The - Effects - of - Stock - Repurchas ON BANK

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THE EFFECTS OF STOCK REPURCHASES ON LONG TERM OPERATING
PERFORMANCE IN BANKING FIRMS: AN EMPIRICAL STUDY
KAMALA RANGASWAMY RAGHAVAN
Master of Business Administration
Northeastern University, Boston, MA
June 1976
Submitted in partial fulfillment of requirements for the degree
DOCTOR OF BUSINESS ADMINISTRATION
at
CLEVELAND STATE UNIVERSITY
Fall 2004
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This dissertation has been approved
for the College o f Business Administration
and the College of Graduate Studies by
Dr Heidi Hylton Meier

Dissertation Committee Chairperson
Department/ Date
C-
Dr Ravindra Kamath
p i n a pi/lot/
Department/ Date
- f ' ■
y Dr Vijay K. MatJtur
~C- & f\ 0 y r \ f X S i ^ I *3 j o *2
Department/ Date ' 1
Dr Peter J. Poznanski
Department/ Date
To my mother
for her unwavering support.
ACKNOWLEDGEMENTS
With gratitude, I thank the members of my dissertation committee. Dr. Heidi
Hylton Meier, my chair provided overall counsel and guidance based on a meticulous
review of the manuscript. I thank Dr. Peter Poznanski for his suggestions, review, and
support throughout the dissertation process. Drs. Ravindra Kamath and Vijay Mathur
offered valuable insights on the econometric model and theory that helped me with
interpretation of the results.
My special thanks go to Mr. Chanda Sichinsambwe, doctoral candidate at
Cleveland State University for his time, assistance with SPSS, and review.
THE EFFECTS OF STOCK REPURCHASES ON LONG TERM
OPERATING PERFORMANCE IN BANKING FIRMS: AN EMPIRICAL STUDY
KAMALA RANGASWAMY RAGHAVAN
ABSTRACT
Corporate finance theory dictates that managers’ decisions should lead to value
maximization for the firm’s shareholders. When firms have excess cash flow, managers have
to choose among several alternatives to deploy the cash to add value to the firm. In the
absence of profitable investments or debt reduction, they have to choose the best method
to payout the excess cash flow to shareholders to avoid agency conflict. The principal
mechanisms used by firms to distribute excess cash are dividends and share repurchases
(announcing an open market or tender offer to buy back own shares), with an increasing
percentage going to repurchases. The main focus of prior empirical research studies in the
non-financial sector has been the effect of share repurchases on managers’ wealth and its
impact on the choice o f cash payout mechanism.
The purpose of this study is to provide empirical evidence relevant to the
application of existing share repurchase hypotheses to the banking firms while
considering the exponential increase of management incentives during the study period.
Two major themes are pursued using financial firms’ data. First, management’s desire to
signal the market about future performance of the firm, and agency conflicts are reviewed.
Second, the impact of the exponential growth in executive and employee options on share
repurchase decisions and earnings management strategies are addressed.
This study draws upon the rich tradition of management actions - firm operating
performance research in finance and accounting. It concentrates on management behavior
and information asymmetry relative to the size of the firm and utilizes the methodology
typical to market studies. Data was collected from Compustat, Federal Reserve Bank
Holding Companies, and SEC Disclosure databases. Multiple regression and Logistic
regression models are used to test hypotheses derived from prior empirical studies in the
non-financial sector.
The obtained results lead to the following conclusions: (1) Cash flow and
institutional ownership have a strong positive relationship to firm’s operating
performance, while leverage, asset size and market to book value ratio affect it negatively;
(2) Size o f repurchase and performance in satisfying prior repurchase commitments do
not an have impact on the operating performance, contradicting the results of the
signaling and time inconsistency hypotheses from the non-financial sector; (3) Executive
options, transient cash flow and institutional ownership play a significant role in
influencing management choice of repurchase over dividends in banks of all sizes,
confirming the substitution hypothesis; (4) Total options do not show predictive ability of
repurchases, contradicting the option funding hypothesis; and (5) Deferred tax expense
and institutional ownership show significant positive impact on the likelihood o f earnings
management in banks, consistent with prior research in the non-financial sector.
This empirical study makes two important contributions to the accounting and
corporate finance research. First, it tests the existing share repurchase hypotheses in the
banking sector. Second, it examines the interaction of management incentives and firm
characteristics relative to share repurchases in banking firms.
vi
TABLE OF CONTENTS
Page
I. INTRODUCTION
Share Repurchases 1
Research Hypotheses 7
Organization o f Subsequent Chapters 16
II. LITERATURE REVIEW
Share Repurchase Hypotheses 18
Types o f Repurchases 18
Survey Studies 22
Operating Performance and Firm Characteristics

Related Hypotheses 25
Management Incentive Related Hypotheses 36
Selected previous Empirical Research Studies 52
Selected previous Survey studies 57
III. HYPOTHESES AND RESEARCH DESIGN
Hypotheses, Research design 58
vii
TABLE OF CONTENTS (CONTINUED)
IV. ANALYSIS OF EMPIRICAL RESULTS
Data and Sample selection 71
Results 74
V. SUMMARY AND CONCLUSIONS
Summary o f Results 125
Contributions 131
Limitations 132
Suggestions for future research 133
VI. REFERENCES 134
VII. APPENDICES
Appendix A: List of Variables 146
Appendix B: Signaling and Time Inconsistency Hypotheses:

Analysis of 1988- 1991 and 1992-2000 periods 148
Appendix C: Empirical Analysis using Dummy Variables for

Asset Size and Repurchases 154
Appendix D: Empirical Analysis using asset size groups 169
viii
LIST OF TABLES
Table Page
1. Summary Statistics 76
2. Operating performance of firm relative to industry 80
6. Distribution o f payouts and firm characteristics 91
7. Multiple regression of the determinants of payouts 92
8. Determinants of repurchase payouts 95
9. Firm characteristics by payout decision 99
10. Cash flow volatility and payout decision 101
11. Determinants of dividend substitution 105
12. Probability o f repurchases 115
13 Probability o f earnings management- All firms 122
B -l.l Summary Statistics- Years 1988 to 1991 148
B-1.2 Summary Statistics- Years 1992 to 2000 149
B-1.3 Summary Statistics- Years 1988 to 2000 151
B- 2.2 Operating performance of firm relative to industry-1992-2000 152
B-2.3 Operating performance of firm relative to industry-1988-2000 153
C-2.4 Operating performance of firm relative to industry with

Asset size and Repurchase Dummy variables 157
C-8.1 Determinants o f repurchase payouts with dummy variables 159
C-11.1 Determinants o f dividend substitution with dummy variables 160
C-12.1 Probability o f repurchase with dummy variables 164
C-13.1 Probability o f earnings management with dummy variables 167
ix
LIST OF TABLES (CONTINUED)
Table Page
D-3 Operating performance of firm relative to industry- Group 1 171
D-6a Distribution of payouts and firm characteristics- Group 1 174
D-6b Distribution of payouts and firm characteristics- Group 2 174
D-6c Distribution of payouts and firm characteristics- Group 3 174
D-8a Determinants of repurchase payouts-Group 1 176
D-8b Determinants of repurchase payouts-Group 2 177
D-8c Determinants of repurchase payouts-Group 3 177
D-10 Cash flow volatility and payout decision 180
D -llb Determinants of dividend substitution - Group 1 183
D -llc Determinants of dividend substitution - Group 2 183
D - lld Determinants of dividend substitution - Group 3 184
D-12b Probability of repurchase- Group 1 188
D-12c Probability of repurchase- Group 2 190
D-12d Probability of repurchase- Group 3 191
D-13a Probability of earnings management- All firms, Groups 1, 2, 3 195
LIST OF FIGURES
Figure Page
A. Conceptual framework 15
1. Excess return of firms 78
2. Payout ratios by asset size 85
2a. Payout ratios by year 86
3. Payout ratios for Group 1 firms 87
6. Executive and Total options 88
7. Executive and Total options- Group 1 firms 89
10. Payout trends 102
11. Yield trends 102
12a. Executive and Total options 109
12b. Executive and Total options- Group 1 109
12c. Executive and Total options- Group 2 110
12d. Executive and Total options- Group 3 110
13. Earnings Management Hypothesis 120
xi
CHAPTER I
INTRODUCTION
The fundamental premise of corporate finance is that the decisions of the
managers (agents) should lead to value maximization for their shareholders (principals).
When faced with excess cash, managers have to choose among the various alternatives
for use of the funds, i.e., investments, operations (debt reduction), and cash payout
(dividends and repurchases). The principal mechanisms used by firms to distribute excess
cash are dividends and share repurchases (announcing an open market or tender offer to
buy back own shares), with an increasing percentage going to repurchases. According to
the aggregate data from Compustat, dollars spent on repurchase programs relative to total
earnings increased from 4.8% in 1980 to 41.8% in 2000 and share repurchase
expenditures grew at an average annual rate of 26.1%, while dividends grew only at 6.8%
(Grullon and Michaely, 2002).
Share Repurchases
Share repurchases have become commonplace events in the U.S. financial
markets reflecting corporate strategies that are closely related to the firm’s investment,
financing and operating decisions.
2
Numerous theoretical and empirical studies have addressed the rationale and
impacts of share repurchases in the non-financial sector of the market and have presented
a mixed picture on the motivation behind share repurchases and the reasons for the
market reaction to the repurchase announcement. A few studies have examined the role
of repurchases in the financial services sector, but their results have been inconclusive
about the reasons for, and the effect of repurchases [Billingsley et al. (1989), (Laderman
(1995), Hirtle (1998), Kane and Susmel (1999)]. During the period of 1988 to 1997,
average repurchases by bank holding companies increased from $1.0 million to $14
million, with repurchases as a share of earnings increasing from 3% to 50% (Hirtle,
2003). The increased prominence of repurchase programs reflects their importance in the
implementation of the banking firms’ corporate strategies, mirroring the trend in the non-
financial sector of the market. Most of the earlier studies have also concentrated on the
short-term horizon surrounding the repurchase announcement event.
This study observes banking firms’ operating performance over the long term, and
extends the research done by Billingsley et al. (1989), Laderman (1995), Hirtle (1998),
Kane and Susmel (1999) and Hirtle (2003). It examines the relationship between
management compensation structures and repurchases extending the research done by
Lambert et al. (1989), Jolls (1998), Weisbenner (2000), Fenn and Liang (2001),
Jagannathan et al. (2000) and Kahle (2002) to the banking sector. It examines the data to
see if earnings management occurs around the repurchase event, thereby extending the
research done by Phillips et al. (2003) and Beatty et al. (2002). This empirical study looks
3
at the following corporate finance theories about share repurchases as they apply to the
banking sector:
• Signaling (management trying to communicate to the market that the shares are
undervalued relative to inherent earnings ability),
• Time inconsistency (firms’ record of satisfying prior repurchase commitments

before announcing new programs),
• Cash flow (managers deploying excess cash flow to value diminishing

investments),
• Substitution (the advantageous tax treatment for capital gains promoting

repurchases over dividends that are taxed at ordinary income rates),
• Option funding (impact of executive options in firms choice of payout in

repurchases instead o f dividends, and impact of total employee options), and
• Earnings management (management using repurchases for managing earnings).
This study concentrates exclusively on open market repurchases because they
account for 92% o f all share repurchase announcements by all corporations over the
period of 1980 to 1999 (Grullon and Ikenberry, 2000), and for 99% of share repurchase
announcements from 1992 to 1998 in Wall Street Journal for the banking firms (Hirtle,
2003). It reviews the impact of open market repurchases on the banking firms’ long-term
financial performance, as well as the relationship between executive and employee
options, competitive industry environment, investment opportunities and share
repurchases in the banking industry. The study scrutinizes for the existence of “time
inconsistency” in repurchasing banking firms, and its impact on the market reaction to the
repurchase event. It examines the presence of earnings management around share
repurchases and evaluates if managers engage in repurchases to improve the EPS
measures affected by option exercises, and if better financial performance in post
repurchase years is caused by reversals of discretionary accruals.
4
This study makes several contributions to the corporate finance literature by
testing existing share repurchase hypotheses using banking firms’ data while considering
the exponential increase in management incentives during the study period. One of the
key contributions is to look at the stated motives behind the concentrated share
repurchase programs in the last two decades, relative to the comparative lag in banking
firms’ share prices and long term shareholder value. Before deciding to announce a share
repurchase program, the banking firms’ management, investment bankers, financial
analysts and investors have to confront issues such as:
Signaling: Does the market’s assessment of firm’s future cash flow prospects (transient
vs. permanent) change because of the information content (signaling) of repurchases and
is it reflected in the present stock price? Do institutional owners react differently to the
repurchasing signal than individuals? Do repurchases enhance long-term financial
performance and shareholder value?
Cash flow: Does management’s assessment of permanence or transience o f earnings
levels influence the decision to payout in (steadily increasing) dividends versus (flexible)
repurchases for banking firms with limited investment opportunities?
Substitution: Does the tax advantage of repurchases over dividends influence the payout
preference? Did the SEC Rule 10b-18 (1982)1 and Tax Reform Act (1986)2 change the
cash payout preferences o f banking firms?
Option funding: Does the banking industry’s increasingly competitive environment
promote the firms’ reliance on executive stock options as part of total compensation,
leading to preference for repurchases? Are repurchases related to the market-to-book
1 SEC Rule 10b-18 defined a safe harbor for open market repurchases, and was introduced in 1982.
2 Tax Reform Act o f 1986 reduced the capital gains rate.
5
ratio arid volatility of operating income? Are management stock options and repurchases
positively related, and do they have a closed loop of cause and effect? Do outstanding
stock options promote repurchases to minimize dilution to existing shareholder interests?
Earninss Management'. Since banking firms are subject to regulatory capital
requirements based on accounting data, do stock repurchases create a motivation for
managers to engage in earnings management (smoothing)? Is strong (weak) earnings
management related with weak (strong) market reaction to repurchase?
Time Inconsistency. Do banking firms’ prior performance to satisfy commitments to
repurchase affect the market reaction to subsequent repurchase announcements?
Studies by Miller and Modigliani (1961), Black and Scholes (1974), and Miller
and Scholes (1978) provided compelling arguments that in a perfect capital market of
rational investors, the share value depends on the productivity of the firm’s assets,
independent of the cash payout. But market imperfections like tax rates, information
asymmetries between managers and outsiders, transaction and flotation costs, agency
costs, option funding, and investor behavior play a role in the market reaction to the
firm’s cash payout. The principal mechanisms used by firms to distribute excess cash in
addition to debt reduction are dividends and share repurchases.
Numerous studies in corporate finance have attempted to explain the impact of
cash payout decisions on share prices, though with limited success. Empirical and
theoretical studies have tried to ascertain if share repurchases create long-term firm
values, but the evidence has been inconclusive. Share repurchases can change the capital
structure of the firm and be motivated by financing, investment or payout needs. Market
experts propose that increased share repurchases seem to accompany declines in stock
6
market valuations. In spite of the widespread belief in signaling power of share
repurchases, they do not always act as the magic bullet to increase the firm’s share price
causing frustration to management and investors alike. Also, contrary to empirical
evidence, various survey studies conducted since 1967 show that managers place heavy
emphasis on signaling the market about undervaluation o f stock as the predominant
motive for repurchases, followed by cash flow (agency) and option funding needs.
However, empirical studies in non-financial firms clearly show the strong positive
relationship o f share repurchases with cash flow (agency), and substitution o f repurchases
for dividends with increase in executive options.
Survey studies
Leo Guthart (1967) in trying to answer the question “why companies buy back
their own stock” surveyed corporate executives, educators and market participants. The
findings indicated that companies engage in repurchase for the following reasons:
conveying management’s belief to the market that the stock is undervalued (signaling),
limited investment opportunities for deploying excess capital in declining or retracting
industries (cash flow), need to fund stock options and acquisitions (option funding), and
defending against takeovers. Baker et al. (1981) surveyed CFOs of 300 NYSE firms and
found that the major reasons cited for repurchases were excess cash flow and option
funding. The majority of the responding managers viewed share repurchases as an
investment decision and not a dividend substitution or financing decision. Lees (1983)
survey also received similar responses. Wansley et al. (1989) surveyed CFO’s of 620
large U.S. Corporations and found that the reasons most often cited for repurchases were
7
undervaluation o f stock and to signal to investors that managers are confident about the
company’s future. No support was found for substitution of repurchases for dividends.
Tsetsekos et al. (1991) surveyed CFO’s of 1,000 large NYSE firms and found that
even though the most frequently expressed motivation was to change the capital
structure, the majority of responses supported the signaling hypothesis. Baker et al.
(2003) surveyed financial executives of 642 NYSE firms, using a survey modeled after
previous surveys by Baker et al. (1980), Wansley et al. (1989) and Tsetsekos et al.
(1991). They found that the most cited reasons were undervaluation of stock and
managers’ desire to signal to the market, lack of profitable investment opportunities and
capital market allocation. In comparing the reasons cited by the respondents for the
repurchases, the respondents rated signaling and option funding much lower than earlier
surveys by Baker et al. (1980), Wansley et al. (1989) and Tsetsekos et al. (1991). They
also found that changes in capital structure of the firm and a tax efficient way to
distribute funds to shareholders were important reasons cited by the survey respondents,
while Baker et al. (1980) had not found much support for these reasons. The above
survey studies showed that managers placed heavy emphasis on the signaling and cash
flow motives followed by option funding, attributed least importance to substitution of
repurchases for dividends, and that managers’ motives change over time. A brief
summary of existing corporate finance hypotheses and related studies in the non-financial
sector follow.
Research Hypotheses
Signaling hypothesis- Studies by Vermaelen (1981), Dann (1981), Lakonishok
and Vermaelen (1990), Comment and Jarrell (1991), Ikenberry, Lakonishok and
Vermaelen (1995) have documented that stock prices react positively to the
announcement of repurchase programs. Currently the most widely accepted explanation
o f the positive market reaction to a repurchase announcement is the signaling hypothesis,
i.e., repurchases are primarily employed as signaling devices by management to reveal to
the market that the firm is undervalued [Bhattacharya (1980), Vermaelen (1984), Miller
and Rock (1985), Ofer and Thakor (1987), Persons (1995)]. Corporations use dividends
and repurchases to signal higher expected cash flows and payout excess cash to
shareholders. Masulis (1980), Dann (1981), Vermaelen (1981, 1984), Asquith and
Mullins (1986), Comment and Jarrell (1991), Ikenberry, Lakonishok and Vermaelen
(1995), Healy and Palepu (1993) and Davidson and Garrison (1989) have all proposed
that the information asymmetry between the managers and investors contributes to the
signaling effect o f the repurchase event. Bartov (1991) suggested that share repurchase
announcements tend to reduce risk and increase the earnings in the short run. The above
studies looked at a short time horizon (usually within 1 year) surrounding the
announcement event. If the signaling hypothesis holds, the abnormal improvements in the
firms’ operating performance should be positively related to the size of the repurchase
and the market reaction surrounding the announcement, improved financial performance
should continue in the future, and investors will be able to reevaluate their assumptions.
However most o f the above empirical studies have not found conclusive evidence on this
hypothesis. In spite of the popularity of the signaling hypothesis, there has been no
compelling evidence supporting it. The signaling value of repurchases cannot be
confirmed or rejected without a long term follow up of the abnormal performance of
repurchasing firms. Ho, Liu and Ramanan (1997) suggested that the positive reaction to
9
the repurchase announcement is more pronounced in firms that are smaller in size, or
have fewer analysts’ coverage and is directly related to the level of information
asymmetry between the managers and investors.
Testing the signaling hypothesis in non-financial firms undertaking fixed price,
dutch auction tender offers and open market repurchases, Vermaelen (1981), Dann
(1981), Dann, Masulis and Mayers (1991), Bartov (1991), Hertzel and Jain (1991), Nohel
and Tarhan (1998) and Lie and McConnell (1998) found inconsistent support for
signaling hypothesis, with weak evidence of increased earnings after the repurchase
announcement. Very few studies have been done to see the impact of repurchases (event/
long term) in the banking sector. Hirtle (2003) examined the relationship between stock
repurchases and the financial performance for a large sample of bank holding companies
between 1987 and 1998. She found that large banking firms showed better financial
performance after the repurchases, raising the question on impact of firm size and/or
information asymmetry on the effect of the repurchase. This study tests to see if the
signaling hypothesis is confirmed in the banking sector over the study period of 13 years.
Agency / cash flow hypothesis states that repurchases mitigate the agency costs
associated with managers investing in potentially negative NPV projects [Jensen and
Mecklin (1976) and Jensen (1986)], asserting that distribution of excess free cash flows
to shareholders induces the managers (agents) to be more disciplined in their
expenditures. The cash flow hypothesis predicts that firms with few investment
opportunities and large amounts of excess cash will distribute more cash to their
shareholders than firms with many investment opportunities and small amounts of excess
cash [Norgaard and Norgaard (1974), and Finnerty (1975), Lang and Litzenberger
10
(1989)]. In addition, it predicts that the agency cost of cash flows should be more severe
among firms with negative marginal returns on investments and deals with conveying
information to the market about the reduction of the agency costs [Grullon (2000), Fenn
and Liang (2000), Lie et al. (2000)]. The shareholders (principals) expect the managers
(agents) to distribute excess cash flows in the form of cash payout rather than indulge in
unprofitable investments [Easterbrook (1984), Jensen (1986)]. However neither the
signaling nor cash flow hypotheses can fully explain the surge in repurchases during
thel990’s and its continuing popularity. This study observes the banking sector data to
test if repurchases are used for distributing excess cash flow.
Substitution hypothesis- this hypothesis is closely related to the cash flow and
option funding hypotheses and predicts that executive options create incentives for
management to choose the most advantageous cash payout method for them. Most firms
tend to smooth dividends year over year and prefer not to increase dividends unless the
excess cash flows are sustainable. If the managers are not sure about the permanence of
the excess cash flow, using the repurchase option to payout excess cash is a low cost and
safe strategy [Jagannathan et al. (2000), Pettit (2001), Baker et al. (2002), Grullon and
Michaely (2002)]. Even though other methods of cash distribution such as dividends and
debt-for-equity swaps can alleviate agency cost issues, the flexibility and tax efficiency
o f repurchases make them more attractive to management as the payout option. The
advantageous tax treatment for capital gains over ordinary income plays a significant role
in the payout preference for repurchases over dividends.
“According to Executive Compensation Reports mega option grants of 250,000
shares or more are given by one out of four companies” (The Wall Street Journal).
11
Standard and Poor’s Execucomp database shows that the average number of options
outstanding and exercisable by top executives tripled from 1992 to 1997, and the
increases are continuing. Interestingly, the growth in repurchases during the same period
mirrored the increase of stock options. Since dividends reduce the value of exercisable
and future executive options, the executive options create further incentive for
management to payout more cash in repurchases than in dividends.
Lambert, Lannen and Larcker (1989), Jagannathan et al. (2000), Weisbenner
(2000), and Fenn and Liang (2001) studied the non-financial sector to see if executive
stock options provide management the incentive to reduce dividends that have an adverse
effect on the value of executive stock options. They found that dividends were reduced
from expected levels following the adoption of executive stock option plans, and
executive stock options exhibit a significant negative relationship to dividends and
positive relationship to repurchases.
Hirtle (2003) found evidence that for large, publicly traded banking companies a
strong link exists between superior future operating performance and the choice to return
excess cash to the shareholders, but not for small, non-publicly traded companies. These
results are consistent with the substitution hypothesis that firms in competitive
environments and/or have less predictable cash flows will opt for the flexibility of
repurchases, as opposed to the obligatory dividends. She found that banking firms that
pay dividends also use repurchases, but for different reasons. Jagannathan et al. (2000)
also documented the same trend in non-financial firms. In reviewing the decline in
banking firms’ capital ratios during 1990 to 1995, Hirtle (1998) found that it was caused
by increases in the repurchase component of the cash payout. She concluded that the
12
flexibility to adjust the level of repurchase programs during periods of declining earnings
made it easier for managers to adjust the payout and manage the required regulatory
capital ratios. This study examines the relationship of executive options, transient cash
flows and share repurchases in the banking sector.
Option funding hypothesis has evolved as a result of the recent developments in
corporate compensation policy, particularly the award of significant amounts of stock
options to employees as part of their total compensation. The trend started in the
technology firms that needed to conserve their earnings for growth opportunities in
highly competitive industries, and pay out “non-cash” compensation to the managers to
retain them. Almost 74% o f firms grant options to employees as part of ESOP. During
the period of 1992 to 1997, the value of stock options and grants grew from $8.9 billion
to $45.6 billion (Strege, 1999). The option funding hypothesis predicts that repurchases
are intended to fund the exercise of executive and employee stock options and as such,
the decision to repurchase will be related to the volume of options recently exercised and
options expected to be exercised in the near future. Indeed most firms seem to repurchase
shares to avoid earnings dilution from exercise of employee stock options. Fenn and
Liang (1997) found that employee stock options had a significant positive effect on
repurchases. Jolls (1998) added the variable for executive options and found that
executive options have an significant positive effect, and employee options have
insignificant effect on repurchases. She hypothesized that employee options proxy for
executive options when used alone. Kahle (2002) split the executive and employee
options further into exercisable and unexercisable parts, and examined the relationship to
repurchases to observe the impact of managers’ interests on their decision to repurchase
13
shares. She predicted that if companies are repurchasing shares to fund employee stock
options the efficient market will recognize the motive and the announcement period
return will be lower than the level of repurchases undertaken for signaling or cash flow
reasons. This study follows the methodology of Kahle (2002) and tests the relationship
between repurchases, executive options, and total employee options.
Earnings Management hypothesis deals with the motivation of managers to use
earnings management to meet or beat analysts’ expectations on earnings performance
measures such as EPS to influence share prices. A strong motivating factor for engaging
in earnings management is the increasing use of EPS by corporate compensation policies
to reward executives, creating the incentive to take actions to mitigate dilution of EPS
from option exercises. Previous studies have empirically shown that capital market
activities lead managers to engage in earnings management actions to boost share prices
[Teoh, Welch and Wong (1998a and 1998b), Rangan (1998), Erickson and Wang (1999),
Burstahler and Dichev (1997), Beatty et al. (1995), and Collins et al. (1995)]. Beatty et al.
(2002) studied the presence of earnings management in public and private banks, and
found that public banks tend to report fewer earnings decreases, use accruals to eliminate
small earnings decreases, and report longer strings of consecutive earnings. They
extended and confirmed the findings of the study by Burgstahler and Dichev (1997) on
the asymmetric pattern on more earnings increases than decreases attributable to earnings
management. Matsumoto (2002) examined the impact of transient institutional ownership
and value relevance of earnings on the firms’ proclivity to avoid negative earnings
surprises. She found that firms managed earnings upward by employing earnings
management tactics such as positive abnormal accruals, and guided analysts’ forecasts
14
downward to avoid negative earnings surprises. Beatty et al. (1995) and Collins et al.
(1995) looked at the presence of earnings management in banks by using discretionary
accruals. Weisbenner (2000) suggested that managers can use earnings management in
the form of repurchases to counteract the dilution of EPS due to option exercises, and the
impact on the compensation of managers. He did not empirically test the earnings
management hypothesis. Phillips et al. (2003) concluded that managers try to avoid
earnings declines or losses by using earnings management. They used deferred tax
expense as the measure to prove that earnings management is used to manage GAAP
earnings. This study extends the methodologies of Beatty et al. (2002) and Phillips et al.
(2003) to observe if deferred tax expense and discretionary current accruals can predict
the probability of earnings management in repurchasing banking firms. The conceptual
framework of existing share repurchase hypotheses is shown in Figure A.
15
Figure A: Conceptual Framework
Operating Performance and firm

