Inflexibility of Share Repurchases*

• Published date: 01 March 2021
• Author: Satoru Yamaguchi
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/irfi.12267

Inflexibility of Share Repurchases*

SATORU YAMAGUCHI

Faculty of Business Administration, Konan University, Hyogo, Japan

ABSTRACT

This paper investigates the flexibility inherent in open market share

repurchases. Open market share repurchases are recognized as being flexible,

since managers believe that they are not an ongoing commitment. However, I

find that such returns significantly decrease upon announcing the completion

of a repurchase program if firms do not concurrently announce new progra m

authorizations. I also find that announcement returns significantly decline with

completion rates and that a high completion rate acts as a negative signal,

revealing that firms have finished the repurchasing activities and do not intend

to continue share repurchasing in the foreseeable future. These results indicate

that share repurchases are less flexible than they were previously thought to be.

JEL Codes: G35

Accepted: 24 March 2019

I. INTRODUCTION

The flexibility hypothesis is one of the more plausible candidates used to explain

the relative popularity of share repurchases over dividends. Flexibility inherent

in share repurchases comes from their very nature, which dividends, as an alter-

native way to pay out cash, do not have. Once a firm has decided to pay cash

dividends, they need to maintain that level of dividend payout in order to avoid

a stock price reduction.

1

Therefore, dividends become an ongoing commitment,

acting as a constraint upon and stealing flexibility from managers.

Contrary to dividends, open market share repurchases are viewed as being

flexible (Brav et al. 2005). There are two aspects of flexibility in share

repurchases, credibility and continuity. Because managers believe that their stock

price will not change even if they do not buy back any of the intended shares,

that is, generating flexibility in terms of credibility, or if they do not continue

to repurchase without authorizing new programs, that is, generating flexibility

in terms of continuity (Jagannathan et al. 2000; Guay and Harford 2000; Rapp

et al. 2014; Iyer and Rao 2017).

* I appreciate valuable comments and suggestions from Xiaoyun Yu (the editor) and an anony-

mous reviewer. Also, I would like to thank Nobuyuki Isagawa, Shigeki Sakakibara, Takashi Yamasaki,

Taiji Baba, Hiromi Wakabayashi, Konari Uchida, and Kazuo Yamada for their helpful comments.

1 Healy and Palepu (1988), Michaely et al. (1995), and Grullon and Michaely (2002) for US

firms, and Dewenter and Warther (1998), Kato et al. (1997), and Fukuda (2000) for Japanese

firms, all report that the market reaction to dividend decrease or omission announcements is

significantly negative.

© 2019 International Review of Finance Ltd. 2019

International Review of Finance, 21:1, 2021: pp. 255–281

DOI: 10.1111/irfi.12267

Several papers find that managers make use of financial flexibility when

deciding on a financial policy.

2

Recently, Iyer and Rao (2017) directly tested

whether share repurchases are accompanied by flexibility. Using financial crisis

period data, they conclude that repurchases do have such flexibility.

In contrast, Bargeron et al. (2017) find that firms voluntarily announcing

program completion experience a significantly negative stock price reaction

and indicate that share repurchases are not as flexible as previously thought.

The result suggests that there exists inflexibility in terms of continuity. In addi-

tion, Bonaime (2012) reports that investors reflect on information about how

many shares the firms repurchased when computing stock returns, which

shows inflexibility in terms of credibility. Considering that prior studies suggest

the possibility that share repurchases do not have much flexibility, the extent

to which share repurchases are flexible must be clarified.

In the US, firms had not been obligated to report the results of share buyback

activities. To grasp when the program finished and how many shares firms

bought under the program, researchers had to estimate such information

(Stephens and Weisbach 1998). Since the change in SEC Rule 10b-18 in 2003, all

firms engaging in repurchase activities are required to report the results, for

example, the total number of shares repurchased and the average price paid per

share. Bonaime (2015) shows that the number and size of program announce-

ments decreased after the regulatory change and that this rule change helped

reduce the possibility of firms sending false signals. Yet there is no disclosure rule

that forces repurchasing firms to announce program completions including

information on the number of shares repurchased and the amount of money

spent during the authorized period.

In Japan, firms that decide to repurchase shares publicly announce not only

program authorizations but also program completions. Hence, it is appropriate

to use information contained in program completion announcements to test

the flexibility of share repurchases because completion announcements not

only include information pertaining to the number of shares bought by the

firms but also allow investors to identify whether firms continued repurchasing

by observing if firms concurrently announce new programs.

3

Therefore, the

Japanese disclosure policy framework provides an appropriate environment to

test flexibility under share repurchases.

2 Bonaime et al. (2014) present the results that managers use flexible share repurchases as a tool

for risk management. Hoberg et al. (2014) argue that firms confronted with product market

threats tend to initiate payout cash through repurchases seeking their flexibility. Rapp et al.

(2014) develop the value of financial flexibility which shareholders assign to and report that

the value of financial flexibility affects corporate payout policy.

3 Iyer and Rao (2017) analyze flexibility of share repurchase regarding continuity by testing the

negative effect of omitting or reducingrepurchase on stock prices. To get rid of the difficulty of

not being able to observe omission or reduction announcements for share repurchases, they

measure a repurchase omission or reduction on the basis of whether firms omit or reduce

repurchases compared with a pre-crisis period. The authors find that abnormal returns for

financial crisis period are significantly higher for firms omitting or reducing share repurchases

than dividends, reportingthat share repurchase are a flexible way to pay out cash.

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