EQUITY ISSUES AND TOBIN'S Q: NEW EVIDENCE REGARDING ALTERNATIVE INFORMATION RELEASE HYPOTHESES

Announcements of seasoned equity offerings are associated with a statistically significant negative market reaction. This finding is consistent with both the cash flow signaling and the free cash flow hypotheses. We test these hypotheses by examining whether revisions in analyst earnings forecasts and abnormal stock returns associated with equity offering announcements are related to the issuing firm's q-ratio. We find an inverse relation between revisions in analysts' earnings forecasts and q-ratios, and no relation between announcement-period abnormal returns and q-ratios. These findings provide direct evidence of the cash flow signaling hypothesis and, at best, indirect evidence of the free cash flow hypothesis.     

Signaling, investment opportunities, and dividend announcements

This article examines potential explanations for the wealtheffects surrounding dividend change announcements. We find thatnew information concerning managers' investment policies isnot revealed at the time of the dividend announcement. We alsofind that dividend increases (decreases) are associated withsubsequent significant increases (decreases) in capital expendituresover the three years following the dividend change, and thatdividend change announcements are associated with revisionsin analysts' forecasts of current earnings. These results areconsistent with the cash flow signaling hypothesis rather thanthe free cash flow hypothesis as an explanation for the observedstock price reactions to dividend change announcements.     

Stock repurchases: A further test of the free cash flow hypothesis

This study explores the empirical puzzle currently existing regarding the observed positive stock price reaction associated with self-tender offer announcements. The puzzle stems from Lang and Litzenberger's (1989) findings that Jensen's (1986, 1989) free cash flow (overinvestment) hypothesis is consistent with changes in cash dividends, whereas Howe, He and Kao's (1992) study of analogous cash events (i.e., self-tender offers and specially designated dividends) finds no support for the free cash flow hypothesis. By stratifying our sample of firms repurchasing their stock by the source of the firm's free cash flow (overinvestment) problem, additional light is shed on the interaction between the signalling and free cash flow theories.     

SEASONED EQUITY OFFERINGS FOR NEW INVESTMENT AND THE INFORMATION CONTENT OF INSIDER TRADES

Significant negative valuation effects are widely acknowledged for firms announcing seasoned equity offerings. This result is consistent with theoretical models linking new equity issues to increased adverse-selection costs, lower management ownership in the firm, misuse of free cash flow, or expectations for earnings declines. Also increasingly evident, insiders trade around corporate announcements. We test the hypothesis that insider trading and announcements of new equity issues serve as joint signals in the market's evaluation of prospective capital investment projects. Our findings are consistent with the hypothesis that insider trading is related to market reaction to announcements of new equity issues.     

Share Repurchases, the Clustering Problem, and the Free Cash Flow Hypothesis

We examine the market reaction to announcements of actual share repurchases, events that cluster both within and across firms. Using a multivariate regression model, we find that the market reacts positively to the events, indicating that these announcements provide additional information to that contained in the initial repurchase intention announcements. Further, the market response is especially favorable for firms with overinvestment problems as measured by Tobin's q , and is not related to signaling costs as measured by the size of the repurchase. Our findings generally support the hypothesis that share repurchases reduce the agency costs of excessive free cash flow .     

The Information Content of Dividend Surprises: Evidence from Germany

This paper reconsiders the issue of share price reactions to dividend announcements. We use the difference between the actual dividend and the analyst consensus forecast as obtained from I/B/E/S as a proxy for the surprise in the dividend announcement. Using data from Germany, we find significant share price reactions after dividend announcements. We use panel methods to analyze the determinants of the share price reactions and find evidence in favour of the cash flow signaling hypothesis and dividend clientele effects. We further find that the price reaction to dividend surprises is related to the ownership structure of the firm. The results do not support the free cash flow hypothesis. An additional result of our analysis is that dividend changes are not an appropriate measure to capture the information content of dividend announcements.     

STOCK BUYBACKS, CORPORATE PERFORMANCE, AND EVA

Most studies of corporate stock repurchase focus on the effect of stock buyback announcements on the stock price performance of companies announcing the programs, and on the corporate motives for undertaking stock buyback programs. The study described in this article examines the effects of actual stock buyback activities on corporate performance, addressing the question whether buybacks are associated with increases in economic value or EVA. In general, the study reports that the operating performance of buyback companies is better than that of non-buyback companies, and that performance improves in the year following the initiation of repurchasing activities. Although it is not the central focus of this study, the findings are consistent with both the free cash flow and the information signaling hypotheses as motives for engaging in stock buybacks.     

