Good News and Bad News about Share Repurchases*

We estimate the cross-sectional relationship between open market repurchases and accounting data for a large sample of dividend-paying and non-dividend-paying firms over a twelve year period (1984-95). Consistent with the hypothesis that firms use open market repurchases to reduce the agency costs of free cash flow, we find that repurchases are positively related to proxies for free cash flow and negatively related to proxies for marginal financing costs. We also examine the extent to which management stock options influence the choice between open market repurchases and dividend payments. Because the value of management stock options--like any call option--is negatively related to expected future dividend payments, management can increase the value of its stock options by substituting share repurchases for dividend growth. We find evidence that such substitution occurs: for dividend-paying firms, share repurchases are positively related and dividend increases are negatively related to a proxy for management stock options, whereas for non-dividend-paying firms, the relationship between repurchases and options is weak and statistically insignificant. Correspondence to: George Fenn, Milken Institute, 1250 Fourth St., Santa Monica, CA, 90401, 310-998-2699, [email protected] ; Nellie Liang, Federal Reserve Board, Stop 89, 20 and C Sts., NW, Washington, DC 20551, 202-452-2918, [email protected]. th * The views expressed in this paper are those of the authors and not necessarily those of the Milken Institute or the Federal Reserve Board. We thank Manju Puri and Stewart Myers for helpful comments, and Kyle Nagel, Mike Pizzi, and Melissa Post for outstanding research assistance. Such models posit that managers' utility depends, in part, on the current stock price; 1 consequently, managers have the incentive to signal undervaluation and raise their firm's stock price. Vermaelen's (1984) model further assumes that repurchases occur at a premium to the true 2 value of a firm's shares. This assumption implies that stock prices fall subsequent to repurchases, a pattern that is observed in tender offers (Vermaelen, 1981), but not in open market repurchases where long-term positive excess returns are observed (Ikenberry, Lakonishok, and Vermaelen, 1995). Good News and Bad News about Share Repurchases