SHARE REPURCHASES AND THE FLEXIBILITY HYPOTHESIS

• Date: 01 September 2017
• Author: Subramanian Rama Iyer,Ramesh P. Rao
• Published date: 01 September 2017
• DOI: http://doi.org/10.1111/jfir.12125

SHARE REPURCHASES AND THE FLEXIBILITY HYPOTHESIS

Subramanian Rama Iyer

University of New Mexico

Ramesh P. Rao

Oklahoma State University

Abstract

Using the financial crisis as a natural experiment, we test whether repurchases are more

flexible than dividends. We document that the proportion of repurchasing firms that

reduced repurchase payouts is greater than the proportion of dividend payers that

reduced their dividends during the financial crisis period. We find that the market

performance of repurchase-reducing firms is better than that of dividend-reducing firms

over the financial crisis period. Finally, we find that the operating performance of share

repurchasers is better than dividend payers during the financial crisis and postcrisis

periods. Overall, we conclude that share repurchases are more flexible than dividends.

JEL Classification: G35

I. Introduction

Firms distribute cash through dividends and through share repurchases. Over the last two

decades, share repurchases have become increasingly popular and dividends less so.

1

One key differentiating factor between dividends and share repurchases is the potential

flexibility offered by the latter. Brav et al. (2005) survey financial executives and find that

managers like the flexibility of share repurchases and dislike the rigidity of dividends.

Survey results reveal that this preference for repurchases stems from the view that once a

firm initiates a dividend, it is expected to continue to pay dividends. This expectation acts

as a deterrent for non-dividend-paying firms to initiate dividend payouts. However, share

repurchases are not viewed as being subject to a similar expectation. Although most

We appreciate helpful comments and suggestions received from Betty J. Simkins, Joel T. Harper, Lee C.

Adkins, two anonymous referees, and presentations at the 2013 European Financial Management conference, 2013

Southwestern Finance conference, Oklahoma State University, and University of New Mexico.

1

By share repurchases we mean open-market share repurchases. We focus on open-market repurchases

because they are considered to be an alternative form of disbursing cash flows to shareholders similar to dividends

(Brav et al., 2005). Historically, firms have also engaged in non-open-market share repurchases, which were

considered to be one-off events used mainly to signal undervaluation (e.g., Dutch auction and tender offer

repurchases). However, non-open-market repurchases have been relatively few and have become especially rare in

recent years. Oded (2011), who studies three decades of data, finds that open-market repurchases outnumber tender

offers by a ratio of 10 to 1. In our sample period encompassing the estimation period through the crisis period

(2000–2009), we find that only 5% of all share repurchase announcements employed a non-open-market

repurchase method.

The Journal of Financial Research Vol. XL, No. 3 Pages 287–313 Fall 2017

287

© 2017 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

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managers agree that reducing dividends will draw negative abnormal market reaction,

only a small proportion of financial executives consider reducing repurchases as having

such an adverse consequence.

2

Consequently, it is not surprising that when asked to pick

between dividends and repurchases if they were to initiate a payout policy today, two-

thirds of managers choose repurchases over dividends.

3

Consistent with the reservations expressed by managers on dividends, Fama and

French (2001) note that the proportion of firms paying cash dividends has decreased

drastically. They document a lower propensity to pay dividends even after controlling for

the observed tilt in listed firms toward firm characteristics that do not favor payment of

dividends: small, low-earnings, and high-investment firms. They also state that the

perceived value from paying dividends has declined. Grullon and Michaely (2002) and

Jagannathan, Stephens, and Weisbach (2000) find that share repurchases have increased

in prominence compared to dividends. Grullon and Michaely document that large,

established firms have not decreased their dividend payouts, but they display a higher

propensity to pay out cash through share repurchases.

4

Together, these two papers find

that the increase in share repurchases can explain the decreasing propensity to pay

dividends, which also corroborates the survey evidence in Brav et al. (2005). However,

none of these studies explicitly tests the flexibility hypothesis. The flexibility offered by

share repurchases could be a primary factor explaining why firms choose to repurchase

shares instead of paying dividends.

5

Flexibility refers to the ability of firms to decide whether to distribute cash to

shareholders or to keep it in the firm (e.g., for investments). Dividends and share

repurchases may differ in their inherent flexibility. Instituting dividends may preclude

firms from investing in profitable ventures or enhancing liquidity if reducing dividends is

met with adverse market reaction. As noted earlier, share repurchases may not suffer

from this drawback. Additionally, repurchasers may have the flexibility to alter or

suspend an already announced repurchase program. A dividend once announced is rarely

reversed. On the contrary, a share repurchase announcement is not a firm commitment.

Firms can decide to delay or even suspend an ongoing open-market share repurchase

program if the economy turns hostile.

2

These observations can be gleaned from Table 3 in Brav et al. (2005).

3

Financial flexibility appears to play a significant role in other corporate financial policies, for example,

capital structure (Graham and Harvey 2001). Using a novel measure to capture the value of financial flexibility,

Rapp, Schmid, and Urban (2014) find that financial flexibility is significantly related to several firm policies,

including payout policy.

4

However, in a recent paper, Floyd, Li, and Skinner (2015) suggest that dividends are resilient and on an

aggregate basis have exhibited remarkably stable payout ratios over the past 15 years.

5

Contemporaneous to our study, Bliss, Cheng, and Denis (2015) also examine the flexibility of repurchases

and dividends using the financial crisis as a natural experiment. Although our conclusions are similar, we provide

additional insights beyond their paper: (1) Bliss, Cheng, and Denis (2015) do not examine the market and operating

performance effects associated with the relative flexibility of repurchases and dividends during the financial crisis

period, and (2) they do not control for firm characteristic differences between various payout types simultaneously,

though they do control for firm characteristics within each payout type. That is, if repurchasers are fundamentally

different from dividend payers, the observed results with respect to flexibility may be due to differences in firm

traits rather than inherent differences in flexibility.

288 The Journal of Financial Research