Share repurchases and firm
performance: new evidence on the
agency costs of free cash flow
Nohel and Tarhan (1998, JFE)
Contents
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Abstract
Introduction
Information signaling and free cash flow
Data and variables
Empirical finding and interpretation
Conclusion
abstract
• Information signaling hypothesis
• Free cash flow hypothesis
• Using changes in operating performance (this
paper) rather than stock abnormal returns or
long run return (previous studies)
• Low q firms—operating performance improve
cause of efficient utilization of assets and asset
sales.
• The result support free cash flow hypothesis
Information signaling hypothesis
• Repurchasing sends a strong signal to
lesser-informed outside investors that firm
performance will be improved in the future.
Free cash flow hypothesis
• Firm with excess cash and a poor portfolio
of investment opportunities will face
sizable agency costs if the excess cash is
not distributed to shareholders.
• Excess cash  managers might
perquisites, empire building
(entrenchment), and invest other negative
NPV projects.
Dividend payout issue
• Supported free cash flow hypothesis
– Lang and Litzenberger (1989)
• Market reacts more to dividend changes of low q firms than
those of high q firms (why supports free cash flow
hypothesis?)
• Low q do not have more positive NPV projects, as a result,
using dividend payout to mitigate excess cash problem.
– Perfect et al. (1995)
• Support LL(1989)’s results.
• Disputed free cash flow hypothesis
– Howel et al. (1992)
– Denis et al. (1994)
Rationale of hypotheses
• Signal
– Repurchasing announcement => tangible improvement in
operating performance
• Free cash flow
– Repurchasing announcement => may or may not exhibit
improved performance.
• Note: signaling implies an improvement in performance,
but a performance improvement need not imply signaling.
• Note: Assets sale (poor performance assets) => execute
share repurchase => operating performance
improvement => spirit of the free cash flow
Purpose of this paper
• Distinguish between the information signal
hypothesis and free cash flow hypothesis
by using operating performance changes
rather than “earning changes”.
• Decompose firm operating performance
– Performance improvement: repurchasing,
efficient mgr, or cost down,…etc.
– Understanding the motive behind the
repurchase.
Purpose of this paper
• Examine the relationship between
performance and risk.
– How these variables related to announcement
period returns.
– Long term return to realize the anticipated
performance and risk.
• Subsample: low q and high q
Information signaling
• Repurchasing sends a strong signal to
lesser-informed outside investors that firm
performance will be improved in the future.
• Literatures (skip)
Free cash flow
• Firm with excess cash and a poor portfolio
of investment opportunities will face
sizable agency costs if the excess cash is
not distributed to shareholders.
• Excess cash  managers might
perquisites, empire building
(entrenchment), and invest other negative
NPV projects.
• Literatures (skip)
How to discriminate between the
two hypotheses?
• Three measurements:
– Operating performance
– Abnormal stock return
– Long run returns
• In this paper, three measurements are
implemented.
Data
• Tender offer stock repurchase ( why not open
market repurchase?)
• 1978-1981
• COMPUSTAT, NYSE, AMEX, and NASDAQ
• Data processing
• Matching firms selection
– Criterion
Data
• Using firm performance rather than
abnormal stock return. (why?)
– Healy et al. (1992), Cornett and Tehranian
(1992), and Tarhan et al. (1998)
• Measurement of firm performance
– The ratio of an upstream measure of cash
flow, defined as EBITDA / market value of the
assets (why market value of assets?)
Variables
Decomposition of cash flow return
on asset
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Du Pont analysis
ROA= cash flow margin + asset turnover
Cash flow margin = Net income / sales
Asset turnover = sales / total assets
Deep discussion on firm performance
Empirical findings—univariate
statistics
Empirical findings—univariate
statistics
• Low q firms’ operating performance
improve after repurchasing announcement.
• Low q firms are undervalued.
• Low q firms’ asset turnover rate are
significantly positive not only before
repurchasing but also after repurchasing.
Regression analysis for each
variable
The results of regression analysis
The results of regression analysis
The results of regression analysis
• Why check each variable? But not
regression on all variables.
• Why test for a zero intercept terms (Healy
et al., 1992)
• Low q firms performance improvement
cause of better utilization of assets or
reduce unproductive assets?
Which one drives performance
improvement
• Information signal hypothesis
– Managers repurchase shares to signal their improved
growth prospects.
• Free cash flow hypothesis
– Managers return cash to shareholder in lieu of
investing in unproductive assets.
• Two way to improve the efficiency of the assets:
– Acquire highly productive assets
– Liquidating unproductive assets
Which one drives performance
improvement
Which one drives performance
improvement
• Asset sale is positive significant (firms sale
their assets) => firms reduce unproductive
assets and distribute cash to shareholder
=> support free cash flow hypothesis
• This result implies that share repurchase
is used as part of a corporate restructuring
package.
Robustness check
Robustness check
Robustness check
• Asset sales positively related to the firms’
performance improvement
• The results are robust to reduce
unproductively assets => support free
cash flow hypothesis again.
Market reaction to repurchase
Market reaction to repurchase
• Short run abnormal return are significantly
positive. (including AR and AER)
• These results are consistent to Lakonishok
and Vermaelen (1990)
• Denis (1990) and Comment and Jarrell
(1991) suggest that takeover risk and
officers and directors risk are related to
firm repurchase. => another robustness
check.
Robustness check--risk
Robustness check--risk
Robustness check--risk
• Negative coefficient on INPLAY supports
the results of Denis (1990) => firm
repurchase as a defensive move against a
takeover threat.
• Positive coefficient on ODRISK
– Signal hypothesis: insiders send a strong
signal of firm’s prospects.
– Agency cost: insiders increase their shares =>
reduce agency cost.
What factors result in abnormal
return? —Announcement return
What factors result in abnormal
return? —Announcement return
What factors result in abnormal
return? —Announcement return
• Cash flow:
– positive significant in low q firms and
insignificant in high q firms.
– Investor correctly anticipate the superior
performance of low q firms and the mediocre
performance of high q firms
• PREM, FRAC, and INPLAY are important
determinants of announcement return.
What factors result in abnormal
return?—Long run return
What factors result in abnormal
return?—Long run return
What factors result in abnormal
return?—Long run return
• Cash flow:
– positive significant in high q firms and
insignificant in low q firms.
– Indicate that the systematic performance
improvements displayed by low q firms are
correctly anticipated by investors.
– Investors do not expect systematic post
repurchase improvement from high q firms.
Conclusion
• Repurchasing firms significant improve their
performance, relative to control firms
• Low q firms => performance improvement by assets
efficient utilization (turnover)
• Firm’s repurchase of stock is part of a restructuring
program (shrink the assets of the firm => and then
distributing cash).
• AR and LR indicates that investors correctly anticipate
that the low q firms generate performance improvement,
and high q firms do not.
• These results support the free cash flow hypothesis over
the information signaling hypothesis.