©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - -...

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston

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- - - - - - - - Chapter 18 - - - - - - - -

Share Repurchases


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Introduction

• Share repurchases are cash offers for outstanding shares of common stock

• Share repurchases change the book capital structure of the firm by reducing the amount of common stock


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• Effects on leverage ratio– Leverage ratio increases because the

amount of common stock is reduced– Leverage ratio is magnified if excess cash,

which is used to extinguish common stock, is no longer deducted from debt to measure leverage ratio

– If additional debt is used to buy common stock, similar magnification of leverage ratio


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The Use of Share Repurchases

• Share repurchases have increased in absolute terms– Repurchases increased from $0.3 billion in

1980 to $236.2 billion in 1998– Repurchases have grown at a compound

annual rate of 29.9% per year


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• Share repurchases have increased relative to the use of dividends– Repurchases were a 0.5% percentage of

cash dividend payouts in 1980. By 1998, it was 84.6%

– Between 1980 and 1998, cash dividends grew at a rate of 8.7% per year compared to 29.9% for share repurchases

– For the S&P 500 companies, share repurchases have exceeded cash dividends beginning in 1997


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• Some factors in the growth of share repurchases– Tax savings

• Cash dividends subject to maximum individual tax rate of 39.6%

• Returns of cash from share repurchases may qualify for long-term capital gains rate of 20%

– Timing of taxes• Shareholders can choose whether or not to

participate in a buyback program• Shareholders can choose to defer tax payments


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– Management incentives• Share repurchases increase the percentage

ownership of the firm for nonparticipants such as officers and directors

• Incentives of officers and directors to think as owners will be strengthened

• Reduce agency problems

– Management responsibility• Returning excess cash to shareholders may

demonstrate that officers and directors acted in the best interest of shareholders

• Shareholders' trust in their officers and directors is strengthened because excess funds were not used for negative NPV investments


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– Undervaluation signal• Non-participation of officers and directors in

buyback programs may signal that stock price is undervalued

• Cash flows are likely to increase in the future

– Sharp price declines• After sharp decline in the stock market in October

1987, many firms initiated substantial share repurchase programs

• Share repurchases represent a statement by management that overall market decline did not justify the sharp drop in their firm's share price

• Special case of undervaluation scenario


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– Greater flexibility• Market rewards a history of consistent increases

in dividends and punishes company that fails to do so

– Patterns of dividend behavior by individual firms are established over time

– Earnings rise with fluctuations while dividends increase in a stair step fashion with a lag behind growth in cash flows

• In share repurchases, the expectation is that cash will be returned to shareholders when funds are available in excess of needs to finance sound investment programs


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– Accounting treatment• Accounting for shares repurchases

– Reduce (debit) shareholders' equity account• Accounting principles permit charge at cost or market

• Common practice is to charge the actual amount paid for shares (at market)

– Reduce (credit) cash by the required outlay

• Accounting effect after share repurchase– If net income remains at the same level, EPS increases– If P/E ratio remains at the same level, market price per

share will rise and market capitalization will remain the same

– Book value per share will decrease since book shareholders' equity decreases by more than book value of shares when market to book ratio is greater than 1

– Return on book equity will increase


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– Debt to equity ratio• Share repurchases increase leverage ratio • Share repurchases could be used to move the

firm toward its target debt leverage ratio

– Offset stock options• Stock options increasingly used in executive

compensation programs and in employee incentive plans

• Exercise of stock options increases firm's shares outstanding creating downward pressure on the firm's stock price

• Share repurchases can be used to offset the potential dilutive effect of stock options


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– Takeover defenses• Share repurchase price may be viewed more

favorably than takeover price• Share repurchase may cause takeover bidders

to offer a higher premium – When a firm tenders for 10% or 20% of its shares,

shareholders who offer their shares are those with the lowest reservation prices

– Shareholders who did not tender have the highest reservation prices

– In order for takeover bidder to succeed, he must offer a higher premium to the remaining higher reservation price shareholders

– Required higher premium may deter potential bidders


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– Restructuring factors• Share repurchases may be part of general

restructuring programs• Influence on share prices is likely to be

positive, but it is the restructuring that is the stronger casual force


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Fixed Price Tender Offers

• Tender offer– Company sets number of shares it is offering

to purchase– Company sets price at which it will repurchase

shares– Company sets period of time offer will be

open– Officers and directors of repurchasing firm do

not participate in tender offer


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• Tender price– Average 20% over prevailing market price– Tendering shareholders receive full tender

offer price• Tendering shareholders pay no brokerage fees• Company pays any transfer taxes levied

