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A comparison of the market reaction to specially designated dividends and tender offer stock repurchases.

Miller and Modigliani's (1961) premise - that valuation depends only upon the productivity of the firm's assets and not the form of payout - is an issue that continues to draw attention in the literature (e.g., Brennan and Thakor, 1990). Much of the debate surrounding the methods of equity payout compares regular dividends and share repurchases. Inasmuch as both specially designated dividends (SDDs) and tender offer common stock repurchases (TOSRs) are irregular and nonroutine equity payouts, examination of the stock market's reaction to them might provide additional insights into shareholder preferences on payout policy. Our results show that the stock market reacts positively to announcements of both SDDs and TOSRs. However, we find a larger market reaction for TOSRs even after controlling for their larger relative size and preferential capital gains tax rate.

I. Literature Review and Hypothesis Development

Prior research compares TOSRs with regular dividends. This comparison is appropriate only if a firm is expected to repurchase shares periodically (e.g., Asquith and Mullins, 1986; Vermaelen, 1981). However, most firms that repurchase shares do so on an irregular basis. Barclay and Smith (1988) conclude:

If managers are unwilling to increase the regular dividend when there is a significant probability that the new level cannot be maintained, infrequent distributions can still be made through a repurchase or through a specially designated dividend.

Comment and Jarrell (1991) argue that TOSRs might be used more as a mechanism for distributing excess cash than for signaling the firm's future prospects. While SDDs and TOSRs provide alternative mechanisms for equity payout that do not carry an "implied" commitment of periodicity, they might differ from each other in three important ways.

First, TOSRs generally involve a larger cash distribution to the shareholders than do SDDs. Brennan and Thakor (1990), in modeling the choice between dividends and repurchases, conclude that relatively large distributions are likely to be made through repurchases and smaller ones through dividends.

A second major distinction between them is the shareholder-tax impact. TOSRs lead to capital gains, while SDDs are ordinary income. The Tax Reform Act of 1986 (TRA) which took effect in 1987, abolished the lower capital-gains-tax rate, but subsequent tax changes have restored it. The tax issue is not a clear-cut one, however, because corporate stockholders receive the 70% tax exclusion for dividends, and tax-free investors would have no tax preferences.(2) Thus, the issue of investor preferences for capital gains, if any, becomes an empirical one. By comparing the relative market reaction to SDDs and TOSRs both before and after the Tax Reform Act, we can develop additional insights?

Third, managers may use changes in dividend policy or TOSRs to reduce the information asymmetry between them and the shareholders (Miller and Rock, 1985; Jensen and Johnson, 1995). Typically, managers do not tender their personal shares in TOSRs, which increases their personal undiversifiable risk (Ofer and Thakor, 1987). This gives credibility to the signal sent by repurchase. Managers do not increase their personal undiversifiable risk when an SDD is paid. They may actually reduce their risk since they (personally) have additional cash available for other investments. Thus, TOSRs may provide a positive signal, since managers are willing to increase their own risk.

In this study, we examine the market reaction to SDDs and TOSRs to see if the shareholders prefer one cash distribution mechanism over the other. We also conduct several preliminary tests to examine whether the differences between the two methods are related to size, taxes, or signaling effectiveness?

II. Sample and Methodology

Our sample consists of 117 share repurchases via tender offers identified from the entries in The Wall Street Journal Index between January 1978 and September 1989 with returns available on the Center for Research in Security Prices (CRSP) tapes for the estimation and event period (191 days). The terms of repurchase and company-specific data (number of common shares outstanding and the stock price at the end of the month before the announcement) came from the original WSJ article and the CRSP Daily/Monthly Stock Master Files, respectively. The SDD sample consists of 381 firms announcing 1,277 SDDs over the sample period and is identified from the CRSP Monthly Stock Master Files.(5) For the TOSRs in our sample, the mean percentage of shares sought is 19.02%, and the median is 16.03%. The mean offering premium is 22.23%, and the median is 17.2%.

We calculate the SDD yields by dividing the SDDs by the stock price at the end of the month prior to the announcement. While the mean yield is 2.62%, the median is only 0.866%, indicating a skewed distribution. As shown in Table 1, SDDs are generally smaller than repurchases. The largest category for SDDs is for cash distribution less than $500,000; for repurchases it is those above $128 million. Panel B of Table 1 shows that for SDDs, 61.9% of the transactions are for less than 1.25% of the firms' equity market value. Most TOSRs (38.3%) are between 10% and 19.9% of firm value. This is consistent with Brennan and Thakor's (1990) contention that small cash distributions are more likely to be made through dividends, while larger distributions are more likely to be made through repurchases.

We utilize the event study methodology developed by Dodd and Warner (1983) to estimate abnormal returns and test statistics. Our estimation period for the market-model parameters is Days -170 to -21 (relative to announcement day). We compute average and cumulative prediction errors (APE and CPE) over various intervals during the test period, Days -20 to +20.

