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The Market Valuation of Open-Market

Share Repurchases in the UK

MSc International Financial Management

Can Cao

S2085208

Supervisor:

Prof. Lammertjan Dam

 

University of Groningen

Faculty of Economics and Business

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The Market Valuation of Open-Market Share Repurchases in the UK

Can Cao

*

Faculty of Economics and Business, University of Groningen, Groningen, the Netherlands

Email address: c.cao@student.rug.nl

Abstract

This paper presents an overview of the open market share repurchase activities in the UK market, and investigate the drivers of market reaction to these share repurchases using a latest data set of 230 intended share repurchase announcements between 2008 and 2013. Standard event study and regression analysis are applied in this study. Two 3-day windows abnormal returns (i.e. -1 to +1 and 0 to +2) surrounding announcement date are statistically significant at 1.873% and 1.682% respectively. However, there is no evidence to support any relationship between market reaction and characteristics of UK share repurchases firms, such as pre-announcement returns, size, dividend payment and leverage ratio. The event study results are in line with results reported by Oswald and Young (2004), and Rau and Vermaelen (2002). In addition, signaling hypothesis is supported, but I suggest that the UK market reaction to share repurchase is unlikely mainly influenced by share undervaluation. Finally, it seems that the free cash flow hypothesis, dividend substitution hypothesis and the capital structure hypothesis fail to explain the announcement abnormal returns of the UK open market share repurchase activity.

Keywords: UK share repurchase, signaling hypothesis, free cash flow hypothesis,

dividend substitution hypothesis, capital structure hypothesis, announcement abnormal returns, event study

JEL classification: G14, G32, G35,

                                                                                                               

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Table of Contents

1. Introduction ... 1

2. Literature Review and Hypotheses Development ... 4

2.1 Hypotheses ... 5

2.1.1. Signaling hypothesis ... 5

2.1.2. Free cash flow hypothesis ... 7

2.1.3. Dividend substitution hypothesis ... 8

2.1.4. The capital structure hypothesis ... 9

2.2 Share repurchase framework in the UK ... 9

3. Data ... 11

4. Methodology ... 13

4.1. Event study analysis ... 13

4.2. The drivers of the announcement market reaction ... 16

5. Results and Discussion ... 17

5.1. Market reaction to intended share repurchase announcement ... 18

5.2. Regression results ... 20

5.3. Robustness test ... 24

6. Conclusion ... 26

References ... 28

Appendix ... 32

List of Figures and Tables

Figure 1: Yearly distributions of share repurchase announcements ... 13

Figure 2: Cumulative abnormal returns of whole sample ... 19

Table I: Definitions of variables used to regression model analysis ... 17

Table II: Abnormal returns of UK open market share repurchase, 2008-2013 ... 20

Table III: Summary descriptive statistics for regression variables ... 21

Table IV: Effect firm characteristics on share repurchase activity, 2008-2013 ... 23

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1. Introduction

Share repurchase activities have been rapidly rising in the open market both in the number and the amount (Grullon & Michaely, 2002; Kooli & L'Her, 2010). This paper focus on examining the share repurchase activity in the UK market, which is the largest market for share repurchases in Europe (Lasfer, 2000). The performance of US open market repurchase has been widely studied, and several explanations offered to explain abnormal returns surrounding the announcement date. For example, Peyer and Vermaelen (2009) propose that abnormal returns are strongly related to preannouncement share undervaluation. Grullon and Michaely (2004) reports support for the agency cost explanation, they find that the market reacts favorably to share repurchase program announcement. Will these hypotheses explained US open market share repurchase activity even be supported in the UK market? Therefore, the aim of this paper is to investigate the market valuation of announcements of intention to repurchase share in the UK open market, and analysis whether characteristics of repurchase firms have significantly impacted on market reaction.

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the announcement. In the UK, an open market share repurchase announcement does not lead to an obligation for a firm to accomplish the full repurchase, while some firms actively and quickly commence share repurchase activity, other firms repurchase only a small percentage of the initial announcement target number of shares. Therefore, it appears that announcing a share repurchase program provides firm with an extra option for payout policy.

In 2007 market conditions in the UK and globally have changed as a result of the global financial crisis, major western economies have moved into recession, and as a consequence, the growth in share repurchase activity has rapidly reversed. Dhanani and Roberts (2009) show that UK FTSE 100 companies share repurchases in 2008 reported with 43% decrease compared to the same period the previous year. As a results of few studies investigate the UK stock price behavior for share repurchase announcement after the financial crisis in 2007. Whether the UK share repurchase activity is influenced by financial crisis is unclear. As a consequent, it inspire me to investigate the following question,

Whether open market announcements of intention to share repurchases by UK firms attracting a positive and significant return after 2007?