characteristics hypotheses
Firm has
excess cash
Cash flo w hypothesis Permanent cash
flow
Dividends
Transient cash
flows
Executives feel
stock undervalued Signaling hypothesis
Time Inconsistency hypothesis
Management Incentive hypotheses
Substitution hypothesis
Options to be Option funding hypothesis

exercised
Earnings Management
Earnings management hypothesis
16
Organization of Subsequent Chapters
The study is organized as follows: Chapter II provides an overview of the literature on
the major issues involving share repurchases and existing hypotheses for the impact of
share repurchases on share prices. Chapter III outlines the proposed hypotheses and
empirical tests, sample selection, data collection and sources. Chapter IV presents
summary statistics, analysis and interpretation of the results. Chapter V presents the
results, concluding comments, limitations and areas identified for further research.
General data sources, data summaries and statistical analyses are embodied in the
appendices and tables.
17
CHAPTER II
LITERATURE REVIEW
The proposed empirical study seeks to make a useful contribution to the literature
concerning the long term operating performance of banks relative to stock repurchases
and management incentives. The purpose of this chapter is to provide the reader with an
understanding of the existing corporate finance hypotheses relating to stock repurchases
in the non-financial sector, as well as to summarize relevant theoretical and empirical
research. It reviews existing empirical research and survey studies conducted on
repurchases with the common goal of explaining the short and long term effects of share
repurchases. The first section of the chapter describes the existing hypotheses on stock
repurchases. The second section summarizes the survey and empirical research relevant
to this study.
18
Share Repurchase Hypotheses
Grullon and Ikenberry (2000) discuss five major hypotheses in trying to explain why
a corporation may undertake to repurchase their own shares: signal information to
financial markets, reduce agency problems with free cash flows, distribute excess cash to
shareholders in lieu of unprofitable investments, substitute repurchases for dividends for
tax avoidance, and adjust capital structure to fund options. The existing literature is
strongly in favor of the signaling and cash flow hypotheses, but arguments supporting
substitution, option funding and dividend tax avoidance hypotheses merit attention also.
Several approaches have been used towards ascertaining the purpose of share repurchases:
• direct approach o f surveying the management personnel responsible for making

the decision, and
• indirect approaches such as reviewing market returns around the event; computing
changes in risk levels around the event; testing to see if analysts’ estimates were
affected; and testing if long term operating performance measures increased.
Most studies to-date have looked at the abnormal returns around the event, with very
limited amount of empirical research done on long term effect of share repurchases on the
share prices.
Types of repurchases
The types o f share repurchase programs can range from “going private”
(repurchase 100% o f the outstanding shares), to the other extreme where the company
repurchases a small number o f shares to reduce shareholder servicing costs. Utilization of
significant resources for the repurchase program will affect the allocation of corporate
19
resources and can be viewed by the market as a signal of change in corporate strategy.
Share repurchases can cause changes in the firm’s capital expenditure strategy, functional
strategy, financial and investment strategy (agency costs, cost o f capital and investment
expenses). The decision to repurchase shares can be linked to the firm’s financing
strategy when the firm believes that its stock is undervalued and/or inadequate investment
opportunities exist, and the repurchase will be a positive NPV investment. Alternatively
share repurchase can signal a change in corporate strategy such as a financial
restructuring plan or a corporate reorganization.
A corporation can repurchase its own common shares using various techniques:
open market, dutch auction and fixed price tender offers, exchange offer, transferable put
rights, or a privately negotiated transaction. The choice of the repurchase technique is
usually motivated by the company’s strategic goals such as higher share price, or
avoiding earnings dilution. If investors perceive the company’s decision to repurchase
shares as a positive net present value project, it will lead to increase in future cash flows.
Existing empirical research studies have documented significant positive effects from the
announcement in fixed price tender offers, and to a lesser extent from dutch auction
tender offers and open market repurchases. The predominant technique employed by U.S.
firms is the open market repurchase. A brief description of each repurchase technique is
given below.
Fixed price tender offers are one time offers to purchase a stated number o f shares at a
premium above the stock’s current market price. The company can buy more than the
amount specified, to purchase shares pro rata, and extend the offer period. In general,
20
fixed price tender offer repurchase announcements tend to have an immediate positive
impact on stock returns, supporting the signaling hypothesis.
Dutch Auction Tender offers require the company to specify a range of prices at which
shares can be tendered. At the expiration of the offer period, the firm repurchases
according to an ascending order o f bids, and in accordance with SEC rules all
shareholders whose shares were accepted are paid the highest accepted price. Dutch
auction tender offers also have an immediate impact on stock market values at their
announcement, but the effect is somewhat less significant. The risk of overpayment is
limited by the amount of the minimum offer premium for dutch auctions, while fixed
price offers do not have a minimum range as a fail-safe device.
Open market repurchases occur when the firm repurchases shares of its common stock at
current market prices. In general, open market repurchases occur much more frequently
than the other types of share repurchases and tend to be of smaller magnitude. Open
market repurchase announcements have a considerably smaller, but still significant,
impact on market returns. This outcome could be because open market repurchases are
generally for smaller number of shares to be purchased in the market at the prevailing
market prices, and there is no guarantee that the firm will complete the repurchase
subsequent to the announcement. The largest positive market reaction occurs from the
announcement of fixed price tender offers, followed by dutch auction tender offers, and
open market repurchases.
Banking firms have been following the general business trend of increasing the
total shareholder cash payouts. In the last decade banks have returned an increasingly
larger portion of their profits to their shareholders than the non-financial firms (Hirtle,
21
1998). Another notable difference with the banking firms’ payout policy is that
repurchases have steadily increased, and consumed a higher percentage o f the total
payout than the non-financial firms. The top 25 banking companies bought back $22.7
billion o f their own stock in 1999 vs. $10.6 billion in 1998. The accelerated trend has
continued through 2001, and the repurchase programs announced in the first half of 2001
amounted to $14.1 billion. But this generous cash payout policy at the banking firms has
not produced commensurate positive impact on their share prices. The relationship
between the undervaluation of shares of banking firms, increased mergers and
acquisitions activity and the diversification into non- traditional product offerings has
been o f considerable interest to the investors and analysts. The share repurchase
announcement can be interpreted as a signal of the firms' foregoing positive net present
value investments, or as a lack of investment opportunities. Investment analysts have
proposed several theories about the impact of repurchases of a banking firm on its share
price (shareholder value) without any clear consensus as to lack of investment
opportunities (agency), or management’s desire to signal the market about undervaluation
o f stock relative to inherent financial strength (signal).
Relevant theoretical and empirical research: In the following sections, works in
two broad areas o f research relevant to this study are reviewed. First, survey studies are
discussed to reflect the expressed motivations behind stock repurchases. Second,
empirical studies investigating the effects of stock repurchases in a short time horizon
around the event.
22
Survey studies
Surveys are a source of direct evidence of management intentions, while
empirical studies provide indirect support for their conclusions. The surveys reviewed in
this section provide support to the idea that management intends to signal to the market
that the firm’s shares are undervalued. Management has several reasons for initiating
share repurchase programs, as shown in the survey literature [Baker, Gallagher, Morgan
(1981), Wansley, Lane and Sarkar (1989)), Tsetsekos, Kaufman and Gitman (1991),
Cudd, Duggal and Sarkar (1996), and Baker, Powell and Veit (2003)]. Grullon and
Ikenberry (2000) list five hypotheses as to why firms initiate repurchases: signaling,
excess cash flow, capital market allocation, tax motivated substitution of repurchases for
dividends and capital structure adjustments. The reasons tested by earlier surveys include
signal by management of future confidence, increasing the firm’s leverage, using excess
cash flow in view of insufficient investment opportunities, substituting for cash dividend,
funding shares for employee bonus/retirement plans, and trying to avoid takeover by
competition.
Baker et al. (1981) surveyed CFO’s of 150 randomly selected repurchasing firms
and 150 non-repurchasing firms listed on the NYSE during the late 1970’s. The majority
o f the responding managers viewed share repurchases as investment decision, not a
financing or dividend decision. The respondents cited investment of excess cash and
option funding as the 2 major reasons for initiating a repurchase program. The managers
discounted substitution of repurchases for dividends as a motive.
Wansley, Lane and Sarkar (1989) surveyed CFO’s of 620 large U.S. corporations
identified in the 1986 Institutional Investor’s CFO roster and by Merrill Lynch, and
23
obtained usable responses from 98 repurchasing and 42 non-repurchasing firms. The
respondents cited undervaluation of stock and signal to market as the primary motives for
engaging in repurchases. Both repurchasing and non-repurchasing groups agreed that
repurchases were used as a signal of confidence in the level of future earnings and stock
prices, but not as a substitute for dividends. They disagreed on lack of investment
opportunities or availability of excess cash being the motivators for share repurchases.
Tsetsekos, Kaufman and Gitman (1991) surveyed CFO’s of 1,000 large NYSE
firms and based on 183 usable responses to determine the stock repurchase motives, they
found that the primary reason for repurchases was stock undervaluation. Most of the
respondents cited changing capital structure as the primary motive, but the responses
pointed to signaling the market as the reason. Contrary to the results from Baker et al.
(1981), they found that managers of the repurchasing firms view repurchases as a
financing rather than investment decision.
Davidson and Garrison (1989) used the publicly announced reasons for
repurchase to divide the overall sample into 3 sub samples- Takeover defense, Investment
repurchases, and ESOP needs. They found that the market reacted 1) negatively to the
takeover defense motive (control); 2) substantially positively to undervalued stock motive
(signaling); and 3) neutrally to ESOP motivated repurchase (option funding). Cudd,
Duggal and Sarkar (1996) extended the Wansley et al. (1989) research by using the same
sample and exploring how the market prices the repurchase motives given by
management. They analyzed market premiums relative to 77 survey responses using a
design similar to Davidson and Garrison (1989). They found a positive relationship
24
between repurchase premium and takeover defense, while Davidson and Garrison study
did not. Both studies found strong support for the signaling hypothesis.
Baker, Powell and Veit (2003) surveyed financial executives of 642 firms listed
on NYSE, AMEX and NASDAQ, using the proprietary database developed by Birinyi
Associates Inc. to identify firms with assets exceeding $50 million that had announced
repurchase programs from January 1998 to September 1999, and received 218 usable
responses. They found that undervaluation of stock and signaling to the market were the
most cited motives, followed by adjusting the firm’s capital structure and avoiding
dividend taxes. To improve comparability of the responses, their survey was patterned
after Baker et al. (1980), Wansley et al. (1989), and Tsetsekos et al. (1991) studies. The
respondents did not consider substitution and option funding motives very important.
All of the abovementioned survey studies provide strong support for the signaling
hypothesis consistent with the empirical studies by Vermaelen (1984), Ofer and Thakor
(1987), Sinha (1991) and Bartov (1991), and somewhat weak support for the capital
structure re-alignment motive. The survey studies considered both regulated and
unregulated firms in the market, while most of the empirical studies excluded the
regulated firms from their samples.
Empirical studies: The studies reviewed in this section examined the stock market
impacts o f the repurchase announcements and employed event study methodology to test
the significance. The observations and results were based on the positive share price
movements for a period of 180 days or less around the repurchase announcement event
that were found to be statistically and economically significant. The empirical studies fall
into two distinct groups of corporate finance hypotheses:
25
• Firm operating performance related hypotheses such as signaling, time

inconsistency and cash flow hypotheses, and
• Management incentive related hypotheses such as substitution, option funding and

