Share Repurchases by Financially Constrained Firms

1
Share Repurchases by Financially Constrained
Firms
Sheng-Syan Chen National Taiwan University Yanzhi
Wang Yuan Ze University
2
Motivation

• Prior finance literature has documented the value
  enhancing nature of corporate share repurchase
  programs.
• Vermaelen (1981), Asquith Mullins (1986),
  and Comment Jarrell (1991) show positive
  announcement-period abnormal returns associated
  with share repurchases and attribute their
  finding to a signal of undervaluation for
  repurchasing firms.
• Ikenberry et al. (1995, 2000) find positive
  long-term abnormal returns following share
  repurchases for a period of up to four years.
• Other authors have since provided
  explanations for the long-term drift in stock
  prices.

3

• Grullon Michaely (2004) argue that prices
  impound the change in the cost of capital only
  gradually and that the risk changes associated
  with repurchases provide an explanation for the
  long-run price drift.
• Chan et al. (2004) suggest mispricing, and to
  some degree, the disgorging of free cash flows as
  the sources for the long-horizon return drift.
• Gong et al. (2008) suggest that deflating
  earnings around repurchase announcements is one
  reason for repurchasing firms to experience
  post-repurchase abnormal returns.
• Peyer Vermaelen (2009) find strong support
  for the long-term abnormal returns as a
  correction of an overreaction to bad news prior
  to the repurchase.

4

• Although previous studies suggest that repurchase
  programs enhance firm value, repurchasing firms
  may suffer a reduction in corporate liquidity
  subsequent to share repurchases.
• The repurchasing firms spend cash and/or
  raise leverage when they buy back shares (Jensen,
  1986 Stephens Weisbach, 1998 Dittmar, 2000
  Hovakimian, 2004).
• The reduction in cash balance and the lift in
  financial leverage following repurchases lead to
  a decline in corporate liquidity for repurchasing
  firms.
• For repurchasing firms that are financially
  constrained prior to the buyback, a lower degree
  of corporate liquidity resulting from repurchases
  can be harmful.

5

• With more difficulty in financing future
  investment, they may have a worse competitive
  ability due to their underinvestment in the
  product market (Froot et al., 1993 Chevalier
  Scharfstein, 1996 Campello, 2003 Almeida et
  al., 2004).
• With less cash, they also could not have
  technological improvements in cash management
  (Opler et al., 1999).
• Moreover, they may have a greater chance of
  suffering financial distress risk (Opler et al.,
  1999 Kaplan Zingales, 2000 Lamont et al.,
  2001 Almeida et al., 2004 Whited Wu, 2006
  Denis Sibilkov, 2009).
• Therefore, financially constrained
  repurchasing firms are expected to exhibit poor
  post-repurchase performance due to a decline in
  their corporate liquidity.

6

• In this study, we examine how the financial
  constraints of repurchasing firms affect firm
  performance following share repurchases.
• Consistent with prior studies, we find that both
  the initial and long-run stock price reactions to
  the repurchase announcements are significantly
  positive for our sample firms.
• We then examine the impact of financial
  constraints on these price reactions.
• We find that financially constrained
  repurchasing firms exhibit an average five-day
  announcement-period abnormal return of 0.7,
  which is significantly lower than the average
  abnormal return of 2.06 for financially
  unconstrained repurchasing firms.

7

• Surprisingly, we show that for a period of up
  to four years following the announcements, the
  financially constrained subsample experiences a
  significantly negative average buy-and-hold
  abnormal return of 2.98 per year.
• In contrast, the average long-run stock
  performance for the financially unconstrained
  subsample is significantly positive with an
  abnormal return of 1.44 per year.
• Moreover, our regression analyses show that
  the abnormal return over the four-year
  post-repurchase period is significantly more
  positive for financially unconstrained firms than
  for financially constrained firms.
• These results hold even after we control for
  other potential explanatory variables.

8

• Our findings suggest that share repurchase
  programs lead to poorer post-buyback stock return
  performance for firms that are financially
  constrained.
• Our evidence also suggests that share
  buybacks by financially constrained firms are
  harmful to firm value, in contrast to the
  findings in previous studies that share buybacks
  are value-enhancing in the long run.