This study is distinct from the existing literature in several respects. First, my study relies on the update data, since most research data so far regarding to UK market is around 2004. Given the financial crisis affect, it is important to find out whether there is new trend in firm preference in share repurchase activity. Second, apart from the signaling hypothesis which prevails in most studies, I also include cash flow, dividend and leverage ratio in my analysis. Third, although I confirm the findings of previous studies that market reaction positively to share repurchase announcements. I also relate the results to different factors to investigate the whether these factor positively or negatively impact on market reaction.

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reaction. I first consider the share performance surrounding and following the announcements. The average stock price shows steady prior to share repurchase announcements, and then go up significantly at the announcement date. In line with previous evidence, the average market return of sample firms surrounding and following the announcement is positive and statistically significant. Further I test four popular hypotheses on drivers of market reaction to open market share repurchase announcements. The results show evidence to suggest that the market reaction to share repurchase is response to share undervaluation on announcement date, but limit evidence to support this conclusion for 3-day event windows. The regression results indicate that the market reaction to share repurchase announcement is unrelated to characteristics of firms, such as market-to-book ratio, dividend payment, free cash flow and leverage ratio.

The remainder of the paper proceeds as follows. Section 2 Literature reviews and hypothesis development. Section 3 presents the data. Section 4 presents the methodology. Section 5 reports the empirical results. Section 6 concludes.

2. Literature Review and Hypotheses Development

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is a positive information signal to the market or reflects benefits in a reduction of agency costs. There also have other reasons which influence share repurchase activity such as tax rates, regulatory restraints, increased concern about shareholders’ value, and the adoption of stock option plans.

Many literatures provide motivations for firms might tend to repurchase their own shares. These researches demonstrate a positive stock price reaction to the announcement of intention to repurchase shares. Various hypotheses provide explanation to this positive, including the signaling of undervaluation, agency theory, capital restructuring, dividend substitution, management compensation incentives and company’s reputation. The most commonly motive for initiating a repurchase program is the perception of manager that their stock is undervalued. In this subsection, I review the main theories studies in the financial literature that gives potential explanation of the market reaction to the announcement of a share repurchase program.

2.1 Hypotheses

2.1.1. Signaling hypothesis

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H1a: The market reaction to share repurchase announcements is negatively related to

the preannouncement returns.

Nevertheless, some studies suggest that the signal has become weaker. Lasfer (2000), Ikenberry and Vermealen (1996) and Rau and Vermaelen (2002) argue that the signaling hypothesis is controversial, because open market share repurchases are not costly signals and there is no obligation for the company to actually repurchase the shares, under this situation they are contradictory with the principles of the signaling theory, which regard as signals of the undervaluation of the share price. Therefore, open market share repurchase announcements are poor signaling instrument. The abnormal return surrounding announcement shows steadily decreasing over time, which implying those firms are no longer able to send a valuable signal of undervalued (Kahle, 2002). Grullon and Michaely (2004) find that announcements of the open market share repurchase programs do not lead to a better operating performance. However, studies through management survey, still find evidence that undervalued is a main motivation for manager to engage to share repurchase activity (Baker et al. 2003; Brav et al. 2005).

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asymmetries. In contrast, Ikenberry et al. (1995) find that large firms dominate the US open market share, but their results show that the mean abnormal return on the announcement is mainly driven by the returns from small firms. This finding is supported by further study (Dittmar, 2000; Grullon & Michaely, 2002). I expect to find that large UK firms, proxied by Size are more likely to affect the market reaction to intention to undertake share repurchase programs. This is stated as the second hypothesis.

H1b: The market reaction to share repurchase announcement is negatively related to

firm size, but not related to the market-to-book ratio.

2.1.2. Free cash flow hypothesis

The agency problem of free cash flows is another explanation for share repurchases. According to Evans et al. (2003) free cash flow commonly defined as “the total after tax cash flow generated by the firm and available to all providers of the company’s capital”. Easterbrook (1984) argue that the option for firm to distribute cash to shareholders is paying dividends, otherwise might be spent by managers on unprofitable projects. Jensen (1986) suggests that firms with free cash flow beyond their investment opportunities more likely suffer from agency costs because of overinvestment. This argument is easily related to share repurchases, since share repurchase help alleviate agency cost. Thus, many studies use the free cash flow hypothesis to examine the share repurchase announcements. Lie (2000) finds that the market reaction to firm share repurchase announcement tender offers is positively related to the amount of excess cash held by the repurchasing firms. Grullon and Michaely (2004) find that market reaction to the repurchase announcement is negative related to free cash flow and systematic risk, implying when agency conflicts of overinvestment arise, firms would increase their payouts to shareholders through share repurchases. Lo et al. (2008) also provide similar results that share repurchases can address agency problem, which resulting in higher abnormal announcement returns.