• Number of shares– Offer specifies maximum number of shares

the firm will buy


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– If oversubscription• Company may buy pro rata basis from all

tendering shareholders up to a maximum• Company may buy all tendered shares

– If undersubscription • Company buys all shares tendered• Company may cancel offer if it includes a

minimum acceptance clause• Company may extend offer period• Company purchases shares offered during

extension period either pro rata or on basis of order in which shares are offered


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• Stock repurchase model– Assumptions

• Efficient markets — prices reflect all publicly available information

• Informationally efficient market — information is costless and is received simultaneously by all

• Perfectly competitive securities markets — individuals are price takers

• Wealth-maximizing investors• Homogeneous expectations• Maximum limit offers• Price changes are net of market-wide effects


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– Model variables• Po = preannouncement stock price

• PT = tender price

• PE = postexpiration share price

• No = preannouncement number of shares

outstanding

• NE = postexpiration number of shares outstanding

• W = shareholder wealth effect

• FP = fraction of shares repurchased = (No - NE)/No

• 1 - FP = fraction of untendered shares = NE/No


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– Model

PE NE = Po No - PT (No - NE ) + W (18.1)

• Total share value postexpiration (PE NE) is equal to:

– total share value preannouncement (Po No)

– minus the total value of shares repurchased [PT (No - NE)]

– plus the change in shareholder wealth associated with the repurchase offer (W )


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• In rate of return form

W/(No Po) = FP [(PT - Po)/Po]

+ (1 - FP)[(PE - Po)/Po] (18.2)

• Total return associated with repurchase,

W/(No Po) is made up of two components– Return received by tendering shareholders, weighted by

percent of shares purchased, FP[(PT - Po)/Po]

– Return received by nontendering shareholders, weighted by percent of nontendering shares,

(1 - FP)[(PE - Po)/Po]


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• Empirical studies– General patterns

• Initial premium = (PT - Po)/Po = 15-25%

• Fraction of shares repurchased = FP = 15-20%

• Wealth effect = W/(No Po) = 10-16%

• Premium of postexpiration price = (PE - Po)/Po = 11-15%

• Percent wealth effect to tendering shareholders = FP[(PT - Po)/Po] = 3-5%

• Percent wealth effect to nontendering shareholders = (1-FP)[(PE - Po)/Po] = 10-13%


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– Premium of postexpiration price = (PE - Po)/Po

(Assume FP = 20%)

• If (PT - Po)/Po = 20% and W% = 15%

15% = 0.20(20%) + 0.80(X)

X = 13.75% = (PE - Po)/Po

– Of 15% wealth effect associated with share repurchase offers,

• 0.20(20%) = 4% went to tendering shareholders• 0.80(13.75%) = 11% went to nontendering

shareholders


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• If (PT - Po)/Po = 15% and W% = 10%

10% = 0.20(15%) + 0.80(X)

X = 8.75% = (PE - Po)/Po

– Of 10% wealth effect associated with share repurchase offers,

• 0.20(15%) = 3% went to tendering shareholders• 0.80(8.75%) = 7% went to nontendering shareholders


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• Rationale for postexpiration price changes– Introduction

• Size of premium offered to shareholders to tender about 15-20% over prevailing stock price

• At expiration of tender offer period, price of stock remains 8-10% above pretender offer announcement price

• What is the source of the postexpiration stock price increases associated with share repurchase programs?


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– Masulis (1980) emphasized benefits of increased leverage

– Vermaelen (1981)• Argued for positive signaling hypothesis• Repurchase tender offers associated with future

cash flow levels above what would have been predicted by a time-series model using preannouncement data

• Concludes information/signaling effect carries more weight than leverage — although the two are related


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– Nohel and Tarhan (1998)• Sample of 290 share repurchase companies for

period 1978 to 1991• Companies divided into low q-ratio firms and

high q-ratio firms• Sample compared to a control group of

nonshare repurchase firms• Share repurchase firms, net of control group,

have significantly positive event returns


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• Improvement comes entirely from low q-ratio firms

– Low-q firms have higher asset turnover ratios relative to control group, both before and after the repurchase

– Difference widens after repurchase– Improvement associated with asset sales by low-q

firms — successful repurchasing firms dispose of poorly performing assets as part of a restructuring program


