An empirical study of equity repurchase decisions and market reaction

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Virginia Tech


This study is an empirical investigation of the managements’ motivations behind corporate equity repurchases in the open market, via private repurchase, or through self tender offer. The hypotheses concerning motivations for stock repurchases investigated in this dissertation include (1) signalling undervaluation of stock prices; (2) free cash flows; and (3) increasing leverage. A series of statistical analysis and tests are conducted against the empirical implications concerning the three decision variables in a repurchase decision process: (1) whether to repurchase; (2) what method (self tender, open market, and private repurchase) to use; and (3) the size and the price of repurchase under each motivational hypothesis, using the sample of all repurchases announced from January, 1986 through April, 1989.

The motivational proxies are (1) the percentage changes of the median (and mean) earnings forecasts in the first, second, third months after the announcement of a repurchase program from the month prior to the repurchase for signalling hypothesis; (2) Tobin’s Q, the ratio of a firm’s total market value to the market-value replacement costs of its assets, based on the Lindenburg-Ross Algorithm for the free cash flow hypothesis (another measure is also used in this dissertation, that is, the net cash flow after taxes and dividends relative to the market value of a firm’s common stock); arid (3) the market-value based debt-equity ratios for the increasing leverage hypothesis.

The empirical portion of this study is composed of four sections: (1) a comparison study of subsamples of repurchases with their control samples of non-repurchasing firms constructed by the criteria of data availability in both the /B/E/S and the COMPUSTAT database, three-digit industry code, and the market value of common stocks; (2) a comparison study of the three repurchasing methods; (3) the determination of the terms of repurchases; and (4) the market reaction to the announcement of repurchase and its relationship with the motivational proxies.

The major conclusions of this study are as follows:

  1. The signalling hypothesis is supported for the sample of open market repurchases which occurred over the 1987 crash period (from October 19 to November 9, 1987).
  2. The free cash flow hypothesis is supported for the sample of ordinary open market repurchases which occurred outside the 1987 crash period.
  3. None of the three motivations investigated in this study is supported for the sample of private repurchases.
  4. The results are not conclusive for the sample of self tender offers, though the signalling hypothesis and the free cash flow hypothesis are not rejected.