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about the firm future prospects. Since a firm would decide to distribute cash to its shareholders when the firm has excess cash, hence firm send a message to the market that instead of investing the money in potential projects, it is giving the money back to shareholders. Grullon and Michaely (2002) argue that free cash flow hypothesis expects that repurchasing firms should experience a decrease in investment opportunities, which is a decline in profitability, systematic risk and capital expenditure after the share repurchase announcement.

H2: Market reaction to share repurchase announcement is negatively related to free

cash flows of the repurchasing firm.

2.1.3. Dividend substitution hypothesis

When Securities and Exchange Commission (SEC) ruling first provided a legal safe harbor for managers implementing open market share repurchases, there is a significant increase in the number and total value of US firms repurchasing their own shares since 1982 (Grullon & Ikenberry, 2000; Grullon & Michaely, 2004). Using share repurchase to distribute excess cash to shareholders is both more flexible than paying regular cash dividends and tax-favored. Some explanations of intention to share repurchase have proposed. Prior studies show positive share repurchase announcement effects compare to dividend increases (Dann, 1981; Vermaelen, 1981; Jagannathan, Stephens, & Weisbach, 2000; Maxwell & Stephens, 2003). Brav et al. (2005) find that managers prefer to repurchasing share than increasing dividends in the presence of free cash flows. Because paying dividends is less flexible than share repurchases as they are more costly to reverse. This finding suggests that share repurchases are not a replacement for dividends since repurchasing firms do not pay lower dividends, in other words, these firms with relatively higher dividends per share are less likely to engage in open market share repurchases.

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under this system, shareholders receive credit for taxes paid by the firm on earnings distributed as dividends and on the “distribution element” of share repurchases” (Rau & Vermaelen, 2002).

H3: Market reaction to share repurchase program is negatively related to existing

dividend payout policy.

2.1.4. The capital structure hypothesis

As presented former share repurchases can be used to distribute excess cash to shareholders. When the firm distributes cash, it result in reduces equity and increases leverage ratio. Thus, firms undertake share repurchases with purpose of managing their capital structure, even though there is debate about the effectiveness of open market share repurchases for capital structure management. A share repurchase reflects management prefer to use debt rather than equity, it increase the leverage ratio and can be used to reach an optimal capital structure. Jensen (1986) stats that optimal capital structure occurs when the sum of the agency costs of equity and the agency costs of debt is minimized, which leading to market value of the firm is maximized. Therefore, a firm prefer to undertake share repurchase program if its leverage ratio is below its target leverage ratio, a firm’s capital structure will influence the decision to repurchase. However, Stulz (1990) point out that a manager rather than owners is not preferred to achieve optimal capital structure. Manager is willing a lower leverage, which means keep them in control of more cash flow that can be used to pursue their own needs.

H4: Market reaction to share repurchase is negatively related to existing leverage

ratio of the firm.

2.2 Share repurchase framework in the UK

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including the duration of the repurchase program, the number of shares intended to be repurchases, and the reason for the share repurchase. According to Company Act of 1985, a company in UK allowed to make a share repurchase as long as the amount does not include all its non-redeemable shares, and authorized by articles. It is require authorize an approval at the shareholder meeting, which is valid for 18 months. An open market share repurchase decision has to be reported immediately to the Financial Supervisory Authority (FSA). The report must include the date of purchase, the number of equity shares purchased, and the range of purchase price in a day. On of requirements is repurchase cannot exceed 15% of the number of outstanding share of any class of equity, and the payment should not be more than 5% above the average price for the five business days before the repurchase day (Kim, Varaiya, & Schremper, 2004).

However, as a result of UK traditional law system discourage the repayment of capital to shareholders, there were not many share repurchases activities. Until in the early 1980s, the UK company law changed to permit companies to repurchase their own shares. In 1985, the Companies Act allows a company to make an equity repurchase as long as the amount does not include all its non-redeemable shares, and its articles authorized to do so (Scholey, 2002). In the 1990s, these changes have resulted in a major number of companies have actually started to repurchase. As from the 1st of December 2003, firms purchase their own shares out of distributable profits have the option to hold them as “in treasury” for sale later or of transfer them to an employee’s share scheme.

