Dividends, Share Repurchases, and The Substitution Hypothesis
Dividends, Share Repurchases, and The Substitution Hypothesis
Dividends, Share Repurchases, and The Substitution Hypothesis
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THE JOURNAL OF FINANCE * VOL. LVII, NO. 4 * AUGUST 2002
ABSTRACT
1649
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1650 The Journal of Finance
1 The average growth rate in dividend payments declined from 15 percent in the 1970s to
4.6 percent in the 1990s.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1651
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1652 The Journal of Finance
2 As we discuss later in the paper, there is evidence that the SEC was concerned with firm
using share repurchase programs to illegally manipulate their stock prices.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1653
Most of the signaling models imply that dividends and repurchases are
perfect substitutes. For example, in Bhattacharya (1979), the signaling cost
is the transaction cost associated with raising new capital, and in Miller and
Rock (1985), it is the cost of reducing investments. Neither is related to the
choice of payout. An exception is the John and Williams (1985) model, in
which the higher taxes on dividend are the costs of the signal. This model
suggests that share repurchases and dividends are not interchangeable.
Allen et al. (2000) develop a model in which share repurchases and divi-
dends are not substitutes because the latter payout method attracts insti-
tutions. Allen et al. argue that institutional investors are more likely to
discover whether a firm is overvalued or undervalued because institutions
have better information-gathering abilities and are also better monitors. Sinc
institutions prefer dividends, only undervalued firms want to be monitor
(or signal they are undervalued); thus, these are the firms that will pay
higher dividends. This signaling equilibrium is not achieved with share
repurchases.
Investigating the extent of substitutability of dividends and repurchas
DeAngelo, DeAngelo, and Skinner (2000) examine the relation between the
disappearance of special dividends and the appearance of repurchase pro
grams. They do not find evidence that share repurchase programs have r
placed special dividends and therefore no evidence for a substitution effe
Jagannathan, Stephens, and Weisbach (2000) find that firms that pay d
idends have more stable earnings than do firms that use share repurchas
They conclude that share repurchases are used to pay out extraordinary
transitory earnings and dividends are used to pay out permanent earning
We could argue that if we just look at the sources and uses of funds ide
tity, share repurchases and dividends should be substitute payout method
This argument is correct if all else is constant. However, firms can alway
adjust their sources of funds, and therefore it is possible that dividends a
share repurchases are determined independently. For example, it is possib
that dividends are determined together with investment, as Miller and Ro
(1985) suggest, and that repurchases are determined independently. In su
mary, current theories do not provide a unique prediction on what the re
tion should be between dividends and share repurchases. It is clear that t
question of the extent to which dividends and repurchases are substitutes
a central issue, and has important implications for many of the existin
payout theories.
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1654 The Journal of Finance
For each observation in the final sample, we create the following variables
using data from Compustat: MB is equal to the book value of the total assets
plus the market value of equity minus the book value of equity, scaled by the
book value of the total assets. CASH is the book value of cash and short-
term investments (Compustat item #1) scaled by the book value of the
assets. ROA is the operating income before depreciation (Compustat it
#13) scaled by the book value of the total assets. The ar(ROA) is the stan
deviation of ROA. NOPER is the nonoperating income before depreciatio
(Compustat item #61) scaled by the book value of the total assets. DEB
the book value of total long-term debt (Compustat item #9) plus the bo
value of total short-term debt (Compustat item #44) scaled by the book valu
of the total assets.
The final sample contains 15,843 firms, and an overall total of 134,646
firm-year observations over the period 1972 to 2000.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1655
Table I
early 1980s, share repurchases were a small fraction of total earnings and
total dividends. For example, between 1972 and 1983, repurchases amounted
to an average of 10.9 percent of dividend payments. However, since the mid-
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1656 The Journal of Finance
0.35
0.3 -
0.25 -
0.2 -
0.15 -
0.1 -
0.05 -
1972 1975 1978 1981 1984 1987 1990 1993 1996 1999
Year
Figure 1. Cash distributions to equityholders. This figure depicts the equally weighted
average total payout ratio, dividend payout ratio, and repurchase payout ratio for a sample of
U.S. firms. The data sample consists of all firm-year observations on Compustat (Full-
Coverage, Primary, Secondary, Tertiary, Research, and Back Files) over the period 1972 to 2000
that have available information on the following variables: REPO, DIV, EARN, and MV. REPO
is the expenditure on the purchase of common and preferred stocks (Compustat item #115)
minus any reduction in the value (redemption value) of the net number of preferred shares
outstanding (Compustat item #56). DIV is the total dollar amount of dividends declared on the
common stock (Compustat item #21). EARN is the earnings before extraordinary items (Com-
pustat item #18). MV is the market value of common stock (Compustat item #24 times Com-
pustat item #25). The sample used in this analysis only includes firms with positive earnings.
