Why Do Firms Announce Open-Market Repurchase Programs?

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1 Why Do Firms Announce Open-Market Repurchase Programs? Jacob Oded, (2005) Boston College PhD Seminar in Corporate Finance, Spring 2006

2 Outline 1 The Problem Previous Work 2 3

3 Outline The Problem Previous Work 1 The Problem Previous Work 2 3

4 The Problem Previous Work What is the main problem in this paper? Presentation focus on most interesting part of paper: separating equilibrium in which good firms announce repurchase programs and bad firms do not Price increase accompanies announcement of open-market stock repurchase program (OMRP), even though no commitment and often no actual repurchases Oded constructs two-type signaling model that delivers announcement returns, because in separating equilibrium, good firms don t incur cost when announcing, but mimicry costly for bad ones

5 Outline The Problem Previous Work 1 The Problem Previous Work 2 3

6 Literature Review The Problem Previous Work Repurchase programs increasingly popular relative to other common forms of payout: appr. 90 percent of all announced repurchases (only percent in 1980s) "Most buybacks are stated, not completed" WSJ, 1995, speculated actual repurchase rates of percent Stephens and Weisbach (2000), and with Jagannathan (1998), suggest actual repurchase rate of percent Grullon and Michaely (2002) show growth in repurchase programs in addition to dividend payouts Netter and Mitchell (1989) report after market crash in 1987, many firms announced programs, but most did not repurchase at all

7 Literature Review The Problem Previous Work Miller and Modigliani (1961) demonstrated that in perfect markets, firm s payout policy irrelevant Theories tried to explain why firms distribute cash in general and why they choose specific payout forms Information-signaling theory suggests firms better informed than investors, so good firms can distinguish themselves by sending costly signal about their type Daniel and Titman (1995) review signaling models in corporate finance

8 Literature Review The Problem Previous Work Bhattacharya (1979), John and Williams (1985), and Miller and Rock (1985), present signaling with dividends Ofer and Thakor (1987), and Persons (1994) study models of signaling with tender offer repurchases Ikenberry and Vermaelen (1996) view repurchase program as option that gives firm ability to exchange market value for "true" value if prices fall Announcing program grants firm option whose value reflected in announcement return

9 Literature Review The Problem Previous Work Brennan and Thakor (1990) suggested stock repurchases transfer wealth from small uninformed investors to large informed investors Oded suggests that Ikenberry-Vermaelen option generates announcement returns because trading gains allow (good) firms to signal their value regards OMRP as non-dissipative signaling tool in spirit of Ross (1977), Heinkel (1982), and Brennan and Kraus (1987), and partly Bhattacharya (1980)

10 Outline 1 The Problem Previous Work 2 3

11 Intro Timeline consists of three dates: t 0, t 1, t 2 Agents risk neutral, zero interest rate, no taxes or transaction costs Firm entirely equity financed: value of assets, V t, follows exogenous random process At t 0 firm owns assets in place with fixed value θ and risky project with random payoff value c

12 Intro N outstanding shares owned by "original" shareholders Firm type characterized by project value C j where jɛ{b, G}, C j ɛ(0, 1) and C B < C G (notice type "increasing" in volatility) At t 1, with probability q > 1 2 project value realized to C j, and with (1 q) to C j, where 0 < C j < θ Fraction p of firms Bad type, and (1 p) Good type Good firms have more investment opportunities than bad firms, but investment opportunities associated with higher risk than assets in place

13 Intro After project value realized, some original shareholders become constrained and sell K shares at market price through auction (price bidding for entire block of shares) At t 2 whole firm sold (dismantled), so N K shares of original shareholders sold along with those of new shareholders, and proceeds represent terminal wealth At all dates firm has all available information At t 0 knows its type and can announce OMRP, i.e. option to repurchase fixed number γ < K of shares at t 1