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take advantage of tax loophole to sell indirectly to the company and claim back the tax credits. As from the July 1997, the UK tax authorities not allowed pension funds to claim the tax credit on dividends anymore, then they are indifferent between dividends and share repurchases.

Unlike the US share repurchases procedure, which only need to be approved by the board of directors with no timing, price and volume restrictions, within the member countries of the European Union (EU), the legislation on share repurchases is relatively standardized. The EU legislation requires that firms not only need to be approved by the board of directors, but also need the shareholders’ approval at the general shareholder meeting. This approval is for a maximum of 18 months, the proportion of shares allowed to repurchase is limited to 10% of the firm’s issued capital, the repurchase price range is disclosed and repurchases should be made out of distributable profits only. However, there are significant regulatory differences across EU countries. For example, in France open market share repurchases became legal since 1998, firms needs to be adopted by the AGM and the announcement documents should be approved by the financial regulator AMF, but after 2004, firms only need shareholder approval. Firms are restricted from repurchasing over 10% of the issuer’s capital. The purpose of share repurchases could be cancelled or kept as treasury stock (Ginglinger & L'Her, 2002). In Germany legalized share repurchase since 1998, as a result of prohibited repayment of capital (Hackethal & Zdantchouk, 2003). The share repurchase program must be announced in advance, the proportion of shares to be repurchased is constrained to 15% of the issued capital. In addition, German managers must follow stricter reporting requirements than those in other EU countries. In UK, a corporate governance system is similar to the US system (i.e., the Anglo-American model), there is a relatively more active market for corporate control, and more UK managers to engage in share repurchase program than in France or Germany.

3. Data

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to repurchase shares in the open market news from LexisNexis Academic (mainly from The Financial Times and London Stock Exchange Aggregated Regulatory News Service (ARNS)), and InvestEgate website1. To be more specific, in order to include all UK open market share repurchases announcements from 1st January 2008 to 31st December 2013. I search all repurchase announcements published in The Financial Times and ARNS through LexisNexis Academic for the sample period with keywords such as “share repurchase”, “share buybacks” and “share buy-back”. The initial sample consisted of 654 share repurchase announcements. In order to make the results comparable, I collected the announcement dates, exclude close-fund investment trusts, tender offers, repurchases of B-shares and preference shares. After this the sample consisted of 436 share repurchase announcements. Since The Financial Times reports repurchase news when company makes an indication of repurchases explicitly or has already repurchased some shares in the market, all announcement confirmed again via InvestEgate deducted backwards. InvestEgate provides several types of announcement, including an initial announcement of intention to obtain the shareholders’ general meeting authorization named “share repurchase program or buyback program”; a repurchase resolution passed by shareholders at a general meeting named “result of AGM”; the actual share buyback transactions named “transaction in own securities”. This process yields 326 open-market repurchase announcements. The information regarding the daily share price, market capitalization and market-to-book ratio of repurchases companies are collect from DataStream. AS market-to-book ratio is required for subsequent analysis, companies without market-to-book ratio in DataStream are excluded from the analysis. After eliminate sample companies without complete financial and market data, the final sample includes 139 companies and a total of 230 repurchase announcements (see Figure 1). The announcements are constantly except in 2008 and 2009. The majority of the UK announcements occurred in 2013, the lowest is in 2009.

Figure 1 shows the yearly distributions of intention to repurchase shares. The announcements are volatile, ranging from 32 in 2008 to 49 in 2013. Moreover, majority of announcements occurred in the UK is in 2013, and the frequency is the lowest in 2009.

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Figure 1.

Yearly distributions of share repurchase announcements

This figure shows the number of open market share repurchase announcement from January 2008 to December 2013. The sample includes 230 open market share repurchases announcement in the UK.

4. Methodology

4.1. Event study analysis

This study focus to investigate the impact of share repurchase announcement by examining the reaction of share price using event study methodology to explore share returns surrounding and following the announcement. An event study is the chosen method for achieving the purpose of this study. According to Mackinlay (1997), an event study describes a technique of empirical financial research that permits an observer to evaluate the effect of a particular event on a share price, assuming that share prices instantly reflect the impact of such an event. the impact of a particular event on. Event study studies the behavior of companies’ share price around corporate or economic events such as earning announcement, dividend announcement, mergers and acquisitions, and issues of new equity or debt. Event study has been frequently used in the previous finance, accounting and management field. Mostly, the focus is the effect of an event on the price of a particular class of share. This particular method originated by Dolley (1933), but was mainly introduced by Ball and Brown (1968) and Fama et al. (1969).