earnings management hypotheses.
Operating Performance and Firm Characteristics related Hypotheses
Signaling Hypothesis: Signaling refers to the process by which investors and other
information users interpret and decipher the information content of management’s
decisions. This hypothesis is based on the premise that when management has favorable
insider information about the company’s expected future cash flow increases that is
unknown to the market, it will use cash payout to shareholders as a signal that
management views the stock price to be undervalued. The hypothesis states that
announced share repurchase programs signal managements' positive information about
the future prospects for the firm. Most research studies looking at the reasons for the
companies’ repurchase decision have supported the signaling hypothesis. Signaling
models have been the centerpiece of most share repurchase studies, and are now a
familiar and accepted approach in the finance literature.
The first major study on repurchases was done by Masulis (1980), who examined
199 fixed-price repurchase tender offers during the period from 1963-1978 with an offer
premium o f 23%. He found an average 2-day cumulative abnormal return (CAR) of 17%,
and concluded that the results provided partial support for the dividend tax avoidance,
leverage and bondholder expropriation hypotheses. The simultaneously published studies
of Dann (1981) and Vermaelen (1981) supported the notion that the informational content
of repurchases was the primary reason for the significant gains in stock prices. Dann
26
(1981) reviewed 143 cash tender offers during 1962 to 1976 with a premium of 22.5%.
He found that the 2-day post repurchase CAR was significant and positive, averaging
15.41%. Furthermore, these returns were considered permanent gains based on the stock
prices 60 days after the repurchase announcements.
Vermaelen (1981) hypothesized that management will embark on share
repurchase programs to signal future confidence and higher future value. In an event
study o f stock price response to 131 tender offers and 243 open market purchases (1962-
1978), he found a 3.4% and 14.1% CAR around the open market repurchase and tender
offer announcement events, respectively. He proposed that the favorable information
being signaled will reveal itself in the form of higher net present value of future cash
flows, and higher levels of corporate value will be revealed in higher levels of operating
flows, investment flows and free cash flows subsequent to the repurchase announcement.
He used earnings per share as a proxy for net cash flows per share and found significant
positive changes in future years. He used regression analysis and tested the factors
contributing to the abnormal returns such as percent premium offered, the fraction of
shares the firm offered to repurchase, and the percent of insider holdings. All of these
factors had the predicted positive regression coefficients, with the premium being the
most important contributor to the explainable variability of the abnormal returns.
Ofer and Thakor (1987) introduced a framework for an integrated model of the
information content of stock repurchases and dividends. The framework attempted to
explain why repurchases have higher information content and significantly higher price
response than dividend announcements. Constantinides and Grundy (1989) investigated
the signaling role o f stock repurchases and showed how the issuing senior security with a
27
stock repurchase allowed management to signal its information to the market. Both of the
above studies supported the findings of Vermaelen (1981).
Davidson and Garrison (1989) studied 62 tender offers from 1978 to 1983, and
measured the abnormal returns for the 181 trading days around the repurchase
announcements to see if the announced intents of the repurchases contributed to the
market returns. The repurchasing firms that cited investment / stock undervaluation
showed significant abnormal gain in line with previous research, and those that cited
takeover defense as the motive showed significant abnormal losses. In both of these
situations, the market reacted predictably to two opposing signals. Pugh and Jahara (1990)
compiled a sample of 45 fixed-price tender offers from 1978 to 1985 by non-financial,
non-utility firms with an offer premium of 19.4%. They reaffirmed the previous studies’
results that the offer premium is the primary determinant o f abnormal returns, and the
percent repurchased and insider ownership provided limited but significant information.
They found that small firms and firms with low institutional holdings set higher
premiums confirming the effect of information asymmetry.
Lakonishok and Vermaelen (1990) studied 221 fixed-price tender offers between
1962 and 1986 and found that abnormal return possibilities were available around the
tender offer expirations. Their investment strategy involved purchasing stock in the
market just prior to the expiration of the tender offer and immediately tendering the
shares. The studies cited above showed that fixed-price tender offer repurchase
announcements have an immediate positive impact on stock returns. The positive market
returns of the repurchasing firms' stock around the announcement date supported the
28
signaling hypothesis, with management's primary signaling tool being the size o f the
premium offered.
Bagwell (1992) examined 32 dutch auction tender offers from 1981 to 1988, and
found significant abnormal returns, and significant relationship between the excess return
and the purchase premium. She obtained confidential bid data about the firms which
revealed the presence of an upward sloping supply curve. Bagwell believed that her
findings challenged the prevailing belief in the signaling hypothesis as the predominant
reason for announcement period effects. She made a strong case for the market price
impacts being associated with an upward sloping supply curve for shares. She agreed that
the signaling and cash flow hypotheses have some explanatory power, but felt that
heterogeneous valuations must be incorporated explicitly into any explanation of the
stock price reaction to the repurchase.
Peterson and Peterson (1993) compared the repurchase prices paid by 78 fixed-
price tender offers to 60 dutch auction tender offers during 1981 to 1989. They looked at
the premiums offered, the percentage of shares repurchased, and the offer expiration price
to make their determination. Employing regression analysis and controlling for firm size
and the percentage of shares repurchased, they concluded that there were no significant
differences between the two types of offers, i.e., firms employing fixed-price offers paid
more for shares because the upward sloping supply curve required them to do so to
successfully repurchase a larger percentage of outstanding shares.
Vermaelen (1981) examined 243 open market repurchase announcements from
1962 to 1977. He proposed that open market repurchases tended to occur after significant
price declines, and the price declines reversed after the announcement. Comment and
29
Jarrell (1991) compared the relative signaling values of the three types of repurchases -
fixed price, dutch auction tender offers and open market repurchases by examining
market returns around the announcement. Their sample included 97 fixed price tenders
and 72 dutch auction tenders during 1984 to 1989, and 1,197 open market repurchase
announcements from 1985 to 1988. They found that firms engaging in dutch auctions
tend to be larger than those involved in fixed price tenders, and desire a lower percentage
o f outstanding shares. The market reaction to dutch auction tender offers trailed
significantly behind that o f fixed price offers. Like Vermaelen (1981), they found that the
firms undertaking open market repurchases had experienced significant declines in share
prices prior to the announcements, their returns around the announcement event were
positive and significant, and were in line with the returns seen in tender offers.
Liu and Ziebart (1997) grouped repurchase announcements into “good news”
(initial positive reaction to the announcement) and “bad news” (negative initial reaction
to the announcement) groups based on the stock performance in a 5-day event period
surrounding the repurchase announcement. Cross sectional OLS regression models were
used to test the relation between the price reactions around the repurchase announcement
and in subsequent periods for the two groups. The sample was split into portfolios based
on the sign and magnitude of the reaction to the repurchase announcement. They
observed that significant price reversal occurred for the “good news” firms but not for
“bad news” firms. Consistent with Comment and Jarrell (1991), size of repurchase
programs had a positive relationship with market reactions, with size of firm and size of
repurchases inversely related. The studies cited above showed that information signaling
represents a major motivation for share repurchases. If repurchases are truly a signal of
30
increased value, then there should be tangible proofs of value in subsequent periods such
as increased earnings and/or decreased level of risk. Changes in analysts' expectations
would show that investors believe that earnings potential of the firm has increased due to
repurchase announcement. The following studies found that there were positive abnormal
increases in earnings and reductions in the level of risk subsequent to repurchase
announcements, and that analysts revised their short-term earnings expectation in
response to the announcements.
Vermaelen (1981) tested abnormal earnings per share (EPS) figures for the 11-
year period surrounding his sample of 131 fixed-price tender offers. He discovered
significant increases in EPS in the year of the repurchase and in the following years.
Hertzel and Jain (1991) studied 127 fixed-price tender offers from 1970 to 1984 to
determine if Value Line earnings estimates changed based on the favorable signal about
the level and risk of fixture earnings. They looked at the changes in the risk level by
measuring changes in equity and asset betas and financial leverage. They found
significant reduction in equity betas in spite of increases in debt to equity ratio, showing
the market perception of decreased risk level of the underlying assets. They concluded
that repurchases provided information about short-term earnings impacts only.
Dann, Masulis and Mayers (1991) used a sample of 122 fixed-price repurchase
tender offers from 1969 to 1978, and compared EPS and earnings before income and
taxes (EBIT) to market expectations for ten years surrounding the event. They found
significant positive surprises for EBIT and for EPS. They found positive relationship
between abnormal announcement period returns and fixture earnings, leading them to
conclude that the repurchases provided information about fixture earnings expectations.
31
They calculated the betas for 3 years before the repurchase and 2 years after, and
concluded that repurchases were related to a significant reduction in systematic risk.
Bartov (1991) examined 185 open market repurchases from 1978 to 1986, and found that
the announcement effects on EPS were mixed and weak, but the market risk of the
sample declined substantially from the previous year. Overall, the above studies provided
further support for the signaling hypothesis by showing that there were significant
positive earnings surprises and declines in systematic risk of the repurchasing firms after
repurchases, indicating change in investor perceptions.
Other empirical studies attempted to examine if the market reinterpreted prior
accounting information of the repurchasing firms. Ho, Liu and Ramanan (1997)
examined 335 open market repurchases during 1978 to 1992, and found that the market
reaction to the announcement was significantly associated with the firm's sales growth
and accounting profitability in prior periods, after controlling for 2 known correlates of
the market response: size of the repurchase and prior returns. This result was consistent
with the market reinterpreting previously released accounting information of the firm due
to subsequent repurchase announcement. The association between the market response
and prior accounting information was more pronounced for smaller firms, and for firms
that have few analysts following them suggesting that the degree of reinterpretation of
prior accounting information is proportional to the information asymmetry between
managers and investors. They included alternative proxies for information asymmetry
(size of the firm, number of analysts following, dispersion in analysts' forecasts of
earnings) to test the relation between the market response to the announcement and prior
accounting information. Their study extended Banker et al. (1993) by demonstrating that
32
the market's reinterpretation o f prior accounting information upon release of the
announcement was directly proportional to the information asymmetry between managers
and investors.
Healy and Palepu (1993) developed the framework to examine the role of both
accounting and non-accounting disclosures on firm valuation. Their framework suggested
that if the market viewed the financial disclosures as credible, it would alter the
interpretation of previously released accounting information. They argued that a cash
payout using dividends or repurchases would be the managerial response available to
undervalued firms to signal their confidence in the level of future earnings to the
investors.
Use of open market repurchase as a signal to the market about the undervaluation
of the firm was also studied by Asquith and Mullins (1986), Netter and Mitchell (1989),
and Ikenberry et al. (1995). These studies found that the signaling was motivated by
information asymmetry between the market and the managers, leading to subsequent
positive market reaction to the announcement. They showed that the market reaction to
financial signals like repurchases were related to prior accounting information, enabling
the market to reassess the valuation implications of prior accounting disclosures and
triggering potential revaluation of prior accounting performance.
Cash flow hypothesis'. Jensen’s (1986) free cash flow hypothesis suggested that
when managers (agents) have excess funds at their disposal, they may use the funds in
ways other than the shareholders' best interests such as undertaking negative net present
value projects, or consuming excessive amount of perks. Therefore, any method that
restricts management's unwise use of funds is seen as a positive sign by the marketplace.
33
Perfect, Peterson and Peterson (1995) tested the effect of investors’ revision of expected
cash flows (cash flow signaling) on the firm’s market value due to the share repurchase
announcement. Investors could interpret that the company is repurchasing shares due to
lack of other attractive investment opportunities for available net cash flows, leading to
negative investor perception. Alternatively, investors could reward the firm for
distribution of “free cash” and reducing the likelihood that management will squander the
cash flow on value minimizing investments.
Once the decision to payout excess cash flow is made, the choice of the
repurchase method depends on the firm's pre-repurchase stock performance, free
cashflow, leverage, and insider ownership at the time of the repurchase. Howe, He and
Kao (1992) found no empirical support for the free cash flow benefits of self tender
offers, while Perfect, Peterson and Peterson (1995) found that support for the free cash
flow hypothesis depended on the time horizon used to classify the firms as value
maximizing and value minimizing. Porter, Roenfeldt and Sichermann (1994) and Vafeas
and Joy (1995) also documented empirical support for free cash flow hypothesis, and
suggested that the likelihood of choosing a tender offer among over-investing firms is
inversely related to the firms' pre-repurchase level of free cash flow.
Vafeas (1997) provided an empirical examination of the determinants of the
choice between share repurchase methods. He showed that the likelihood of selecting a
self-tender offer over an open market share repurchase increased with the repurchasing
firm's agency costs of free cash flow, inside ownership percentage, leverage, pre
repurchase stock performance, and the magnitude of cash involved in the transaction. The
evidence was consistent with the impact of free cash flow and signaling hypotheses on
34
the choice of repurchase methods among firms. He found that the firm’s choice of
repurchase method would depend on the duration and size of prior market under
performance.
Hirtle (2003) showed that repurchases have become an important form of payout
for U.S. bank holding companies with all firms exhibiting a higher propensity to pay cash
through repurchases than in dividends. Her results suggested that prior to 1983,
regulatory constraints inhibited banking firms from aggressively repurchasing shares.
Using data from bank holding company regulatory reports (the FR Y-9C reports), she
examined the relationship between stock repurchases and financial performance for a
large sample of bank holding companies with assets exceeding $150 million during 1987
to 1998. The regulatory data provided aggregate information about the actual stock
purchases by bank holding companies in a given year, and enabled examination of their
impact on the companies’ subsequent operating performance. She found that higher
levels o f repurchases in a year were associated with higher profitability measures and a
lower share of problem loans in the subsequent year. These results were robust to several
different ways of measuring share repurchase activity and to alternative specifications of
the regression model. She proposed that better financial performance in post repurchase
years could be explained by cash flow and/or signaling hypotheses. The findings
suggested that repurchases by the banking institutions were used primarily as a means to
distribute strong past profits to shareholders. This study observed bank holding company
behavior for a wider range of institutions and over a longer horizon than Laderman (1995)
and Hirtle (1998) and over a period when stock repurchases were more prominent than in
the Kane and Susmel (1995) and Billingsley et. al. (1989) samples. It focused on the
35
operating performance o f bank holding companies, as opposed to the event study
methodology o f stock price reaction around the event. Using the regulatory (FR Y-9C)
reports and dropping observations with missing data, negative reported equity capital,
and significant mergers the final sample consisted of 8,725 observations for 1,718 bank
holding companies over the years 1987 to 1998.
Bank holding company regulatory reports provide detail on the equity capital
accounts including dividend payments, treasury stock purchases and sales. Since the
regulatory reports do not contain direct information about the extent of actual share
repurchases by bank holding companies, Hirtle used gross treasury stock purchases as the
basic measure. To study the relationship of stock repurchases to the future performance
of the bank holding company she used a simple, reduced-form equation that relates a
series o f performance variables to contemporaneous and lagged control variables. The
operating performance measures used are: return on equity (ROE), return on assets
(ROA), real growth o f earnings (defined as the year-over year change in real net income
divided by beginning-of-year equity capital), non-performing loan share (loans 90 or
more days past due plus non-accrual loans divided by total loans), and net charge-offs
divided by total loans. The estimation equation regressed each of these variables in turn
on a set o f contemporaneous and lagged control variables. The control variables included
lagged values of the log of real asset size, the equity capital ratio, and the loan-to-assets
ratio, as well as a variable that measures contemporaneous personal income growth in the
states where the firms are located. She found a positive and statistically significant
relationship between lagged repurchases and profitability (as measured by ROE and
ROA), and a negative and marginally statistically significant relationship between lagged
36
repurchases and non-performing loans and charge-offs when repurchases are expressed in
continuous form.
The size of the coefficients on the lagged repurchases were markedly smaller in
the specification including the lagged dependent variable suggesting that the economic
impact of repurchases may be quite modest once the past behavior of the performance
variables are taken into account. The results suggested that banking companies that
repurchased stock had statistically significantly higher than average profitability (ROE
and ROA), lower than average charge-offs and non-performing loans, and higher than
average equity capital ratios in the two years prior to the repurchase. They also showed
that for publicly traded firms higher repurchases are associated with enhanced earnings
and better asset quality in the year following repurchases. Hirtle proposed that the higher
operating performance in post repurchase years could be the effect of signaling and / or
cash flow hypotheses.
Management Incentive related Hypotheses
Substitution Hypothesis states that repurchases are used as a substitute for
dividends for two reasons: the historically favored tax treatment of cash received in
repurchases, and managers’ preference for repurchases over dividends to preserve the
value of the executive stock options. Masulis (1980) and Barclay and Smith (1988),
concluded that the personal tax benefit of repurchases was a significant factor in the
decision of dividends versus repurchases. However the survey by Wansley, Lane, Sarkar
(1989) found that the respondents ranked tax effects as a very low motivating factor in
the repurchase decision. The role of tax advantage leading to preference of share
37
repurchase over dividend as cash payout mechanism by firms has not been clearly
determined.
Several authors have documented a relationship between the use o f executive
stock options and repurchases [(Lambert et al., (1989), Jolls (1998), and Fenn and Liang
(2001)) and presented analyses showing that repurchases are associated with management
compensation structure. They showed that managers holding options will prefer stock
repurchases to dividends due to tax incentives and dilution of owned share values.
Lambert et al. (1989) looked at the negative relationship between executive stock options
and dividend payouts by firms, but only a few relatively recent studies have empirically
reviewed the relationship to repurchases. Hirtle (2003) felt that the managerial incentives
are likely to play a much smaller role in the banking sector because as a rule, bank
executives tend to receive a much smaller share of their compensation in stock options
than managers in non-financial firms (Houston and James 1995) and instead,
concentrated on the signaling and free cash flow hypotheses.
Jolls (1998) suggested that the structure of its executive compensation packages
could be an important factor in a firm’s decision to repurchase stock, and companies with
large numbers of executive stock options outstanding are more likely to embark on
repurchase programs. She looked at the increase of stock repurchases as a means of
distributing earnings to shareholders, relative to the compensation incentives of the
agents (managers). The increased use of repurchases has been contemporaneous with an
increasing reliance on stock options to compensate top managers during the past decade.
She proposed that stock options would encourage managers to choose repurchases over
dividend payments that dilute the per-share value of the stock. Consistent with the
38
substitution hypothesis, Jolls found that firms relying heavily on stock option based
compensation were significantly more likely to repurchase their stock. She did not find
any such relationship between repurchases and restricted stock, an alternative form of
stock-based compensation that is not diluted by dividend payments.
Jolls’ research differed from Fenn and Liang (2001) who examined the effect of
employee stock options on repurchase behavior by concentrating on the stock options
held by the top executives. From an agency theory perspective, it is to be expected that
agents making the payout decisions would choose the option that is best suited to their
interests. Jolls used the stock option data from proxy statements on SEC Disclosure
database for firms that increased dividends and/or initiated repurchases in 1993, and data
on Compustat, obtaining a final sample of 324 firms. She used multinomial logit
regression model with the dependent variables of institutional ownership, operating
income as a percent o f assets, Tobin’s q, debt to equity ratio, executive options as a
percent o f shares outstanding, employee options as percent of shares outstanding,
restricted stock grants, non-stock based compensation, market value, and increase in
stock price. She found that institutional ownership had a positive relationship to
repurchases while operating income, restricted stock, increase in stock price and debt-
equity ratio had a negative relationship to repurchases.
Fenn and Liang’s (2001) results showed that cash payouts were positively related
to net operating cash flow and size, and negatively related to market-to-book and
leverage. Similar to Lambert et al. (1989) they found a strong negative relationship
between dividends and management stock options, and a positive relationship between
repurchases and management stock options Their results showed that a one standard
39
deviation change in the management stock option variable reduced dividend yields by an
economically significant 38 basis points. They found a statistically significant positive
relationship between repurchases and management stock options, suggesting that stock
options could help explain the rise in repurchases at the expense o f dividends. The results
were robust to estimation across various sub samples. They examined the relationship
between payouts and stock incentives while controlling for measures of free cash flow.
They used management stock and option holdings from company proxy statements in S
& P's Execucomp database and Compustat for 1,100 non-financial firms during 1993-97
to examine the determinants of total payouts, open market share repurchases and
dividends. They examined the influence of firm characteristics on long-term corporate
payout policy. For repurchase payout they used open market repurchases of common
stock as a fraction of the market value. The primary measures of managerial stock
incentives were stock and stock options held by executives as a percentage of total shares
outstanding, as reported in company proxy statements in Execucomp. Similar to Jolls
(1998) they used data that included exercisable and unexercisable options. Their proxies
for free cash flow were earnings before interest, taxes and depreciation (EBITDA) less
capital expenditures, net operating cash flow divided by assets, and a measure of
investment opportunities - market to book ratio. They used firm size, measured as the log
o f assets as proxy for external financing costs because larger firms have more stable cash
flow and less information asymmetries leading to lower financing costs. They controlled
for leverage because increasing leverage will increase the probability of financial distress
and external financing costs and firms that increase debt will not be able to engage in
dividends and share repurchases (Jensen, 1986, Berger et al., 1997). They controlled for
40
the volatility o f operating income measured as the standard deviation of EBITDA divided
by assets, because uncertainty about future cash flow will reduce the level of cash
payouts (Jagannathan et al., 2000). They used Tobit regression models for data analysis
and found that repurchases as a share o f total payouts was positively related to the market
to book ratio and operating income volatility, consistent with the cash flow and
substitution hypotheses. Jolls (1998), Bartov et al. (1998), and Weisbenner (2000) had
used a discrete-choice framework to examine the impact of employee and executive stock
options on a firm’s choice o f increasing dividends and repurchasing stock.
Fenn and Liang’s (2001) results were consistent with other studies that the
probability of repurchasing stock is positively related to stock options. They found that
high market to book (proxy for growth) firms with greater uncertainty of future
investment opportunities opted for the more flexible repurchases than dividends, and
increases in volatility of operating income showed a positive relationship to repurchases,
similar to Jagannathan et al. (2000). They found that payouts appeared to behave
according to cash flow (agency) hypothesis, with both dividends and repurchases
increasing with free cash flow and decreasing with external financing costs. The mix of
repurchases and dividends was dependent in part on the need for financial flexibility, as
suggested by the positive relationships with market to book ratios and volatility of
operating income. Other studies (Jagannathan et al., 2000, Guay and Harford, 2000,
Stephens and Weisbach, 1998) showed that firms distribute permanent (temporary) cash
flow as ordinary dividends (open market repurchases), and the market interprets payout
announcements in a manner consistent with this policy. The above studies also showed
41
that firms favored open market repurchases when shares are undervalued, consistent with
the theoretical prediction of Chowdhry and Nanda (1994).
Jagannathan, Stephens and Weisbach (2000) measured the growth in open market
stock repurchases and use of stock repurchases and dividends by U.S. corporations. They
re-examined Lintner's (1956) premise that managers prefer to increase dividends
regularly, and avoid decreasing dividends that cause unfavorable reaction from investors.
They proposed that share repurchases are pro-cyclical, and are used by firms with
temporary, non-operating cash flows. They suggested that dividends increase steadily
over time representing an ongoing commitment, and are paid by firms with higher
permanent operating cash flows, and that dividend decreases will be accompanied by
poor performance. They constructed a database of repurchase announcements and actual
repurchases of U.S. public firms during 1985 to 1996 from Compustat, CRSP, and
Securities Data Company (SDC) databases. They found that repurchasing firms have
more volatile cash flows and distributions. Firms used repurchases following declining
stock performance and increased dividends following increases in stock prices. They
found that repurchases seemed to preserve the financial flexibility relative to dividends of
not committing the firm to future payouts. Their results were consistent with the view
that the financial flexibility of repurchases is the significant reason for their increased use
in place o f dividends. The authors tested the view empirically, and found it supported by
the data. Although dividends appear to be paid out of permanent earnings, they did not
find evidence of subsequent earnings improvements following dividend increases. They
tested the substitution (financial flexibility) hypothesis empirically by constructing cross-
sectional measures of the likelihood of temporary increase in cash flow, and used these
42
measures to predict the likelihood of the firm to increase dividends, repurchases, or both
in any given year. The temporary cash flows are likely to increase when a firm has a
higher proportion of non-operating income relative to operating income, or when a firm's
earnings volatility is high. The results showed that each of these measures increased the
likelihood of the cash payout method being repurchases rather than dividends, showing
that managers tend to use dividends to pay out permanent cash flows and repurchases to
pay out temporary cash flows.
Stephens and Weisbach (1998) had suggested that share repurchases be measured
using the monthly decreases in shares outstanding as reported by CRSP, and adjusted for
non repurchase activity such as stock splits and dividend reinvestments. Jagannathan et al.
used an adapted version of this method by using Compustat data item “Purchases of
Common and Preferred Stocks” and adjusting for new stock issues. Similar to Guay and
Harford (2000), they focused on the impact of the permanence of cash flows on the
choice between dividends and repurchases. Since operating cash flows tend to be more
permanent than non-operating cash flows, they looked for a positive relationship between
operating income and dividends, and non-operating income and repurchases. Consistent
with cash flow and signaling hypotheses, they hypothesized that dividend-increasing
firms will have larger subsequent cash flows than repurchasing firms, and firms selecting
repurchases would have lower stock returns prior to the payout change. They constructed
proxies of variables that could influence the repurchase decision for the periods before
and after each potential payout increase, and focused on cash flow and its components of
operating income, non-operating income, and capital expenditures. The sample for their
cross-sectional analysis was limited to the period from 1985 to 1994, and they used the
43
variables of firm size, operating income, non-operating income, standard deviation of
operating income measured over the 5-year period, capital expenditures, lagged dividend
payout ratio from prior year dividends, market to book ratio, debt ratio, institutional
ownership, increase in year-over-year dividends divided by equity, increase in
repurchases defined as the value of the open market repurchase program divided by
equity, and stock returns from CRSP.
The results of the cross-sectional regression analysis showed that firms with
higher operating cash flows are more likely to increase dividends and firms with higher
non-operating cash flows and / or higher standard deviation of cash flows are more likely
to increase repurchases, consistent with substitution hypothesis. They found that stock
valuation and financial flexibility play significant roles in determining the payout method
similar to previous studies on dividend payouts (Fama and French, 1988, Kothari and
Shanken, 1992).
Option funding hypothesis predicts that repurchases are undertaken to fund the
exercise o f employee stock options and avoid dilution of earnings per share. Kahle (2002)
examined open market share repurchases during 1993-1996 to determine the effect of
options on the firm’s election to repurchase shares, the extent of actual repurchases, and
the market reaction to the event. Similar to previous studies Kahle found that repurchases
are more likely in large firms with low market to book ratios, high free cash flow, and
low capital expenditures consistent with the signaling and free cash flow hypotheses. She
also examined the hypotheses relating growth in executive and employee stock options to
repurchases: option funding and the substitution hypotheses. To test the impact of total
options on repurchases, both options recently exercised and options to be exercised in the
44
near future needed to be included. Since the latter variable was not available, she used
outstanding and exercisable options as proxies. To test substitution hypothesis that
executive options create an incentive not to pay dividends, she used exercisable and
unexercisable options held by managers. Common market wisdom would dictate that
firms are more likely to announce a repurchase when total options exercisable as a
percentage of shares outstanding are high, and when many options have recently been
exercised.
Kahle found that executive options increased the likelihood of repurchasing
(substitution), but once the repurchase decision is made the size of actual repurchase
depended only on total exercisable options (option funding). She looked at the market
reaction to the repurchase announcement relative to option funding and signaling
hypotheses. In an efficient market, the announcement period return for funding option
exercises should not be less pronounced than for signaling and cash flow considerations.
Her results supported both the option funding and the substitution hypothesis. She found
that consistent with the option funding hypothesis, the repurchase decision was positively
related to total options exercisable, but unrelated to total unexercisable options.
Confirming the substitution hypothesis, unexercisable executive options (managerial
wealth) were positively related to the repurchases, and negatively related to dividends.
Stephens and Weisbach (1998) study showed that managers take advantage of the
flexibility inherent in repurchases, and are more likely to follow through with a
repurchase under two situations: poor stock performance, and positive cash flows. In
reviewing the levels o f outstanding shares after repurchases, they found that repurchases
are always widely publicized by companies, but offsetting dilutive actions such as option
45
exercises and halts in repurchase programs are not. These offsetting actions cause
increases in outstanding shares in the months subsequent to the repurchase announcement
(The Wall Street Journal). They proposed several alternative measures of actual shares
repurchased and found that only a fraction of announced open market repurchases
actually take place. Kahle (2002) used an adapted version of the repurchase measure used
by Stephens and Weisbach (1998) and Jagannathan et al. (2000) by subtracting decrease
in the par value of preferred stock from dollars spent on repurchases divided by the
market value of equity from Compustat database.
Bartov et al. (1998), Jolls (1998), Weisbenner (2000), Jagannathan et al. (2000),
Guay and Harford (2000) and Fenn and Liang (2001) examined the payout policy of
firms in the 1990s relative to executive and employee options and the permanence of the
cash flow using proxies. Kahle collected data on total options and executive options from
Standard and Poor’s Execucomp database and annual reports, rather than using proxies
She collected data on the total number of options outstanding and exercisable in the three
years around the repurchase for both employee options and executive options, and
decomposed each into exercisable and unexercisable options to disentangle the effects of
substitution from option funding. Her final sample consisted o f 712 repurchases using
data on all open market repurchases announced between 1991 and 1996 on SDC, CRSP,
Execucomp and Compustat data bases. To examine the characteristics that lead to a firm’s
choice of payout method, she collected a sample of firms that increased their dividends
during 1991 to 1996 using the same data bases listed above, and selected a random
sample of one-fifth o f these observations for a final dividend-increasing sample of 205.
46
Kahle calculated the total number of options held, the number o f exercisable and
unexercisable options held, and the shares owned by top executives. By combining the
Execucomp data with the data on options held by all employees collected from the annual
reports, she separated options outstanding (exercisable and unexercisable) into executive
versus non-executive options. Market to book ratio was used as a proxy for investment
opportunities and debt as a proxy for financial distress or as a substitute for payouts to
shareholders (Bagwell and Shoven, 1989). Kahle’s analysis showed that dividend-
increasing firms had more debt, less free cash flow and same capital expenditures as the
repurchasing firms. She used a multiple regression model and found that unexercisable
executive options and exercisable total options are significantly positively related to the
decision to repurchase supporting both the option funding and the substitution hypotheses.
Firms announced repurchase programs when they needed shares to fund option exercises
among employees and when managerial wealth would be negatively impacted by a
dividend increase.
Weisbenner (2000) investigated the effect of growth of stock option programs on
corporate payout policy and proposed two hypotheses: 1) corporations repurchase shares
to avoid the dilution of earnings per share (EPS) from option exercises, because EPS is
widely used in equity valuation and executive compensation (option funding); and
2) executives prefer repurchases over dividends to enhance the value of their own stock
options (substitution). Guay and Harford (2000) and Jagannathan, Stephens, and
Weisbach (2000) had proposed that repurchases will be influenced by temporary cash
flow, proxy by non-operating income and dividends by permanent cash flow, proxy by
operating income.
47
Following the above studies, Weisbenner broke cash flow into two components:
operating income and non-operating income. He tested the importance of these two
hypotheses using cross-sectional and panel data on stock options, and found that
executive options had significant positive relationship to repurchases and affected payout
policy differently from employee options. His results supported both hypotheses. He
showed that executive options lead to the firm retaining more earnings and distributing
less cash flow, consistent with the previous studies on the negative relationship between
dividends and executive options [Lambert, Lanen, and Larcker (1989) and Fenn and
Liang (2001)].
Similar to Jagannathan, Stephens, and Weisbach (2000), Bagwell and Shoven
(1988), and others, Weisbenner used a reduced form regression model of the firm’s
payout policy against the variables: total options, executive options and individual
ownership. He defined payout policy as the level of share repurchases, but regressions of
total payouts and earnings retention were also estimated. Covariates representing the
firm’s financial characteristics and industry effects are included to control for additional
factors that may influence payout policy. The sample consisted of 826 non-regulated
publicly traded companies listed in Compustat during 1994-95, with data on executive
options and/or total outstanding options, executive compensation, and stock returns
derived from the annual report, 10-K, proxy statement and CRSP data. He calculated
direct individual ownership by subtracting institutional ownership from total outstanding
shares. Standard and Poor’s Security Owner’s Stock Guides provided institutional
ownership data. Weisbenner used an adapted version of the measure of repurchases used
by Stephens and Weisbach (1998) and Jagannathan et al. (2000) by subtracting any
48
decreases in the par value of preferred stock to be more reflective o f repurchases of
common stock. He used a Tobit regression model because of the substantial mass point at
zero caused by a drop in repurchase activity in 1995. Consistent with the option funding
hypothesis, he found a positive relationship between total options outstanding and share
repurchases.
Grullon and Michaely (2002) tested the data to see if firms substitute share
repurchases for dividends to reduce shareholder’s tax liability. Since individuals should
have the biggest preference for share repurchases from a tax perspective, they proposed
that a positive relationship would exist between share repurchases and individual
ownership. They looked at other factors that could influence the repurchase decision such
as the firm’s cash flow, marginal investment opportunities (proxy by the ratio of the
market to book), undervaluation (proxy by the firm’s stock return), leverage and firm size
(proxy for financing costs, asymmetric information, variance in cash flows).
Stephens and Weisbach (1998), and Jagannathan et al. (2000) noted that the
Compustat measure of dollars spent on repurchases obtained from the firm’s flow of
funds statement will overstate actual repurchases of common stock because it also
includes repurchases o f other securities. Jolls (1998) and Fenn and Liang (2001), Guay
and Harford (2000) and Jagannathan, Stephens, and Weisbach (2000), and Weisbenner
(2 0 0 0 ) found support for the substitution hypothesis from the positive relationship
between executive options and share repurchases and/or earnings retention.
Earnings Management hypothesis deals with the interplay between accounting
practices and economic behavior, and the effect of executive compensation on the firm’s
payout policy, firm valuation, and future trends in cash payouts. The use o f stock options
49
by corporations as part of total compensation has increased steadily in the 1990s. When
exercised, stock options will dilute earnings per share (EPS) in the absence o f any
offsetting actions. Since rising stock prices promote option exercises and cause dilution
to earnings per share, option funding hypothesis may help explain the anomalies of firms
regularly repurchasing shares in spite of soaring stock valuations, and executive
assertions of initiating repurchases for signaling undervaluation.
Anecdotal and empirical evidence shows the importance placed upon reported
EPS by investors, financial advisors, and managers, and the reluctance o f firms to engage
in any transactions that could dilute EPS. Because EPS is an important measure used by
investors to judge the firm performance and to determine executive compensation,
repurchasing shares in response to stock option grants could be used as an earnings
management tool to prevent EPS dilution. An issue for shareholders is the reduction of
funds available to finance future investment due to financing the share repurchases to
avoid EPS dilution. Most firms include the EPS measure relative to benchmarks such as
last year’s earnings or analysts’ expectations in judging managers’ performance,
providing the managers an incentive to manage EPS. Matsunaga (1995) presented
evidence that firms that use income-increasing measures to expense depreciation and
value inventory are also more apt to grant stock options. Firms preparing for capital
market activities such as seasoned equity offering, IPO, stock swap mergers etc., engaged
in earnings management to boost share price, and increase proceeds from the transaction
[Teoh, Welch, and Wong (1998a, 1998b) and Rangan (1998)].
Weisbenner (2000) suggested that managers use earnings management in the form
of repurchases to counteract the dilution o f EPS due to option exercises. He pointed out
50
the importance of EPS as the earnings measure used to assess the performance of firms
and for determining the compensation of managers. He did not empirically test the
earnings management hypothesis. Previous research studies have shown that earnings
management occurs in banking firms by focusing on specific discretionary accruals such
as depreciation estimates, loan loss reserves, deferred tax valuation allowances, etc.
(Beatty et al., 1995, Collins et al., 1995, Collins et al., 1997, Ahmed et al., 1999).
Beatty et al. (2002) extended and confirmed the findings of the study by
Burgstahler and Dichev (1997) that an asymmetric pattern of more earnings increases
than decreases attributable to earnings management exists in banking firms. They studied
the presence of earnings management in public and private banks, and found that public
banks tend to report fewer earnings decreases, use accruals to eliminate small earnings
decreases, and report longer strings of consecutive earnings. Matsumoto (2002) examined
data from non-financial firms to see if firm characteristics such as transient institutional
ownership and value relevance of earnings provide greater incentives for firms to avoid
negative earnings surprises. She found that firms managed earnings upward by
employing earnings management tactics such as positive abnormal accruals, and guided
analysts’ forecasts downward to avoid negative earnings surprises.
Phillips, Pincus and Rego (2003) assessed the use of deferred tax expense to
detect earnings management by firms to avoid earnings declines or losses. They proposed
that managers are motivated by incentives to avoid failing to meet or beat earnings
forecasts, and manage earnings to be on target. They estimated a cross-sectional model
using Probit to assess the ability of deferred tax expense and accrual measures to detect
51
earnings management. Their results showed that using the discretion available under
GAAP, managers could manage earnings to avoid earnings decline or loss.
Vafeas et al. (2003) examined the discretionary accruals by fixed self-tendering
firms (excluding financial and utility firms) against a control sample of industry and
performance matched firms. They found evidence of pre-repurchase accruals and post
repurchase reversals of accruals, showing that managers employed earnings management
at the time of share repurchases. The methodology could be extended to the financial and
utility firms also.
52
Selected Previous Empirical Research Studies

