (1991) suggest that takeover risk and officers and directors risk are related to firm repurchase. => another robustness check.

Robustness check--risk

Robustness check--risk

Robustness check--risk Negative coefficient on INPLAY supports the results of Denis (1990) => firm repurchase as a defensive move against a takeover threat. Positive coefficient on ODRISK Signal hypothesis: insiders send a strong signal of firm’s prospects. Agency cost: insiders increase their shares => reduce agency cost.

What factors result in abnormal return? —Announcement return

What factors result in abnormal return? —Announcement return

What factors result in abnormal return? —Announcement return Cash flow: positive significant in low q firms and insignificant in high q firms. Investor correctly anticipate the superior performance of low q firms and the mediocre performance of high q firms PREM, FRAC, and INPLAY are important determinants of announcement return.

What factors result in abnormal return?—Long run return

What factors result in abnormal return?—Long run return

What factors result in abnormal return?—Long run return Cash flow: positive significant in high q firms and insignificant in low q firms. Indicate that the systematic performance improvements displayed by low q firms are correctly anticipated by investors. Investors do not expect systematic post repurchase improvement from high q firms.

Conclusion Repurchasing firms significant improve their performance, relative to control firms Low q firms => performance improvement by assets efficient utilization (turnover) Firm’s repurchase of stock is part of a restructuring program (shrink the assets of the firm => and then distributing cash). AR and LR indicates that investors correctly anticipate that the low q firms generate performance improvement, and high q firms do not. These results support the free cash flow hypothesis over the information signaling hypothesis.