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To test research question, I adopt cumulative abnormal returns (CAR) on the firm’s stock prices around announcement date as a measure of short-term preformance. The price changes are used to infer market reactions. To measure short-term performance surrounding the repurchase announcement events, which consistent with Peyer & Vermaelen (2005) and Zhang (2005), this study estimate the event period is from -20 to +20 trading days relative to the share repurchase announcement. a window of 41 trading days comprising "20 days before” to “20 days after” the event day “0”. This period seems equivalent to one calendar month before/after the event day. To be more specific, three sets of cumulative abnormal returns (CAR) are examined, CAR(20 to -2), CAR(-1 to +1) and CAR(0 to +2). CAR(0 to +2) is designed to investigate the market initial reaction to share repurchase program. As suggested by Ikenberry et al. (1995), abonormal returns calculated over such short intervals, which are not overly sensitive to the benchmark used, hence, I measure abnormal returns in relation to the FTSE All-Share index. The conventional t-tests are applied to interpret significant level.

In general, there are three approaches to calculate the abnormal returns, which are mean-adjusted returns, market adjusted returns and market model. According to Weston et al. (2003) in most situations, these three approaches generate similar returns, hence the well-known market model is the one used for this study. The initial stage of the analysis is the examinational of the abnormal return of share repurchase announcement companies. For obtaining the market returns the Return Index2 (RI)

was used from Datastream. Daily returns for the sample firms were calculated using the continuously compounded method as Eq.(1). Estimate market model based on [-120,-21] period and OLS (Ordinary Least Square). Under the CAPM, the expect daily return 𝐸 𝑅!" is calculated as Eq.(2). Normal returns are expected stock returns under normal circumstances. Abnormal returns are the difference between true stock returns and normal returns. The effect of company-specific events is expected to fully reflect in the unsystematic component which is the error term, which is based on the assumption that the information signal concerning an event has no influence on the return from the market portfolio. In summary, abnormal returns for the sample companies were calculated as following:

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𝑅!,! = ln !"!,!

!"!,!!!      (1)

𝐸 𝑅!,! = 𝛼! + 𝛽!𝑅!"+ 𝜇!"      (2) 𝐴𝑅!,! = 𝑅!,!− 𝐸 𝑅!,!      (3)

Where 𝑅!" is the return on firm i’s shares on day t, 𝐸(𝑅!,!) is the expected return for firm i on day t, 𝛼! and 𝛽! were calculated using an estimation window of 100 days prior to the event window. 𝑅!" is the daily market return on day t, which is FTSE

All-Share Index. 𝜇!" is the residual error. 𝐴𝑅!,! is the abnormal return for firm i at time t, which were calculated for each day of the 41-day event period from Days -20 to +20. These abnormal retunes were averaged across frims in order to draw inferences about the influence on the share repurchase announcements. To obtain a general insight into the abnormal return observations for sample firms, abnormal returns for each day t were averaged as follows:

𝐴𝑅!,!= 1

𝑛 𝐴𝑅!,!

!

!!!

     (4)

After obtain abnormal return of each period, then cacluated the Cumulative abnormal returns (CAR), they are calculated by aggregating daily ARs over time starting from before the day of share repurchase announcement to after the share repurchase announcement date, and were subsequently tested for statistical significance. The effect is captured by the CAR(-20 to -2), CAR(-1 to +1) and CAR(0 to +2) abnormal returns. CAR daily returns for an event period from T1 to T2 can compute as follows:

𝐶𝐴𝑅!,! = 𝐴𝑅!,!

!!

!!

     (4)

The study investigates the following hypotheses:

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If the results from an event is affect a company’s current and future earnings, its stock price changes as soon as the market studies about the event. To research whether an event had any influence on the company values, pre-event and post-event AR and CAR are measured. The CARs calculated in the event study are utilized as dependent variables in the regression analysis.

4.2. The drivers of the announcement market reaction

To assess the drivers of the market reaction to the announcement of share repurchase program, and for Hypotheses 1-4, the resulting CARs were regressed on the sets of dependent and control variables to validate the hypothesized. I perform regression analysis for each event windows, in order to identify the influence on market reaction. I use a number of control variables identified in previous studies that have an impact on the market valuation of share repurchases.

𝐶𝐴𝑅!,! = 𝛼!+ 𝛽!𝑃𝑟𝑒𝑅𝑒𝑡𝑢𝑟𝑛!,!!!+ 𝛽!𝑙𝑛(𝑆𝐼𝑍𝐸!,!!!) + 𝛽!𝐹𝐶𝐹!,!!!