Author Year Title Hypothesis Source of data, Methodology,
Variables Sample size
Asquith and 1986 Signaling with Signaling CRSP- Stock prices Event study
Mullins dividends, stock WSJ- Dividend and Descriptive statistics
repurchases and repurchase 88 firms during
equity issues announcements 1964-80
Bartov 1991 Open market Signaling CRSP- Stock prices Event study
stock Compustat- Multiple
repurchases as Eamings per share, Regression
signals for Year, SIC code,
earnings and risk Long term debt, 185
changes Operating income, announcements
Total assets, during 1978-86
Earnings
Announcement
dates
IBES- Analysts’
forecasts
Billingsley, 1989 Shareholder Signaling CRSP- Stock prices Event study
Fraser and wealth and stock Compustat- Multiple regression
Thompson repurchases by Treasury stock,
bank holding Common stock 15 open market
companies outstanding, ROE, repurchases during
ROA, Equity, 1965-83
Market to Book
value, Purchased
funding
Comment 1991 The relative Signaling CRSP- Stock prices Event study
and Jarrell signaling power Compustat- offer OLS regression
of dutch auction premium,
and fixed price repurchase size, 0 & 165 self tender
self tender offers D holdings, BV of offers during 1984-
and open market assets 89
repurchases
Cudd, 1996 Share Signaling CRSP- Stock prices Event study
Duggal and repurchase Survey data from OLS Regression
Sarkar motives and Wansley et al. Survey data from
stock market 1987
reaction
Dann, 1991 Repurchase Signaling CRSP- Stock prices OLS regression
Masulis and tender offers and WSJ- MV of equity, 122 tender offers
Mayers earnings change in shares during 1969-78
information outstanding, size of
repurchase
Fenn and 2001 Corporate Option Compustat- Tobit regression
Liang payout policy funding EBITDA, size, 1108 non-financial
53

and managerial Market to Book firms during 1993-
stock incentives ratio, Free cash 97
flow, Capital
expenditures, Long
term debt
Grullon 1999 Essays on Signaling, Compustat- Shares Cross sectional
corporate payout Cash flow sought, Price regression
policy elasticity, Size,
Market to Book 3,109 firms with
ratio, Dividend yield open market
repurchases during
1972-2000
Grullon and 2002 Dividends, share Substitution Compustat- Cross sectional
Michaely repurchases, and Eamings before regression
the substitution extraordinary items, 15,843 firms with
hypothesis Market value, repurchases during
Dividends, 1972-2000
Repurchases, Cash,
ROA, Debt, Non
operating income
Guay and 2000 Cash flow Cash flow, CRSP- share prices Multiple regression
Hartford permanence and Substitution Compustat- Assets, 1,068 repurchases,
information Market to Book 5007 dividend
content of ratio, Leverage ratio, changes during
dividend Cash flow. 1981-93.
increases versus SDC- Dividends,
repurchases Repurchases
Hirtle 1998 Bank Holding Cash flow FDIC data- Capital Descriptive
Company capital and leverage ratios, statistics
ratios and Net income, 25 largest bank
shareholder Unrealized holding companies
payouts securities gains, during 1994-97
Shareholder payouts
Hirtle 2003 How do stock Signaling- FDIC data- ROE, Multiple regression
forthcoming repurchases operating ROA, Non FRB database for
affect bank performance performing loans, bank holding
holding Charge-offs, Asset companies with
company size, Equity capital assets over
performance? ratio, Repurchases, $150MM during
Dividends, Income 1986-98.
growth
Ho, Liu and 1997 Open market Signaling Compustat, CRSP- Event study
Ramanan stock repurchase Income before Correlation
announcements extraordinary items, analysis, Multiple
and revaluation Operating income, regression
o f prior Sales growth rate, 335 announcements
accounting Market value, CAR, during 1978-92
54

information Capital
expenditures,
repurchase size,
IBES-analysts’
forecasts, # of
analysts, forecast
dispersion.
Howe, He 1992 One time cash Signaling CRSP- Stock price, Event study
and Kao flow WSJ OLS regression
announcements announcements, 55 tender offers
and free cash Compustat- Cash 60 specially
flow theory: payout, MV of designated dividend
share equity, Debt, Fixed offers during 1979-
repurchases and assets, Inventory, 89
special BV of assets
dividends
Howe, Vogt 2003 The effect of Signaling, CRSP- Stock price, Event Study, Cross
and He managerial Cash flow WSJ sectional regression
ownership on announcements, 124 repurchases,
the short and Compustat- Insider 6534 dividend
long-run holdings, FCF, increases during
response to cash Tobin’s Q, Dividend 1980-1993.
distributions yield, Capital
Expenditures, Long
term debt, ROA
Ikenberry, 1995 Market under Signaling CRSP- Stock price, Event study
Lakonishok reaction to open CAR, Compustat- Cross sectional
and market Book to Market regression
Vermaelen repurchases ratio, Firm size, 1,239 OMR
WSJ- dollar and announcements
percent of during 1980-90
repurchase
Ikenberry, 1996 The option to Signaling CRSP- Stock price, Event study
Vermaelen repurchase stock Compustat- Cross sectional
Volatility of stock, regression
correlation with 892 OMR
market, WSJ- Size announcements
of repurchase CRSP- during 1980-90
Stock price, NYSE
Jagannathan, 2000 Financial Substitution, CRSP- Stock prices, Multinomial logit
Stephens and flexibility and Cash flow Compustat- Total model
Weisbach the choice assets, Capital 338,801 open
between expenditures, market repurchase
dividends and Operating income, announcements
55

