Question

Your friend has thought about repurchases of common stock by the issuing company and has concluded that this is unethical. Specifically, this friend says that the company knows more than you do and if the company decides to repurchase shares, it is taking advantage of shareholders. How do you respond?

Answer 1

he repurchase of common shares by businesses is a common practice. For example, in 1996 a record
1,475 U.S. companies announced plans to buy back $177 billion worth of common stock.Although the level of repurchase activity tends to be related to stock market performance, some repurchase activity continually takes place.

Although some earlier studies have implied the possible existence of unethical behavior related to stock
repurchase announcements, a lack of research exists into the explicit motivations of managers who fail to complete
announced stock repurchases. The purpose of this study is to investigate the practice of repurchasing fewer shares
than announced. In the current study we focus on the signaling motivation for share repurchase.
The remainder of the paper has the following organization. Section I presents relevant literature about
stock repurchases and focuses on signaling and ethical issues. Section II presents our research questions and
hypotheses. Section III describes the methodology used by the study and Section IV reports the empirical results.
Section V reports the study limitations and Section VI contains conclusions.

II. Literature Review
According to signaling theory, companies use common stock repurchases to convey to the market positive
information about the firm’s future prospects. Those involved in developing signaling models related to stock
repurchases include Vermaelen (1984), Ofer and Thakor (1987), Constantinides and Grundy (1989), and Hausch and
Seward (1993). Vermaelen (1984) found evidence that permanent increases in stock prices follow repurchase. His
findings suggest that the signaling hypothesis is the most likely explanation for the resulting abnormal returns.
Vermaelen also developed a model showing a positive relationship between the strength of a repurchase signal
through tender offers and three variables: the size of the offer premium, the percentage of shares the firm intends to
repurchase, and the proportion of insider stock ownership.
Ofer and Thakor (1987) presented a model in which firms use both dividends and stock repurchases to
signal financial markets. They show that firms prefer to signal the market using dividends when the difference
between the market price of the stock and the stock’s intrinsic value is small. Conversely, when this difference is
large, firms use stock repurchases to signal the market. The reason for the preference for repurchases under these
conditions is that repurchases contain more information.

III. Research Questions and Hypotheses
We designed the current study to test the following research questions and hypotheses, which are based on
information presented in the literature review:
1. How prevalent is the practice of repurchasing fewer shares than the firm announced? We hypothesize that
managers recognize that repurchasing fewer shares than a firm announced is a common practice.
2. Why do firms repurchase fewer shares than they initially announce? We hypothesize that firms repurchase
fewer shares than they initially announce for a variety of reasons, including the original purpose of the
repurchase no longer exists, the firm needed to use the funds elsewhere, the stock price rose.
3. Do managers believe that:
A. Failing to follow through with announced repurchases sends a false signal to the market?
B. Sending false signals to the market damages a firm’s credibility with its stockholders? We
hypothesize that the majority of responding managers agree with each of these statements.
We developed several additional hypotheses to be tested with the collected data. These hypotheses
represent extensions of the previously listed hypotheses.
4. Do managers believe that the practice of repurchasing fewer shares than announced:
A. Is legal?
B. Is ethical?
C. Sends a false signal to the market?
We hypothesize that managers typically are unaware of the legality of this practice, but the majority
believes this practice is unethical and sends a false signal to the market.
5. Do managers believe that firms should publicly announce:
A. The reason for not repurchasing all shares initially announce?
B. The amount by which a firm repurchases fewer shares than announced?
We hypothesize that, on average, managers agree with both statements.
6. Does the failure to follow through with an announced repurchase of shares of its common stock damage the
firm’s credibility with its stockholders? We hypothesize that managers, on average, believe that failing to
follow through on repurchase announcements damages firm credibility because the firm is not keeping its
word.

V. Survey Results
We present the survey results in two subsections. The first subsection focuses on the prevalence of
repurchasing fewer shares than initially announced and the reasons underlying this practice. The second subsection
reports the opinions of the respondents about practices used in repurchasing stock.