+ 𝛽!𝐷𝐼𝑉𝐷!,!!!  +𝛽!𝑙𝑛  (𝑀𝑇𝐵!,!!!) + 𝛽!𝐿𝐸𝑉!,!!!   + 𝜀!"      (5)

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Table I

Definitions of variables used to regression model analysis Notation Variable Definition PreReturn Pre 20-days

returns

It is used as a proxy for the short term undervaluation. Pre 20-days return is the daily cumulative abnormal return for the period of 21 to 1 days prior to the announcement of share repurchases.

SIZE Firm size It is measured as the natural log of the market value of total assets. Size is expressed as a proxy for the extent of information asymmetries between a company and capital markets.

FCF Free cash flow The measure of free cash flows is followed Dittmar (2000), which is the firm’s ratio of net income before taxes plus depreciation and changes in deferred taxes and other deferred changes to total assets, at the end of the year prior to the share repurchase announcement.

DIVD Dividend payment

To assess whether firms dividend substitution hypothesis has impact to share repurchase, I include the dummy variable, it take the value of one if a firm has paid cash dividends in the year prior to the share repurchase announcement, otherwise zero. MTB Market to book

ratio The Market-to-Book ratio is defined as the market value of equity divided by the book value of equity as reported in the most recent financial statement prior to the share repurchase announcement.

LEV Debt ratio The leverage ratio of total debt to total asset at the end of the calendar year prior to the announcement of the share repurchases date (follow Dittmar, 2000 and Grullon and Michaely, 2002). Total assets are used instead of equity because some of the sample firms have negative equity values.

5. Results and Discussion

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5.1. Market reaction to intended share repurchase announcement

I use the standard event study methodology to examine share price performance around the intended share repurchase announcements. Figure 2 portrays the daily CARs for the whole sample from 2008 to 2013, and figure for sub-group are reported in Appendix A. Table II reports the CARs for three different windows surrounding the announcement day. Abnormal returns estimated by the market model with returns from day -210 to day -21 before share repurchase announcement. The market index is the FTSE All-share index.

Figure 2 plots the CARs movement around a 41-day period. For total 6-year announcements, before Day -2, the stock price, on average, do not show any evidence of good or poor performance, since the line is tend to steady, there is no sign of significant increase and decrease. However, from Day -2, the 41-day CARs line shows that share price began to rise significantly in response to the announcement, reflecting a positive reaction of the stock in line with signaling hypothesis. It is interesting to note that the Total CARs line did not revert back to the pre-announcement level of abnormal returns. In the post-pre-announcement period (from day +2 to day +20), the average share price did not change significantly. Therefore the results consistent with the results of Otchere and Ross (2002) suggesting that the market believed that the share price was indeed undervalued.

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Figure 2.

Cumulative abnormal returns of the whole sample

This figure presents the market reactions before and after the announcements of share repurchases between 2008 and 2013. CAR is beginning at day -20 and ending at day +20.

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Table II.

Abnormal returns of UK open market share repurchase, 2008-2013

Time Period N Days relative to share repurchase announcement AR(0) CAR(-1 to +1) CAR(0 to +2) 2008 32 2.077% (1.158) 2.061% (0.890) 0.912% (0.337) 2009 27 1.778% (1.071) 3.223%* (1.872) 2.387% (1.300) 2010 45 0.064% (0.110) -0.500% (-0.733) 0.359% (0.503) 2011 40 1.53% (1.382) 2.239%* (2.023) 2.280%* (1.999) 2012 37 2.189%** (3.367) 3.277%*** (3.767) 2.890%*** (3.660) 2013 49 1.211%** (2.400) 0.941%* (1.722) 1.265%** (2.303) Total 230 1.387%*** (3.354) 1.873%*** (3.477) 1.682%** (3.074)

The table reports annual data on share repurchases and related CARs for the sample firms over the period 2008 to 2013. T-test results are presented in parenthesis. *** statistically significant at 1% level. ** statistically significant at 5% level. * statistically significant at 10% level.

5.2. Regression results

In order to investigate the hypotheses previously presented- the Signal hypothesis, the Free Cash Flow hypothesis, Dividend Substitution hypothesis, and the Capital Structure hypothesis, I examine the determinants of the market reaction to the share repurchase in a multivariate framework. I explore how abnormal returns are related to firm characteristics and how undervaluation, free cash flow, dividend payment and leverage related to market reaction to open market share repurchase announcements. Multicollinearity check is reported in Appendix table B.

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positive return over the prior 19 days, with the mean value 0.01. The firms that announce intended share repurchase have lower leverage ratio relative to other variables. Furthermore, all variables have positive mean.

Table III.