14 Intro Firm can repurchase only if announcement made, gets priority allocation, and remaining K γ shares allocated to market according to price bids Market cannot tell firm type at t 0 (first asymmetry), but knows distribution of firms and value processes At t 1 firm knows realization of c but market gets no new information (second asymmetry) At t 2 all information public

15 Figure 1. - Timeline

16 Case (1) No program-signaling ability Firm knows realization of c but knowledge worthless because firm cannot participate in t 1 market, consequently P 0 = E p [E[V 2 ]]/N = (θ + (2q 1)C)/N, where E p [.] expectation with respect to distribution of firm population P 1 = P 0 and P 2ji = V 2ji /N = (θ ± C j )/N, where jɛ{b, G}, type, and iɛ{l, H}, realization at t 1 : e.g. P 2BL = (θ C B )/N and P 2GH = (θ + C G )/N

17 Figure 3(a) Price paths without program signaling

18 Case (1) No program-signaling ability Types unobservable at t 1, so short-term shareholders of both types get KP 1 = K [θ + (2q 1)(pC G + (1 p)c B )]N regardless of type and value realization At t 1 short-term shareholders of bad firms gain at expense of those of good firms At t 2 long-term shareholders get prices according to type and value realization (all information known then) Competitive market, expected gain of new shareholders 0 They pay KP 1, and get expected terminal wealth KE p [E(P 2 )] = KP 1 = K [θ + (2q 1)(pC G + (1 p)c B )]N (no quantity risk without program)

19 Case (2) Program signaling possible At t 0 firm can announce repurchase program and condition t 1 bid on value realization (but market cannot do so) Seek separating equilibrium in which only good firms announce program at t 0 and repurchase or not at t 1, depending on realization Bad firms don t announce at t 0 and can t repurchase at t 1

20 Case (2) Program signaling possible Oded assumes existence of such separating equilibrium, so prices must equal (when types known to market): At t 0, P 0j = V 0j /N = (θ + (2q 1)C j )/N where jɛ{b, G} At t 1, P 1G = q K γ N γ (θ+c G)+(1 q) K N (θ C G) qγ(k γ) +K qγ N γ and P 1B = P 0B At t 2, P 2GL = (θ C G )/N, P 2GH = (θ+c G) γp 1G N γ (firm repurchased γ shares at t 1 ) P 2BH = (θ + C B )/N, and P 2BL = (θ C B )/N.

21 Figure 3(b) Price paths with program signaling

22 Case (2) Program signaling possible At t 0 good firms announce program and enjoy positive announcement returns Bad firms do not announce, and their stock price falls Post-announcement, t 0 stock price higher for good firm, and lower for bad one (can separate types already) Given separation, P 0j = expected value of stock type At t 1, good firms repurchase if high value realization and do not repurchase if low

23 Case (2) Program signaling possible For good firm, t 1 price lower than expected value because market takes informed trading into account (firm takes γ shares if high value, less available for market) For bad firm, t 1 price equal to expected value (no quantity risk), lower than in no-program economy At t 2, for good firm with high realization price reflects gains from informed trading, higher than in no-program case (?) With low realization same as in no-program economy For bad firm, t 2 price same as in no-program economy

24 Case (2) Program signaling possible Repurchasing option separates good firms and increases expected terminal wealth of their original shareholders Terminal wealth of original shareholders of bad firms not affected by quantity risk because they don t announce Compared to no-program economy, original shareholders of good firm better off by (2q 1)(1 p)(c G C B )(K /N), and original shareholders of bad firm worse off by (2q 1)p(C G C B )(K /N) Distribution of wealth between short-term and long-term shareholders also different Good firm transfers wealth from short-term shareholders to long-term ones (because it announced), bad firm doesn t

