Corporate governance and the market reaction to stock repurchase announcement
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Corporate governance and the market reaction to stock repurchase announcement Salim Chahine • Mohamad Jamal Zeidan • Hala Dairy
Published online: 5 March 2011 Springer Science+Business Media, LLC. 2011
Abstract This paper investigates the effect of corporate governance on market reaction around of a stock repurchase announcement. We argue that corporate governance affects the ability of a stock repurchase to alleviate agency costs related to free cash flows, and the credibility of the undervaluation signal sent by the announcement of buyback programs. We find a higher 3-day cumulative abnormal return to programs announced by firms with better corporate governance practices than those with bad governance (1.6% and 0.85% respectively), and the market reaction is significantly higher following the successive scandals in year 2001 (Enron, Arthur Anderson, WorldCom…) and the resulting Sarbanes–Oxley Act of 2002. Further investigations indicate that firms with a lower Free Cash Flow to Asset ratio have a higher market reaction, which is consistent with the information signaling hypothesis, and this is more significant in firms with good governance practices, and following post Sarbanes–Oxley Act. Keywords Corporate governance Stock repurchase Sarbanes–oxley Undervaluation JEL classification
G30 G32 G34
1 Introduction Stock repurchase programs have recently become a significant component of payout policies in the US. Share repurchase announcements in the US increased from 25 billion US dollars in the mid-1980 s to almost 550 billion US dollars between 1996 and 1998 (Ikenberry et al. 2000), and later fell back to 270 billion USD in 2005. S. Chahine (&) M. J. Zeidan H. Dairy The Olayan School of Business, American University of Beirut, Bliss Street, Beirut, Lebanon e-mail: [email protected]
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According to the free cash flow hypothesis, a share repurchase is usually used to mitigate agency conflicts related to free cash flow that might be used by managers in unprofitable projects (Jensen 1986). Alternatively, the information signaling hypothesis argues that a company can use a stock repurchase to send a costly signal that it is undervalued (Dittmar 2000). Recent corporate scandals have shaken the trust between shareholders and managers, and raised the awareness of shareholders on issues related to the credibility of managers and the importance of corporate governance in setting financial policies. While there is considerable research that relates the magnitude of the response to different firm characteristics such as firm size, repurchasing ratio, book-to-market ratio (B/M), firm’s payout policy, as well as free cash flow (FCF), there is little research on the effects of corporate governance around stock repurchase events. This paper tries to fill this gap in literature by examining the differential role played by corporate governance and its effect on the market reaction around stock repurchase announcements. Specifically, we verify whether good corporate governance stan
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