Why Do Firms Announce Open-Market Repurchase Programs?

Motivation Model Comments and Extensions

Why Do Firms Announce Open-Market Repurchase Programs?

Jacob Oded, (2005)

Presented by R. Djeliov

Boston College

PhD Seminar in Corporate Finance, Spring 2006

Outline

1

Motivation The Problem Previous Work

2

Model Setup

Empirical Results

3

Comments and Extensions

Motivation Model Comments and Extensions

The Problem Previous Work

Outline

1

Motivation The Problem Previous Work

2

Model Setup

Empirical Results

3

Comments and Extensions

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

Motivation Model Comments and Extensions

The Problem Previous Work

Outline

1

Motivation The Problem Previous Work

2

Model Setup

Empirical Results

3

Comments and Extensions

Literature Review

Repurchase programs increasingly popular relative to other common forms of payout: appr. 90 percent of all announced repurchases (only 10–15 percent in 1980s)

"Most buybacks are stated, not completed" – WSJ, 1995, speculated actual repurchase rates of 30-40 percent Stephens and Weisbach (2000), and with Jagannathan (1998), suggest actual repurchase rate of 70-80 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

Motivation Model Comments and Extensions

The Problem Previous Work

Literature Review

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

Literature Review

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

Motivation Model Comments and Extensions

The Problem Previous Work

Literature Review

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)

Outline

1

Motivation The Problem Previous Work

2

Model Setup

Empirical Results

3

Comments and Extensions

Motivation Model Comments and Extensions

Setup Empirical Results

Model Intro

Timeline consists of three dates: t

, t

, t

Agents risk neutral, zero interest rate, no taxes or transaction costs

Firm entirely equity financed: value of assets, V

, follows exogenous random process

At t

firm owns assets in place with fixed value θ and risky

project with random payoff value ˜c

Model Intro

N outstanding shares owned by "original" shareholders Firm type characterized by project value C

where j{B, G}, C

(0, 1) and C

< C

(notice type "increasing" in volatility) At t

, with probability q >

project value realized to C

, and with (1 − q) to −C

, where 0 < C

< 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

Motivation Model Comments and Extensions

Setup Empirical Results

Model 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

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

knows its type and can announce OMRP, i.e. option to

repurchase fixed number γ < K of shares at t

Model 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

(first asymmetry), but knows distribution of firms and value processes

At t

firm knows realization of ˜c but market gets no new information (second asymmetry)

At t

all information public

Motivation Model Comments and Extensions

Setup Empirical Results

Figure 1. - Timeline

Case (1) – No program-signaling ability

Firm knows realization of ˜c but knowledge worthless because firm cannot participate in t

market, consequently P

= E

[E [V

]]/N = (θ + (2q − 1)C)/N, where E

[.]

expectation with respect to distribution of firm population

P

= P

and P

= V

/N = (θ ± C

)/N, where j{B, G},

type, and i{L, H}, realization at t

: e.g. P

= (θ − C

)/N

and P

= (θ + C

)/N

Motivation Model Comments and Extensions

Setup Empirical Results

Figure 3(a) – Price paths without program signaling

Case (1) – No program-signaling ability

Types unobservable at t

, so short-term shareholders of both types get KP

= K [θ + (2q − 1)(pC

+ (1 − p)C

)]N regardless of type and value realization

At t

short-term shareholders of bad firms gain at expense of those of good firms

At t

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

, and get expected terminal wealth

KE

[E (P

)] = KP

= K [θ + (2q − 1)(pC

+ (1 − p)C

)]N

(no quantity risk without program)

Motivation Model Comments and Extensions

Setup Empirical Results

Case (2) – Program signaling possible

At t

firm can announce repurchase program and condition t

bid on value realization (but market cannot do so) Seek separating equilibrium in which only good firms announce program at t

and repurchase or not at t

, depending on realization

Bad firms don’t announce at t

and can’t repurchase at t

Case (2) – Program signaling possible

Oded assumes existence of such separating equilibrium, so prices must equal (when types known to market):

At t

, P

= V

/N = (θ + (2q − 1)C

)/N where j{B, G}

At t

, P

=

K −γ

N−γ(θ+CG)+(1−q)^K_N(θ−CG)

qγ(K −γ)

N−γ +K −qγ

and P

= P

At t

, P

= (θ − C

)/N,

P

=

(firm repurchased γ shares at t

)

P

= (θ + C

)/N, and P

= (θ − C

)/N.

Motivation Model Comments and Extensions

Setup Empirical Results

Figure 3(b) – Price paths with program signaling

Case (2) – Program signaling possible

At t

good firms announce program and enjoy positive announcement returns

Bad firms do not announce, and their stock price falls

Post-announcement, t

stock price higher for good firm,

and lower for bad one (can separate types already)

Given separation, P

= expected value of stock type

At t

, good firms repurchase if high value realization and

do not repurchase if low

Motivation Model Comments and Extensions

Setup Empirical Results

Case (2) – Program signaling possible

For good firm, t

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

price equal to expected value (no quantity risk), lower than in no-program economy

At t

, 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

price same as in no-program economy

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

− C

)(K /N), and original shareholders of bad firm worse off by

(2q − 1)p(C

− C

)(K /N)

Distribution of wealth between short-term and long-term shareholders also different

Good firm transfers wealth from short-term shareholders to

Motivation Model Comments and Extensions

Setup Empirical Results

Figure 3(ab) – Price paths compared

Robustness of equilibrium

Recall without announcement P

= P

, but with program under separation P

< P

and P

< θ/N

All parameters fixed (including C

> C

> 0), separating equilibrium exists iff γ(γ

, K ), where γ

=

1+_2q−1^{1−q N−K}_N

If program big enough, t

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"

Motivation Model Comments and Extensions

Setup Empirical Results

Robustness of equilibrium

Implies that separating equilibrium exists for all γ(γ

, 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

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

Robustness of equilibrium

With large enough program, good firms can push their t

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

Motivation Model Comments and Extensions

Setup Empirical Results

Figure 4. - Separating Equilibrium

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

, bad firm would mimic good one

At γ = γ

, benefit from mimicry exactly offsets cost (notice that pooling equilibrium also possible here – need extra assumption to resolve issue)

For γ > γ

, mimicry results in net loss and separating

equilibrium exists (set γ(γ

, K ) as close as possible to γ

)

Motivation Model Comments and Extensions

Setup Empirical Results

Outline

1

Motivation The Problem Previous Work

2

Model Setup

Empirical Results

3

Comments and Extensions

Model Implications

Model predicts announcing firms condition actual

repurchases on future realization of value – consistent with Stephens and Weisbach (1998) findings

Model 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".

Motivation Model Comments and Extensions

Setup Empirical Results

Model Implications

Model 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)

Model also predicts long-run returns correlated with actual

level of repurchase – consistent with Ikenberry, Lakonishok

and Vermaelen (2000)

Model Implications

Model 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"

Model 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

Motivation Model Comments and Extensions

Setup Empirical Results

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

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

Motivation Model Comments and Extensions

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