25 Figure 3(ab) Price paths compared

26 Robustness of equilibrium Recall without announcement P 1 = P 0, but with program under separation P 1G < P 0G and P 1G < θ/n All parameters fixed (including C G > C B > 0), separating equilibrium exists iff γɛ(γ c, K ), where γ c = K 1+ 1 q N K 2q 1 N If program big enough, t 1 equilibrium price decreasing in C Proposition 3: "in this range, given a marginal increase in C, the marginal increase in the value of the option to repurchase is larger than the marginal increase in expected stock value"

27 Robustness of equilibrium Implies that separating equilibrium exists for all γɛ(γ c, K ), because gap between types in option value larger than gap in expected value, and hence enough to deter bad type from mimicking Good firms announce program and their t 1 price reflects informed trading (quantity risk) Announcement costless for good firms because loss of short-term shareholders exactly offsets gain of long-term shareholders from informed trading When bad firm announces, short-term shareholders suffer losses of good firm, but long-term shareholders only enjoy informed trading gains of bad firm (lower, IC)

28 Robustness of equilibrium With large enough program, good firms can push their t 1 price so low that mimicking bad firm s long-term shareholders never recover what short-term ones lose Firms maximize expected aggregate wealth of original shareholders, so bad firm better off not announcing, and separating equilibrium holds

29 Figure 4. - Separating Equilibrium

30 Robustness of equilibrium Shows "single-crossing property" of indifference curves Announcing program costless for good firm regardless of γ, but for bad firm announcing cost strictly increasing in γ For γ < γ c, bad firm would mimic good one At γ = γ c, benefit from mimicry exactly offsets cost (notice that pooling equilibrium also possible here need extra assumption to resolve issue) For γ > γ c, mimicry results in net loss and separating equilibrium exists (set γɛ(γ c, K ) as close as possible to γ c )

31 Outline 1 The Problem Previous Work 2 3

32 Implications predicts announcing firms condition actual repurchases on future realization of value consistent with Stephens and Weisbach (1998) findings assumes uncertainty in production technology positively correlated with firm quality consistent with Jagannathan, Stephens, and Weisbach (2000) findings that announcing firms have a more volatile cash flow than firms that do not announce, and with Ikenberry and Vermaelen (1996) findings that firms with higher β are more likely to announce".

33 Implications predicts post-announcement expected returns relatively low in short run and relatively high in long run Ikenberry, Lakonishok, and Vermaelen (1995) find one-year abnormal return in year 3 (4.6 percent), significantly higher than in years 1 and 2 (2 and 2.3 percent, respectively) also predicts long-run returns correlated with actual level of repurchase consistent with Ikenberry, Lakonishok and Vermaelen (2000)

34 Implications suggests that during repurchase period announcing firms "time" market empirical evidence inconclusive: Cook, Krigman, and Leach (2004) "find that many firms repurchase following price drops, and Stephens and Weisbach (1998) found that actual repurchases are timed with temporary undervaluation" shows no relation between program size and announcement return consistent with findings of Stephens and Weisbach (1998), but Ikenberry, Lakonishok, and Vermaelen (1995), Ikenberry and Vermaelen (1996) find positive relation

35 Conclusions OMRPs puzzle explained in part by model with separating equilibrium where good firms send costless signal about their type, too costly for bad firms to mimic when program size large enough Equilibrium robust, implications supported in research Modest contribution to literature

36 Critique Some comments already noted during presentation Paper overall very interesting but somewhat lengthy Results depend crucially on assumptions of severe liquidity constraints, and variance positively correlated with expected return (in production technology) across types Abstracts from cost of paying out cash, which may create value [Jensen (1986), and Chowdhry and Nanda (1994)] Some predictions contradict empirical evidence

37 Extensions noted by author If type correlated more with wealth of long-term shareholders versus short-term shareholders in management objective function, repurchase programs can deliver announcement returns without assuming expected return correlated with variance across types Program announcement also generates risk among shareholders, and risk aversion may affect payout policy Informed competitors may motivate program announcement rather than type signalling, but if informed competitors employees, firm could favor such value leakage

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