Share Repurchases by Financially Constrained Firms Sheng-Syan Chen National Taiwan University Yanzhi Wang Yuan Ze University
Motivation Prior finance literature has documented the value enhancing nature of corporate share repurchase programs. Vermaelen (1981), Asquith & Mullins (1986), and Comment & Jarrell (1991) show positive announcement-period abnormal returns associated with share repurchases and attribute their finding to a signal of undervaluation for repurchasing firms. Ikenberry et al. (1995, 2000) find positive long-term abnormal returns following share repurchases for a period of up to four years. Other authors have since provided explanations for the long -term drift in stock prices.
Grullon & Michaely (2004) argue that prices impound the change in the cost of capital only gradually and that the risk changes associated with repurchases provide an explanation for the long-run price drift. Chan et al. (2004) suggest mispricing, and to some degree, the disgorging of free cash flows as the sources for the longhorizon return drift. Gong et al. (2008) suggest that deflating earnings around repurchase announcements is one reason for repurchasing firms to experience post-repurchase abnormal returns. Peyer & Vermaelen (2009) find strong support for the longterm abnormal returns as a correction of an overreaction to bad news prior to the repurchase.
Although previous studies suggest that repurchase programs enhance firm value, repurchasing firms may suffer a reduction in corporate liquidity subsequent to share repurchases. The repurchasing firms spend cash and/or raise leverage when they buy back shares (Jensen, 1986; Stephens & Weisbach, 1998; Dittmar, 2000; Hovakimian, 2004). The reduction in cash balance and the lift in financial leverage following repurchases lead to a decline in corporate liquidity for repurchasing firms. For repurchasing firms that are financially constrained prior to the buyback, a lower degree of corporate liquidity resulting from repurchases can be harmful.
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