The Information Content of Share Repurchase Programs

Contrary to the implications of many payout theories, we find that announcements of open‐market share repurchase programs are not followed by an increase in operating performance. However, we find that repurchasing firms experience a significant reduction in systematic risk and cost of capital relative to non‐repurchasing firms. Further, consistent with the free cash‐flow hypothesis, we find that the market reaction to share repurchase announcements is more positive among those firms that are more likely to overinvest. Finally, we find evidence to indicate that investors underreact to repurchase announcements because they initially underestimate the decline in cost of capital.     

The Impact of Investment Opportunities and Free Cash Flow on Financial Liberalization:A Cross-Firm Analysis of Emerging Economies

This study undertakes firm-level analysis of investment opportunities and free cash flow in an attempt to explain the source of the wealth effect of financial liberalization for 14 emerging countries. We find that the market's responses to stock market liberalization announcements are more favorable for high-growth firms than for low-growth firms, a result that is consistent with the investment opportunities hypothesis. We also demonstrate that firms with high cash flow experience lower announcement-period returns associated with stock market liberalization than do firms with low cash flow. Our findings suggest that the free cash flow hypothesis dominates the corporate governance hypothesis in terms of the net effect of stock market liberalization on a firm's stock returns. We further document similar evidence with regard to banking liberalization. Finally, we demonstrate that stock market liberalization leads to the more efficient allocation of capital.     

Investment Opportunities,Free Cash Flow and Stock Valuation Effects of Corporate Investments: The Case of Taiwanese Investments in China

This paper examines the importance of investment opportunities and free cash flow in assessing the stock market reaction to announcements of cross-border investments in China by Taiwanese firms. Our results support the investment opportunities hypothesis that Taiwanese firms with favorable investment opportunities have significantly positive response to the announcements of their investments in China whereas firms with poor investment opportunities have negative response to such announcements. In contrast, we find no support for the free cash flow hypothesis. Our findings add to the understanding of the determinants of the wealth effect of cross-border investment decisions in the Asia-Pacific region.     

The Wealth Effects of Repurchases on Bondholders

Prior research has documented positive abnormal stock returns around the announcements of repurchase programs; several explanations of these returns have been suggested, including signaling, free cash flow, and wealth redistributions. This study analyzes abnormal stock, bond, and firm returns around repurchase announcements to examine these hypotheses. We find evidence consistent with both signaling and wealth redistribution. The loss to bondholders is a function of the size of the repurchase, and the risk of the firm's debt. We also find that bond ratings are twice as likely to be downgraded as upgraded after the announcement of the repurchase program.     

Does CEO reputation matter for capital investments?

This paper examines the association between CEO reputation and corporate capital investments. The efficient contracting hypothesis predicts a positive association between CEO reputation and wealth effects of corporate capital investments. In contrast, the rent extraction hypothesis predicts that the wealth effects of capital investments are negatively associated with CEO reputation. We find that the stock market's responses to announcements of capital investments are more favorable for firms with more reputable CEOs. Moreover, CEO reputation mitigates the negative stock price reaction associated with announcements of capital investments by firms with high free cash flow and low growth opportunities. Additional analysis indicates that firms with more reputable CEOs exhibit significantly better post-investment operating performance improvements than those with less reputable CEOs, especially in firms with high free cash flow and low growth opportunities. Collectively, our results suggest that the efficient contracting hypothesis dominates the rent extraction hypothesis in terms of net economic impact of capital investments on the investing firm.     

The Long Run Abnormal Performance of UK Acquirers and the Free Cash Flow Hypothesis

Abstract:   Evidence from recent US and UK studies reveals a pattern of poor long run post acquisition performance by acquiring firms. One explanation, due to Jensen (1986) is that acquirers with an excess of free cash flow (FCF) will have a propensity to squander this on wasteful investments, including take‐overs. In this paper, using a dataset of UK take‐overs and proxies for free cash flow similar to those used by Lang, Stulz and Walking (1991) , we find no support for the FCF hypothesis and show that this conclusion is robust to the model of long run returns employed. Contrary to the free cash flow hypothesis there is evidence that acquirers with high free cash flow perform better than acquirers with low free cash flow. Although not consistent with the Jensen hypothesis, this evidence is compatible with the emerging UK evidence that shows cash flow‐to‐price measures are associated with market returns.     