To mitigate the effect of outliers, we eliminate observations with a total payout ratio greater
than one.
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Table II
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1658 The Journal of Finance
1979, 1980 to 1983, 1984 to 1987, 1988 to 1991, 1992 to 1995, and 1996 to
2000. For example, if a firm pays dividends in 1981 and repurchases shares
in 1982, then we classify this firm as a dividend-paying and repurchasing
firm (DIV > 0, REPO > 0) during the period 1980 to 1983. (We repeat all
analyses when we define a subperiod as one year. The results are qualita-
tively the same.)
Table II reveals several interesting facts about the relation between firms'
characteristics and payout policy. First, dividend-paying firms (DIV > 0) are
much larger and more profitable than firms that do not pay dividends
(DIV = 0). For example, the average (median) market value of firms that
pay dividends and do not use repurchases is $1,076.2 million ($102.8 mil-
lion) and $1,803.6 million ($144.9 million) for firms that both pay dividends
and repurchase. The average (median) market value of firms that do not pay
dividends and do not repurchase is $167.5 million ($16.3 million) and $359.0
million ($28.2 million) for firms that only repurchase. In addition, firms that
pay dividends have a lower variability of return on assets [f(ROA)] than
firms that do not pay dividends (regardless of their repurchase policy). The
mean (median) standard deviation of the return on assets is 3.6 percent
(2.6 percent) for firms that only pay dividends (DIV > 0, REPO = 0), and
3.4 percent (2.5 percent) for firms that pay dividends and repurchase shares
(DIV > 0, REPO > 0). Overall, it seems that the firms that pay dividends
but do not repurchase shares (DIV > 0, REPO = 0) are similar to those that
pay dividends and repurchase shares (DIV > O, REPO > 0).
Firms that repurchase shares but do not pay dividends (DIV = 0, REPO > 0)
appear to have similar characteristics to firms that do not pay out any cash
(DIV = O, REPO = 0). These are small, high market-to-book firms with high
earnings volatility. The average (median) standard deviation of the return
on assets is 7.5 percent (4.9 percent) for repurchasing non-dividend-paying
firms and 9.4 percent (6.1 percent) for nonpayers. There is a big difference
in earnings volatility between firms that pay dividends and those that do
not pay dividends.
The relation between earnings volatility and payout method is important
given the possibility that firms with higher earnings volatility may tend to
pay out more in the form of repurchases rather than dividends. A relevant
comparison is the findings of Jagannathan et al. (2000). Like them, we
find that firms that only repurchase have higher earnings volatility than
do firms that only pay dividends. Moreover, we find that repurchasing
firms are younger than dividend-paying firms: Only 34.1 percent of the
repurchasing firms (DIV = 0, REPO > 0) in our sample have been traded
for more than eight years. In contrast, we find that 63.4 percent of the
dividend paying firms (DIV > 0) in our sample have been traded for more
than eight years.3
3 CRSP started to report data on Nasdaq stocks only in 1972. Restricting our sample to the
period 1980 to 2000, we can classify firms to "young" and "old" using eight years of trading as
the cutoff.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1659
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1660 The Journal of Finance
Table III
grams. As a percentage of th
their shareholders, the number
cent in 1972 to 80 percent in
firms only paying dividends
distributing cash to their shar
20 percent in 2000. Since the
almost constant over time, th
displacing dividends. This evidence is also consistent with the recent find-
ings of Fama and French (2001) that the proportion of dividend-paying firms
has declined over time. However, contrary to their results, we find evidence
consistent with substitution.
