Wealth Transfer, Governance and Free Cash Flow - Literature review Example

Introduction Since the past 20 years, it has been seen that that repurchase of shares have become an important policy in the USA. According to the information from Thomson Financial, companies that have made up the S&P 500 in the year 2003 had bought back $284 millions to repurchase their own stock. The amount rapidly increased to $973 billion in 2006. But it had been seen that when expenditures of repurchasing of stocks had grown during the period 1980-2006 by 37.1% average annual rate but the dividends only grew by 7.9% at an average annual rate. According to Grullon and Michaely (2002), during 1998 the companies had spent more money to repurchase the existing shares rather than payment of dividends on them. According to Varaiya, Kim and Schremper (2005), in most of the cases shareholders have no knowledge that whether an organization is buying back its shares or not because in the USA, the rules that govern the repurchase option of own shares has not made it compulsory that shareholders’ approval is needed. Thus the decision of the board of directors is enough to initiate the repurchase program and it is totally a managerial decision. Board of directors has the right to prohibit or authorize the announcement of repurchase according to their decision and interest. Thus it supports the opportunistic behavior of the directors when it comes to announcing the repurchasing decisions. According to Fried (2005), the share repurchase program in open market is used to transfer the wealth from uninformed stockholders to the managers of the company. Literature Review Signaling According to Bhattacharya (1979), the repurchases of stocks happen when managers and directors think that the stock of the company is undervalued and it might be positive news for the firm and its future performances. Other authors have reported that repurchases of shares are not positively related to the price decline of shares which might lead the management to think that the stocks are undervalued. On the other side, Bartov, Krinsky, and Lee (1998) have found out that repurchases describes the information about the future earnings and risks probabilities of the company. Dittmar and Dittmar (2002) have stated that firms mainly repurchase their shares to get the advantage of undervaluation of the shares. Managers use the tender of repurchase to offer the signal that the shares are undervalued. In addition, operating performances of some companies have improved after repurchasing their own stocks. Another survey conducted by Brav et al. (2005), managers has stated that announcements of dividends or repurchasing of stocks convey the information about the financial position of the company to the investors. Ben- David et al. (2007) found out that managers are sometimes overconfident and this may lead them to take the decision about repurchases of shares. Although there is some decrease in wealth may attached to the repurchase but it may act as a positive signal which increases the wealth of the shareholders. However, it is very difficult to detect the positive effect of repurchases of stocks. Wealth Transfer Wealth transfer hypothesis can be considered as another explanation for repurchases of stocks. Repurchasing of equities decreases the assets of the company which further reduces the value of the wealth of bondholders. Along with this repurchases can transfer the wealth from the bondholders of the company to the equity shareholders of the company. To support the theory of wealth transfer, Maxwell and Stephens (2003) performed an experiment using a sample of repurchases of stocks during the period of 1980 to 1997 and they stated that losses to the bondholders are related to both the riskiness of the company’s debt and the size of the repurchases of shares. Moreover, the rating of the bonds may be downgraded twice as the amount of repurchases increases. The redistribution of wealth between bondholders and shareholders can be seen in corporate financial policies also. Equity shareholders captured the positive effect of increment in dividend resulting from improved profitability while the effect of dividend reduction is shared by both bondholders and equity shareholders. Governance and free cash flow It recognizes that repurchasing of shares is an important part which expels the free cash flows. Some studies have shown that managers and directors use the repurchase option to distribute the temporary cash flows. Along with this, Nohel and Tarhan (1998) found out that to support the free cash flow hypothesis, consistency can be seen with improving performance of operations in the firms. Recent studies have stated that governance may have an impact on the returns of the bondholders but not certainly in the similar way in which it affects the wealth of the shareholders. Impact of Stock Repurchase on Stockholders’ Wealth Publicly traded companies often use share repurchase program to reward or return cash to shareholders in addition to declaration of dividends. Share repurchase reduces the total number of outstanding shares of the company available in the market. Needless to say, the immediate impact of buyback would be on the earnings per share (EPS) of the stockholders. The repurchase program generally increases EPS and stockholders’ wealth (assuming the company’s price-to-earnings multiple (P/E) remains constant after the repurchase). It also increases the market price per share of the company and is thus a widely used tool for stock appreciation. To illustrate this point, consider the company specific case of Apple Inc. that reported net income of $10.22 billion for the quarter ending March 2014. According to Marketwatch.com (2014), the company’s share price rose from $10.09 to $11.62 during the first quarter period as a result of stock repurchase program. The market price of the company is approximately $567.77; market capitalization of the company is $510.16 billion with number of outstanding shares 861.38 million. The current P/E of the company is 13.66 and is expected to remain