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Dutch Auction Repurchases (DARs)

• Implementation– Firm specifies number of shares and range

of prices for share repurchase– Shareholders can tender shares at any

price within stated range– Firm puts together shareholder responses

into supply schedule curve for the stock


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– Firm repurchases shares at lowest price (purchase price) that allows it to buy number of shares it sought in offer

– Purchase price is paid to all shareholders who tendered at or below purchase price

– If oversubscribed — firm purchases shares tendered on pro rata basis


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• Upward sloping supply schedule curve– Shows evidence of shareholder

heterogeneity• Different expectations and valuations• Different tax basis for low and high reservation

shareholders


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– Equation for upward sloping supply schedule is of the form:

V(r) = a + br• Each share is assumed to be held by an

individual shareholder• V(r) indicates reservation price of the rth

shareholder • Intercept term a represents the prevailing market

price of the stock• More steeply sloped (slope b) schedule, higher

reservation price schedule• Premium paid in Dutch auction share

repurchases lower than fixed price tender offers


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• Comment and Jarrell (1991)– Influences on share repurchase wealth

effects• Pro rata transaction — if reservation prices of

shareholders are so low that tender offer stimulates flood of tenders, wealth effects not very high

• Officers and directors (OD) at risk of personal wealth loss if

– OD collective proportional ownership interest in company's stock must increase as result of tender offer and

– Premium in tender offer more than 2% above market price of stock four days before offer is announced


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– Results • Average wealth effects

– Fixed price tender offers = 12-13%– Dutch auctions = 8%

• With prorationing– Wealth effects virtually zero

• Fixed price tender offers = 0-5%• Dutch auctions = 0%

– Shareholder reservation prices are low — signaling of future value increase is less credible


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• No prorationing– Large wealth effects

• Fixed price tender offers = 15%• Dutch auctions = 8%

– Shareholder reservation prices are high — premia offered in share repurchases is credible signal of future value increases


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• Officers and directors at risk– Signaling credible– Large wealth effects


• Officers and directors not at risk– Signaling not credible– Small or negligible wealth effects



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• Conclusions– Dutch auctions favored by firms that are

• Relatively large and widely followed by security analysts and other informed investors

• Management owns low percentage of stock– These firms do not need to send strong credible

signals in premium repurchase offers– For these firms, Dutch auctions likely to be a

substitute for open market repurchases


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• Lie and McConnell (1998)– Compares fixed price (FP) versus Dutch

auctions (DA) self tender offers– Sample

• 130 FP and 102 DA between 1981 and 1994

• DA started in 1981 and accounted for less than 10 transactions per year through 1987

• Period 1988-1989, DA accounted for slightly above 20 per year

• In 1991, 1 FP and 2 DA; in 1993, 6 DA; in 1994, 4 DA

• Most FP are pre-1990

• Sharp decline in self tender sample after 1989 suggests that open market share repurchases were substituting for both FP and DA repurchases


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– Event returns• Three-day window centered on announcement

date• FP abnormal returns were mean of 7.9% and

median of 6.8%• DA abnormal returns were mean of 7.7% and

median of 6.4%• Excluding offers with coincident confounding

news– FP abnormal returns were mean of 10.2% and median

of 8.6%– DA abnormal returns were mean of 7.6% and median

of 6.2%– Difference is significant at the 5% level


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– Comparison of earnings pattern• Both FA and DA firms exhibit superior

performance during year of self-tender offer• Both FA and DA firms exhibit slower mean

reversion in their operating performance than firms not undertaking tender offers

• FA and DA firms continued to exhibit superior performance longer than what otherwise would have been expected

• There was no significance difference in the measured subsequent performance between FA and DA firms


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Transferable Put Rights (TPRs)

• Implementation– Firm issues put options to shareholders in

proportion to number of shares owned– If firm wishes to repurchase 10% of

outstanding shares, it gives shareholders 1 TPR per 10 shares owned

– Each TPR gives shareholder right to sell one share back to firm at fixed price within specified period


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– All shares put back to firm are repurchased — no prorationing occurs

– Shareholders that do not wish to sell shares back to firm can sell their TPRs in open market

– If significant premium of put price over prevailing market price

• TPRs have value• Trading in TPRs will take place

• TPR trading can discover market clearing price of shares company seeks to repurchase


