The integration of share repurchases into investment decision-making: Evidence from Japan

Share repurchases have become a significant global transaction and skepticism persists about their ambiguous effect on investment. We enter this debate motivated by inconclusive relevant empirical evidence and the remarkable evolution of share repurchases in Japan. Accordingly, we explore the investment-share repurchases nexus using panel data from Japanese listed firms between 2000 and 2019. We document a negative relationship consistent with the notion that firms curtail repurchases in the presence of investment spending and vice versa. We establish this contention by using subsamples stratified according to financing constraints, growth opportunities and cross-shareholdings. The findings endure after controlling for self-selection, endogeneity and heterogeneity and suggest that firms' investment decision precedes share repurchases which are adjusted accordingly. The results highlight how the widely criticized feature of cross-shareholdings, which is a distinct trait of the Japanese market, affects the integration of share repurchases into investment decision making.     

Do firms follow GAAP when they record share repurchases?

This paper examines U.S. firms' accounting for share repurchases and the accounting choice provided to Delaware-incorporated firms between the treasury and retirement methods. This accounting choice does not affect income, cash flows, or net assets, but it nevertheless affects financial reporting transparency and the allocation of equity between retained earnings and contributed capital. According to Generally Accepted Accounting Principles (GAAP), the accounting choice to record share repurchases should reflect management's intended disposition of the repurchased shares. We compare characteristics of Delaware-incorporated treasury and retirement firms and find that the choice between the two accounting methods is not always consistent with GAAP, but neither is it random; rather, this choice is related to a number of firm characteristics including firm growth, industry membership, trading exchange, and price–earnings ratio. We also find that a firm's accounting method for share repurchases is associated with a firm's propensity to make future share repurchases.     

Share repurchases and institutional supply

Consistent with the predictions of Brennan and Thakor's (1990) model of shareholder preferences, we find that, on average, institutional shareholders are net sellers during share repurchases. After controlling for liquidity provision and characteristics investing, we find that a one standard deviation increase in share repurchases during a given quarter is associated with a 0.11 standard deviation decrease in institutional investor demand. We estimate that 37% of the inverse relation is attributed to institutional investors executing liquidity provision strategies, 8% is explained by institutions reacting to the investment characteristics signaled by a repurchasing firm. We attribute the majority, 55%, to the information asymmetry between institutions and individual investors. This work is one of the first to exploit the SEC mandate requiring firms to report the actual number of shares they repurchase each quarter, beginning in 2004. Using actual number of shares repurchased, we find evidence of institutional investors increasing their selling as firms increase their repurchasing. This finding is robust to models of endogeneity and autocorrelation in share repurchases and institutional investor trading.     

Payout flexibility and capital expenditure

Over the past two decades or so, repurchases have become an appealing method for disbursing cash to shareholders compared to the traditional dividends. Managerial perception as well as empirical evidence suggests that repurchases are inherently more flexible than dividends, which may account for their increasing popularity. The rigidity of dividends and the apparent flexibility of share repurchases could impact firm investments. Firms may forego profitable investment opportunities to maintain their dividend levels, while repurchases could be easily scaled back to fund profitable investment projects without fear of an adverse market reaction. We test the flexibility hypothesis of repurchases by regressing capital expenditures on repurchases and dividends in addition to other control variables. Consistent with our hypotheses, we find an inverse relationship between capital expenditures and repurchases but an insignificant relationship with dividends. Further, we find that the flexibility associated with repurchases is especially evident for firms that are financially constrained, and during the recent financial crisis period when external capital constraints were severe. Finally, we find that flexibility of repurchases with respect to capital expenditures is stronger in the more recent time period during which regulatory changes made repurchases more attractive as a mechanism to disburse cash back to shareholders.     

Share repurchases,catering, and dividend substitution

We first extend Baker and Wurgler's (2004a) catering theory of dividends to share repurchases. Consistent with the notion that firms cater to investor demand for share repurchases, we report evidence that the market's time-varying repurchase premium positively affects firms' choice to repurchase shares. Next, we use the catering behavior as a novel framework for testing the dividend substitution hypothesis. Consistent with the notion that managers consider dividends and share repurchases to be substitute payout mechanisms, we find that the dividend premium negatively affects the repurchase choice, whereas the repurchase premium negatively affects the choice to pay dividends.     

