Information Content and Intra‐industry Effects of Cash Refund Capital Reduction Announcements in Taiwan

• Published date: 01 June 2016
• Author: Chu‐hsuan Chang,Te‐kang Lu
• Date: 01 June 2016
• DOI: http://doi.org/10.1111/ajfs.12134

Information Content and Intra-industry

Effects of Cash Refund Capital Reduction

Announcements in Taiwan*

Chu-hsuan Chang**

College of Business, National Taipei University of Business

Te-kang Lu

College of Commerce, Chien Hsin University of Science and Technology

Received 13 February 2015; Accepted 20 January 2016

Abstract

Capital reduction through returning cash to shareholders is one mechanism by which firms

distribute their surpluses. While distribution of excess funds can lower agency costs, it may

also signal a decline in the firm’s future investment opportunities. In this paper, we examine

the information content and information transfer effects of the announcement of capital

reduction and cash distribution in Taiwan during the period 2002–2010. We find that there

is a significantly positive market reaction when Taiwanese firms announce a reduction in

their capital and return cash to shareowners. We also document contagion intra-industry

effects by showing that portfolios of rival firms in the same industry experience a significant

and contemporaneous positive stock price performance. Consistently, our results support the

free cash flow hypothesis of contagion intra-industry effects in the long-run stock return and

operating performance of firms following cash refund capital reduction announcements.

Moreover, multivariate analysis indicates that these contagion effects are influenced by com-

petitors’ features, which are negatively correlated with competitors’ size and growth opportu-

nity, and positively influenced by their dividend policy and ownership structure.

Keywords Capital reduction; Contagion effects; Agency costs; Payout policies

JEL Classification: G14, G35

1. Introduction

Capital reduction and cash distribution is one mechanism by which a company can

return cash to its shareholders and deduct the corresponding paid-up capital

*The authors thank the editor and two anonymous referees for their insightful comments

and suggestions.

**

Corresponding author: Chu-hsuan Chang, College of Business, National Taipei University

of Business, 321, Sec 1, Jinan Rd, Taipei 100, Taiwan. Tel: +886-2-2322-6389, Fax: +886-2-

2322-6378, email: ntcbcch@ntub.edu.tw.

Asia-Pacific Journal of Financial Studies (2016) 45, 405–438 doi:10.1111/ajfs.12134

©2016 Korean Securities Association 405

contributed by shareholders. Unlike regular dividend payouts drawn from the com-

pany’s current-year profits or cumulative retained earnings, capital red uction and

cash distribution constitutes a transfer of capital from the company back to its

shareholders. The advantages of returning the surplus to shareholders and the cor-

responding capital reduction (hereafter also called the cash refund capital reduc-

tion) include: (i) enhancing shareholders’ value through improved financial ratios,

such as return on equity (ROE) and earnings per share (EPS); (ii) achieving a more

efficient capital structure; and (iii) mitigation of the agency problem. However,

investors may infer overall lower prospects for growth from the announcement of a

cash refund capital reduction. The investor may conjecture that the firm faces poor

investment opportunities, and as a result, the company has returned its excess sur-

plus and taken the corresponding capital reduction.

Jensen (1986) identifies conflicts of interest between shareholders and managers

over payout policies. Payouts to shareholders may reduce the resources under man-

agerial control, reducing managers’ power. Recently, for many Taiwanese firms,

capital reduction and cash distribution programs have become an important payout

method, along with cash dividends and share repurchases. Although the results for

the firm’s financial ratios are similar for both cash refund capital reduction and

share repurchase, some important features of these methods are different. First,

potentially contradictory signals may be sent by these payout methods. While open

market share repurchase signals to the market that the firm has better prospects

(Bhattacharya, 1979; Vermaelen, 1984; Miller and Rock, 1985), whether the marke t

has positive or negative reactions to cash refund capital reduction announcements

is still an open question. The market may be expected to react positively to cash

refund capital reduction announcements because these events are associated with a

