There are many theories explaining the pros and cons of share repurchase.  Joe and I have debated many of these points in a series of four posts (to see the links to all of these see Repurchases: Part 4 - Some Concluding Comments).  One theory is that share repurchases signal positive information.  Another theory suggests repurchases transfer wealth from bondholders to shareholders because repurchases erode the equity base and increase risk to debt.  

Previous research is generally supportive of positive signaling but inconclusive with regard to wealth transfer.  Part of the problem with testing the wealth transfer hypothesis is that all bond repurchases are not alike.   In a very interesting article Kathy Kahle notes that the purpose of many share repurchases is to support executive options and that it is important to disentangle these effects when testing various hypotheses. (See When a Buyback Isn't a Buyback.) We utilize this result in a more refined test of the signaling and wealth transfer hypotheses that was published in the Journal of Corporate Finance in 2009.  The abstract and download information is below.

Share Repurchase, Executive Options and Wealth Changes to Stockholders and Bondholders

Sang-Gyung Jun 
Hanyang University 
Mookwon Jung  Kookmin University 
Ralph A. Walkling  Drexel University - Lebow College of Business 

We test the signaling and wealth transfer hypotheses around the announcement of share repurchases using a recent and larger sample of data than previously examined while employing a methodology designed to enhance the power of our tests. Disentangling the wealth transfer and signaling hypotheses is difficult; they are not mutually exclusive and can have opposite effects for bondholders. Wealth transfers will decrease bondholder wealth while positive signals will increase it; the combined effects obscure tests of each hypothesis. By focusing on sub-samples where signaling is more and less likely to be present we increase our ability to isolate the separate effects. In addition to traditional tests of wealth effects, we feature information inherent in the relation of wealth changes to equity and debt. Also, it is important to examine more recent evidence surrounding repurchases, particularly for bondholders. Most work on wealth changes to bondholders ends in 1997 with the demise with the Lehman Brothers Bond Database. Our results are generally consistent with the positive signaling effect of stock repurchases, but also provide some support for wealth transfer. Our work also emphasizes the importance of trying to disentangle the various hypotheses. In the subset of option funding repurchases, where signaling effects are less likely, the positive correlation of wealth changes between stockholders and bondholders is completely eliminated. Bond ratings are much more likely to be upgraded in samples without executive options which is precisely where the signaling effects are expected to be concentrated. Governance factors are insignificant.

Click here to find the final version of the article  or here to download a free, slightly earlier version.

All the best,

Ralph

US Air Merges with American Airlines

US Air announced that it will acquire American Airlines today in an all stock deal valued at $11 billion.  Shares of USAIR dropped $0.67 to close at $13.99, a 4.6% drop in value.   Shares of American Airlines rose  $0.82 to close at $2.12 a 63%  rise in value!  We've noted before that (ignoring the effects  of anticipation) bidders tend to break even or report small losses upon the announcement of a deal for a public company.  This is especially true when stock is involved.  The prevailing logic on the drop in value when stock is issued involves a signaling effect:  "Hmmm, they offered stock.  Guess they wouldn't have done that if they thought it was undervalued."

 In contrast,  shareholders of target firms typically earn 20 - 40%.  The results of this deal are loosely consistent with those statistics.  One can argue, however that although the dramatic rise for American Airlines and the sharp loss for US Air are surprising, since the deal was widely expected to happen.  The price changes may reflect surprise not in the deal itself, but in the particular terms of the offer.  Certainly, shareholders of American Airlines, a company in bankruptcy must be esctatic.  (See, for example,  AMR shareholders to receive rare value from Chapter 11.)

------

Next week we'll talk about a dramatic rise in merger related litigation and also begin exploring motives for mergers.  I think there is a good probability that we may have a bit more to say about the Dell LBO as well!

All the best,

Ralph