stock Non-operating during 1985- 96.
repurchases income, Total
dividends, Net
income, Share price,
BV of equity, MV
of equity, Long term
debt, # of shares
outstanding, SDC-
Repurchase
announcements
Jolls 1998 Stock Cash flow, Compustat-
repurchases and Substitution, Operating income, Multinomial logit
incentive Option Market value, Book regression
compensation funding value of equity, 324 firms during
Total assets, Debt, 1971-72.
Share prices,
Common shares
outstanding. Proxy
Statements-
Executive options,
Employee options,
Restricted stock
grants, Executive
compensation. S &
P Stock Owners
Guide- Shares held
by institutional
investors
Kahle 2002 When a Substitution, Compustat- Percent Logit regression
repurchase isn’t Option sought, Market 712 repurchases
a repurchase funding capitalization, Size, during 1991- 96.
Free cash flow,
Market to Book
ratio, Capital
expenditures, and
Long term debt.
Execucomp-
Executive options,
Total options. SDC-
Repurchases
Nohel and 1998 Share Signaling Compustat- SIC Event study
Tarhan repurchases and Cash flow code, EBITDA, Multiple Regression
firm Market value of 242 Tender offer
performance: assets, Market to repurchases during
new evidence on Book ratio, Capital 1978-91
the agency costs expenditures, Asset
of free cash flow growth rate, Sales
56

growth rate, Cash,
Leverage
Phillips et al. 2003 Earnings Earning Compustat- Total Probit regression
management: Management accruals, Income 2,179 firms and
New evidence before extraordinary 2530 observations
based on items, Cash flow during 1994- 2000.
deferred tax from operations
expense IBES- Analysts’
forecasts
Pugh and 1990 Stock Signaling Compustat- Event study
Jahera repurchases and Premium, CAR, Cross sectional
excess returns: Debt to asset ratio, regression
an empirical Fixed assets, 32 firms during
examination Common stock 1978-85
capitalization,
Institutional
holdings, Future
growth rate, Percent
to be repurchased,
Insider holdings
Stephens and 1998 Actual share re Signaling CRSP- stock price, Event study
Weisbach acquisitions in CAR 370 Open market
open market Compustat- repurchases during
repurchase Repurchase, 1984-90
programs Treasury stock
Vafeas 1997 Determinants of Signaling, CRSP- stock price, Logit regression
the choice Cash flow Compustat- Equity
between capitalization, Cash 197 repurchase
alternative share flow, Total assets, announcements
repurchase Total liabilities, during 1985- 91
methods Book value of
assets, Dividend
yield, Insider
ownership
Vafeas et al. 2003 Earnings Earnings Comment and Jarrell Matched pairs,
management management database, WSJ 100 fixed tender
around share announcements repurchase offers
repurchases: a during 1984- 92.
note
Vermaelen 1981 Common stock Signaling, CRSP- stock prices, Event study
repurchases and Substitution, WSJ- Tender Multiple regression
market Leverage premium, 131 tenders, 243
signaling: an Compustat- size, OMR repurchases
empirical study EPS, Insider during 1970-78
holdings
Weisbenner 2000 Corporate share Substitution, Compustat- Tobit and
repurchases in Option Operating income, OLS regression
57

the 1990’s: what funding Non operating 826 firms with
role do stock income, Long tem option programs
options play? debt, Capital during 1994- 95.
expenditures,
Market-to-book
ratio, Repurchase
dollars. CRSP-
Stock prices, Return
in previous year.
SEC 10-K reports-
Options. Standard
and Poor’s Security
owner’s stock
guides- Individual
ownership.
Selected Previous Survey Studies
Author Year Title Methodology

Baker, Powell and Veit 2003 Why companies use open market repurchases: a Survey
managerial perspective
Baker, Gallagher and 1980 Management’s view of stock repurchase programs irvey
Morgan
Cudd, Duggal and Sarkar 1996 Share repurchase motives and stock market
reaction
Tsetsekos, Kaufman and 1991 A survey of stock repurchase motivations and
Gitman practices of major U.S. corporations
Wansley, Lane and 1989 Management’s view on share repurchases and
Sarkar tender offer premiums
58
CHAPTER III
HYPOTHESES AND RESEARCH DESIGN
Economic and finance models have established the relationship between share
repurchases and change in shareholder value as measured by the change in share prices
and operating performance of the firm. Empirical research studies have looked at existing
hypotheses o f signaling (undervaluation of stock), cash flow (agency), substitution
(repurchases instead of dividends), and option funding (funding employee options), as the
major drivers for the firm’s decision to employ share repurchase as the chosen payout
method [Vermaelen (1981), Ofer and Thakor (1987), and Comment and Jarrell (1991),
Grullon and Michaely (2000), Jagannathan et al. (2000), Lie et al. (2000), Weisbenner
(2000), Fenn and Liang (2001), Kahle (2002)]. The above mentioned studies
concentrated on the non-financial sector, and excluded regulated industries such as
financial institutions and utilities due to lack of available data on repurchases in
Compustat and CRSP. All of the above studies except Hirtle (2003) looked at the short
term impact of the repurchase announcement. The purpose of this study is to examine the
59
applicability of the hypotheses in the banking sector and review the impact of
repurchases on long term operating performance of the firms.
The first part of the study concentrates on the three hypotheses dealing with firm
characteristics and operating earnings. The second part of the study deals with the three
hypotheses dealing with management incentives. This chapter describes the proposed
research hypotheses and models tested. This study concentrates exclusively on publicly
traded banking firms.
Signaling hypothesis states that repurchasing firms should experience
improvement in their future operating performance following the announcement, and the
changes in operating performance should be positively related to both the market reaction
(measured by stock price movements), and the magnitude of the repurchase program. The
evidence from previous empirical studies is inconclusive.
Time inconsistency hypothesis states that the market reaction measured by the
stock price movement will be based on the firms’ track record of announcing the
repurchase programs, and completing the commitments from prior repurchase programs
before announcing the new program. The common practice in the banking industry is to
announce repurchase programs before the previous program has been completed and
accounted for.
Hypothesis 1: Repurchase size and firm size will positively affect the
repurchasing firm’s operating performance relative to the industry.
Hypothesis 2\ Banking firms that had fulfilled prior repurchase commitments will
experience better long term operating performance relative to the industry.
Hypotheses 1 and 2 are be tested using model (1).
60
DROA = Po + pi PURSUE + 02 In SIZE + 03PRIORPCT + 0 4MB + 05 In INSTL +
06 LTD + 0 7In EARN + 0 8BHR + £ (1)
DROA is repurchasing firm’s excess return on assets relative to industry for year
t, PURSIZE is size o f repurchase, SIZE is book value of assets, PRIORPCT is percent of
shares repurchased from prior repurchase announcements, MB is market to book ratio,
INSTL is institutional ownership, LTD is debt to equity ratio, EARN is operating income
before depreciation and BHR is total return over 5 yeas.
Consistent with the signaling hypothesis that banking firms will increase the size
o f the repurchase as a signal for expected future profitability, this study examines the
association between repurchase decision and size of the repurchase, volatility of income,
leverage, firm size, and market to book ratio. The relationship between the long term
operating performance, book value of assets, percent of shares to be repurchased, market
to book ratio and firm’s performance in meeting previous repurchase program
commitments are examined. Following the methodology of previous studies cited above,
income before extraordinary items (ROA) and operating income before depreciation
(EARN) are used as the operating performance measures.
Other variables such as size of the firm, number of previous programs, market to
book ratio, institutional ownership, operating income before depreciation, and 5-year
total return may be correlated to the future change in operating performance. Therefore a
cross sectional regression model is used to examine the relationship between the change
in future operating performance and the size of the repurchase program in a multivariate
61
framework. If the predictions o f signaling hypothesis hold, coefficients Pi and p2 are
expected to be positive. The relationship between the repurchasing banking firms’
operating performance relative to the completion of prior repurchase commitments will
be examined by including the variable measuring the average percentage of shares
repurchased from previous programs to see if it has any influence on the long term
operating performance o f the firms. Coefficient P3 is expected to be positive confirming
the time inconsistency hypothesis.
Previous empirical studies such as Grullon (1999) and Stephens and Weisbach
(1998) looked at the non-financial firms experience with successive share repurchase
announcements and the resulting stock price movements. Grullon (1999) found that the
market expectations for share repurchase announcements were proportional to the
number o f previous repurchase programs, and the market reaction (stock price
movement) was a decreasing function of the firm size. Interestingly the negative drift in
operating performance was highest in repurchasing firms with no previous programs, and
least in firms with more than four previous programs. Stephens and Weisbach (1998)
found that on average firms acquire about 80% of the repurchase targets within three
years of the announcement.
Cash flow hypothesis states that firms with few profitable investment
opportunities will payout their excess cash flow to shareholders to reduce the agency
conflict between the shareholders and managers. The cash payout can occur in the form
of dividends or repurchases, or both. If the firm has unexpected excess cash flows in a
year any increases in dividend payouts to mitigate agency conflicts will provide an
implicit commitment to keep future payouts at the same or higher level. Historically, the
62
market has rewarded firms for keeping the dividends in a smooth upward slope over time,
with increase in dividends in one year providing an implicit commitment to keep future
payouts at the same or higher level, and any decreases in dividends resulting in stock
price declines. Since dividend decreases cause the stock price to drop, firms tend to keep
dividend payout in a steadily increasing pattern. On the other hand, announcing a
repurchase program is essentially costless to the firm due to lack of future commitments.
The decision to repurchase shares could depend upon the marginal investment
opportunities of the firm, undervaluation, size of firm, and debt ratio. A negative
relationship between outstanding debt and share repurchases would confirm that a cash
payout is less desirable for the highly leveraged firm (greater financial distress).
Hypothesis 3a: Market to book ratio and the volatility of operating income will
positively affect repurchase as a share of total payouts.
Hypothesis 3b: Transient non-operating cash flows will positively influence
repurchase payout.
Hypotheses 3a and 3b are tested using model (2).
REP OPA YOUT- p 0 + P i In CFO + p2 In ASSETS + p3MB + p4LTD + p 5LTD2 +
p6<y (ROA) + P 7o (ROA) + ps In EXECOPTION+ # (2)
The dependent variable is REPOPAYOUT (Repurchase as a fraction of
the total payout) = Repurchase/ (Repurchase+ Dividends). Repurchase is the amount of
treasury stock purchases as reported in the bank holding companies’ regulatory reports3
3 This definition of repurchases based on gross treasury stock purchases as reported in the bank holding companies’
regulatory reports can overstate the bank’s net repurchase activity if the organization sold treasury stock in the same
year as they repurchased. Using net treasury stock repurchases (treasury stock purchases minus treasury stock sales)
solves this problem.. However both gross and net treasury stock repurchases can understate total stock purchases
because regulatory reports do not detail the stock that was repurchased and retired. The methodology o f Hirtle
(2003) is modified, and the figures from SEC database on net treasury stock repurchases as reported by the banking
firm are used.
63
obtained from SEC database. The independent variables are: In CFO (log o f cash flow),
In ASSETS (log o f total assets), MB (market to book ratio), LTD (debt to equity ratio),
O(roa) (standard deviation of return on assets over 13 years), and In EXECOPTION (log
o f executive options).
Following the methodology of previous empirical studies, volatility of operating
income is measured by the standard deviation of operating income as a fraction of assets
over the 13 year period. Since large firms are generally regarded as having more stable
cash flows and less information asymmetry, the firm size measured as the log of assets is
used as proxy for external financing costs along with debt. The study tests to see if the
relationship between cash flow volatility and payout policy in the financial sector
behaves similarly to the non-financial firms studied by Jagannathan et al. (2000). A cross
sectional regression model will estimate how the firm characteristics affect the dependent
variable (repurchases as a fraction of the total payout). Coefficients Pi; p3, p 6 and P§ are
expected to be positive showing that repurchases relate positively with cash flows,
market to book ratio, volatility of operating income, and executive options. Coefficient P4
is expected to be negative showing the negative relationship between leverage and
repurchases.
Recent empirical studies have jointly examined dividends and repurchases for
their relative efficiency as signals for future performance, distribution of excess cash flow
and the impact o f uncertainty (volatility) of cash flows upon managers’ choice of
repurchases over dividends. [Ofer and Thakor (1987) Choi and Chen (1997), Bartov et al.
(1998), Fenn and Liang (2001), Jagannathan et al. (2000) and Kahle (2002)].
Jagannathan et al. (2000) and Guay and Hartford (2000) focused on the impact o f the
64
cash flow’s permanence on the choice between dividends and repurchases, and found that
for repurchasing firms with limited investment opportunities management’s assessment
of permanence or transience of earnings levels influences the decision to payout in
dividends (steadily increasing) versus repurchases (flexible). The studies have suggested
that volatility of operating cash flows and uncertainty about future trends can encourage
firms to use repurchases rather than increasing dividends [Ofer and Thakor (1987) Choi
and Chen (1997), Bartov et al. (1998), Fenn and Liang (2001), Jagannathan et al. (2000),
Guay and Hartford (2000) and Kahle (2002)].
Substitution Hypothesis proposes that managers faced with uncertain future cash
flows opt to pay out excess cash flows in the form of repurchases instead of increased
dividends to avoid such stock price fluctuations. Lintner (1956) observed that firms’
dividend policy is based on their targeted payout ratio and a determined rate of
adjustment to current dividends. Given the capital markets’ favorable reaction to dividend
increases, one would expect that firms would aim to get immediate stock appreciation by
declaring increased dividends. Obviously factors other than the signaling and cash flow
hypotheses play a role in the managers’ choice o f cash payout method. Non-operating
cash flow fluctuations introduce year-over-year volatility in operating income, and in the
available cash payout amounts. This uncertainty about fixture cash flows and potential
dividend decreases plays a significant role in the firms’ choice to substitute repurchases
for dividends. Grullon and Michaely (2002) examined the relationship between the
deviation from expected dividend level (dividend forecast deviation) and the repurchase
yield, and found evidence that non-financial firms have been gradually substituting
65
repurchases for dividends, and that repurchases are financed with funds that could have
been used to increase dividends.
Hypothesis 4\ Share repurchase yield negatively relates with the dividend forecast
deviation.
Hypothesis 4 is tested using model (3).
DEVIATION- p 0+ Pi RYIELD++ p 2 In M V + p 3ROA + P4(Jroa +Ps ct(roa )2 + p6Ln CFO+
P?LTD + p 8LTD2+p 9Ln INSTL + £ (3)
DEVIATION is the dividend forecast deviation (actual dividend yield minus
expected dividend payout based on moving average trend over study period), RYIELD is
repurchase amount as a fraction of the market value of equity, MV is market value of
firm, ROA is return on assets, a roa is standard deviation of ROA averaged over 13 years
as a measure o f volatility, CFO is cash flow from operations, LTD is debt to equity ratio,
and INSTL is institutional ownership. A cross sectional regression model is employed to
test if the repurchases are being substituted for dividends in the banking sector, after
controlling for effects o f firm size, volatility of operating income, non-operating cash
flows and debt. A negative relationship between the dividend forecast deviation and the
repurchase yield (coefficient Pi is negative) would signal that repurchases had been
substituted for potential dividend increases.
Option funding hypothesis proposes that repurchases are intended to fund the
exercise of outstanding executive and employee stock options, and to minimize dilution
to existing shareholder interests. One can speculate that the banking industry’s shift to
66
more competitive environment would promote the firms’ reliance on executive stock
options as part of total compensation. The banking firms have indeed started paying out
significant portions of compensation to executives in non-salary components such as
executive options and restricted stock. Firms will announce repurchase programs when
they need shares to fund option exercises by employees, and when managerial wealth will
be negatively affected by dividend increase. If the markets are operating efficiently,
repurchase announcements by companies for funding employee option exercises should
not experience any significant positive stock return.
Fenn and Liang (2001), Weisbenner (1998) and Kahle (2002) examined the
payout policy of non-financial firms and found a positive relation between executive
stock options and choice of repurchases over dividends. Kahle (2002) found that
unexercisable executive options have additional explanatory power on the use of
repurchases. The results of the above studies were consistent with the substitution and
option funding hypotheses that suggest that managers will act in their own best interests
and use repurchases to preserve the value of the outstanding executive options, and to
minimize the dilution of earnings per share from exercise of employee options.
Hypothesis 5: Cash flows, institutional ownership, executive options and total
employee options will positively influence the probability of repurchases.
Hypothesis 6a: Total exercisable options and un-exercisable executive options
will positively affect the probability of repurchases.
Hypothesis 6b: Total un-exercisable options and exercisable executive options
have no explanatory power on the decision to payout in repurchases.
Hypotheses 5, 6 a and 6 b are tested using logit regression model (4).
67
In (P/l-P) = fa + fa Ln M V + fa Ln CFO+ fa MB+ fa LTD+ fa BHR+ fa In TOT OP +
fa In EXECOP + fa In INSTL + £ (4)
ln MV is the log of the market value of equity, ln CFO is the log of cash flow
from operations, MB is market value as a fraction of book value of equity, LTD is debt to
equity ratio, BHR is 5-year total return for the firm, ln TOTOP is the log o f total number
o f options outstanding, ln EXECOP is the log of total number of executive options , and
INSTL is institutional ownership. The relationship between the managers’ choice of
payout method and their compensation in executive options and restricted stock is tested.
The influence of employee options (including executive options) on the decision to
repurchase shares to avoid earnings dilution is also examined. Logit regression model is
used since it is more applicable to the prediction of a dichotomous dependent variable
than the ordinary least squares (OLS) model (SAS, 1990). The outcome variable is the
probability of having 1 o f 2 outcomes based on a non-linear function of the best linear
combination o f predictors. The linear regression equation creates the logit or log of the
odds. It is the natural log of the probability of being in the group of firms engaging in
earnings management divided by the probability of being in the non-eamings-managed
repurchasing group. The logit procedure computes the coefficient for predicting the
probability (P) of being in the earnings managed group (P), Wald test (t-ratio),
probability associated with the Wald test (p-value), and odds ratios (Exp (B)). The odds
ratio shows the change in odds of being in the earnings management outcome category
when the value of the predictor increases by 1 unit. The model is expressed as ln (P/l-P)
= a+ bjXi+ b 2 X2+ ...+ bnXn+ e, where bi is the non-standardized coefficient of Xi, and e
is the stochastic error term. Since firms can have intermittent lapses in repurchases, a
68
minimal value of .00001 for years when the independent variable PURSIZE is equal to 0
will be inserted to make it continuous. The estimation model will be similar to Kahle
(2002) and Grullon and Michaely (2002) will be applied to the data from the banking
sector.
The regression model considers total executive options outstanding and total
options outstanding, and also observes the coefficients after dividing the total and
executive options into exercisable and unexercisable segments to see if the substitution
and option funding hypotheses from the non-financial sector apply to the banking firms.
A positive relationship between the banking firms’ repurchase decision, exercisable
executive options and unexercisable total options is expected. Coefficients P2 , P7 and Ps
are expected to be positive, and P6 negative consistent with the substitution and option
funding hypotheses.
Earnings management hypothesis looks at the reliance of investors and financial
analysts on accounting based information to value stocks, creating the incentive for
companies to manipulate earnings and influence the stock price valuation. Watts and
Zimmerman (1978) cautioned that accounting based compensation contracts create
earnings manipulation. Healy (1985), Holthausen et al. (1995), DeAngelo (1988),
Dechow et al. (1995) found evidence that executives manipulate earnings downwards to
maximize their compensations based on the compensation contracts’ short- term
performance focus. The fact that banking firms are subject to regulatory capital
requirements based on accounting numbers creates a potential incentive for them to
engage in earnings manipulation.
69
Recent studies on banking firms have focused on specific discretionary accruals
such as loan loss provisions and deferred tax allowances, loan write-offs and gains on
securities portfolios to manage regulatory earnings and capital level [Moyer (1990),
Collins, Shackelford and Wahlen (1995), Collins et al. (1995), Beatty et al. (2002)].
Repurchasing firms can report lower earnings by adopting discretionary accounting
accruals that would depress the stock prices and provide the firm with an opportunity to
repurchase the shares at lower than warranted price. Weisbenner (1998) pointed out that
managers can use repurchasing shares to fund option exercises as an earnings
management tool and boost the EPS, thereby counteracting the negative effects of the
discretionary accruals. In subsequent periods, the firm can reduce discretionary accruals
to improve accounting results, leading to higher stock prices. Teoh, Welch and Wong
(1998) showed that earnings management occurs at the time of IPO. Since share
repurchases are mirror images of IPO, they would offer management the incentive to
manage earnings and share prices temporarily downward by using discretionary accruals
prior to repurchase. Burgstahler and Dichev (1997) found evidence that firms manage
reported earnings to avoid earnings decreases and losses, and they used cash flow from
operations and changes in working capital to achieve increases in earnings. Beatty et al.
(1995) examined the framework where bank managers make accounting, financing and
operating decisions by exercising discretion over managing loan loss provisions, loan
charge-offs, pension settlement, miscellaneous gains and losses, and issuance of new
securities. Beatty et al. (2002) found that public banks manage earnings to achieve simple
benchmarks such as increases in earnings and to avoid reporting declines in earnings, by
studying regulatory data from the Federal Reserve Bank database. Phillips et al. (2003)
70
extended prior research and showed that deferred tax expense is a useful proxy for book-
tax differences because it is computed in accordance with SFAS No. 109, and can
identify the presence o f earnings management.
Hypothesis 7: Deferred tax expense and discretionary current accruals prior to the
repurchase followed by decline in stock prices predict the probability of earnings
management.
Hypothesis 7 is tested using model (5).
Ln (P/ 1-P) = [i0 + p, LLP + p 2 DTE + fh ACFO + p 4 Ln EXECOP +
p 5 In INSTL + £ (5)
LLP is the loan loss provision as the fraction of total loans, DTE is deferred tax
expense as a fraction of assets, ACFO= change in firm’s cash flows from continuing
operations from year t-1. Inclusion of both DTE and DCA in the model helps to
determine the incremental usefulness of each measure in detecting earnings management.
Coefficients Pi and P2 are expected to be positive indicating that the positive relationship
exists between earnings management, deferred tax expense and discretionary accruals.
ACFO is also included to control for the effect of change in cash flows on the firm’s
inclination to manage earnings.
71
CHAPTER IV
ANALYSIS OF EMPIRICAL RESULTS
The presentation of research results in this chapter is divided into three sections.
The first section describes the data collection process and sample selection. The second
section presents the results of testing three hypotheses- signaling, time inconsistency and
cash flow hypotheses, that relate to firm characteristics and operating earnings. The third
section contains the results of tests of the remaining three hypotheses relating to
management incentives and their impact on strategic decisions on the payout mechanism.
The management incentive hypotheses deal with substitution of repurchases for
dividends, repurchases to fund option exercises and earnings management. The main
purpose of the latter part of this study is to investigate managers’ choices of payout
mechanism relative to its potential effect on their own wealth.
Data and Sample Selection
In order to identify potential sample firms, Compustat and Federal Reserve’s
Bank Holding Companies data bases were searched for publicly traded U.S. banking
firms with assets over $2 billion that had data on treasury stock purchases and treasury
stock sales during the period of 1988 to 2000. The period of 1988 to 2000 was chosen to
72
avoid the abnormal market fluctuations in 1987. Since share repurchases are undertaken
by firms with assets over $2 billion, the asset size of firms in the sample data was limited
to firms over $2 billion. After applying the selection criteria on gross treasury stock
purchases to the data in the Federal Reserve Bank’s Bank Holding Companies database,
the two sets of data were matched using the unique bank number from the regulatory
reports and key variables such as entity name and assets.
Data from Compustat for the banking firms were matched to Federal Reserve’s
Bank Holding Companies database using the regulatory (FR Y-9C) reports and dropping
observations with missing data, reported negative equity capital, and significant mergers.
The bank holding company regulatory reports provided detail on the equity capital
accounts including dividend payments, treasury stock purchases and sales, and restated
results for mergers and acquisitions. Because Compustat database tends to be incomplete
for firms in regulated industries, data from regulatory reports were used to overlay data
from Compustat in cases of discrepancies. As regulatory reports do not contain direct
information about the extent of actual share repurchases by bank holding companies,
gross treasury stock purchases are used as the basic measure similar to Hirtle (2003). The
search yielded 124 firms that had data available in both databases, with 1,612 firm-year
cases.
Data on executive options, total employee options, deferred tax, shares announced
for repurchase, total number o f shares repurchased, and dollar amount of treasury share
repurchases are collected from the annual reports, proxy statements and 10-K reports in
SEC Disclosure database. Proxy statements and annual reports contain information on
compensation and stock option holdings for top executives, as well as the exercisable and
73
unexercisable portions of all options. The data collection from the SEC Disclosure
database was done manually on an individual firm basis. The unique bank number, assets,
and name were used to match data from SEC Disclosure database to previously collected
data from Compustat and Federal Reserve Bank’s Bank Holding Companies databases.
SEC Disclosure database was also used to authenticate restated data on
performance related measures such as dividend payout and dividend per share for merged
firms. The search yielded 93 banking firms that had data for the study period of 1988 to
2000, with 1,203 firm-year cases for the study population (due to missing data for 6
cases). All observations could not be used for testing the six hypotheses for two reasons.
First, data on executive and total options were not available in the SEC Disclosure
database for some firms during the early years of the study. This could possibly be due to
the increased popularity of management incentives after 1992. Second, Compustat
database omits numerous data elements for financial and other regulated firms. Cases
with any missing values were excluded from analyses. In the following sections, each
hypothesis test result shows the relevant number of observations. All analyses presented
in this study were generated by statistical procedures in SPSS version 11.5.
Prior to the analyses, the data on variables were re-examined through various
SPSS programs for accuracy of data entry, missing values, and fit between the
distributions. To improve normality and to reduce skewness, some of the independent
variables were logarithmically transformed [Tabachnick and Fidell (2001), Hair et al.
(1992)]. Squares of standard deviation of operating income (volatility), and debt to equity
were added to the models to accommodate non-linearity of data (Berry and Feldman,
74
1985). Dividend forecast deviation variable was calculated using trend analysis on a
rolling average basis for individual firms.
All data variables are defined in Appendix A showing the source- Compustat,
Federal Reserve Bank, SEC Disclosure databases, or calculated using data from the
databases. The descriptive statistics for model 1 showed high incidence of zero median
values for repurchase size and excess return in early years of the study. To assess the
impact of the zero values, the population was divided into two sub groups based on year-
1988 to 1991, and 1992 to 2000. The results of applying model 1 to the subgroups are
similar to the results from the total sample, as presented in Appendix B. The results of the
preliminary analysis o f the study sample pointed to high concentration of data points in
small asset size group. Appendix C shows the results of using dummy variables for asset
sizes and purchase size and testing the seven hypotheses in the study. The results do not
show any variation from the original results. Detailed results of the analysis due to asset
sizes are presented in Appendix D, and relevant differences due to asset size are
discussed briefly in the body of this chapter.
Results
Operating Performance and Firm Characteristics related Hypotheses: Signaling
hypothesis states that repurchasing firms will experience improvement in their future
operating performance following the repurchase announcement, and the changes in
operating performance will be positively related to both the market reaction (measured by
stock price movements), and the magnitude of the repurchase program. The evidence
75
from previous empirical studies [Bartov (1991), Comment and Jarrell (1991) and
Ikenberry, Lakonishok and Vermaelen (1995)] on non-financial firms is inconclusive.
Time inconsistency hypothesis states that the market reaction (measured by the
stock price movement) will be based on the firms’ track record of repurchasing shares
satisfying the commitments from prior repurchase programs before announcing the new
program. The common practice in the banking industry is to announce repurchase
programs before the previous program has been completed and accounted for. Empirical
studies by Grullon (1999) and Stephens and Weisbach (1998) looked at the non-financial
firms’ experience with successive share repurchase announcements and resulting stock
price movements. Grullon (1999) found that the market expectations for share
repurchases were proportional to the number of previous repurchase programs, and stock
price movement was a decreasing function of the firm size. Stephens and Weisbach
(1998) found that on average non-financial firms acquire about 80% of the repurchase
targets within 3 years of the announcement. On average the banking firms in the study
population acquired 31% of the prior repurchase target volume during the study period.
Table 1 presents summary statistics on performance measures, firm and payout
characteristics for repurchasing banking firms during the period of 1988 to 2000. It shows
that the average difference between return on assets of repurchasing firms and the
industry (DROA) is .0127%, average size of repurchasing firm (ASSETS) was $16.3
billion, and average size of repurchase program (PURSIZE) was 10.45%. It appears that
the repurchasing banking firms have marginally higher average return on assets than their
peers in the industry.
76
Table 1: Sum m ary Statistics on performance measures
N= Number of firms with data for the variable for year t, DROA= Return on assets of
sample firm in year t minus the industry average return on assets in year t, PURS1ZE=
Shares to be repurchased as a fraction of total outstanding shares, Assets= Book value of
assets, Dividend yield= Dividends/ market value of equity, Repurchase yield=
Repurchase amount/ market value of equity.
Year DROA PURSIZE Assets Dividend Repurchase

