Stock Repurchase and Cash Acquisition - A Payout Policy Perspective

Abstract

We examine a firm's repurchase and acquisition decision in a cash payout framework with a focus on the interaction between corporate finance and governance. A comparison of repurchase and acquisition gives us a unique perspective in a sense that they both deal with the question of how to expend cash in a hierarchy of spending priorities that involve decisions not only about payout policy but also on investment strategies. Ours is the first empirical study to investigate a possible pecking order among a set of cash spending options as recently documented in a field survey of financial executives. We find evidence that both repurchase and acquisition will not be considered until cash requirements of internal investment, dividend payout and debt reduction have been satisfied. Furthermore, repurchase is of secondary importance to acquisition in that the former is usually initiated only after substantial amount of cash are accumulated while the latter can be prompted when strong free cash flow starts to generate. This also points to the observation that repurchase firms are often bigger with more cash, better operating performance and low debt, signs of firms that are in later stages of the life cycle. Our results from the study of repurchase in conjunction with cash acquisitions prove to be particularly enlightening in the context of free cash flow hypothesis (Jensen 1986). We conjecture that managers are prone to wasting free cash on acquisitions when cash flow is strong and it is only when cash stock begins to pile up that they are thinking about paying back extra cash to shareholders. This is a strong version of free cash problem as originally pointed out by Jensen. To mitigate the agency problem as manifested by value destroying acquisitions and facilitate repurchase as a way of giving value back to shareholders, the classic theories that propose more management ownership and advocate greater role of institution monitoring seem to be supported in our empirical exercises. Our event study results buttress the assumption that repurchase is more value enhancing than acquisition in that it may alleviate the agency problem of free cash flow.