Figure 3 shows the proportion of cash distribution initiations by payo
method over the period 1974 to 2000. We define a cash distribution initi
tion as the first time that a firm pays dividends and/or repurchases sh
after 1972. This figure shows that the proportion of firms that initia
cash distribution using only share repurchases increased from less than 27 p
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Dividends, Share Repurchases, and the Substitution Hypothesis 1661
0.8
0.7-
0.6 -
0.5-
0.4 -
0.3 -
0.2 -
0.1
1972 1975 1978 1981 1984 1987 1990 1993 1996 1999
Year
Figure 2. Distribution of firms by payout method. This figure depicts the distribution of
firms by payout method for a sample of U.S. firms. We determine the payout policy of a firm by
observing the cash disbursements of the firm over a period of a year. The data sample consists
of all firm-year observations on Compustat (Full-Coverage, Primary, Secondary, Tertiary, Re-
search, and Back Files) over the period 1972 to 2000 that have available information on the
following variables: REPO, DIV, EARN, and MV. REPO is the expenditure on the purchase of
common and preferred stocks (Compustat item #115) minus any reduction in the value (re-
demption value) of the net number of preferred shares outstanding (Compustat item #56). DIV
is the total dollar amount of dividends declared on the common stock (Compustat item #21).
EARN is the earnings before extraordinary items (Compustat item #18). MV is the market
value of common stock (Compustat item #24 times Compustat item #25). The data sample
contains 136,646 firm-year observations and excludes banks, utilities, and insurance companies.
cent in 1974 to more than 84 percent in 2000. This evidence indicates that
share repurchases have become the preferred method of payout among firms
initiating cash distributions to their equityholders.
Finally, we can draw a more complete picture by examining the dynamics
of firms' payout methods during this time period. Table IV reports the tran-
sition probabilities of changing from payout policy i at time T - 1 to payout
policy j at time T. As before, we determine the payout policy of a firm by
observing the cash disbursements of the firm over the following time peri-
ods: 1972 to 1975, 1976 to 1979, 1980 to 1983, 1984 to 1987, 1988 to 1991,
1992 to 1995, and 1996 to 2000. The firm's payout policy can fall into one of
four categories in each period: (1) no cash distribution, (2) only dividends,
(3) only repurchases, and (4) both dividends and repurchases. The transi-
tions probabilities are equal to the number of firms changing their payout
policy from i to j divided by the total number of firms with payout policy i at
time T - 1.
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1662 The Journal of Finance
0.9
0.8 -
0.7 -
0.6 -
0.5 -
0.4 -
0.3 -
0.2 -
0.1 -
Year
Figure 3. Cash distribution initiations. This figure depicts the proportion of cash distribu-
tion initiations by payout method for a sample of U.S. firms. We define a cash distribution
initiation as the first time that a firm pays dividends and/or repurchases shares after 1973.
The data sample consists of all firm-year observations on Compustat (Full-Coverage, Primary,
Secondary, Tertiary, Research, and Back Files) over the period 1972 to 2000 that have available
information on the following variables: REPO, DIV, EARN, and MV. REPO is the expenditure
on the purchase of common and preferred stocks (Compustat item #115) minus any reduction in
the value (redemption value) of the net number of preferred shares outstanding (Compustat
item #56). DIV is the total dollar amount of dividends declared on the common stock (Compu-
stat item #21). EARN is the earnings before extraordinary items (Compustat item #18). MV is
the market value of common stock (Compustat item #24 times Compustat item #25). The data
sample contains 134,646 firm-year observations and excludes banks, utilities, and insurance
companies.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1663
Table IV
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1664 The Journal of Finance
with 16.38 percent in the later period (Panel D). Firms that have been re-
purchasing (but not paying dividends) continue to do so at a higher propor-
tion in the later period (55.51 percent vs. 30.66 percent). Fourth, that during
the period 1972 to 1979, of the firms that only repurchased in a given pe-
riod, 15.1 percent switched to only paying dividends in the following period
and 29.06 percent switched to using both methods of payments. Only 1.24
percent and 6.28 percent, respectively, of the firms follow this strategy in
the later period. Finally, firms that use both methods of payment are less
likely to switch to only dividends in the later periods. In the earlier period
(Panel B), 37.52 percent of firms that have been using both methods to dis-
tribute cash to equityholders in period t - 1 switch to only dividends in
period t. In the later period (Panel D), the proportion drops to 16.38 percent.
In the 1972 to 1979 period, 57.52 percent of firms that paid in the form of
dividend and repurchases continue to do so, compared with 73.74 percent in
the 1990s. (Using a binomial test, we find that all the differences discussed
above are significantly different from zero at the one percent level.)