To compare the market response to stock repurchases and SDDs, we regress the CP[E.sub.i] for the interval, Days -1 to 1, as the dependent variable, against independent variables that control for transaction size, firm size, transaction frequency, and tax law changes. Transaction size (PC[T.sub.i]) is measured as a fraction of the market value of the firm's equity at the end of the month prior to the [TABULAR DATA FOR TABLE 1 OMITTED] announcement. The equity value of the firms that select TOSRs is higher by about 87% ($872.6 million vs. $466.5) than that of firms selecting SDDs. To control for this, we include the log of the market value of the firm's equity (M[V.sub.i]). Because there might be differences in the expectations of the investors for the firms that tend to use these methods more frequently than others, we also control for the frequency of SDD/TOSR usage by a firm (FRE[Q.sub.i]) in our sample period. Finally, we examine the differences between the markets' reaction to the two methods of payout before and after the TRA of 1986.

III. Results

In this section, we discuss the cumulative prediction errors (CPE), the results from our cross-sectional regressions, the ownership distribution, and dividend yield analysis.

A. CPE Results

As shown in Panel A of Table 2, the stock market reacts positively to the TOSR and SDD announcements. The CPEs are positive and statistically significant in the Days -1 to 1 interval. For TOSRs, the Days -20 to -2 interval is also significant, suggesting that some of this news is anticipated. Panel A also shows that for Days -1 to 1, the difference between the CPEs for SDDs and TOSRs is 7.534% (Z = 9.094), which is highly significant. Although this test does not control for differences between SDDs and repurchases, it does show that the TOSR-firm CPEs are larger.

The TRA of 1986, which actually took effect on January 1, 1987, eliminated the differential tax rate between dividends and capital gains. We divided our sample into transactions occurring before 1987 (87 TOSRs and 970 SDDs) and those occurring in 1987 or later (30 TOSRs and 307 SDDs). As Panel B of Table 2 shows, the CPEs (Days -1 to 1) of TOSRs are significantly larger before 1987 than they were for the transactions occurring after January 1, 1987. There is no difference between the CPEs of SDDs in these periods. This result might be expected, since a change in the capital gains tax rate should only affect TOSRs. It also shows that payout decisions might be influenced by shareholder tax rates.

We also examine the comparison of SDDs to TOSRs for the before-and-after TRA subsamples (Panel C). While the TOSRs are always valued more highly than the SDDs, the difference between their CPEs is statistically higher in the pre-1987 period than it is thereafter. Thus, the [TABULAR DATA FOR TABLE 2 OMITTED] market reaction is nominally more positive to TOSRs relative to SDDs before 1987 than thereafter. This is consistent with the presence of a tax effect.

B. Cross-Sectional Regression Results

Table 3 presents the pooled cross-sectional regression results with the Days -1 to +1 CP[E.sub.i] regressed against factors suggested by theory.(6) We use a dummy variable [D.sub.TOSR] (TOSRs = 1, SDDs = 0) to measure the relative market reaction of SDDs and TOSRs. In Regression 1, the coefficient for [D.sub.TOSR] is positive at a significance level greater than 0.01. Even when we control for the relative size of the transaction (PCT), the market value of the firm (MV), and transaction frequency (FREQ), TOSRs are still associated with larger abnormal returns.

The coefficient for PCT is significantly positive. [TABULAR DATA FOR TABLE 3 OMITTED] Larger transactions, as expected, elicit a larger response. Lakonishok and Vermaelen (1990) note that larger firms, which are more widely followed, have less need for "signaling" their true value, and thus bigger firms' response to these announcements might be smaller. Consistent with this explanation, we find the coefficient for MV is significantly negative. The coefficient for FREQ also is significantly negative. Jayaraman and Shastri (1988) show that frequent SDDs could be partially expected with a weaker market response. Our results support this argument.

One criticism against making the comparison of SDDs and TOSRs is that SDDs are smaller and more frequent than TOSRs. We initially addressed this issue by including PCT and FREQ variables in Regression 1. To further explore this matter, we run three additional regressions. In Regression 2, we eliminate firms with frequent transactions and include only those having two or fewer SDDs (n = 410) or TOSRs (n = 117) during our sample period. In Regression 3, we eliminate "smaller" transactions - as measured by PCT. We use 2.63% of the firm's equity value (the mean SDD yield of our sample) as the cutoff. In making the somewhat arbitrary decision about the cutoff to be used for this regression, we balance two conflicting objectives: retaining as many SDDs as possible and choosing only those SDDs with high PCT.

Finally, in Regression 4, we include only less frequent (FREQ [less than] 3) and relatively larger (PCT [greater than] 2.63%) transactions (n = 105 for SDDs and 115 for TOSRs).