9

• We also examine how the impact of financial
  constraints on the post-repurchase stock
  performance of buyback firms depends on the
  proportion of repurchases that are actually
  undertaken.
• In practice, many firms announce repurchase
  programs without following through (Ikenberry
  Vermaelen, 1996 Stephens Weisbach, 1998 Lie,
  2005).
• If the firms actually buy back more shares in
  the aftermath of a repurchase program
  announcement, it is more likely that their cash
  balance decreases and financial leverage
  increases, resulting in lower corporate liquidity
  following repurchases.
• Therefore, the post-repurchase stock
  performance of financially constrained firms is
  expected to be poorer when they actually buy back
  more shares.

10

• Our results show that the post-buyback stock
  performance is more unfavorable for financially
  constrained firms with a high actual buyback
  ratio.
• Financial constraints are less important in
  explaining the long-run stock performance of
  repurchasing firms with a low actual buyback
  ratio.
• Our findings support that the vulnerability
  of financially constrained firms in share
  buybacks is more severe when they actually
  undertake higher proportions of repurchases.
• Our evidence also suggests that the actual
  repurchases, rather than the announcements of the
  repurchase programs per se, determine performance
  deterioration for financially constrained firms.

11

• We next investigate the impact of the financial
  constraints of repurchasing firms on their
  post-buyback operating performance.
• Consistent with Lie (2005) and Gong et al.
  (2008), we find that the whole sample of
  repurchasing firms experience a significant
  improvement in abnormal operating performance
  over the eight quarters following the repurchase
  announcement quarter.
• However, when partitioning our sample into
  financially constrained and unconstrained firms,
  we find that share buyback programs result in
  poor abnormal operating performance for
  repurchasing firms that are financially
  constrained.
• In contrast, the financially unconstrained
  subsample displays improvements in post-buyback
  abnormal operating performance.

12

• Furthermore, our cross-sectional regression
  analyses show that financially constrained firms,
  especially those with a high actual buyback
  ratio, experience more unfavorable post-buyback
  operating performance than financially
  unconstrained firms.
• Our findings suggest that the lower degree of
  corporate liquidity resulting from share buybacks
  is harmful to the competitive ability of
  financially constrained firms, which leads to a
  corresponding deterioration in their operating
  performance in the post-buyback period (Froot et
  al., 1993 Chevalier Scharfstein, 1996
  Campello, 2003 Almeida et al., 2004).

13

• We also examine the impact of share buybacks on
  financial distress risk for financially
  constrained and constrained firms.
• Share repurchases reduce the cash level and
  increase the leverage ratio, resulting in a
  greater financial risk (Maxwell Stephens,
  2003).
• This increase in financial risk is more
  likely to occur for the financially constrained
  repurchasing firms, because they tend to have
  lower corporate liquidity in the post-buyback
  period (Opler et al., 1999 Kaplan Zingales,
  2000 Lamont et al., 2001 Almeida et al., 2004
  Whited Wu, 2006 Denis Sibilkov, 2009).

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• Using Altmans (1968) Z-score to measure
  distress risk, we find that following the
  repurchase announcement, financially constrained
  firms experience a significantly greater increase
  in distress risk than financially unconstrained
  firms.
• The increase in distress risk is more likely
  to occur for financially constrained firms that
  have a high actual buyback ratio.
• We also find that the increase in the
  fraction of firms with a high probability of
  default in the post-buyback period is
  significantly higher for financially constrained
  firms.
• Our results indicate that financial
  constrained firms are more likely to suffer the
  risk of financial distress following the
  repurchase announcement.

15

• One crucial question that needs to be addressed
  is why a financially constrained firm buys back
  its own shares even if the repurchase does not
  align with the shareholder wealth.
• In this study, we propose two possible
  explanations based on agency problems and
  managerial hubris.
• We document that top managers of financially
  constrained firms tend to own more vested,
  exercisable options around buyback announcements
  than those of financially unconstrained firms.
• As suggested by Fenn Liang (2001), Kahle
  (2002), and Chan et al. (2009), increasing
  executive vested options lures managers into
  boosting stock price via stock repurchases.
• Our evidence indicates that managers of
  financially constrained firms have greater
  incentive to boost up stock price for their own
  personal wealth through buying back shares, even
  though share repurchases are not value-enhancing.
  