Overall, the results in Table IV indicate that relative to the 1970s, U.S.
corporations are more likely to use share repurchase programs and less likely
to use dividends. It seems that corporations have been changing their pref-
erences on the form of payout they use to distribute cash.
Using a different measure of share repurchases, a recent paper by Fama
and French (2001) does not detect a strong relation between share repur-
chase activity and changes in dividends. The Fama and French measure
may cloud the relation between dividends and repurchases, since their mea-
sure of repurchases (either the change in Treasury stocks or the amount
repurchased minus amount issued by the firm) involves not only repurchase
activity, but also equity issuance and payment to labor in the form of stock
options.
This measure may pose two problems. First, since our objective is to com-
pare dividends to repurchases, we do not want to subtract another financing
activity of the firm (equity issuance) from repurchases and not from divi-
dends. Otherwise, we would be comparing net repurchase activity to gross
dividends. Second, the exercise of stock options decreases the amount of
Treasury stocks, and therefore results in an underestimate of the true amount
that was repurchased (see also Stephens and Weisbach, 1998). Moreover,
stock options are a form of payment to labor and should be viewed as such.
Thus, by calculating the net change in Treasury stocks, we might be mea-
suring a net impact of financing (repurchases and equity issuance) and in-
vestment decisions (payment to labor).
For example, imagine a firm that repurchases 1,000 shares, say for $10,000,
and then a few months later the firm turns around and gives these shares
to its CEO as part of her compensation. The firm is involved in two distinct
actions. The first is a financing action (repurchase shares), and the second
is an investment decision (to pay the manager). In this example, the net
change in Treasury stocks is zero. Thus, this measure of repurchase could
underestimate the extent of repurchase activity since it combines payment
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Dividends, Share Repurchases, and the Substitution Hypothesis 1665
to labor through stocks and repurchase of shares. Indeed, Stephens and Weis-
bach (1998) show that measuring repurchase activity through changes in
Treasury stocks results in estimates that are 60 percent lower than the mea-
sures that use the cash amount spent on repurchases (as we do) or the amount
firms announce they will repurchase.
4 Using such firms results in more precise parameters for the Lintner (1956) model. We
repeat the analysis by using portfolios of firms instead of individual firms. The results are
qualitatively the same.
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1666 The Journal of Finance
5 We note that the number of observations varies across groups. The reason for this is that
RYIELD is not uniformly distributed.
6 We also ran a simple regression of the ERROR on RYIELD, and found that the coefficient
of RYIELD is negative and significantly different from zero at the one percent level.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1667
Table V
where ADJVt,j is the actual change in dividends at time t, EARNt,i is the earnings at time t,
DIVt_, i is the dividend level at t - 1, and MVt_,i is the market value of equity at time t - 1.
The coefficients /3i,, fP2,, and P3 3 are the parameters of Lintner's (1956) model that have been
estimated for each firm over a preforecast period. To be included in the sample, each firm must
have paid dividends continuously over the entire preforecast period. If the absolute value of the
forecasting error is greater than five percent, then the observation is eliminated to reduce the
effect of extreme values. RYIELD is the total expenditure on share repurchases at time t scaled
by the market value of equity at time t - 1. DYIELD is the total expenditure on dividends at
time t scaled by the market value of equity at time t - 1. The number of observations varies
across groups because RYIELD is not uniformly distributed. RYIELD and DYIELD have been
truncated at the 99th percentile.
Preforecast Entire 1 5
Period Sample (Low) 2 3 4 (High) (5-1)
1973-1983
ERROR
Mean 0.017%b 0.044%a 0.030%b -0.034% -0.149%a -0.144%a -0.188%a
Median -0.009% 0.012%a -0.005%b -0.041%a -0.108%a -0.177%a -0.189%a
N 9,521 4,354 3,558 896 342 371
RYIELD
Mean 1.61%a 0.00% 1.01%a 4.29%a 7.27%a 14.61%a 14.61%a
Median 0.06%a 0.00% 0.81%a 4.19%a 7.06%a 12.70%a 12.70%a
N 9,521 4,354 3,558 896 342 371
DYIELD
Mean 2.82%a 3.00%a 2.66%a 2.68%a 2.52%a 2.82%a -0.18%b
Median 2.70%a 2.86%a 2.56%a 2.57%a 2.41%a 2.79%a -0.07%
N 9,521 4,354 3,558 896 342 371
1973-1990
ERROR
Mean -0.088%a -0.060%a -0.079%a -0.119%a -0.237%a -0.326%a -0.266%a
Median -0.026%a -0.001% -0.021%a -0.072%a -0.117%a -0.221%a -0.220%a
N 4,116 1,713 1,712 429 154 108
RYIELD
Mean 1.47%a 0.00% 1.04%a 4.23%a 7.21%a 12.31%a 12.31%a
Median 0.16%a 0.00% 0.86%a 4.11%a 7.00%a 11.34%a 11.34%a
N 4,116 1,713 1,712 429 154 108
DYIELD
Mean 2.64%a 2.88%a 2.53%a 2.41%a 2.06%a 2.32%" -0.56%a
Median 2.48%a 2.75%" 2.39%a 2.28%a 1.99%" 2.23%a -0.52%a
N 4,116 1,713 1,712 429 154 108
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1668 The Journal of Finance
a spurious correlation between the dividend forecast error and the share
repurchase yield, because the increase in earnings volatility could be caus-
ing both the decline in dividends and the increase in share repurchases.