The results of Regressions 2 through 4 are qualitatively similar to those of Regression 1. The F-statistic for all regressions is highly significant, and the coefficients for [D.sub.TOSR], PCT, and MV retain their sign and significance. The coefficient for FREQ, however, is not significant in Regression 3. The continued strong significance of [D.sub.TOSR] shows that shareholders value TOSRs more than SDDs.

We include a tax dummy, [D.sub.1986], in Regression 5, which takes the value of one for transactions before 1987 and zero otherwise. While all other variables retain their signs and significance from earlier regressions, the coefficient for [D.sub.1986] is not significant.

To further explore the relative valuation of SDDs and TOSRs in the pre- and post-TRA period, we include a dummy-interaction variable ([D.sub.TOSR][D.sub.1986]) in Regression 6. The coefficient for this variable is significantly positive. Prior to 1987, TOSRs (vis-a-vis SDDs) are more positively valued by the market than those occurring in 1987 and after.(7) Tax differences partly explain the difference between the market's valuation of SDD and TOSR transactions. Because the coefficient for [D.sub.TOSR] is still positive, however, not all the difference in repurchases and SDDs can be attributed to the lower capital gains tax rate. Signaling may explain some of the difference.

C. Further Results

To explain the usage of SDDs by a number of firms - even when the size of the payout is large and a larger stock market response might have been expected with a TOSR - we look at two possible explanations: a dividend-clientele effect and an ownership distribution.(8) These are discussed below.

The dividend-clientele effect (e.g., Miller and Modigliani, 1961) is supported by a number of researchers (e.g., Elton and Gruber, 1970; and Litzenberger and Ramaswamy, 1982). If firms attempt to play to the desires of their shareholder clientele, then high-dividend-yield companies might be more likely to issue SDDs (despite the smaller abnormal returns) than would lower-dividend-yield companies.

We calculated the regular dividend yield by summing all regular (non-SDD) dividends in the 12-month period ending in the month prior to the announcement date and dividing by the stock price at the end of the month prior to the SDD/TOSR announcement. Panel A of Table 4 shows the results. For the total sample, the average regular dividend yield is 5.79% for the SDD firms and 3.74% for TOSR firms. A two-sample t-test shows that the means are significantly different. We recompute these statistics for a subsample of firms whose size and frequency of SDD payout, as discussed earlier, are similar to those of TOSR firms. The difference in means in either case is significant at beyond the 0.01 level. Firms that pay SDDs have higher dividend yields than those that repurchase stock.

As discussed earlier, both SDDs and TOSRs seem to send a positive signal to the market. However, if insiders own a large proportion of total outstanding shares, signaling could be less important. In addition, a TOSR tends to increase the insiders' percentage ownership (because of a precommitment not to take part in the tender offer) and thus, increases their personal undiversifiable risk. SDDs provide them with cash that can be used to reduce their risk. Thus, we expect firms with larger inside ownership to declare SDDs rather than repurchase shares. Hansen, Kumar, and Shome (1994) also show that ownership impacts the payout policy.

We collect ownership data from the Compact Disclosure database and the S&P Stock Guide for 393 SDDs and 45 TOSRs. As shown in Panel B of Table 4, the percentage of inside ownership is 34.53% for SDD and 19.67% for TOSR firms. The difference is significant at greater than the 0.01 level. We then recompute these statistics for the two subsamples with similar frequency and transaction amounts. The results support the hypothesis that larger insider ownership might sway the directors to declare a SDD rather than to repurchase shares.

IV. Conclusions

We find that even after controlling for transaction size and frequency, the stock market reacts more positively to TOSRs than it does to specially designated dividends. One explanation is that because of the lower capital gains tax rates, stock repurchases are more valuable than SDDs.

Our results suggest that a tax effect indeed exists. In our sample, repurchases are valued somewhat less positively after the capital gains tax rate was increased to the same statutory rate as for dividends. The difference in the market response between SDDs and repurchases also decreases following this tax-law change.

After controlling for tax-rate changes, transactionsize differences, frequency of transactions, and market-value differences of the firms, firms that repurchase earn larger abnormal returns than those that issue SDDs. While this is not a direct test of signaling, it does not eliminate signaling as a possible explanation. The difference between the market reaction to SDDs and repurchases could also be a price-pressure effect, as documented for repurchases in Davidson, Chhachhi, and Glascock (1996).


We also find that the SDD firms have, on average, higher non-SDD dividend yields than repurchasing firms, which suggests a possible clientele motive in the decision to pay an SDD. Furthermore, the average percentage ownership by insiders is 75.5% greater for SDD firms than for repurchasing firms. Insiders may not want to sell their stock and could therefore prefer to receive the cash as a SDD. Future research may explore this motivation, because the insiders appear to be a clientele that prefers the SDD.

