The influence of taxes and risk in open market stock repurchase transactions

Abstract

This study investigates the impact of taxes and risk on firm's repurchasing decision and the subsequent market reaction to their announcement. I extend the repurchase literature by examining the tax and risk motivations for firms repurchasing their stock and increasing their borrowing, while controlling for the alternative explanations for repurchases. In a stock repurchase, a firm can quickly change the ratio of debt to equity in its capital structure, and, when combined with the positive change in debt, a setting where the firm is altering the balance of its capital structure in two similar directions is revealed. If there are both significant benefits and costs to debt financing, as suggested by trade-off theory, then firms should make financing choices that are related to these factors. The results revealed that firms increasing their borrowing as part of the repurchase transaction are significantly more under-leveraged, realize greater tax benefits, and have lower default risk than firms that are decreasing their borrowing. These findings are consistent across univariate analysis and multivariate logistic analyses that control for free-cash-flow and signaling explanations. Also, I show that the tax benefits for firms increasing their debt are positively related to the announcement period abnormal returns. Collectively, these results suggest that debt-financed repurchases are being used, in part, to re-balance firms' capital structures, and that the resulting tax benefits have a positive influence on firm value.