That is, it is possible that firms with high-repurchase yields have differ-
ent characteristics than firms with low-repurchase yields. Therefore, the
apparent substitution effect could be caused only by differences in firm
characteristics.
Therefore, we control for several factors that might affect the decision
the method of payment. In Table VI, we report the results of cross-
sectional regressions of the dividend forecast error on the repurchase yield,
the logarithm of size, the return on assets, the volatility of return on as-
sets, the nonoperating income scaled by total assets, and the debt-to-total
assets ratio. To reduce the effect of cross-correlated residuals, we use Fama
and Macbeth (1973) type regressions to estimate the coefficients and stan-
dard errors. First, we estimate year-by-year annual average coefficients.
Then, we estimate time-series averages for each coefficient. We estimate
the standard errors by using the Hansen-Hodrick standard error correc-
tion method.
Our results indicate that the repurchase yield has a negative effect on
the dividend forecast error even after we control for firm characteristics.
The average regression coefficient of RYIELD is equal to -0.01312 when
preforecast period is 1973 to 1983 and -0.01766 when the preforecast p
is 1973 to 1990. These coefficients are significantly different from zer
the one percent confidence level.
The evidence in this section seems to suggest that dividend-paying fi
have been substituting dividends with share repurchases.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1669
Table VI
Preforecast Period
1973-1983 1973-1990
a Significantly
different from zero
parentheses.
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1670 The Journal of Finance
7 Conditioning on the firm repurchasing shares in only the prior year (rather than in the two
years before the announcement of dividend reduction), we find similar results.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1671
Table VII
Difference
Entire Nonrepurchasing Repurchasing (Repurchasing -
Sample Firms Firms Nonrepurchasing)
CAR
Mean -1.59%a -1.93%a -0.45% 1.48%a
Median -0.58%a -0.72%a 0.10% 0.82%a
N 1,253 965 288
CHGDIV
Mean -43.42%a -43.91%" -41.78%" 2.13%b
Median -44.44%a -44.44%a -43.54%" 0.90%b
N 1,255 967 288
CARit = Po + 31DU
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1672 The Journal of Finance
Table VIII
The sample consists of firms that reduce their cash dividends during the period 1974 to 1996.
Each observation in the sample satisfies the following criteria: (1) the firm's financial data is
available on CRSP and Compustat, (2) its dividend is paid quarterly, (3) the dividend is taxable,
(4) the cash dividend change is greater than 10 percent, and (5) the cash dividend is not an
omission. CAR is the three-day cumulative abnormal return around the announcement of the
dividend decrease. DUMREPO is a dummy variable that is equal to one if the firm has repur-
chased shares over the two years prior to the announcement of the dividend decrease, zero
otherwise. CHGDIV is the percentage change in the cash dividend payment. SIZE is the log-
arithm of the book value of the total assets at the time of the announcement of the cash divi-
dend decrease. DYIELD is the dividend yield at the time of the announcement of the cash
dividend decrease. ROA is the operating income before depreciation scaled by the book value of
the total assets. DROAO is the change in ROA from year -1 to year 0 (year of the event).
DYIELD has been truncated at the 99th percentile. ROA has been truncated at the 1st and 99th
percentiles. We use Fama-MacBeth type regressions to estimate the coefficients and standard
errors. First, we estimate year-by-year annual average coefficients. Then, we estimate time-
series averages for each coefficient. We estimate the standard errors using the Hansen-Hodrick
standard error correction method.