The Takeover Deterrent Effect of Open Market Share Repurchases

This paper examines whether open market share repurchases deter takeovers. We model pre‐repurchase takeover probability as a latent variable and examine its impact on the firm's decision to repurchase shares. Given specification tests reject the Tobit model, we turn to the censored quantile regression method of Powell (1986, Journal of Econometrics 32, 143–155). We find a significantly positive relation between open market share repurchases and takeover probability, and we reconcile empirical findings in previous studies that contradict predictions. Repurchase activity is inversely related to firm size, consistent with smaller firms having greater information asymmetry, and is related to temporary, but not permanent, cash flows.     

An Empirical Examination of the Stated Purposes of Issuer Tender Offers to Purchase Common Stock

This paper documents the purposes of issuer tender offers to repurchase stock, as stated in Securities and Exchange Commission (SEC) disclosures, over the period 1994‐2006. We explore whether stated purposes relate to announcement period returns and find returns are significantly lower when repurchases replace dividends, distribute cash from unspecified sources, or occur subsequent to third‐party tender offers. Announcement period returns are significantly higher when repurchases are viewed by management as the best investment opportunity available or when they occur subsequent to previous repurchase programs. Finally, we find evidence in support of signaling theory and Jensen's (1986) agency cost of free cash flow theory.     

Growth Opportunities and the Choice of Leverage, Debt Maturity, and Covenants

We investigate the effect of growth opportunities in a firm's investment opportunity set on its joint choice of leverage, debt maturity, and covenants. Using a database that contains detailed debt covenant information, we provide large‐sample evidence of the incidence of covenants in public debt and construct firm‐level indices of bondholder covenant protection. We find that covenant protection is increasing in growth opportunities, debt maturity, and leverage. We also document that the negative relation between leverage and growth opportunities is significantly attenuated by covenant protection, suggesting that covenants can mitigate the agency costs of debt for high growth firms.     

Controlling shareholders’ opportunistic use of share repurchases

This study examines how share repurchase and dividend policies are influenced by controlling shareholders in an emerging market. We maintain that the controlling shareholders can utilize share repurchase opportunistically, particularly when they exercise voting rights in excess of cash-flow rights. The evidence of Korean firms suggests that the wedge between the voting rights and cash-flow rights positively affects share repurchases but negatively affects cash dividends. We also find that share repurchases are not always supported by operating performances. The results indicate that firms may utilize share repurchases as a means to pursue private benefits of the controlling shareholders. We also document that share repurchases do not substitute for cash dividends, suggesting that share repurchases are not genuine distributions. Furthermore, we find that the wedge of share repurchases reduces firm value. Overall, our results indicate that the controlling shareholders of Korean firms use share repurchases opportunistically rather than strategically.     

Interactions of corporate financing and investment decisions: The effects of agency conflicts

We examine interactions between flexible financing and investment decisions in a model with stockholder–bondholder conflicts over investment policy. We find that financial flexibility encourages the choice of short-term debt thereby dramatically reducing the agency costs of under- and overinvestment. However, the reduction in agency costs may not encourage the firm to increase leverage, since the firm's initial debt level choice depends on the type of growth options in its investment opportunity set. The model has a number of testable predictions for the joint choice of leverage and maturity, and how these choices interact with a firm's growth opportunities.     

MANAGING FOR RATINGS: REAL EFFECTS OF A CORPORATE RATINGS CRITERIA CHANGE

We exploit a criteria change by Standard & Poor's (S&P) to examine the real effects of a credit ratings change. Using a recalibration by S&P, unrelated to firms’ fundamentals, as a quasi-natural experiment we analyze the impact of a ratings upgrade on the issuance activity, investment, cash holdings, and payout policy of companies. Our findings suggest upgraded firms subsequently issue more debt relative to equity, enjoy lower debt yields, and increase their investment rate and share repurchases. We find limited evidence that upgraded firms decrease their cash holdings. Our results support the view that credit ratings have a real effect on corporations.     

Payout policy in the 21st century

We survey 384 financial executives and conduct in-depth interviews with an additional 23 to determine the factors that drive dividend and share repurchase decisions. Our findings indicate that maintaining the dividend level is on par with investment decisions, while repurchases are made out of the residual cash flow after investment spending. Perceived stability of future earnings still affects dividend policy as in Lintner (1956. American Economic Review 46, 97–113). However, 50 years later, we find that the link between dividends and earnings has weakened. Many managers now favor repurchases because they are viewed as being more flexible than dividends and can be used in an attempt to time the equity market or to increase earnings per share. Executives believe that institutions are indifferent between dividends and repurchases and that payout policies have little impact on their investor clientele. In general, management views provide little support for agency, signaling, and clientele hypotheses of payout policy. Tax considerations play a secondary role.     

How do share repurchases affect ownership concentration?

