1. Share repurchases and firm performance: new evidence on the agency costs of free cash flow
Nohel and Tarhan (1998, JFE)

2. Contents Abstract Introduction
Information signaling and free cash flow
Data and variables
Empirical finding and interpretation
Conclusion

3. 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

4. Information signaling hypothesis
Repurchasing sends a strong signal to lesser-informed outside investors that firm performance will be improved in the future.

5. 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.

6. 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)

7. 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

8. 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.

9. 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

10. Information signaling
Repurchasing sends a strong signal to lesser-informed outside investors that firm performance will be improved in the future.
Literatures (skip)

11. 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)

12. How to discriminate between the two hypotheses?
Three measurements:
Operating performance
Abnormal stock return
Long run returns
In this paper, three measurements are implemented.

13. Data Tender offer stock repurchase ( why not open market repurchase?)
COMPUSTAT, NYSE, AMEX, and NASDAQ
Data processing
Matching firms selection
Criterion

14. 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?)

15. Variables

16. Decomposition of cash flow return on asset
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

17. Empirical findings—univariate statistics

18. 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.

19. Regression analysis for each variable

20. The results of regression analysis

21. The results of regression analysis

22. 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?

23. 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

24. Which one drives performance improvement

25. 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.

26. Robustness check

27. Robustness check

28. 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.

29. Market reaction to repurchase

30. 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.

31. Robustness check--risk

32. Robustness check--risk

33. 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.

34. What factors result in abnormal return? —Announcement return

35. What factors result in abnormal return? —Announcement return

36. 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.

37. What factors result in abnormal return?—Long run return

38. What factors result in abnormal return?—Long run return

39. 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.

40. 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.