Intercept 3.6402a
(6.48)
DUMREPO 1.1423a
(7.45)
CHGDIV 0.0640a
(15.56)
SIZE 0.10927
(0.58)
DYIELD -67.1891a
(58.46)
DROAO 12.0684a
(6.08)
a Significantly different from zero at the 1 percent level. Wald statistics are reported in paren-
theses.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1673
8 Following Ikenberry, Lakonishok, and Vermaelen (1995), we exclude this period from the
sample because many corporations established open-market share repurchase programs during
this period to stabilize their stock prices after the market crash of October 1987. Furthermore,
during this period, many companies did not announce the number of shares to repurchase over
the duration of the program.
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1674 The Journal of Finance
Table IX
CAR
Mean 3.13%a 4.03%a 2.94%a -1.09%b
Median 2.19%a 3.09%a 1.89%a -1.20%a
N 2,331 416 1,915
PSOUGHT
Mean 6.70%a 5.87%a 6.88%a 1.01%a
Median 5.00%a 4.60%a 5.00%a 0.40%a
N 2,331 416 1,915
Table IX indicate that the mean (median) market reaction around the an-
nouncement of share repurchase programs declined after the Tax Reform
Act of 1986, from 3.49 percent (2.56 percent) to 2.42 percent (1.65 percent).
The difference in the market reaction is significantly different at the 1 per-
cent level. Since the average magnitude of share repurchase programs
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Dividends, Share Repurchases, and the Substitution Hypothesis 1675
(PSOUGHT) increased slightly after the Tax Reform Act of 1986, we cannot
attribute the decline in the average market reaction after the tax reform to
differences in the magnitude of the programs.
Since many repurchase programs that were authorized after the TRA of
1986 were announced by firms with previous announcements, we could ar-
gue that the decline in the average market reaction after 1986 is related to
the fact that share repurchase programs became more predictable. To inves-
tigate this possibility, Panel B of Table IX reports the market reaction for
only first-time announcements. We define a first-time announcement as the
first announcement made by a particular firm over the period 1980 to 1997.
Consistent with our previous findings, the average (median) market reac-
tion declined after the TRA of 1986, from 4.03 percent (3.09 percent) to 2.94
percent (1.89 percent).
To control for other factors that might affect the market reaction around
share repurchase programs, we estimate the following cross-sectional
regression:
(3)
where CAR is the three-day cumulative abnormal return around the an-
nouncement of the open market share repurchase program, TAXt is the tax
differential between the top marginal tax rate on ordinary income and the
top marginal tax rate on capital gains, Log(PSOUGHT) is the logarithm of
the amount of shares authorized for repurchase scaled by the number of
shares outstanding at the time of the announcement, SIZE is the logarithm
of the book value of the total assets at the time of the announcement of the
repurchase program, and DYIELD is the dividend yield at the time of the
announcement of the repurchase program.
Table X presents the estimated coefficients from this cross-sectional re-
gression. It shows that the differential tax variable is positively related to
the market reaction surrounding open market share repurchase programs
(and significant at the five percent level). We obtain similar results when w
include only first-time announcers in the sample (last column of the table)
Not surprisingly, the regression also indicates that the market reaction i
inversely related to the market value of equity (i.e., larger firms experienc
a small market reaction to announced repurchases), and it is positively re-
lated to the amount of the announced repurchase.9
9 We also estimate a regression in which, for each year, the ordinary income and the capita
gains income tax rates are two separate variables. We find that only the coefficient of th
ordinary income tax rate is positive and significant, indicating that the source of tax savings
comes from the variation in the ordinary income tax rate.
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1676 The Journal of Finance
Table X
The sample consists of firms that establish open-market share repurchase programs over the
period 1980 to 1997 and that satisfy the following criteria: (1) the firm's financial data is
available on CRSP and COMPUSTAT, (2) the share repurchase announcement does not coincide
with the announcement of a dividend change, (3) the firm discloses the number or the percent-
age of shares sought during the duration of the share repurchase program, and (4) the an-
nouncement of the share repurchase program is not made during the last quarter of 1987. CAR
is the three-day cumulative abnormal return around the announcement of the share repurchase
announcement. TAX is the tax differential between the top marginal tax rate on ordinary in-
come and the top marginal tax rate on capital gains. Log(PSOUGHT) is the logarithm of
the amount of shares authorized for repurchase scaled by the number of shares outstanding at
the time of the announcement. SIZE is the logarithm of the book value of the total assets at the
time of the announcement of the repurchase program. DYIELD is the dividend yield at the time
of the announcement of the repurchase program. DYIELD has been truncated at the 99th
percentile. We define a first-time announcement as the first announcement made by a partic-
ular firm over the period 1980 to 1997. The standard errors of the coefficients have been ad-
justed for heteroskedasticity using White's (1980) procedure. The significance levels of the
estimated coefficients are based on a two-tailed t-test.