Firms that declare SDDs rather than repurchasing stock may do so when the transaction size is small; when their clientele prefers dividends, over capital gains; and when insiders who already control a large amount of that firm's voting stock choose not to increase their undiversifiable risk by increasing their control after a repurchase.

We cannot, however, state that repurchases are superior to SDDs in all cases. Had the SDD firms chosen to use repurchases, their results might not have changed. Further research on this topic may be needed to examine the characteristics of firms that pay SDDs versus those that choose repurchases via tender offers.

The authors would like to thank Marcia Millon Cornett, Ike Mathur, Nanda Rangan, Stuart Rosenstein, Tom Schwarz, and two anonymous referees for their helpful suggestions. All errors remain the responsibility of the authors.

1 We do not include open market repurchases in our sample because they, unlike TOSRs, do not represent a "definite commitment" on the part of the corporation to complete the repurchase (e.g., Ikenberry and Vermaelen, 1996).

2 The 70% tax exclusion applies if the investment constitutes less than 20% of another firm. An 80% dividend tax exclusion applies if the investment is greater than 20%. The TRA has been shown to impact corporate payout policy (e.g., Papaioannou and Savarese, 1994).

3 A tax advantage is still associated with TOSRs. Shareholders who receive SDDs all face ordinary income tax liability. Shareholders of tender-offer firms, however, may choose not to tender their shares, and thus postpone the tax liability.

4 There may also be transaction-cost differences between SDDs and TOSRs, which seem to favor SDDs. The transaction costs of an SDD can include only the cost of printing and mailing the checks. On the other hand, tender offers for stock require payment of investment banker's fees, the preparation of legal documents, filings with the SEC, and considerable administration. TOSRs are thus more costly than issuing an SDD. Barclay and Smith (1988) maintain that the large, fixed costs of tender offers favor dividends in smaller transactions and repurchases in the case of larger distributions.

5 We eliminated companies that had other news releases during a nine-day window surrounding the announcement day. That left us with an uncontaminated sample of 64 TOSRs and 198 SDDs. Takeover-related news is the most common "contaminating" event for TOSRs, as are regular dividend announcements for SDDs. The results for the uncontaminated sample, however, are qualitatively similar to those for the entire sample. Thus, only the results for the entire sample are reported here. (A copy of the tables for the uncontaminated sample are available from the author upon request.)

6 In these regressions, we control for heteroskedasticity by scaling the dependent and independent variables by the inverse of the standard error of the prediction error. We also perform collinearity diagnostics to check for linear dependencies among our independent variables. No significant collinearity problems are found.

7 We reran Regressions 5 and 6 without any of the data points from 1986 and 1987. These are the years in which the tax law was debated in Congress, and there may have been some uncertainty about future tax laws. The results lead to similar conclusions except that the coefficient for [D.sub.1986] is now significant in Regression 5, suggesting a difference in the market reaction from before to after the tax change.

8 A third explanation may be the impact on the liquidity of the stock. However, Singh, Zaman, and Krishnamurti (1994) find that repurchases do not appear to impact liquidity. We leave it to future research to explore this issue in depth.


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Barclay, M.J. and C.W. Smith, Jr., 1988, "Corporate Payout Policy," Journal of Financial Economics (October), 61-82.

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Comment, R. and G.A. Jarrell, 1991, "The Relative Signaling Power of Dutch-Auction and Fixed Price Self-Tender Offers and Open Market Share Repurchases," Journal of Finance (September), 1243-1271.

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Litzenberger, R. and K. Ramaswamy, 1982, "The Effects of Dividends on Common Stock Prices: Tax Effects or Information Effects?" Journal of Finance (May), 429-444.

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Ofer, A. R. and A.V. Thakor, 1987, "A Theory of Stock Price Responses to Alternative Corporate Cash Disbursement Methods: Stock Repurchases and Dividends," Journal of Finance (June), 365-394.

Papaioannou, G. and C. Savarese, 1994, "Corporate Dividend Payout Policy Response to the Tax Reform Act of 1986," Financial Management (Spring), 56-63.

Singh, A., M.A. Zaman, and C. Krishnamurti, 1994, "Liquidity Changes Associated with Open Market Repurchases," Financial Management (Spring), 47-55.

Vermaelen, T., 1981, "Common Stock Repurchases and Market Signaling: An Empirical Study," Journal of Financial Economics (June), 139-183.

Indudeep S. Chhachhi is an Associate Professor of Finance at Western Kentucky University. Wallace N. Davidson, III is Henry Rehn Research Professor of Finance at Southern Illinois University at Carbondale.
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Author:Chhachhi, Indudeep S.; Davidson, Wallace N., III
Publication:Financial Management
Date:Sep 22, 1997
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