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• We also show that in the period surrounding
  repurchases, top managers of financially
  constrained firms tend to hold more in-the-money
  unexercised vested options than those of
  financially unconstrained firms.
• One interpretation of the failure to exercise
  in-the-money vested options is managerial
  overconfidence, as suggested by Malmendier and
  Tate (2005, 2008) and Ben-David et al. (2007).
• Our results indicate that managers of
  financially constrained repurchasing firms tend
  to overestimate the future returns of their firms
  and thus postpone the exercise of their stock
  options.

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Sample Design

• We obtain our sample of common stock repurchases
  from the Securities Data Companys (SDC) U.S.
  Mergers and Acquisitions database.
• The sample is constructed based on original
  announcement dates between January 1, 1990 and
  December 31, 2007.
• Our procedures require listing on the Center
  for Research in Security Prices (CRSP) and
  COMPUSTAT.
• We exclude firms with shares prices less than
  3 to avoid the skewness of the long-run return
  estimation (Loughran and Ritter, 1996).

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• American Depository Receipts (ADRs), Real
  Estate Investment Trusts (REITs), and closed-end
  funds are also excluded from our sample.
• We require our sample firms to have positive
  intended buyback ratios, size, assets, sales, and
  book-to-market (B/M) ratios.
• Our final sample consists of 4,710 repurchase
  announcements.

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Methodology

• Measuring financial constraint
• We use the KZ index (Kaplan Zingales, 1997)
  to measure a firms financial constraint.
• This index has been widely used in previous
  studies (e.g., Lamont et al., 2001 Baker et al.,
  2003 Chen et al., 2007 Hennessy et al., 2007).
• A firm with a high KZ index is considered
  more financially constrained.
• The KZ index attaches positive weight to
  Tobins Q and leverage, and negative weight to
  operating cash flow, cash balances, and
  dividends.

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• Specifically, we construct the KZ index for
  each firm-year as the following linear
  combination
• KZ 1.002(CF/TA) 39.368(DIV/TA)
  1.315(CA/TA)
• 3.139LEV 0.283Q
• where CF/TA is cash flow over lagged book
  assets, DIV/TA is cash dividends over lagged book
  assets, CA/TA is cash balances over lagged book
  assets, LEV is total debt over book assets, and Q
  is the ratio of the market to book value of the
  firms assets.
• For every year of data, we sort firms into
  quintiles based on the value of their KZ indexes.
  
• Firms with the lowest value of the KZ index
  are placed into quintile one, firms with the
  highest value of the KZ index are placed into
  quintile five and so forth.

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• We define the financial constraints of our
  repurchasing firms based on their KZ quintiles
  for the fiscal year before the repurchasing
  announcement.
• Following Baker et al. (2003) and Chen et al.
  (2007), we consider repurchasing firms in the
  highest KZ quintile to be financially
  constrained, and repurchasing firms in other KZ
  quintiles to be financially unconstrained.
• Kaplan Zingales (1997) report that around
  15 of firms are financially constrained at any
  given time, which reflects the fact that
  repurchasing firms in the highest KZ quintile are
  more likely to be financially constrained.

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• Measuring abnormal stock returns
• We measure initial stock price responses to
  announcements of share repurchases by the 5-day
  buy-and-hold abnormal return (BHAR) over the
  period from day 2 to day 2, where day 0 is
  defined as the initial announcement date.
• The 5-day BHAR measures the difference in the
  5-day compound return between the repurchasing
  firms and the matching firms.
• To be selected as matching firms, they must
  be listed on the same stock exchange as the
  repurchasing firms they must not have had a
  share repurchase announcement in the five years
  before the repurchasing firms announcement date
  and they must be within the same size decile, B/M
  quintile, and KZ index quintile as the
  repurchasing firm.