Overinvestment,corporate governance,and dividend initiations

Firms with low Tobin's Q and high cash flow have significantly more positive dividend initiation announcement returns than do other firms. I interpret this result as consistent with the hypothesis that reductions in the agency costs of overinvestment at firms with poor investment opportunities and ample cash flow are reflected in higher dividend initiation announcement returns. Further tests, such as examining the impact of governance metrics on initiation announcement returns following the dividend tax cut of 2003 and examining the long-run cash-retention policies of dividend-initiating firms, are consistent with this interpretation. There is also some evidence that is consistent with the cash flow signaling hypothesis, as dividend-initiating firms with low Tobin's Q and low pre-initiation cash flow experience substantial revisions in analysts' earnings forecasts and significantly positive initiation announcement returns.     

Investment opportunities,free cash flow,and stock valuation effects of secured debt offerings

This paper examines the role of investment opportunities and free cash flow in explaining the source of the stock valuation effects of secured debt offerings. We find a significantly positive relation between a firm's investment opportunities and its stock price response to announcements of secured debt issues. This evidence supports the investment opportunities hypothesis that secured debt financing is more valuable for issuing firms with high growth opportunities. In contrast, we find a lack of support for the free cash flow hypothesis. These findings hold even after controlling for other potentially influential variables. Our study provides a better understanding of the relative importance of various potential determinants in explaining the variation in the valuation impact of secured debt issues.

Financing decisions and bidder gains

This paper analyzes the relation between bidder gains and the source of financing funds available. We document that after controlling for the form of payment, financing decisions during the year before a takeover play an important role in explaining the cross section of bidder gains. Bidder announcement period abnormal returns are positively and significantly related to the amount of ex ante equity financing. This relation is particularly strong for high q firms. We further report a negative and significant relation between bidder gains and free cash flow. This relation is particularly strong for firms classified as having poor investment opportunities. The amount of debt financing before a takeover announcement is not significantly related to bidder gains. Together, we take these findings as supportive of the pecking-order theory of financing and the free cash flow hypothesis.     

A Direct Test of the Free Cash Flow Hypothesis: Evidence from Real Estate Transactions

This paper tests (Jensen The American Economic Review, 76, 323–329 1986) free cash flow hypothesis using data on real estate transactions. We find that firms with either higher free cash flow or higher cash reserve pay more fore real estate, which is consistent with the free cash flow hypothesis. We also find that the agency costs of free cash flow associated with real estate transactions are more severe when firms have lower Tobin’s Q. Furthermore, we find that among the commonly used corporate governance measures, only equity compensation is effective in mitigating the agency problem of free cash flow.     

Failed takeovers, methods of payment, and bidder returns

This study documents bidding-firm stock returns upon the announcement of takeover terminations. On average, bidding firms that offer common stock experience a positive abnormal return, and firms that offer cash experience a negative abnormal return. The positive performance is primarily driven by bidders initiating the takeover termination. Commonstock-financed bidders earn a return not significantly different from that earned by cashfinanced bidders when terminations are initiated by the target firm. The results are consistent with the asymmetric information hypothesis, that the decision not to issue common stock conveys favorable information to the market. In addition, bidder returns at takeover termination are positively related to the amount of undistributed cash flow, supporting the free cash flow hypothesis.     

Asymmetric Information,Asset Allocation,and Debt Financing

We analyze a signaling game where firms' financing announcements convey private information about their prospects but a moral hazard problem exists in that managers may suboptimally invest. Consequently, the attempt to address an asymmetric information problem exacerbates moral hazard. The equilibrium recognizes both imperfect information problems. Additionally, the firm must determine how to allocate funds between two technologies differing in cash flow timing and managerial accessibility. We define an above-average firm's comparative advantage as that technology which is most dominant relative to a firm with lesser prospects and show that the resultant equilibria follow the lines of the firm's comparative advantage. Finally, we show that separation may be achieved costlessly, i.e., with no explicit signaling cost.     

Earnings Announcements and Systematic Risk

Firms scheduled to report earnings earn an annualized abnormal return of 9.9%. We propose a risk‐based explanation for this phenomenon, whereby investors use announcements to revise their expectations for nonannouncing firms, but can only do so imperfectly. Consequently, the covariance between firm‐specific and market cash flow news spikes around announcements, making announcers especially risky. Consistent with our hypothesis, announcer returns forecast aggregate earnings. The announcement premium is persistent across stocks, and early (late) announcers earn higher (lower) returns. Nonannouncers' response to announcements is consistent with our model, both over time and across firms. Finally, exposure to announcement risk is priced.