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• TPRs vs. fixed-price offer– In fixed-price offers, shareholders avoid

risk of prorationing by selling shares to arbitragers

– Arbitragers can accumulate shares and achieve strong bargaining position

– TPRs prevent arbitrager from driving up prices in fixed-price offers


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• TPRs can be used to consolidate control position of a group– TPRs are issued with put price at a

substantial premium– Dissident group happy to accept the

substantial premium– Noncontrolling group purchases TPRs from

control group– After TPRs plus stocks are put, control

group ends up with increased ownership percentage of firm


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• Use in takeover defense; trading in TPRs result in– Low reservation price shareholders put

their shares for repurchase– Remaining shareholders will be high

reservation price shareholders


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Open Market Share Repurchases (OMRs)

• Firm repurchases its common stock in open market transactions

• OMRs outnumber other three methods by at least 10 to 1

• OMRs involve a smaller percentage of total shares outstanding than other methods — average 5% vs. 16% for fixed price tender offers


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• Ikenberry, Lakonishok and Vermaelen (1995)– Aggregate value of stock repurchases

• 1980-1990, one-third of dollar amount of cash dividends

• Later years of 1980s, one-half of dollar amount of cash dividends

– 1,239 open market share repurchases between 1980-1990

– Announced repurchases for 6.6% of outstanding shares on average — percentage rising over sample time period


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– Market response to announcement of OMR• Average of positive 3.5%• For event window [-2 days,+2 days]

– Period 1980-1986 = 4.2%– Period 1987-1990 = 2.3%

• Based on size of repurchase program– 10% or more of outstanding shares = 4.51%– Less than 2.5% of outstanding shares = 2.58%

• Based on firm size– Firm in two smallest size deciles, highest abnormal

returns = 8.19%– Firm in largest size decile, abnormal returns = 2.09%


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– Market underreacts to OMR• Buy and hold strategy, four-year abnormal

performance following announcement = over 12%• Combined with announcement effect, total

undervaluation about 15%• Firms ranked by book to market

– Firms in top quintile, four-year abnormal performance following announcement = 45.3%

– Firms in bottom two quintiles, four-year abnormal performance following announcement close to zero

– Abnormal performance measure is net of a benchmark that explicitly controls for size and book-to-market effects


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– Conclusions• Stronger market response to larger share

repurchase consistent with signaling hypothesis• If firm size is proxy for informational asymmetries,

inverse relationship between size and abnormal return consistent with signaling hypothesis

• Based on four-year abnormal performance results, market reaction to new information is not completed over short time periods

• Companies with high book to market ratios that engage in share repurchases show higher returns in future compared with high book to market ratio stocks in general


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• If market underreacts to first OMR announcement, managers may make a series of OMRs

• If major reason for repurchase is that shares are underpriced, as share price increases with announcement and initiation of repurchase program, managers have less incentive to complete OMR

• Evidence consistent with market timing ability of managers

• In recent years, firms with depressed stock prices have announced OMRs. But if future cash flow outlook is unfavorable, market prices will not rise — no wealth effect


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• Accounting manipulation – Reduction in book value of shareholders'

equity as a result of share repurchase may be substantial for high market to book firms — debit to record repurchase can be made at market value

– For a given level of net income, accounting return on equity (ROE) would increase substantially


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• OMR model (Rappaport, 1998)

where R = rate of return in share repurchaseKs = market required cost of equity = 10%V = intrinsic value = $100

P = market price = $80

%5.12Value Intrinsic Market to Actual of Ratio

Equity ofCost

8.0

10.0

)]100/()20[(1

10.0

)(1

ondervaluatiPercent Un1

Equity ofCost

VP

k

VPV

k

R

s

s


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– Non-selling shareholders will earn a rate of return greater than the market required cost of equity

• if a company's shares are undervalued and • if stock is repurchased in OMRs at an

undervalued price.

– Share repurchase financed by foregoing value-creating investments makes sense only if the investment would have yielded a rate of return less than the rate of return on a share repurchase.


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– Returns on OMRs can be increased by the use of puts

• Company sells put warrants — income from put is net since tax code allows corporations to sell options on their stock tax-free

• Buyer of put warrant hedges his position by buying company's shares in the open market

– If stock goes up:• Warrants are worthless• Owner of put can sell stocks in the open market for

profit — needs fewer shares to hedge position– If stock falls below exercise price:

• Warrants are valuable• Owner of puts can exercise

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - -...

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