constant during the period (Bloomberg, 2014). Hence, the EPS of the company before purchase was $10.18 per share and after purchase it increased to 11.86. Thus, practically share repurchase program increase the overall stockholders’ wealth in the market. Empirical Evidence The empirical evidence propose that any share repurchase program by the company suggest the availability of some private information held by the corporate without knowledge of the market (Kim and Varaiya, 2008; Comment and Jarrell, 1991). Also, previous studies found that insiders often hunt for an opportunity to make abnormal profits at the cost of shareholders which could be achieved with share buyback program (Ginglinger and Hamon, 2009). Empirical evidence show that as the managers can sell and buy shares prior to repurchase announcements, they are the probably better positioned and better informed relative to other investors, especially from the fundamental point of view. Additionally, not every firm commits exactly according to the announced repurchase plans and many have even been found to cancel the repurchase plan after public announcements especially when the market value of the firm under consideration reaches intended market value (Stephens and Weisbach, 1998). It is also widely believed that when the insiders are looking forward to send any negative signal to market they would cancel their tender repurchase offer plan. Empirical evidence also reveal that more than 90 percent of share repurchase announcements are conducted in open market. (Table I: Distribution of Share Repurchase Over Time) (Table II: Stock Market Reactions to the Announcement of Share Repurchases) The above discussion indicates that evidence consistent negative or positive signaling to market about share repurchase program has negative or positive impact on shareholders’ wealth respectively. Hence, in-context to signaling and wealth transfer theory it can be said that such evidence were found to be limited post 1997 period. A sample consisting of 366 observations spread over 12-year time period shows that the empirical results of the study were consistent with the findings of Kahle (2002). The percentage repurchase median and mean of the study were 5.5 percent and 7 percent respectively, which is very near to the findings of Kahle (2002) who showed mean and median of 7 percnet and 5.2 percent respectively. (Figure I: Wealth Changes to Equity Shareholders) The Table II and Figure I shown above indicates how the stock market reacts when companies announce share repurchase plans in future. The table shows calculations of abnormal returns implementing the standard market model technology. The model considers period of observations from t-100 days to t-6 days (that is 1 week prior to actual repurchase program). Empirical results show positive market signaling wit average abnormal returns over 1.6 percent for 3 day announcement window. Hence, positive results and increase in stockholders’ wealth is found to be the impact of share repurchase on stockholders’ wealth. Conclusion The previous studies on share repurchases targeted mainly on the effect of stock price of targeted buybacks. Conclusively, empirical evidence show that on an average stock prices react positively in response to share repurchase announcements and it results in higher EPS of the stockholders’ thereby increase in overall stockholders’ wealth. Practical company specific case analysis shows that share repurchase also tend to increase the market price per share of the target firm. Hence, market reactions are generally led to favorable outcomes after share repurchase announcements. References Bartov, E., Krinsky, I., & Lee, J. (1998). “Determinants of alternative corporate payout policies: cash dividends and open-market repurchases”. Journal of Applied Corporate Finance, 11. Bhattacharya, S. (1979). “Imperfect information, dividend policy, and The bird in the hand fallacy”. Bell Journal of Economics, 10. Bloomberg. (2014). Apple Inc AAPL:US. Retrieved from http://www.bloomberg.com/quote/AAPL:US. Comment, R., & Jarrell, G. A. (1991). “The relative signaling power of Dutch-auction and fixed-price self-tender offers and open-market share repurchases”. The Journal of Finance, 46, 1243–1271. Dittmar, K., & Dittma, F. (2002). “Stock repurchase waves: an explanation of the trends in aggregate corporate payout policy”. Working Paper, Indiana University. Fried, M. (2005). “Informed trading and false signaling with open market repurchases”. California Law Review. Ginglinger, E., & Hamon, J. (2009). “Share repurchase regulations: Do firms play by the rules?”. International Review of Law and Economics, 29, 81–96. Grullon, G., & Michaely, R. (2002). “Dividends, share repurchases, and the substitution hypothesis”. Journal of Finance. Jun, S., Jung, M., & Walkling, R. A. (2009). “Share repurchase, executive options and wealth changes to stockholders and bondholders”. Journal of Corporate Finance, 15, 212-229. Kahle, K. M. (2002). “When a buyback isn’t a buyback: Open market repurchases and employee options”. Journal of Financial Economics, 63, 235–261. Kim, J., & Varaiya, N. (2008). “Insiders’ timing ability and disclosure on corporate share buyback trading”. Review of Accounting and Finance, 7, 62–82. Marketwatch.com. (2014). Apple boosts buyback, to split stock 7-for-1 Earnings, revenues top forecasts; shares rally after hours. Retrieved from http://www.marketwatch.com/story/apple-boosts-buyback-to-split-stock-7-for-1-2014-04-23. Maxwell, W. & Stephens, C. (2003). “The wealth effects of repurchases on bondholders”. Journal of Finance, 58. Nohel, T. & Tarhan, V. (1998). “Share repurchases and firm performance: new evidence on the agency costs of free cash flow”. Journal of Financial Economics, 49. Stephens, C. P., & Weisbach, M. S. (1998). “Actual share re acquisitions in open-market repurchase programs”. The Journal of Finance, 53, 313–333. Varaiya, N., Kim, J., & Schremper, R. (2005). “Survey on open market repurchase regulations: Cross- country examination of the ten largest stock markets”. Corporate Finance Review. Read More