We study how share repurchases affect the ownership stake of outside blockholders in 950 publicly-traded US corporations from 1996 through 2001, using a control function approach to address the possible endogeneity of repurchases. We find that share repurchases tend to make outside ownership less concentrated: repurchasing 1% of outstanding common equity decreases the fraction owned by large shareholders by around one and a half percentage points. This may decrease outside shareholders' influence over firm decision-making. Our results are confirmed when we restrict the sample to institutional owners, but not to individual owners.     

THE MARKET REACTION TO STRAIGHT DEBT ISSUES: THE EFFECTS OF FREE CASH FLOW

In this paper we measure the market reaction to 937 straight debt issues between 1983 and 1993. We find a negative and significant market reaction to a straight debt announcement. In addition, we find that the market reaction to a straight debt issue is directly related to the issuing firm's level of existing cash and inversely related to the issuing firm's investment opportunities.     

The effects of ownership and stock liquidity on the timing of repurchase transactions

We analyze detailed monthly data on U.S. open market stock repurchases (OMRs) that recently became available following stricter disclosure requirements. We find evidence that OMRs are timed to benefit non-selling shareholders. We present evidence that the profits to companies from timing repurchases are significantly related to ownership structure. Institutional ownership reduces companies' opportunities to repurchase stock at bargain prices. At low levels, insider ownership increases timing profits and at high levels it reduces them. Stock liquidity increases profits from timing OMRs.     

Investment opportunities and market reaction to capital expenditure decisions

In this study, we argue that share price reaction to a firm's capital expenditure decisions depends critically on the market's assessment of the quality of its investment opportunities. We postulate that announcements of increases (decreases) in capital expenditures positively (negatively) affect the stock prices of firms with valuable investment opportunities. Contrarily, we predict that announcements of increases (decreases) in capital spending negatively (positively) affect the share prices of firms without such opportunities. Our empirical results are generally consistent with these predictions. Overall, empirical evidence supports our conjecture that it is the quality of the firm's investment opportunities rather than its industry affiliation which determines the share price reaction to its capital expenditure decisions.     

A Time-Series Analysis of Corporate Payout Policies

I conduct a time-series analysis of corporate payout policies that accounts for the dynamic nature of these decisions and for the interaction among investment decisions and payout policies. The estimation is done with a VAR model of investments, earnings, total payout, and the split of the total payout between dividends and share repurchases. I control for changes in the legal treatment of share repurchases in 1982 and for changes in the relative taxation of dividends and capital gains. I find that: (i) an increase in the taxation of capital gains relative to dividends shifts the split of total payout away from share repurchase and toward dividends; (ii) corporate investment decisions lead payout policies and not the other way around; (iii) increases in corporate total payout are associated with long-term subsequent increases in earnings; (iv) changes in the composition of corporate payout away from share repurchases and toward dividends are associated with subsequent increases in earnings.     

THE INVESTMENT OPPORTUNITY SET AND ITS PROXY VARIABLES

We use a real options approach to evaluate the performance of several proxy variables for a firm's investment opportunity set. The results show that, on a relative scale, the market‐to‐book assets ratio has the highest information content with respect to investment opportunities. Although both the market‐to‐book equity and the earnings–price ratios are related to investment opportunities, they do not contain information that is not already contained in the market‐to‐book assets ratio. Consistent with this finding, a common factor constructed from several proxy variables does not improve the performance of the market‐to‐book assets ratio.     

Share repurchases on trial: Large-sample evidence on share price performance,executive compensation,and corporate investment

Using a large sample of US stocks covering more than three decades, we empirically examine common criticisms of and rationales for stock repurchases. Repurchases account for a tiny fraction of the trading volume in a typical stock, making their price impact too small to generate short-term price manipulation. Price appreciation following repurchases is modest and does not reverse on average, suggesting the small price increases following repurchases signal firms’ good prospects. Also, we find no evidence that CEOs of repurchasing firms are paid excessively or that repurchases crowd out valuable investment opportunities. Because repurchases do not appear to be systematically abusive, enforcement action should be sufficient to deal with any bad actors, and significant regulation seems unwarranted.     

Does Labor Power Affect the Likelihood of a Share Repurchase?

This research examines the impact of labor power on the firm's repurchase decisions. Firms facing stronger labor power repurchase fewer shares, suggesting that, on average, repurchases are against the interests of labor. However, the negative effect of labor power on repurchases is significantly reduced when repurchases benefit employees by fending off an unwanted takeover or countering the dilution effects of employee stock options. We also examine the ex post consequences of share repurchases. Repurchases are positively related to the probability of a strike. Repurchase announcement returns and the operating performance of repurchasing firms are negatively related to labor power.