a,b Significantly d
T-statistics are rep
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Dividends, Share Repurchases, and the Substitution Hypothesis 1677
Indeed, for decades, the SEC has occasionally charged companies with
illegally manipulating their stock prices during share repurchase pro-
grams.10 Due to the unique nature of stock buybacks, the SEC has been
concerned that repurchasing firms might be engaging in certain types o
activities that might disrupt the natural order of financial markets. But
until 1982, there were no explicit rules directly regulating share repurchas
activity in the United States. This situation exposed repurchasing firms to
the risk of triggering a SEC investigation and being charged with illegal
market manipulation. Since the direct and indirect costs of a regulatory in
quiry can be very large (see Feroz, Park, and Pastena (1991), Karpoff and
Lott (1993), Nourayi (1994), and Beatty, Bunsis, and Hand (1998)), it seem
that firms were indeed deterred from repurchasing shares.11
10 See, for example, Genesco, Inc., (1964-66 Transfer Binder) Fed. Sec. L. Rep. (CCH) ?77,354
(May 10, 1966); SEC v. Georgia-Pacific Corporation, (1964-66 Transfer Binder) Fed. Sec.
Rep. (CCH) 1[91,680, (S.D.N.Y. 1960) (complaint); and Atlantic Research Corp., Sec. Exch. A
Release No. 4657 (December 6, 1963), (1961-64 Transfer Binder) Fed. Sec. L. Rep. (CCH) [76,9
11 Since the antimanipulative provisions of the SEA of 1934 apply to all participants involve
in an illegal manipulation scheme, this situation may have also deterred brokers and speci
ists from participating in share repurchase programs as well.
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1678 The Journal of Finance
Aware of this problem, the SEC started to design guidelines for corpora-
tions on how to carry out share repurchase programs without raising sus-
picions of manipulative behavior. In 1967, the SEC proposed Rule 10b-10,
which, if it had been approved, would have required repurchasing firms to
disclose information and to comply with certain mandatory rules on the price,
time, volume, and manner of share repurchases.12 In 1970, the SEC pro-
posed Rule 13e-2, which in essence was very similar to Rule 10b-10.13 Other
versions of Rule 13e-2 were proposed in 1973 and 1980.14 However, the SEC
did not adopt any of these rules.
As part of the deregulation wave of the early 1980s, the SEC finally ap-
proved legislation to regulate open-market share repurchases. In 1982, the
SEC adopted Rule 10b-18, which provides a safe harbor for repurchasing
firms against the antimanipulative provisions of the Securities Exchange
Act (SEA) of 1934.15 Rule 10b-18 was adopted to establish guidelines for
repurchasing shares on the open market without violating Sections 9 (a) (2)
or 10 (b) of the SEA of 1934.16 In general, Rule lOb-18 requires that firms
repurchasing shares on the open market should only use one broker or dealer
on any single day, avoid trading on an uptick or during opening or the last
half-hour before the closing of the market, and limit the daily volume of
purchases to a specified amount.
After the adoption of Rule lOb-18 in 1982, the chairman of the SEC at that
time, John Shad, expressed that "without the change, companies are inhib-
ited from making big open-market buys" (Wall Street Journal (1982, p. 2)).
Apparently, the adoption of this rule represented a major change in the SEC's
regulatory policy. John Evans, a SEC commissioner at that time, said "this
is much-reduced regulation from what we had before" (Wall Street Journal
(1982, p. 2)), suggesting that share repurchases were heavily regulated be-
fore the adoption of Rule 10b-18.
Thus if managers were reluctant to repurchase shares because of the po-
tential risk of being charged with illegal market manipulation, then share
repurchase activity should have increased significantly after the adoption of
Rule 10b-18 in 1982.