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• For all firms meeting the criteria, we then
  select five matching firm based on the closest
  B/M ratio to the repurchasing firm.
• As suggested by Lee (1997) and Chan et al.
  (2004), using five matching-control firms avoids
  potentially noisy point estimates as indicated by
  Lyon et al. (1999).
• The average compound return of the five
  matching firms over the 5-day announcement period
  is used as the benchmark.

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• To estimate long-horizon return performance
  associated with a share repurchase, we use annual
  buy-and-hold returns, an approach that is widely
  used in previous studies (e.g., Lakonishok et
  al., 1994 Chan et al., 2001).
• We calculate the average annual buy-and-hold
  returns for both the repurchasing firms and the
  matching firms from the first year (year 1)
  following the repurchase announcement to the
  fourth anniversary, or to the delisting date or
  December 2007 if the full sample period is not
  available.
• The long-run abnormal stock performance of
  firms that announce repurchase programs is
  measured by the difference between their average
  annual buy-and-hold returns and their matching
  firms over the four-year post-repurchase period.
  

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• Measuring operating performance
• Following Lie (2005) and Gong et al. (2008),
  we measure the operating performance of
  repurchasing firms over the eight quarters after
  the repurchase announcement quarter (quarter 0).
  
• Operating performance is measured by
  return-on-assets (ROA), which is defined as
  operating income divided by total book assets at
  the beginning of the quarter.
• The abnormal operating performance for a
  given firm is the firm-specific ROA minus the ROA
  of its matching firm.
• We select the matching firms using the
  matching procedure, which is similar to Lie
  (2001, 2005) and Gong et al. (2008) and also
  matches the KZ quintile.

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• Measuring financial distress risk
• We follow the prior literature and use
  Altmans (1968) Z-score to measure financial
  distress risk (e.g., Officer, 2007 Purnanandam,
  2008).
• Altmans Z-score is negatively correlated
  with the probability of financial distress and is
  computed as
• Z-score 1.2X1 1.4X2 3.3X3 0.6X4
  0.999X5
• where X1 is working capital divided by book
  assets X2 is retained earnings divided by book
  assets X3 is earnings before interest and taxes
  divided by book assets X4 is market value of
  equity divided by total liabilities and X5 is
  net sales divided by book assets.
• Altmans model classifies firms with a
  Z-score of less than 1.81 as failing. We thus
  define a repurchasing firm to have a high
  probability of default if its Z-score is less
  than 1.81.

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Results
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• Test the robustness of the results
• We also use four alternative measures of
  corporate financial constraints suggested in the
  literature.
• First, following Kaplan and Zingales (1997) and
  Lamont et al. (2001), we deflate CF, DIV, and CA
  by the lagged property, plant, and equipment
  (PPE) in the KZ index.
• The modified five-variable version of the KZ
  index is constructed as follows
• KZ 1.002(CF/PPE) 39.368(DIV/PPE)
  1.315(CA/PPE)
• 3.139LEV 0.283Q

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• Second, following Baker et al. (2003), Chen et
  al. (2007), and Hennessy et al. (2007), we
  exclude the Q term when computing the KZ index
  for each firm.
• That is, the modified four-variable version
  of the KZ index that omits Q is constructed as
  follows
• KZ 1.002(CF/TA) 39.368(DIV/TA)
  1.315(CA/TA)
• 3.139LEV
• Third, we replace TA in the above equation by PPE
  as follows
• KZ 1.002(CF/PPE) 39.368(DIV/PPE)
  1.315(CA/PPE)
• 3.139LEV

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• Finally, following Fazzari et al. (1988), Cleary
  (1999), and Korajczyk Levy (2003), we measure a
  firms financial constraint by its
  investment-cash flow sensitivity.
• We run the following regression using
  firm-level time-series data over the period
  1980-2007
• where I is the firms capital expenditures.
• The firms investment-cash flow sensitivity
  is measured by the coefficient a2 of CF/PPE in
  the above equation.
• As before, we regard financially constrained
  firms as those repurchasing firms in the highest
  quintile of the KZ index or the investment-cash
  flow sensitivity.