Summary descriptive statistics for regression variables

Mean Median Max. Min. Stdev. AR(0) 0.014 0.002 0.537 -0.175 0.063 CAR(-1 to +1) 0.017 0.007 0.548 -0.336 0.073 CAR(0 to +2) 0.016 0.006 0.548 -0.573 0.079 PreReturn 0.010 0.003 0.535 -0.366 0.115 SIZE 13.267 13.238 19.450 7.191 2.614 FCF 0.204 0.079 5.873 -3.252 0.696 DIVID 0.739 1 1 0 0.440 MTB 0.675 0.577 5.186 -2.408 1.103 LEV 0.159 0.085 1.672 0.000 0.193

Note: This table shows the mean, median, maximum, minimum and standard deviation for the market reaction to the announcement of an open market share repurchase program and explanatory variable employed on the regressions over the period 2008 to 2013. AR(0) is abnormal return on the announcement date. CAR(-1 to +1) is the 3-day cumulative abnormal return surrounding the announcement date. CAR(0 to 2) is the 3-day cumulative abnormal return around the announcement date. PreReturn is CAR(-20 to -2) measure the pre-announcement share price performance. SIZE is the firm size, measured as the natural log of total assets at the previous 1 year-end. FCF is free cash flow, calculated as operating cash flow less capital expenditure scaled by the total assets, measured at the previous 1 year-end. DIVID is the dummy variable of dividend payment, it take the value of one if a firm has paid cash dividends at the end of year prior to the share repurchase announcement, otherwise zero. MTB is the market-to-book ratio, measured as the market value of equity to net tangible assets at the previous 1year-end. LEV is leverage ratio, measured as total debt to total assets for previous 1 year.

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market reaction to the share repurchase announcements. However, there is no evidence to provide support to Hypothesis H2-H4.

The coefficient of the pre-20-days return is not significant, and MTBV is not significant. The result is partly consistent with the findings of Rees (1996). His results show that the announcement abnormal return is not affected by log market value, percentage repurchased, and log liquidity. Firm size is negatively related to the market reaction to share repurchase, in line with Ikenberry et al. (1995) and Grullon and Micharly (2002), the reason is smaller firms experience higher information asymmetric. Bhattacharya and Dittmar (2003) argue that higher information asymmetries experienced by smaller firms leading to a higher market reaction. The results also show that firm size is only significant at AR(0), but not at CAR(-1 to +1) and CAR(0 to 2). This results in line with Lasfer (2000), he regresses the abnormal return at day 0 and cumulative abnormal return (+20 to +151) with a range of independent variables, the results show that the log market value is significant at AR(0), but not for CAR(+20 to +151). As a consequent, in general, I could not exclude the effect of signaling hypothesis, but the result is not statistically significant, hence the UK market reaction to intention to repurchase share between 2008 and 2013 is not mainly influenced by share undervaluation.

In term of free cash flow effect, the results show positive relationship but not statistically significant, indicating that the market may prefer to return excess cash to the shareholders in the form of share repurchases rather than retain free cash flow for investment. This finding is consistent with the explanation by Dittmar (2000) and Mitchell and Dharmawan (2007). They find that firms with excess cash and fewer investment opportunities are more likely to repurchase their shares. The results is line with the free cash flow predictions, which is the market does view share repurchases as a sufficient way to mitigate the agency conflicts. However, the results are not significantly, I cannot conclude that free cash flow has significant effect on market reaction.

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dependent. The results in contrast to Jagannathan et al. (2000), they show that share repurchase decision and cash dividend payout are complimentary.

Finally, for the impact of leverage, its shows mix results, in the announcement date, it is negative, for the surrounding announcement event windows it is positive, but they are all not significant, which indicating that leverage ratio does not have a strong effect on market reaction. The results suggesting that undertaking share repurchases are not likely to increase leverage and gain from the tax shields.

Table IV.

Effect firm characteristics on share repurchase activity, 2008-2013.

Note: The table reports regression results for drivers of stock market reaction to share repurchase announcements. The coefficients on the independent variables are reported along with their p-value in parenthesis. PreReturn is CAR(-20 to -2) measure the pre-announcement share price performance. SIZE is the firm size, measured as the natural log of total assets at the previous 1 year-end. FCF is free cash flow, calculated as operating cash flow less capital expenditure scaled by the total assets, measured at the previous 1 year-end. DIVID is the dummy variable of dividend payment, it take the value of one if a firm has paid cash dividends in the year prior to the share repurchase announcement, otherwise zero. MTBV is the market-to-book ratio, measured as the market value of equity to net tangible assets at the previous 1year-end. LEV is leverage ratio, measured as total debt to total assets for previous 1 year.*** statistically significant at 1% level. ** statistically significant at 5% level. * statistically significant at 10% level.