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Dividends, Share Repurchases, and the Substitution Hypothesis 1679
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1680 The Journal of Finance
Table XI
where /lt (/itI) is the sample mean of the variable of interest over the period 1972 to 1982 (1983
to 2000) and a(2 (r-2) is the sample variance of ti (/ii). The data sample consists of all firm-
year observations on Compustat (Full-Coverage, Primary, Secondary, Tertiary, Research, and
Back Files) over the period 1972 to 2000 that have available information on the following
variables: REPO, DIV, EARN, and MV. REPO is the expenditure on the purchase of common
and preferred stocks (Compustat item #115) minus any reduction in the value (redemption
value) of the net number of preferred shares outstanding (Compustat item # 56). DIV is the
total dollar amount of dividends declared on the common stock (Compustat item #21). EARN is
the earnings before extraordinary items (Compustat item #18). MV is the market value of
common stock (Compustat item #24 times Compustat item #25). The data sample contains
134,646 firm-year observations and excludes banks, utilities, and insurance companies. ADREPO
is REPO adjusted for inflation using the producer price index (PPI). PAY is the total payout
(REPO + DIV). 1i represents the aggregation of data by calendar year. We use the bounds test
proposed by Ohtani and Kobiyashi (1986) to determine the significance levels of the Wald statistics.
liADREPO
(millions of $)
Mean 40,575 5,528 61,993 56,465 16.6a
i REPO/Ei DIV
Mean 38.31% 10.44% 55.35% 44.91% 28.7a
EiREPO/EiPAY
Mean 24.53% 9.29% 33.85% 24.56% 51.0a
Ei REPOl/i EARN
Mean 17.39% 4.18% 25.46% 21.28% 47.9a
, i REPO/Ei MV
Mean 0.96% 0.42% 1.30% 0.88% 30.4a
market activity, we use the one-year return on the market value of equity of
the firms in our main sample (MRET). We also include a time trend variable
to control for any learning effect (TIME).
To examine the effect of the different factors on the time-series behavior of
share repurchase programs, we estimate the following time-series regression:
(5)
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Dividends, Share Repurchases, and the Substitution Hypothesis 1681
Table XII
et = At + 0oit-1.
The data sample consists of all firm-year observations on Compustat (Full-Coverage, Primary,
Secondary, Tertiary, Research, and Back Files) over the period 1972 to 2000 that have available
information on the following variables: REPO, DIV, EARN, and MV. REPO is the expenditure
on the purchase of common and preferred stocks (Compustat item #115) minus any reduction in
the value (redemption value) of the net number of preferred shares outstanding (Compustat
item #56). DIV is the total dollar amount of dividends declared on the common stock (Com-
pustat item #21). EARN is the earnings before extraordinary items (Compustat item #18). MV
is the market value of common stock (Compustat item #24 times Compustat item #25). The data
sample contains 136,646 firm-year observations and excludes banks, utilities, and insurance
companies. REG is a dummy variable that is equal to one if the year is greater than or equal
to 1983, zero otherwise. TAX is the tax differential between the top marginal tax rate on or-
dinary income and the top marginal tax rate on capital gains. TIME is a time trend variable.
MRET is the one-year return on the aggregate market value of common stock. 1i represents the
aggregation of data by calendar year.
Equation 1 Equation 2
Since preliminary tests indicate that the residuals of this model seem to
follow a MA(1) process, we assume that
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1682 The Journal of Finance
for other factors, the effect of Rule 10b-18 on share repurchase activity ap-
pears to be highly significant. Moreover, we note that the coefficient of the
tax differential, TAX, is positive and statistically significant, which indi-
cates that share repurchase activity is positively correlated with the relative
tax benefit of capital gains (after controlling for the change in regulation).
This result suggests that taxes are a significant determinant of share re-
purchase activity. This evidence is consistent with the recent findings in Lie
and Lie (1999) and Sarig (2000), which indicate that the propensity to re-
purchase shares increases with the relative tax benefit of capital gains.
Overall, the evidence in this section suggests that the adoption of Rule
lOb-18 had a positive and significant impact on share repurchase activity. It
seems that corporations were deterred from repurchasing shares before the
adoption of Rule 10b-18. However, with the adoption of this safe-harbor rule
and thus no longer being threatened with being charged with stock manip-
ulation, corporations have begun substituting repurchases for dividends.
VII. Conclusion
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Dividends, Share Repurchases, and the Substitution Hypothesis 1683
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