($millions) yield (%) yield (% )
1988 N 55 16 58 48 46
Mean -.0189 .0128 7713 2.983 5.408
Median .0 0 0 0 .0 0 0 0 3327 3.139 .0 0 0 0
1989 N 58 17 58 48 46
Mean .2148 .00574 8397 3.1807 4.391
Median .1700 .0 0 0 0 3968 3.2014 .0 0 0 0
1990 N 66 16 58 48 46
Mean .3136 .00139 9177 3.1807 8.107
Median .2900 .0 0 0 0 3919 3.2014 .0 0 0 0
1991 N 69 16 58 51 49
Mean -.1661 .00619 10198 2 .6 8 6 1.603
Median .2300 .0 0 0 0 4065 2.7548 .0 0 0 0
1992 N 74 10 23 22 22
Mean -.1931 .00566 16132 2.2917 3.9799

Median -.3650 .0 0 0 0 10213 2.4844 .001574
1993 N 78 14 23 22 22
Mean -.0486 .01914 18117 2.711 14.994

Median -.1850 .0 0 0 0 10476 2.785 3.931
1994 N 80 19 32 31 30
Mean -.0513 .00957 21653 3.6392 18.757
Median -.0450 .0 0 0 0 10868 3.3247 3.882
1995 N 81 35 92 80 72
Mean .0791 .02515 12323 2.5502 9.346
Median .0300 .01458 3255 2.6186 .6914
1996 N 82 37 92 81 73
Mean -.0 0 2 1 .022576 13592 2.4546 1.7908
Median -.0050 .01405 3771 2.4694 2.087
1997 N 82 38 79 70 63
Mean -.0033 .0279 16987 1.7239 11.459
Median -.0150 .00616 5307 1.7009 1.9617
1998 N 82 45 92 87 78
Mean -.2422 .3672 21509 2.127 1.340
Median -.2250 .0331 5920 2.094 6.394
1999 N 82 56 92 91 82
Mean .0498 .3672 24174 2.6896 3.848
Median .0500 .0331 6990 2.970 1.699
77
20 0 0 N 82 52 92 91 83
Mean .1887 .2491 25897 2.845 24.503
Median .245 .0327 7763 2 .6 8 6 12.085
Total N 971 371 849 770 712
Mean .0127 .1045 16313 2.726 15.007
Median .0 0 0 0 .00995 5372 2.580 .7449
It should be noted that most of the repurchases occurred in the post 1992 period of
the study, as evidenced by the small number of cases and zero median values in the early
years of the study. In spite of the later start of repurchases, the average size of repurchase
program in the banking firms (10.45%) is higher than the size of programs in non-
financial firms (5%) as reported by previous empirical studies [Bartov (1991), Comment
and Jarrell (1991) and Ikenberry, Lakonishok and Vermaelen (1995)], showing the
impact of higher repurchase payout levels in the banking firms.
The research studies in the non-financial sector cited above had documented that
excess return of firms relative to industry had a positive relationship to market to book
ratio, confirming the signaling hypothesis. Figure 1 shows the relationship between
excess return of firm relative to industry (DROA), market to book ratio, and percent of
shares repurchased from prior programs (PRIORPCT). Prior empirical studies such as
Masulis (1980), Dann (1981), Vermaelen (1984), Asquith and Mullins (1986), Ofer and
Thakor (1987), and Comment and Jarrell (1991) had suggested that repurchases are
primarily employed as signaling devices by non-financial firms’ management to reveal
the undervaluation of the shares, and improvements in firms’ operating performance
would continue in the future. Grullon (1999) found that the market expectations for share
repurchases were proportional to the number of previous repurchase programs. However
a graphical examination of the data from banking firms seems to contradict the above
78
studies. The excess returns of repurchasing firms relative to industry (DROA) are close to
or below zero during the period of 1992-2000, while market to book ratio increases
significantly during the same period. In addition, DROA and PRIORPCT for banking
firms show different trends during 1992 to 2000, contradicting Grullon (1999).
Figure 1: Excess Returns
3 “
DROA
0
Prior pet
Mean
%
Market to book
1988 1990 1992 1994 1996 1998 2000
1989 1991 1993 1995 1997 1999
YEAR
This study will use an econometric model (1), and banking firms’ data to examine
if the results support signaling and time inconsistency hypotheses. Model (1) tests
signaling (hypothesis 1 ) and time inconsistency (hypothesis 2 ), using dependent variable
DROA- excess return on assets of firm relative to industry in year t, and independent
variables: PURSIZE (shares to be repurchased as a percent of total shares outstanding),
ASSETS (book value of assets), PRIORPCT (percent of shares repurchased from prior
repurchase programs), MB (market value to book value ratio), INSTL (institutional
ownership), LTD (long term debt as a fraction of equity), EARN (operating income
before depreciation), and BHR (total return over 5 years).
79
Since variables such as size of the firm, market value to book value ratio,
institutional ownership, debt to equity, operating income before depreciation, and 5-year
total return may be correlated to the firm’s operating performance, a cross-sectional
regression model is used to examine the relationship between the firm’s excess return on
assets and the size of the repurchase program in a multivariate framework. Because
signaling hypothesis holds that firms will increase the size of the repurchase as a signal
for expected future profitability, the relationship between excess return relative to
industry, size of the repurchase and firm size is examined while controlling for leverage,
firm’s performance in meeting previous repurchase program commitments and market-
to-book ratio.
The relationship between the repurchasing banking firms’ operating performance
and completion of prior repurchase commitments is examined by including the variable
PRIORPCT (average percentage of shares repurchased from previous programs).
Hypothesis 2: Banking firms that had fulfilled prior repurchase commitments will
experience better operating performance relative to the industry.
DROA = p 0 +Pi PURSUE +p2 In ASSETS + p 3 PRIORPCT + P4MB + p 5 In INSTL+
P6LTD +P?lnEARN + p sBHR + £ (1)
Both hypotheses 1 and 2 are tested using model (1). If the predictions of the
signaling hypothesis hold, coefficients Pi and P2 are expected to be positive. Time
inconsistency hypothesis will be validated if coefficient P3 is positive.
80
The hypotheses can be stated in symbolic form as:
Hoi: p i > 0 andP 2 > 0 H0 2 : p3 > 0
Hai: pi < 0 and P2 ^ 0 Ha2 : P3 < 0
Table 2: Operating performance of sample firm relative to industry

Asset Group: All Cases: 243
Variable Correlation F / Adj. Pi t-stat p-value

R2
Dependent variable
DROA - - - -
Independent 16.88
variables / .344
Constant 1.196 2.584 .010
PURSIZE -.122 -.038 -1.616 .107
Ln ASSETS .171 -2.028** -7.594 .000
PRIORPCT .028 -.003 -.068 .946
MB -.029 -.035** -1.714 .088
LTD -.145 -.080** -3.189 .002
BHR .096 -.002 -.691 .490
Ln INSTL .337 .153** 7.912 .000
Ln EARN .222 .754** 7.016 .000
**p <. 0 1
(DROA = ROA o f sample firm - ROA of industry for year t), PURSIZE (shares to be
repurchased as a percent of total shares outstanding), ASSETS (book value of assets),
PRIORPCT (percent of shares repurchased from prior repurchase programs), MB (market
value to book value ratio), INSTL (institutional ownership), LTD (long term debt as a
fraction o f equity), EARN (operating income before depreciation), and BHR (total return
over 5 years).
Table 2 presents the results of cross sectional regressions of the excess return on
assets of the firm relative to industry (DROA) on repurchase variables and firm
characteristics for the whole population. Size of repurchase (PURSIZE), and percentage
of shares repurchased as a fraction of prior announcements (PRIORPCT) do not show
high correlation to DROA. A standard multiple regression is performed between return
on assets for firm relative to industry (DROA) as the dependent variable, and operating
81
performance and firm characteristics related independent variables- repurchase size,
percentage o f shares acquired from prior announced repurchases, market value to book
value of firm, debt to equity ratio, total return over 5 years, institutional ownership,
operating earnings and total assets. SPSS regression and SPSS frequencies are used for
evaluation of assumptions. Results of the evaluation led to transformation of the variables
to reduce skewness and improve the linearity and normality of residuals. Logarithmic
transformations are used on institutional ownership and operating earnings. Cases with
missing data were excluded leaving N= 243 cases for the analysis. Table 2 shows the
correlations between the independent and dependent variables, F, adjusted R , intercept,
non-standardized coefficients (B), t-statistics and p-values. R for regression was
significantly different from zero F (8, 234) = 16.88, p < .001. The explanatory variables
o f market to book ratio, debt to equity ratio, institutional ownership, operating earnings
and total assets relate significantly to DROA. Altogether 37% (34% adjusted) of the
variability in DROA is accounted by these independent variables. Size of repurchase and
percentage o f shares repurchased as a fraction of prior announcements do not contribute
significantly to the explanation of variance of DROA. Total assets of the firm shows a
significant negative relationship with DROA contradicting the results of studies cited
above.
Prior empirical studies cited above found that operating performance of non-
financial firms had a statistically significant positive relationship to the size of the
repurchase consistent with the signaling and cash flow hypotheses. The results from
testing model (1) using banking data show a negative (though not significant) relationship
between DROA and size of repurchase rejecting signaling hypothesis and contradicting
82
the previous studies. Because banking firms are highly regulated and followed closely by
institutional investors, information asymmetry about their operating performance and
share valuations is minimal. Hence management’s efforts to signal the market about
hidden strengths by launching share repurchases do not show the same positive
relationship between operating performance and repurchases as the non-financial firms.
The significant negative relationship of total assets to DROA shows that excess
return of firm relative to industry decreases as size increases, causing the rejection of the
signaling hypothesis. This phenomenon is possibly due to diverse businesses of large
firms having a moderating effect on the firm’s ROA relative to industry. For example,
during the 1990’s when all banking firms experienced the improvement in ROA due to
lower interest rates causing the industry average to increase, large firms’ did not
participate fully in the trend due to their business mix, while medium size firms with a
more narrow business mix enjoyed significant increases in their DROA.
Grullon (1999) found that the market reaction (stock price movement) had an
inverse relationship to the number of previous repurchase programs, contrary to the time
inconsistency hypothesis. Repurchasing banks’ data are analyzed to see if a positive
relationship exists between operating performance (DROA), and percent of shares
repurchased as a fraction of prior repurchase programs (PRIORPCT). The results of the
analysis do not support the time inconsistency hypothesis. Banking firms showed a weak
positive relationship of prior percent to operating performance, as opposed to the weak
negative relationship exhibited by the non-financial firms. Among the controlling
variables, market to book and debt to equity ratios show strong negative relationships to
83
DROA, while institutional ownership and operating earnings relate positively to DROA.
These relationships can be explained as follows.
Repurchasing banking firms’ market to book ratios relate negatively to DROA,
contradicting the results from non-financial firms. Since banking firms’ regulatory
reports are closely monitored by institutional investors, the market to book ratios reflect
the market perception o f the banks’ operating performance. Repurchases by banking
firms do not have the same signaling power as they do in the non-financial sector.
Leverage ratio (debt to equity) relates negatively to DROA due to the dampening
effect of debt on the operating performance of the firm. Excess return on assets for firm
relative to industry (DROA) relates positively with operating earnings confirming the
cash flow hypothesis. Institutional ownership shows the expected positive relationship to
DROA, indicating that institutional investors favor firms with higher performance.
To analyze the impact of asset size, the model is applied to the three asset size
groups, and results are presented in Tables D-3 to 5 in Appendix D showing variations in
the relationship o f DROA with predictor variables as asset sizes change. The positive
relationship o f DROA to PRIORPCT (percentage of repurchased shares as a fraction of
prior announcements) is significant in large firms, confirming the time inconsistency
hypothesis. These results are insignificant in the other asset sizes. The coefficient for
PURSIZE shows a negative relationship to DROA for all sizes of firms, directionally
contradicting the signaling hypothesis. The magnitudes of the relationship are too weak to
draw any conclusions about signaling hypothesis in banking firms. Institutional
ownership exhibits a strong positive relationship to DROA in small firms, and a weak
84
positive relationship in medium and large banks showing the influence of information
symmetry.
Small firms show the predictable pattern of excess returns relating positively with
institutional ownership, and negatively with leverage ratio confirming signaling and cash
flow hypotheses. Medium size banking firms’ excess return shows a strong positive
relationship to 5-year total return confirming the cash flow hypothesis. In summary, the
results support the signaling hypothesis in small banks only. Time inconsistency
hypothesis is confirmed in large banks only.
The first two hypotheses relating to firm characteristics and operating earnings,
the signaling and time inconsistency hypotheses are rejected. The study will now look at
the cash flow hypothesis.
conflict between the shareholders and managers. The firm’s marginal investment
opportunities should guide the decision to enhance firm value by using excess cash flows
to finance investments or payout to shareholders and reduce the agency conflict between
the shareholders and managers (Jensen, 1986).
The cash payout can occur in the form of dividends or repurchases, or both. If the
firm has unexpected excess cash flows in a year, any increases in dividend payouts to
mitigate agency conflicts will provide an implicit commitment to keep future payouts at
the same or higher level. Historically the market has rewarded firms for keeping
dividends in a smooth upward slope over time. Increases in dividends in one year provide
an implicit commitment to keep future payouts at the same or higher level, and any
85
decreases in dividends result in stock price declines. By contrast, announcing a
repurchase program is essentially costless to the firm since the market does not seem to
impose any penalty for lack of future commitments or not following through on the
repurchase commitments.
The decision to repurchase shares could depend upon the marginal investment
opportunities of the firm (proxy by market to book value ratio), undervaluation (proxy by
the firm’s 5-year stock return), size of firm (proxy for financing costs and asymmetric
information), and debt to equity ratio. A negative relationship between debt to equity
ratio and share repurchases would confirm that a cash payout is less desirable for the
highly leveraged firm (greater financial distress). Figure 2 shows that dividend payouts
increase slightly with size, but repurchase payouts decrease with size of the banking firm.
Figure 2: Payout ratios by asset size
60 ■
50 ■
40 ■
%
30 .
20 .
Div Payout
Repo payout
■I
Total payout
<$20 $20-50 >$50

