Common stock repurchase and market signalling

3278 Words14 Pages
Journal

of Financial

COMMON

Economics

9 (1981) 139-183.

STOCK REPURCHASES

North-Holland

Publishing

Company

AND MARKET SIGNALLING

An Empirical Study*
Theo VERMAELEN lJ/niversity of British Columbia, Vancouver, BC, Canada V6T 2 W5

Received January

1980, final version

received January

1981

This paper examines the pricing behavior of securities of firms which repurchase their own shares. The results are consistent with a market in which investors price securities such that expected arbitrage profits are precluded. The results are also consistent with the hypothesis that firms offer premia for their own shares mainly in order to signal positive information, and that the market uses the
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The direction of this signal is ambiguous.
It may be that the company perceives no profitable use for internally generated funds because of a lack of growth opportunities.
On the other hand, especially when a company offers to buy its shares at a substantial premium above the market price, management may believe that their company is undervalued.
The tender offer then represents an attempt to pass on the value of this inside information to the current shareholders.
(2)

Dividend or personal

taxation hypothesis

Firms repurchase stock in order to let the shareholders benefit from the preferential tax treatment of repurchases relative to dividends; the tax advantage may be weakened to a certain extent by the provisions of Section
302 of the Internal
Revenue Code, which treats redemption of stock as a capital gain only if one of the following cases applies:
(i) the redemption is ‘substantially disproportionate’ to the extent that after the repurchase, the percentage ownership of the shareholder must be less than 80 7; of the percentage ownership he had, before the repurchase; by railroad companies in certain
(ii) the stock is issued reorganizations, defined by section 77(c) of the Bankruptcy
Act;
not equivalent’ to paying a (iii) the distribution is ‘essentially dividend. It is not

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