"Jolls finds that the average executive in her sample of firms with repurchase activity enjoyed a $345,000 increase in stock option value as a result of the repurchase activity."

During the 1980s and 1990s, corporate managers increasingly chose to use corporate earnings for stock repurchases (buy-backs), or to increase corporate liquidity, rather than to pay dividends. In Stock Repurchases and Incentive Compensation(NBER Working Paper No. 6467) , Christine Jolls suggests that part of the explanation for this trend may lie with the increased use of stock options in executive compensation packages. Now extremely popular across a wide range of firms, stock options give the holder the right to purchase stock at a specified price. Unlike holdings of actual stock, though, stock options do not pay managers any dividends.

While a dividend transfers cash from a firm to its outside owners without any reduction in the number of outstanding shares of stock, a repurchase uses the same corporate cash to reduce the number of shares outstanding. Therefore, the value of a share of stock is diluted by the payment of a dividend but is not diluted by a share repurchase. So stock options are more valuable after a repurchase than after a dividend. Indeed, Jolls finds that the average executive in her sample of firms with repurchase activity enjoyed a $345,000 increase in stock option value as a result of the repurchase activity. Thus there appears to be a strong incentive to neglect dividends in favor of share repurchases.

Jolls also observes that when executives are awarded restricted stock, a form of compensation that accrues dividends (in contrast to stock options), there is no observable preference for repurchases over dividends. Nor is the drive to repurchase shares a result of expanded employee stock option programs, she finds; it is executive options, not employee options generally, that are related to repurchase behavior. All in all, if "the average number of stock options held by top executives increases 50 percent from its mean value of 116,060, while the number of outstanding shares remains constant, then the probability of observing a repurchase increases by approximately 4 percentage points," Jolls estimates. In other words, there is a "131 percent increase over the proportion of firms engaging in repurchases in the original sample."

The fact that share repurchases shield owners from the taxes levied on dividends often has been used to explain the popularity of share repurchases. However, as Jolls points out, tax differentials have been around for decades, while "the increase in repurchase activity occurred relatively recently." And though the hostile takeovers prevalent in the mid-to late 1980s undoubtedly fueled a substantial fraction of the repurchase activity during that period, the decline in hostile takeovers in the early 1990s did not produce a reversion to the level of repurchase activity that prevailed before the takeover boom.

The results in the paper come from an initial group of 2539 firms (eventually reduced to a sample of 324 firms) covered by SEC disclosure requirements whose 1992 fiscal years ended between December 31, 1992 and May 31, 1993. To be included, the firms must have been U.S. firms with 500 or more stockholders and fiscal-year-end assets greater than $25,000,000. All 177 firms that announced dividend increases or repurchases or both, as reported by The Wall Street Journal, were included in the sample assembled from this group. A comparison group of 300 firms that announced neither repurchases nor dividend increases was randomly selected from the remaining firms and used as a control group. Data was ultimately collected for a total of 324 firms.

-- Linda Gorman

The Digest is not copyrighted and may be reproduced freely with appropriate attribution of source.

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