billion billion billion
86
Figure 2a shows the relationship between dividends, repurchases, and the total
payout levels for all firms during the period. The steady ascending trend of dividends
compared to the volatile trend of repurchases in the financial firms over the 13 years is
similar to non-financial firms. It shows the reluctance of managers to significantly change
the level of dividends regardless of the net income levels.
Figure 2a: Payout ratios by year
100
40 41 *
Div Payout ratio
repo payoutl
total payout
1988 1990 1992 1994 1996 1998 2000
1989 1991 1993 1995 1997 1999
YEAR
Figures 3-5 show the relationship between dividend payout, repurchase payout,
and total payout for the three asset size groups. It is worth noting that the small firms kept
the upward trend in dividends, while medium size firms show a significant drop in
dividend payouts during the volatile earnings period of 1989-91. The levels of repurchase
payout increased rather steeply after 1992, mirroring the trend in growth of executive
options as shown in Figures 6- 9. The logarithms of executive options and total options
are included in Figures 6-9 to show the exponential growth of executive options during
the study period. Small and medium firms seem to have held the aggressive growth trend
87
in executive and total options throughout the study period, while the large firms have
picked up the pace in total options in the post-1997 period.
Figure 3: Payout ratios for firms under $20 billion
120
100
Mean
Div Payout
R ep o payout
Total payout
1988 1990 1992 1994 1996 1998 2000
1989 1991 1993 1995 1997 1999
YEAR
Figure 4: Payout ratios for firms $20 to 50 billion
100
Mean
%
t *
Div Payout
R ep o payout
Total Payout
1988 1990 1992 1994 1996 1998 2000

1989 1991 1993 1995 1997 1999
YEAR
88
Figure 5: Payout ratios for firms over $50 billion
70
60
50
40
Mean
%
30
20 Div Payout
10 R ep o payout
0 Total payout
1992 1994 1996 1998 2000
1993 1995 1997 1999
YEAR
Figure 6: Executive and Total Options
1988 1 990 1992 1994 1996 1998 2000

19 8 9 1991 1993 1995 1 997 1 999
YEAR
89

Firms < $20 billion
1988 1990 1992 1994 1996 1998 2000

1989 1991 1993 1995 1997 1999
YEAR
Figure 8: Executive and Total Options:

Firms $20 to 50 billion
16
log e x e c option
1988 1990 1992 1994 1996 1998 2000

1989 1991 1993 1995 1997 1999
YEAR
90

Firms > $50 billion
Mean 16
lo g e x e c o p tio n
lo g to ta l o p tio n
1992 1994 1996 1998 2000
1993 1995 1997 1999
YEAR
Table 6 shows the descriptive statistics of the payout variables (repurchase
payout, repurchase yield, and dividend yield), and explanatory variables (cash flow,
assets, market to book ratio, and debt to equity) used in testing cash flow hypothesis.
Cases with any missing values are excluded from analyses. It is worth noting that the
average size of assets in the population is $16.3 billion, dividend yield is 27.3%, and
repurchase yield is 15.0 %.
91
Table 6: Distribution of payouts and firm characteristics- All firms

N Variable Mean Median Standard Minimum Maximum
Deviation
a. Payout variables
770 DYIELD .2726 .2580 .1583 0.000 1.335
712 RYIELD .1501 .0075 .3299 -.3864 3.651
733 REPOPAYOUT .2295 .04219 .3229 -1.253 1.90
b. Related variables
773 Ln CFO 10.327 10.789 2.124 3.76 15.10
847 MB 1.60 1.675 1.462 .000 9.120
760 LTD .7978 .4215 .9626 -.395 7.291
849 Total assets 16314 5372 32748 .000 272426
Payout variables: REPOPAYOUT (repurchase amount/ total payout), RYIELD

(repurchase/ market value o f equity) and DYIELD (dividends/ market value o f equity),
and explanatory variables: CFO (cash flow), Total assets, MB (market to book ratio), and
LTD (debt to equity). N is number of cases for each variable.
Tables D-6a to 6c in Appendix D show the descriptive statistics of the same
variables for the three asset size groups. Mean repurchase payout percentage decreases
from 24.6% to 11.7%, as the average asset size increases from $5.2 billion to $107.3
billion. Medium size banks have the highest mean dividend and repurchase yields, while
small banks have the highest mean repurchase payout ratio.
Jensen (1986) targeted excess cash flow as a factor leading to severe agency
conflicts between the interests of managers (agents) and shareholders (owners). Managers
seem to deploy cash flow to projects that maximize their own wealth, thus raising the
question - can better alignment of management incentives and shareholder interests
reduce agency conflicts? Cross sectional regression is used to test the relationship
between executive options, repurchase payout and dividend payout. Table 7 presents the
results o f multiple regression analysis of the relationship between dividends, repurchase
payout, and total payout (dividends plus repurchases) as the dependent variables.
Management incentives- executive options, and explanatory variables of cash flow,
92
market to book ratio, total assets, debt to equity ratio and volatility of operating earnings
are used as independent variables. The results do not show significant relationships
between executive options and any of the payout variables. However, the explanatory
variables in the banking sector show some interesting differences from previous results
obtained in non-financial firms and are discussed below.
Table 7: Multiple regression of the determinants of payouts

Dependent variable Dividend Repurchase Total
payout payout payout
N 483 472 483
R2 .016 .166 .112
Independent variables
Management incentives
Ln EXECOPTION 2.001 1.326 2.885
(132) (296) (114)
Explanatory variables
Ln CFO .519 5.020** 5.591**
(432) ( 000) ( 000 )
MB .305 .950 1.493
(796) (405) (356)
Ln ASSETS -.002761 -.07079 -.05939
(955) (130) (378)
LTD 1.568 2.289 4.005**
(370) (174) (095)
O (ROA) -6.084 -6.328 -12.819
(.286) (243) ( 101)
** p <. 01
Ln CFO (log of cash flow), Ln ASSETS (log of total assets), MB (market to book ratio),
LTD (debt to equity ratio), o (roa) (standard deviation of return on assets over 13 years),
and Ln EXECOPTION (log of executive options). The first number in each cell is the P-
coefficient; the number in parenthesis is the p-value.
93
Fenn and Liang (2001) found that multiple regression of the determinants of
payouts against the management incentives and explanatory variables of non-financial
firms produced dividend and repurchase payout coefficients with similar sign and
magnitude. The results of the analysis with banking firms’ data show that the coefficients
are similar in sign but different in magnitude, suggesting that dividends and repurchases
serve similar function but they are not close substitutes. The level of cash flows shows a
strong positive relationship with repurchase payouts, confirming the cash flow
hypothesis. Contrary to Fenn and Liang’s (2001) findings in the non-financial sector, the
banking firms show a weak negative relationship between repurchase payout and
volatility o f operating earnings (a (r o a ))- This result could be due to the dominance of
small firms that are usually reluctant to engage in any payout if volatility of operating
income is high. Lambert et al. (1989) suggested that the reduction in the value of
executive options caused by dividends would cause managers to choose repurchases over
dividends for distributing the excess cash flow. The relationship between executive
options and repurchase payouts is analyzed to see if option-induced reductions in
dividends are offset by repurchases in the total population, and in the three asset size
groups, using econometric model (2).
Hypothesis 3a: Market-to-book ratio and the volatility of operating income will
repurchase payout.
Hypotheses 3a and 3b are tested using model (2).
94
REPOPAYOUT= fio + pi In CFO + p 2 In ASSETS + p 3MB + p 4LTD + p 5LTD 2 +
P6 o (r o a ) + P?g (r o a ) + /% EXECOPTION+ £, (2)
The dependent variable is REPOPAYOUT (Repurchase as a fraction of the total
payout) = Repurchase/ (Repurchase + Dividends). Repurchase is the amount of treasury
stock purchases as reported in the bank holding companies’ regulatory reports4 obtained
from SEC database. The independent variables are: ln CFO (log of cash flow), ln
ASSETS (log of total assets), MB (market to book ratio), LTD (debt to equity ratio),
O(roa) (standard deviation of return on assets over 13 years), and ln EXECOPTION (log
of executive options).
Since large firms are regarded as having more stable cash flows and less
information asymmetry, firm size measured as the log of assets is used as proxy for
external financing costs along with debt. The relationship between cash flow volatility
and payout policy is tested to see if the behavior of financial services firms is similar to
those of industrial firms described by the results from Jagannathan, et al. (2000) and Fenn
and Liang (2001) studies on non-financial firms. The data is compiled from Compustat,
Federal Reserve Bank and SEC databases. The cross sectional regression model estimates
how the firm characteristics affect the dependent variable (repurchase payout).
Coefficients pi, P3 , p 6 and Ps are expected to be positive showing that a positive
relationship exists between repurchase payouts and market to book ratio, cash flows,
4 This definition of repurchases based on gross treasury stock purchases as reported in the bank holding companies’
regulatory reports can overstate the bank’s net repurchase activity if the organization sold treasury stock in the same
year as they repurchased. Using net treasury stock repurchases (treasury stock purchases minus treasury stock sales)
solves this problem. However both gross and net treasury stock repurchases can understate total stock purchases
because regulatory reports do not detail the stock that was repurchased and retired. The methodology o f Hirtle
(2003) is modified, and the figures from SEC database on net treasury stock repurchases as reported by the banking
firm are used.
95
standard deviations of operating income and executive options. Coefficient P4 is
expected to be negative showing the relationship between leverage ratio and repurchases.
The hypothesis can be stated in symbolic form as:
Ho3: pi > 0 P3 > 0 p6 > 0 p8> 0 p4< 0
Ha3: P i < 0 p3 < 0 p6< 0 p8< 0 p4 > 0
A standard multiple regression is performed between repurchase payout as the
dependent variable and operating performance and management incentive related
independent variables- cash flow, market value to book value ratio, debt to equity ratio,
standard deviation of return on assets, and executive options. SPSS regression and SPSS
frequencies are used for evaluation of assumptions. Results of the evaluation led to
transformation of the variables to reduce skewness, and improve the linearity and
normality of residuals. Logarithmic transformations are used on cash flow and executive
options. Cases with missing data were excluded leaving N= 481 cases for the analysis.
Table 8: Determinants of repurchase payouts

Asset Group: All Cases: A81
Correlation F/ Adj. R2 Pi t-stat p-value
Dependent Variable
REPOPAYOUT
Constant 13.09/.168 -.416 -1.992 .047
LnCFO .367 .052** 7.943 .0 0 0
Ln ASSETS -.187 _ 1 1 2 ** -3.546 .0 0 0
MB .028 -.009 -.750 .454

LTD .051 -.018 -.408 .683
LTD2 .084 .0 1 2 .845 .399
O (ROA) -.049 .372** 1.974 .049
_ 2 -.062 -.408** -2.570 .0 1 0
G (ROA)
Ln EXECOPTION .0 1 2 .044** 3.183 .0 0 2
** p< .0 1
96
Dependent: REPOPAYOUT (Repurchase/ (Repurchase + Dividends)). Ln CFO (log of

cash flow), Ln ASSETS (log of total assets), MB (market to book ratio), LTD (debt to
equity ratio), a (roa) (standard deviation of return on assets over 13 years), ROA
(operating income divided by total assets), and Ln EXECOPTION (log of executive
options).
Table 8 shows the correlations between the independent and dependent variables,
adjusted R2, intercept, non-standardized coefficients (P), t-statistics and p-values. R for
regression was significantly different from zero, F (8, 472) = 13.09, p < .001. The
variables cash flow, asset size, and standard deviation of return on assets relate
significantly to repurchase payout. Altogether 18% (17% adjusted) of the variability in
repurchase payout is predicted by these independent variables. Market to book and debt
to equity ratios did not relate significantly to REPOPAYOUT.
Tables D-8a to 8c in Appendix D show the correlations between the independent
and dependent variables, adjusted R2, intercept, non-standardized coefficients (P), t-
statistics and p-values for the three asset size groups. The results show some interesting
variations in the relationship of repurchase payout with the predictor variables with the
asset size groupings. The significant positive coefficients for cash flow in all groups are
consistent with the cash flow hypothesis, showing that firms with excess cash flows will
engage in repurchase payouts to mitigate agency conflicts.
Volatility of operating income as shown by the standard deviation of return on
assets has a significant positive relationship with repurchase payout in small and medium
size firms. This relationship is consistent with the substitution hypothesis that transient
excess cash flows will encourage repurchases. The relationship is not significant in the
large firms, possibly due to their ability to manage volatility through diversification.
Interestingly, the relationship of repurchases with volatility of operating income reverses
97
direction and turns negative at an equilibrium point for firms of all sizes (shown by the
results for o (R0A) 2), showing that the volatility of cash flow will cause the managers to
reduce/ eliminate repurchases after reaching a threshold.
Market to book ratio exhibits an inverted U-shaped relationship to repurchase
payout as the asset size increases. It relates marginally negative in groups 1 and 2, and
turns strongly positive for group 3. Management of small and medium banks use
repurchases to signal to the market the firms’ operating performance characteristics and
stock undervaluation. Since large firms do not have the information asymmetry, their
repurchases are caused by the desire to mitigate agency conflicts, confirming cash flow
hypothesis.
Executive options show a horizontal S-shaped relationship to repurchase payout
as asset size increases. The significant positive relationship in group 1 firms confirms the
substitution hypothesis. The relationships in groups 2 and 3 are not significant. Overall
the results indicate that repurchase payouts show a strong positive relationship to
operating cash flow confirming the cash flow hypothesis across all banking firms.
Among the hypotheses relating to firm characteristics and operating earnings,
only the cash flow hypothesis is confirmed by testing the models with banking data. In
the next section, the study examines the three hypotheses relating to management
incentives- substitution, option funding and earnings management for their influence on
the repurchase decisions by banking firms.
98
Management Incentive Hypotheses
Empirical studies by Ofer and Thakor (1987) Choi and Chen (1997), Bartov et al.
(1998), Fenn and Liang (2001), Jagannathan et al. (2000) and Kahle (2002) have
examined dividends and repurchases jointly for their relative efficiency as signals for
future performance and distribution of excess cash flow by non-financial firms. The
studies looked at the impact of uncertainty (volatility) of cash flows upon managers’
choice o f repurchases over dividends. They suggested that managers’ assessment of
permanence or transience of earnings levels in repurchasing firms with limited
investment opportunities influences their decision to payout in dividends or repurchases.
The volatility o f operating cash flows and uncertainty about future trends can encourage
firms to use repurchases rather than increasing the dividends.
Table 9 presents descriptive statistics on firm characteristics by payout policy for
the banking firms in the study sample. The results reveal interesting aspects of the
relationship between the firms’ payout policy, size and operating performance measures.
The results show that:
• Dividend paying firms (DIV > 0) are much larger and more profitable than
non-dividend paying firms (DIV = 0) and repurchasing firms (REPO > 0).
• Repurchasing (REPO > 0) firms are larger and more profitable than non
repurchasing firms (REPO = 0).
• Non- repurchasing firms (REPO = 0) pay larger dividends (mean = 55.5).
• For non-dividend paying firms (DIV = 0) repurchases are at a minuscule

level (mean = 0.9002). It appears that repurchases are undertaken for
tactical reasons like funding employee options without additional dilution.
• Repurchasing firms have much higher non-operating income as a fraction

of net income (mean = 1.35) than the dividend paying firms (mean =
0.7735). It suggests that the transitory nature of non-operating earnings
may be encouraging the firms to engage in repurchases as
substitute for increased dividends.
99
Table 9: Descriptive statistics on firm characteristics by payoiit decision
The variables shown are end of the year values: MV- market value of the firm, ASSETS-
total assets of the firm, MB- market to book ratio, ROA- operating income before
extraordinary items/ total assets, NOPER- non-operating income (expense)/ operating
earnings, DIVPAYOUT- dividend amount/ net income, and REPOPAYOUT-repurchase
amount/ total payout.
Repurchase = 0 Dividend = 0
Variable N Mean Median N Mean Medial
MV 15 1172.6 346.97 231 65.381 .000
ASSETS 13 7224.6 2861.9 116 1677.2 929.42
MB 13 2.161 2.133 115 0.250 0.000
ROA 15 0.9753 1.09 241 0.2336 0.000
NOPER 13 -.0859 .6630 61 7.141 .7278
DIV 15 55.457 36.980 249 0.000 0.000

PAYOUT
REPO 10 0.000 0.000 239 .9002 1.000
PAYOUT
Repurchase > 0 Dividend > 0
N Mean Median N Mean Median
MV 981 2536.4 437.64 807 3112.4 715.4

ASSETS 746 17973.4 5884.4 667 20148.9 7196.2
MB 744 1.6086 1.6595 666 1.842 1.851
ROA 1019 0.9236 1.080 826 1.130 1.150
NOPER 683 1.3496 0.6894 658 0.7735 0.6919
DIV 1019 31.700 31.100 826 41.280 35.750

PAYOUT
REPO 1018 51.668 51.727 819 39.518 30.216
PAYOUT
100
Jagannathan et al. (2000), Grullon and Michaely (2002) reviewed the relationship
between cash flow volatility and payout method in non-banking firms. They analyzed the
data from non-banking firms to see if higher earnings volatility leads to higher propensity
to payout in the form o f repurchases. Both studies found that a negative relationship
exists between earnings volatility and dividend payout in the non-banking sector.
Table 10 shows the relationship between cash flow volatility and payout method
for the banking firms in the study sample. Since size of the banking firms has significant
influence on management decisions, the analyses for the sub groups by asset size- small
(< $20b), medium ($20 - 50b), and large firms (> $50b) are shown in the table also. The
results show that the average dividend payout increases with the size of assets, while
average non-operating income and repurchase payout decrease. The cash flow volatility
follows a U-shaped curve relative to the size of assets.
101
Table 10: Cash flow volatility and payout decisions