A. Buying Fewer Share than Announced
Our first research question focused on how widespread the practice is of repurchasing fewer shares than
previously announced. Specifically, we asked the respondents: “Based on your knowledge of current business
practices, do firms frequently announce the repurchase of a specific number of common shares but intend to
repurchase fewer shares?” Of the 202 managers who responded to this question, more than one-third (38.6 percent)
indicated that this is a common business practice.
We were also interested in whether the respondents’ firms had engaged in this practice. We asked: “Since
1995 has your firm announced the repurchase of shares of common stock and then purchased fewer shares than it
announced it would repurchase?” Of the 216 managers responding, 28.7 percent indicated that their firms had done
so. The literature offers several reasons why firms repurchase fewer shares than announced. Kirch, BarNiv, and
Zucca (1998) suggest that firms repurchase fewer shares of common stock than announced either because of
changes in a firm’s internal or external environment or because of financial problems. Netter and Mitchell (1989)
suggest that some firms stop the repurchase activity when the stock price rises to some desired level

B. Opinions about Repurchase Practices
Regardless of whether respondents were personally aware of instances in which firms repurchased fewer
shares of stock than announced, we wanted to gather the respondents’ views about several issues involving common
stock repurchases. We asked the respondents to indicate their level of agreement or disagreement about six
statements related to common stock repurchases. Respondents were to use a five-point scale where –2 = strongly
disagree, -1 = disagree, 0 = no opinion, +1 = agree, and +2 = strongly agree. For all statements, we used a t-test to
determine if the mean response differed significantly from 0 (no opinion). We also separated the respondents into
two groups. One group included firms indicating that the last time they announced a share repurchase they
repurchased all shares announced (we call this group “All”). The second group consisted of firms that had
repurchased fewer shares than announced (we call this group “Fewer”). We conducted chi-square tests to determine
if there were significant differences between the responses of the two groups.

VI. Study Limitations
The current study has several limitations. First, despite the high response rate for surveys of this type, the
possibility of response bias remains. This is true even though we took the normal precautions to avoid response bias.
We tested for non-response bias by conducting t-tests for differences in the mean value of certain firm
characteristics for responding and non-responding firms. The characteristics tested included total assets, net sales,
total debt to total capital, dividend yield, and price-to-book ratio. We included all firms used in our sample for which
Compustat had data for 1997. We found no significant differences between the mean values for responding and non-
responding firms at the 0.05 level.
A second limitation is that we omitted a few firms from the sample because certain information was
unavailable (e.g. the name of the top financial executive). This increases the possibility of response bias. Third, we
could have asked more questions to gain even greater insight into the attitudes and opinions of financial executives.
Given the tradeoff between survey length and the probability of realizing a high response rate, we chose to limit the
number of questions.
VII. Conclusions and Implications
In this study, we surveyed top financial managers of firms that announced the repurchase of shares of
common stock between January 1998 and September 1999 to obtain their views about various practices and issues
involving repurchases. Based on 218 responses, we found that many of the respondents perceived the practice of
repurchasing fewer shares than initially announced as common. For those firms indicating they had completed their
repurchase programs but had repurchased fewer shares than announced, the primary reason given was that the stock
price rose making the repurchase of shares less attractive than initially anticipated.

In general, respondents were unsure about whether announcing the repurchase of a specific number of
shares of common stock when a firm really intends to repurchase fewer shares is a legal business practice.
However, the respondents generally agreed that such a practice is unethical and sends a false signal to the market.
Despite these views, the practice of repurchasing fewer shares of stock than announced remains a fairly common
practice. The respondents generally agree that failing to follow through with an announced repurchase of shares
damages a firm’s credibility with its stockholders. The respondents also generally agreed that firms should publicly
announce the reason for not repurchasing all shares originally announced and the amount by which the repurchase
fell short of expectations.
We believe the results of this study reveal an inconsistency in the opinions of managers. Managers do not
want to lose credibility with stockholders. In this study, the responding managers generally agreed that not
following through with announced repurchases causes firms to lose credibility with their stockholders. They also
agreed that when firms fail to follow through with announced stock repurchases, this action sends a false signal to
the market. Despite these beliefs, this practice continues. There was agreement that firms failing to complete an
announced repurchase program should publicly announce why the repurchase fell short of expectations. However,
this agreement was far weaker than agreement that firms failing to follow through with announced repurchases can
cause firms to lose credibility with their stockholders.
Based on the study’s findings, we believe that managers need to recognize that a problem exists. The
primary problem is that some managers may be giving false signals to the market by announcing stock repurchase
programs on which the firm does not follow through. Whether this act is intentional or unintentional is less
important than the fact that sending false signals to the market can have negative consequences. Therefore, firms
announcing share repurchases should have every intention of carrying through with the repurchase. If conditions
warrant a change in the repurchase program, managers should publicly announce both the reason for the change and
the nature of the change (how will it affect the number of shares repurchased). In our view, managers should
address this problem before regulatory agencies create rules and regulations that restrict current freedoms.