Independent variables Dependent variables

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5.3.Robustness test

I conduct a robustness test of the share repurchase announcement CARs with respect to the impact of financial crisis. Since 2007 market conditions in the UK and globally have changed due to the global financial crisis, most of western countries have moved into recession. Therefore the growth in share repurchase activity became slow down. Dhanani and Roberts (2009) report that the UK FTSE 100 companies share repurchases between June 2008 and March 2009 were 43% decrease compared to the same period the previous year. Hence I add a dummy variable (D_Year) in the regression; the year dummy variable is designed as equal to 0 for the share repurchase after 2009, and 1 for the repurchase announced between 2008 and 2009.

The robustness test is present in Table V, this table shows the regression test include new dummy variable year, the results of robustness tests are consistent with the results reported in Table IV, which suggesting that characteristics of repurchase firms do not have significantly influence on market reaction, but the evidence of share undervaluation is found in event window AR(0). Furthermore, the results not provide evidence that during financial crisis years, market reaction to share repurchase is affected.

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Table V.

Robustness test results

Note: The table reports regression results for drivers of stock market reaction to share repurchase announcements. The coefficients on the independent variables are reported along with their p-value in parenthesis. PreReturn is CAR(-20 to -2) measure the pre-announcement share price performance. SIZE is the firm size, measured as the natural log of total assets at the previous 1 year-end. FCF is free cash flow, calculated as operating cash flow less capital expenditure scaled by the total assets, measured at the previous 1 year-end. DIVID is the dummy variable of dividend payment, it take the value of one if a firm has paid cash dividends in the year prior to the share repurchase announcement, otherwise zero. MTBV is the market-to-book ratio, measured as the market value of equity to net tangible assets at the previous 1year-end. LEV is leverage ratio, measured as total debt to total assets for previous 1 year.D_Year is the year dummy variable is designed as equal to 0 for the share repurchase after 2009, and 1 for the repurchase announced between 2008 and 2009.*** statistically significant at 1% level. ** statistically significant at 5% level. * statistically significant at 10% level.

Independent variables Dependent variables

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6. Conclusion

I analyze the UK open market share repurchase activity with two purposes. Firstly, to investigate the market reaction to the announcement of open market intended share repurchase in the United Kingdom, and then to test the drivers may have a significant impact on the market reaction to share repurchase regression analysis. This study contributes not only to improving understanding of the share repurchase activity in the UK market, but is also offer an alternative way to investigate the relationship between market reaction and firms’ characteristics. The findings of this study provide an alternative explanation to the topic related to share repurchase activity, especially for the prior studies using US, Canada, Austrila, Taiwan and Hong Kong data. Prior studies largely explain abnormal returns among value firms as evidence to support the share undervaluation hypothesis or the market delayed reaction to the share repurchase announcement (Crawford & Wang, 2012).

The analysis contained in this study use 230 firms for the period 2008-2013. The event study results show that the market reaction to intention of share repurchases announcements is positive and significant. To be more specific, announcement abnormal returns surrounding announcement are statistically significant at 1.873% and 1.682% respectively. The results are consistent with Oswald and Young (2004), Rau and Vermaelen (2002). In addition, for the regression analysis, most of the results are not significant, only the firm size is reported negative and significant to AR(0). Other characteristics of repurchasing firms are not show strong influence on market reaction.

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Appendix

Figure A.

Cumulative abnormal returns of the sub-group

 

Note: This figure shows the number of open market share repurchase announcement for each sample years. The sample includes 230 open market share repurchases announcement over the period 2008-2013 in the UK.

Table B.

Multicollinearity Diagnostics

DIVID FCF LEV LNMTB LNSIZE PRERETURN DIVID 1 FCF 0.0058 1 LEV 0.1675 0.1281 1 LNMTB 0.2324 0.1667 0.1115 1 LNSIZE 0.3763 0.2215 0.2777 0.4511 1 PRERETURN 0.0678 0.1218 0.0265 0.0065 0.0179 1

Note: PReturn is CAR(-20 to -2) measure the pre-announcement share price performance. SIZE is the firm size, measured as the natural log of total assets at the previous 1 year-end. FCF is free cash flow, calculated as operating cash flow less capital expenditure scaled by the total assets, measured at the previous 1 year-end. DIVID is the dummy variable of dividend payment, it take the value of one if a firm has paid cash dividends in the year prior to the share repurchase announcement, otherwise zero. MTBV is the market-to-book ratio, measured as the market value of equity to net tangible assets at the previous 1year-end. LEV is leverage ratio, measured as total debt to total assets for previous 1 year.

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