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• Financially constrained firms experience a
  significantly greater decline in the Z-score
  following the repurchase announcement (?2.69 for
  financially constrained firms and ?0.81 for
  financially unconstrained firms).
• The mean difference between the changes in
  the Z-score from year ?1 to year 4 for the two
  groups is ?1.88, statistically significant at the
  1 level (t-value ?2.77).
• Our results in Panel A indicate that
  financial distress risk significantly increases
  for repurchasing firms after the repurchase
  announcement, with the increase in distress risk
  being greater for financially constrained firms.

40

• The proportion of firms with a high probability
  of default significantly increases for both
  subsamples from year ?1 to year 4 (from 25.43
  to 38.3 for financially constrained firms and
  from 7.66 to 11.49 for financially
  unconstrained firms).
• However, this increase is much higher for
  financially constrained firms (12.87) than for
  financially unconstrained firms (3.83), with the
  difference 9.04 being statistically significant
  at the 1 level (p-value 0.00).
• The results in Panel B suggest that
  repurchasing firms that are financially
  constrained are more likely to suffer the risk of
  financial distress following the repurchase
  announcement.

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• Relative to their matching firms, financially
  constrained firms still experience a significant
  increase in financial distress risk from year ?1
  to year 4, with the increase in distress risk
  being greater than that of financially
  unconstrained firms.
• The mean difference between the changes in
  the abnormal Z-score from year ?1 to year 4 for
  the two groups is ?1.75, statistically
  significant at the 1 level (t-value ?3).

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• In Panel A of Table 10, we investigate the vested
  options (i.e., unexercised exercisable options,
  including both in-the-money and out-of-money
  options) held by top-executives of the
  repurchasing firms for the period spanned by two
  years before through one year after the
  repurchase announcement.
• To standardize the option holdings, we scale
  them by total shares outstanding.
• We obtain compensation information for the
  top 5 executives of the firms from the SPs
  ExecuComp database.
• Due to the data availability on ExecuComp, we
  start our analysis from 1992.
• Panel B of Table 10 shows the average
  in-the-money unexercised vested options held by
  top executives in the years surrounding the
  repurchase announcement.

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Conclusion

• This study examines how the financial constraints
  of repurchasing firms affect their firm
  performance following the buyback announcement.
• For a period of up to four years following the
  repurchase announcement, financially constrained
  firms experience a significantly negative
  abnormal return, whereas the abnormal return for
  financially unconstrained firms is significantly
  positive.
• Our regression analyses show that the
  long-run stock performance of share repurchases
  is significantly more unfavorable for financially
  constrained firms than for financially
  unconstrained firms, even after controlling for
  other potentially influential factors.
• Our results indicate that share repurchases
  by financially constrained firms are harmful to
  their shareholder wealth, in contrast to the
  findings in previous studies that share
  repurchases are value-enhancing in the long run.

46

• We find that the post-buyback performance of
  share repurchases is more unfavorable for
  financially constrained firms with a high actual
  buyback ratio, which are more likely to suffer
  from lower corporate liquidity following
  repurchases.
• We find that share buyback programs lead to poor
  abnormal operating performance for repurchasing
  firms that are financially constrained.
• In contrast, financially unconstrained firms
  display improvements in post-buyback operating
  performance.
• Our cross-sectional regression analyses also
  show that the post-buyback operating performance
  is significantly more unfavorable for financially
  constrained firms than for financially
  unconstrained firms, even after controlling for
  other potential explanatory variables.
• We also show that financial constraints are
  more important in explaining the operating
  performance of share buybacks for firms with a
  high actual repurchase ratio.

47

• We show a significantly greater increase in
  distress risk for financially constrained firms
  than for financially unconstrained firms,
  especially when financially constrained firms
  have a high actual buyback ratio.
• We further find that the increase in the
  fraction of firms with a high probability of
  default in the post-buyback period is
  significantly higher for financially constrained
  firms.
• Our results indicate that financial
  constrained firms are more likely to suffer the
  risk of financial distress following the
  repurchase announcement, because of their lower
  corporate liquidity in the post-buyback period.
• We provide two possible explanations, which are
  based on agency problems and managerial hubris,
  for our finding that a financially constrained
  firm buys back shares even if the repurchase does
  not align with its shareholder wealth.