reduction in the agency costs of free cash flows, or react negatively because of the

anticipation of a decline in investment opportunities and the changes in competi-

tion associated with a large deduction of equity. Second, a cash refund capital

reduction will result in a corresponding cancellation of shares while each share-

holder maintains the same proportionate shareholding in the company. The owner-

ship structure will not be changed after a cash refund capital reduction. Thus,

managers may choose different kinds of payout methods to handle the variations in

ownership structure. Third, the scale of distribution of these two methods is quite

different. Though the Taiwanese government restricts the maximum ratio of buy-

back to 10% of the company’s outstanding shares,

1

there is no limitation on cash

refund capital reduction. Therefore, the magnitude of capital reduction through

simple refunding is greater and will achieve a more efficient capital structure than

repurchasing shares. On average, the cash refund capital reduction rate of Tai-

wanese firms was 25.35% during the period 2002 to 2010. After a cash refund capi-

tal reduction, the company’s financial ratios, such as EPS and ROE, will increase

1

The related regulation for repurchases is listed in the Taiwanese Securities and Exchange

Act, Article 28-2.

C. Chang and T. Lu

406 ©2016 Korean Securities Association

more markedly than after buying back shares. Fourth, in contrast to share repur-

chase, which may transfer wealth to nonparticipating shareholders from participat-

ing (selling) shareholders when shares are undervalued, a cash refund capital

reduction has no wealth transfer effects for any shareholders. Therefore, this kind of

payout mechanism, combined with capital adjustment, has become prevalent in

Taiwan.

2

In addition to Taiwan, since 2006 Singapore has also allowed companies

to adopt capital reduction by returning cash to shareholders.

3

Extant studies show that peer firm behavior also affects intra-industry corporate

financial policies (see e.g., Graham and Harvey, 2001). Previous research has shown

how the behavior of a firm affects other firms belonging to the same industry via

intra-industry information effects. Lang and Stulz (1992) find that intra-industry

transformation effects suggest that investors will use the information release of one

firm to make inferences about competing firms in the same industry. The “conta-

gion effect” refers to the phenomenon whereby a company’s external decl aration,

whether positive or negative, conveys the status of the industry and results in con-

sistent stock price movements for both issuing firms and rival firms. Conversely,

the “competitive effect” occurs when the message conveyed by the announcement

causes the company’s stock price and those of others in the industry to move in

opposite directions. In addition to exploring whether cash refund capital reduction

announcements are overall good news or bad news for investors, we further investi-

gate how the market responds to industry peers. We expect that one of the reasons

for the consistent stock price reaction for issuing firms and competitors (contagion

effect) is that the market consistently interprets the information content of the

announcement of refunding as being associated with capital reductions. Firms

within the same industry tend to act in similar ways because they share similar eco-

nomic prospects. Conversely, if the stock movements of competing companies

within the industry are different from those of the firm making the capital reduc-

tion announcement, the market may interpret the declaration as an indication of

relative changes in firm size and competitive position within the industry, resulting

in the competitive effect.

In this paper, we provide an empirical test of stock price responses to

announcements of capital reduction and cash distribution for announcing firms

and their peer companies in the same industry. Although there is a substantial body

2

The most famous capital reduction and cash distribution event in Taiwan’s history is that of

the Regent Hotel (stock code 2707). In 2002, the board of directors of the Regent Hotel

decided to return half their capital to shareholders at NT$5 per share. The Regent’s stock

price increased from NTD$15 to NTD$22 per share within 2 weeks.

3

According to ShareInvestor of June 8, 2012, “subject to the approval of the shareholders and

the High Court of the Republic of Singapore, a capital reduction exercise may or may not

result in a cancellation of shares or a change in the number of shares held by shareholders

though par value (where applicable) of each share will be reduced correspondingly while each

shareholder maintains the same proportionate shareholding in the company.”

Cash Refund Capital Reduction Announcements in Taiwan

©2016 Korean Securities Association 407