All data were collected from Compustat and SEC databases. The variables used in the
analysis show end of year values: oroa (square of the standard deviation of return on
assets over the study period), NOPER (non operating income/ net income), Dividend
payout (dividend amount/ net income), REPOPAYOUT (repurchase amount/ total
payout)._____________________________________ ______________ _______________
All companies „ 2 NOPER Dividend REPOPAYOUT
oroa
payout
Mean .2800 1.2684 32.690 22.953
Median .21486 .69333 33.960 4.2193
N 777 778 784 733
Group 1: under $20billion
Mean .30629 1.3705 30.408 24.589
Median .21673 .69689 32.085 6.3366
N 603 604 610 563
Group 2: $20 to $ 50billion
Mean .17569 1.0064 39.944 20.819
Median .11313 .72536 35.980 2.318
N 113 113 113 109
Group 3: over $50 billion
Mean .21274 .74300 42.0716 11.655
Median .2306 .603 40.7100 .16528
N 61 61 61 61
Lintner (1956) observed that firms’ dividend decisions are based on their targeted
ratio of total payout to net income at a pre-determined rate of adjustment to current
dividends. Since capital markets react favorably to dividend increases, one would expect
that firms would aim to get immediate stock appreciation by declaring increased
dividends. However, the increase in repurchases during the study period for the banking
firms implies that other behavioral factors may be responsible for the shift of payout
method from dividends to repurchases. Figures 10 and 11 show the trends of repurchase
and dividend payouts, and the repurchase and dividend yields for the study period.
102
Figure 10: Payout trends
100
60
40
Vc
Div P a y o u t
20
R epo payout
&
T otal p a y o u t
1988 1990 1992 1994 1996 1998 2000
1 989 1991 1993 1995 1997 1999
YEAR
F i g u r e 11: Y i e l d t r e n d s
60
Mean
20
D i v i d e n d yield
Repurchase yield
1988 1990 1992 1994 1996 1998 2000
1989 1991 1993 1995 1997 1999
YEAR
103
Substitution hypothesis proposes that managers faced with uncertain future cash
flows opt to payout excess cash flows in repurchases rather than dividends to dampen
stock price fluctuations. The non-operating income component of the firm’s cash flow
can fluctuate due to economic conditions, introducing year-over-year volatility. When
faced with the decision to payout the excess cash flow, managers look at the
sustainability of the cash flow in future years. If the excess cash flow is distributed in the
form of dividends, the higher level of payout will need to be maintained in the future to
preserve the stock price. If on the other hand, transient cash flow is distributed in the
form of repurchases, the level of payout can be adjusted in future years without adverse
impact to the stock price. The uncertainty about future cash flows plays a significant role
in the firms’ choice to substitute repurchases for dividends.
Grullon and Michaely (2002) examined the relationship between the deviation
from expected dividend level (dividend forecast deviation) and the repurchase yield
(repurchase expenditure as a fraction of market value of equity). They found that non-
financial firms have been gradually substituting repurchases for dividends and
repurchases are financed with funds that could have been used to increase dividends. The
relationship between dividend forecast deviation and the repurchase yield in banking
firms is reviewed to see if the results are similar to the non-banking sector. The
dependent variable- DEVIATION (dividend forecast deviation, i.e., actual dividend paid
minus expected dividend payout based on moving average trend over study period) is
calculated. Cross sectional, pooled data gathered from Compustat, Federal Reserve Bank
and SEC Disclosure databases for banking firms is used for analysis. Multiple regression
model (3) is used to test if the repurchases are being substituted for dividends in the
104
banking sector after controlling for effects of market value of firm (MV), return on assets
(ROA), standard deviation of return on assets over 13 years ( ctroa ), cash flows (Ln CFO),
institutional ownership (Ln INSTL), and long term debt as a fraction of equity (LTD).
The square of the standard deviation of ROA ( c ir o a 2) and the square of debt to equity
0 . . .
(LTD ) adjust for the non-linearity of the data. A negative relationship between the
DEVIATION and the repurchase yield (RYIELD = repurchase amount / market value of
equity) i.e., Pi being negative, would signal that repurchases had been substituted for
potential dividend increases.
Hypothesis 4: Share repurchase yield negatively relates with the dividend forecast
deviation.
DEVIATION = 0o+ Pi RYIELD++02 In M V + 0 3ROA + 0 4cr r o a + 05 o 'r o a 2 + 0 6 Ln
CFO+ 0 7LTD + 0 8LTD2+0 9Ln INSTL + £ (3)
H o4: Pi < 0
H 34: pi > 0
A standard multiple regression is performed between dividend forecast deviation
as the dependent variable and operating performance related independent variables-
repurchase yield, market value of firm, return on assets, cash flow, standard deviation of
return on assets over the study period, debt to equity ratio, and institutional ownership.
SPSS regression and SPSS frequencies are used for evaluation of assumptions. Results of
the evaluation led to transformation of the variables to reduce skewness, and improve the
linearity and normality o f residuals. Squares of standard deviation of return on assets and
105
debt to equity ratios are included to improve linearity. Logarithmic transformations are
used on market value, cash flow and institutional ownership. Cases with missing data
were excluded leaving 603 cases for the analysis.
Table 11 shows the correlations between the independent and dependent
variables, adjusted R2, intercept, non-standardized coefficients (B), t-statistics and p-
values for the total population.
Table 11: Determinants of dividend substitution

Asset Group: All________ Cases: 603
Correlation F/ Adj. R2 Pi t-stat p-value
Dependent
variable
DEVIATION - - - - -
Independent 21.72/ .236

variables
Constant -.007 -.070 .944
RYIELD .036 .000 -.641 .522
Ln MV .145 .034** 2.226 .026
ROA .265 .100** 5.887 .000
Ln CFO .099 .007** 2.052 .041
( ctroa ) .245 -.421** -4.793 .000
(c tr o a )2 .308 .543** 7.290 .000
LTD .131 .100** 4.565 .000
LTD z .077 -.023** -3.328 .001
Ln INSTL -.013 -.013** -2.671 .008
** p< .01
Dependent variable: dividend forecast deviation (DEVIATION). Independent variables:
repurchase yield (RYIELD= repurchase amount/ market value of equity), market value of
firm (MV), return on assets (ROA), standard deviation of return on assets over 13 years
(<7 r o a ), Log cash flows (Ln CFO), Log Institutional ownership (Ln INSTL), debt to
equity ratio (LTD). Square of standard deviation of ROA ( c t r o a 2) and square of debt to
equity (LTD2) adjust for the non-linearity of the data.
Repurchase yield did not show high correlation to dividend forecast deviation. R
for regression was significantly different from zero, F (9,593) = 21.72, p < .001. Return
106
on assets, standard deviation of return on assets, debt to equity ratio and institutional
ownership relate significantly to dividend forecast deviation. Altogether 25% (24%
adjusted) of the variability in dividend forecast deviation is predicted by the independent
variables. Repurchase yield did not relate significantly to the dividend forecast deviation
as predicted by the substitution hypothesis.
Tables D- l l b to l i d in Appendix D show the results of analysis for the three
asset size groups. The results show some interesting variations in relationships between
dividend forecast deviations and the predictor variables with changes in asset size.
Repurchase yield does not show significant relationship to dividend forecast deviation in
any asset size group. Return on assets shows a significant positive relationship to
dividend forecast deviation in small and large asset size groups showing that higher
dividends result from better operating performance for these groups, confirming cash
flow hypothesis. Medium size banks show a weaker positive relationship. Volatility of
operating income as shown by standard deviation of ROA shows a horizontal S-shaped
relationship to dividend forecast deviation as the asset size increases. It relates
significantly negative for group 1, shows a weak positive relationship for group 2, and
turns significantly negative for group 3. This phenomenon could be due to the ability of
, the medium size banks to increase cash flows as size (diversity of businesses and
volatility of cash flow) grows, and being able to maintain dividend trends, but only to a
certain level of risk.
Debt to equity or leverage shows a significant positive relationship to dividend
forecast deviation for groups 1 and 2 showing that leverage contributes to increased
dividend payouts. Large banks do not exhibit a significant relationship between debt to
107
equity and dividend forecast deviation, possibly because high leverage is their normal
operating pattern. One interesting point to note is that the relationship of dividend
forecast deviation with leverage ratio turns negative at an inflection (equilibrium) point
for small and medium size banks, as evidenced by the results for the square of the debt to
equity ratio. This shows that cash flows from increased leverage lead to increased
dividend payouts until an equilibrium point is reached when the effects o f increased risk
override the positive effects o f leverage-induced operating performance.
The institutional ownership variable shows a significant negative relationship to
the dividend forecast deviation for small firms, possibly indicating the preference of
institutional shareholders to have the cash flow deployed into building profitable
businesses. The relationship is not significant in medium and large banks, showing that
the institutional shareholders pay less attention to the dividend forecast deviation for
these groups.
In summary, even though the sign of the coefficient in small and medium banks is
in the expected direction, it is not significant enough to rely on the results. Small banks
increase the dividends as return on assets and leverage ratios rise and lower the dividends
with increases in volatility o f operating income and institutional ownership. Medium size
banks increase dividends as cash flow and leverage ratio increase. The return on assets
ratio plays a marginally positive role in the medium size firms’ dividend decision. Large
banks tend to increase dividends as the return on assets increase, and decrease dividends
with increased volatility of operating income. Leverage ratio and institutional ownership
do not seem to have much impact. The results from model (3) are not robust enough to
support or reject the substitution hypothesis in banking firms. This study examines if
108
repurchasing banking firms’ data confirms option funding hypothesis by testing the total
employee options and executive options using a logistic regression model.
payout policy of non-financial firms and found a positive relationship between executive
stock options and choice o f repurchases over dividends. Kahle (2002) found that
unexercisable executive options have additional explanatory power on the use of
repurchases. The results of the above cited studies were consistent with the substitution
and the option funding hypotheses suggesting that managers act in their own best
interests by using repurchases to preserve the value of the outstanding executive options
and try to minimize the dilution of earnings per share from exercise o f employee options.
exercise of outstanding executive and employee stock options and to minimize dilution to
existing shareholder interests. Firms announce repurchase programs when they need
shares to fund option exercises by employees (option funding). If the markets are
operating efficiently, repurchase announcements by firms for funding employee option
exercises should not experience any significant positive stock return. Similar to their
peers in the non-financial sector, the banking firms started paying out significant portions
o f compensation to executives in non-salary components such as executive options and
restricted stock as part of the shift to a more competitive environment during the study
period. This has promoted the firms’ reliance on employee and executive stock options as
part of total compensation. Figures 12a-12d show the trend in employee and executive
options during the study period for the total sample and for the three asset size groups.
Small firms picked up the pace of executive and employee options in post-1992 years.
109
Figure 12a: Executive and Total options
Mean4
log ex ec option
log total option

1988 1990 1992 1994 1996 1998 2000
1989 1991 1993 1995 1997 1999
YEAR
Figure 12b: Executive and Total options

Firms < $20 billion
* ■
s# 0 m »
Mean
log e x e c option
log total option

1988 1990 1992 1994 1996 1998 2000
1989 1991 1993 1995 1997 1999
YEAR
Figure 12c: Executive and Total options
Firms $20-50 billion
16 -----------------------------------------------------------------------------------------------------------------------------------------------
15
M ean 14 ■
13
log e x ec option
12 log total option

1988 1990 1992 1994 1996 1998 2000
1989 1991 1993 1995 1997 1999
YEAR
Figure 12d: Executive and Total options

Firms > $50 billion
18
17 # * * * *
16
Mearj5
14 log e x e c option
13 log total option

1992 1994 1996 1998 2000
1993 1995 1997 1999
YEAR
Ill
The influence of employee options and executive options on managers’ decisions
to repurchase shares to avoid earnings dilution is tested. Logistic regression is chosen
because it is more applicable to the prediction of a dichotomous dependent variable than
the ordinary least squares (OLS) model (SAS, 1990). The outcome variable is the
probability o f having 1 of 2 outcomes based on a non-linear function of the best linear
combination o f predictors. The linear regression equation creates the logit, or log of the
odds. It is the natural log of the probability of being in the repurchasing group divided by
the probability of being in the non-repurchasing group. The logit procedure computes the
coefficient for predicting the probability (P) of being in the repurchase group (B), Wald
test (t-ratio), probability associated with the Wald test (p-value), and odds ratios (Exp
(B)). The odds ratio shows the change in the odds of being in the repurchasing outcome
category when the value of the predictor increases by 1 unit. The probability of the
dependent variable being equal to 1 is expressed as ln (P / 1-P) = a + biXi + b 2 X 2 + ...+
bnXn + e, where b, is the non-standardized coefficient of X; and e is the stochastic error
term. Since firms can have intermittent lapses in repurchases, a minimal value of .00001
is inserted when the independent variable PURSIZE is equal to 0 to make it continuous.
An estimation model similar to the models used by Kahle (2002) and Grullon and
Michaely (2002) for the non-banking sector is applied to the data from the banking
sector. The regression model observes the coefficients considering total executive
options outstanding and total options outstanding, as well as the exercisable and
unexercisable segments of the total and executive options. Hypotheses 5, 6 a and 6 b are
tested using logit regression model (4) to see if the substitution and the option funding
hypotheses hold true in the banking sector also.
112
Hypothesis 6a: Total exercisable options and un-exercisable executive options
Hypothesis 6 b: Total un-exercisable options and exercisable executive options
Hypotheses 5, 6 a and 6 b are tested using the logistic regression model (4).
In (P/l-P) = p 0 + Pi Ln M V + p 2 Ln CFO+ fo MB+ (i4 LTD+ p 5 BHR+
p 6 In TOT OP + p 7 In EXECOP + p 8 In INSTL + £ (4)
ln MV is the log of the market value of equity, ln CFO is the log of cash flow
from operations, MB is market value as a fraction of book value of equity, LTD is debt to
equity ratio, BHR is 5-year total return for the firm, ln TOTOP is the log of total number
o f options outstanding, ln EXECOP is the log of total number of executive options
outstanding, and ln INSTL is the log of institutional holdings. A positive relationship
between the banking firms’ repurchase decision, exercisable executive options and
unexercisable total options is expected. Coefficients 02 , 06, 07 and 0g are expected to be
positive consistent with the substitution and the option funding hypotheses.
H0 5 : p2 > 0 p 7 > 0 and ps>0 H0 6 : 06, > 0
Has: 02 ^ 0 07 < 0 and 0 g< 0 Ha6 : 06 i1 0
Employee compensation is decomposed into employee options and executive
options, and each of them split further into exercisable and unexercisable components to
see if they cause differences in the probability of repurchases. Since asset sizes have been
113
shown to influence managers’ decisions, the model is tested using the full study sample
as well as the individual asset size groups (under $20 billion, $20-50 billion and over $50
billion), and results are shown in Tables D-12b tol2d in Appendix D.
Table 12 shows the results of the analysis with Column 1: outstanding total
options, Column 2: outstanding total options and executive options, and Column 3:
outstanding total and executive options split into exercisable and unexercisable portions.
The first number in each cell is the parameter coefficient estimate (P); the second is the
Wald test (t-ratio). The number in parenthesis is the maximum likelihood p-value. It
shows the results o f logistic regression analysis performed on repurchases as outcome,
and seven performance and compensation related predictors: market value, cash flow,
market to book ratio, debt to equity ratio, 5-year total return, institutional holdings and
total employee options. Executive options are added in the second column, and total and
executive options are split into exercisable and unexercisable parts in the third column.
SPSS LOGIT regression is used for the analysis. After deletion of 669 cases with missing
values, data from 534 repurchasing firms are available for analysis- 177 non-repurchasing
firms and 357 repurchasing firms. The overall prediction success rate is at 74%, with
94% o f repurchasing firms and 34% of non-repurchasing firms correctly predicted. The
regression coefficients, Wald test (t-ratio), odds ratios, and p-values for each of the seven
predictors for each of the three compensation scenarios are presented.
Based on the Wald test from Column 1, only the log of market value, 5-year total
return and institutional holdings predicted the repurchases reliably with t=32.5, 11.4 and
4.9 respectively, p< .001. The negative sign of the coefficients (P) for the 5-year return
and institutional ownership shows that firms with high historical returns and firms with
114
high institutional ownership have lower odds of repurchasing shares, confirming the
signaling hypothesis. However the odds ratios of .971 and .781 for these variables point
to little change in the likelihood of repurchase on the basis on one unit change in total
return or institutional holdings. Log market value with an odds ratio of 6.277 shows
significant positive impact of the size of the firm on the likelihood of repurchase. Total
outstanding options show minimal predictive value, not enough to support or reject the
option funding hypothesis.
The results in Column 2 show the impact of both total and executive options. The
t-ratio of 9.057 and odds ratio of 1.455 for the log of executive options shows the positive
impact o f executive options on the likelihood of repurchase, confirming the substitution
hypothesis. Total options have minimal predictive value, but not enough to support or
reject the option funding hypothesis.
115
Table 12: Probability of repurchase

The first number in each cell is the parameter coefficient estimate (p); the second is the
Wald test (t-ratio); the third is the odds ratio. The number in parenthesis is the maximum
likelihood p-value. _________ _________________ ________________________
(1) (2) (3)
Total Total and Total and Exec, options
options Exec.options outstanding- Exercisable
outstanding outstanding and Unexercisable
N 534 460 359
Pseudo (Nagelkerke) .174 .177 .204
R-sq
Intercept .582 -1.636 -1.348
.103 .605 .332
1.789 .195 .260
(748) (437) (565)
Log of MV 1.837 1.665 1.191
32.521 19.627 8.146
6.277 5.284 3.289
( 000 ) ( 000 ) (004)
Log of Cash flow -.049 -.018 -.045
.970 .102 .513
.952 .983 .956
(325) (749) (474)
Market to Book -.029 -.134 .035
.082 1.474 .065
.972 .875 1.036
(774) (225) (798)
Debt/ Equity -.111 -.156 -.112
.800 1.406 .553

.895 .856 .894
(371) (236) (457)
5-year total return -.029 -.032 -.056
11.422 10.449 17.753
.971 .968 .946
( 001 ) ( 001 ) ( 000 )
Log o f Institutional -.247 .187 -.013
shares 4.932 2.081 .007
.781 .829 1.014
(026) (149) (935)
Log of Total options .004 -.218
.002 3.021
1.004 .804
(961) (082)
Log o f Total options .236
exercisable 1.099
1.267
116
(.295)
Log of Total options -.322
unexercisable 2.437
.725
(118)
Log of Executive .375
options 9.057
1.455
(003)
options exercisable 3.197
1.346
(074)
Log of Executive -.231
options unexercisable 1.752
.794
(186)
Column 3 shows the results with total and executive options split into exercisable
and unexercisable portions, with exercisable executive options showing a positive
relationship to the probability of repurchases. The results show that only the log of
market value, 5-year total return, and exercisable executive options predicted the
repurchases reliably, with t= 8.15, 17.8, and 3.2 respectively, p< .001. The negative sign
of the coefficient for 5-year total return shows that firms with high historical returns have
lower odds of repurchasing shares. But the odds ratio of 0.946 for 5-year return shows
little change in the likelihood of repurchase on the basis on one unit change in total return.
Log market value with an odds ratio of 3.289 shows that size of the firm increases the
likelihood of repurchase. In summary, the results confirm the substitution hypothesis but
confirmation of the option funding hypothesis is inconclusive.
Tables D-12b to 12d in Appendix D show some variations in results due to asset
sizes that are worth reviewing. The negative sign of the coefficients for 5-year total
returns and institutional ownership in small firms shows that firms with high historical
117
returns and firms with high institutional ownership have lower odds of repurchasing
shares. The log of the market value and executive options show significant impact on the
likelihood of repurchase, confirming the signaling and substitution hypotheses.
For medium firms, the log of institutional holdings and exercisable executive
options predicted the repurchases reliably confirming the substitution hypothesis.
Interestingly, medium size firms show a positive relationship between institutional
holdings and repurchases, signaling that high institutional ownership increases the odds
of repurchases in medium firms. These firms may be using repurchases to distribute
excess cash flows to institutional investors due to lack of investment opportunities,
confirming the cash flow hypothesis.
The results of the analysis using large firms show that they are able to use
leverage to generate cash flows and payout the excess cash flow in repurchases. Total
outstanding options relate positively to the probability of repurchase, confirming the
option funding hypothesis. An interesting difference with the large firms is the significant,
negative coefficient for the log of market value, showing that higher market values lower
the odds of repurchases by large banking firms. Higher market values could be the result
o f investors rewarding large firms for their diversity of products and markets. If managers
are deploying cash flows into profitable investments, investors will expect the managers
to continue to increase the value of the firm rather than payout in repurchases, confirming
the cash flow hypothesis. In summary, the results show that the substitution hypothesis is
confirmed for small and medium firms, while the option funding hypothesis is weakly
confirmed in large firms.
118
The results o f model (4) show positive confirmation of the substitution
hypothesis, but show weak support for the option funding hypothesis. Since executive
options are shown to influence management decisions about share repurchases, the
presence of possible earnings management in repurchasing banking firms can provide
avenues for behavioral research. This study now examines the last hypothesis in the
group o f management incentive hypotheses- the earnings management hypothesis.
analysts on accounting based information to value stocks creating the incentive for
companies to manipulate earnings and influence the stock price valuation. Burgstahler
and Dichev (1997) found evidence that firms manage reported earnings to avoid earnings
decreases and losses and used cash flow from operations to achieve increases in earnings.
Healy (1985), Holthausen et al. (1995), DeAngelo (1988), and Dechow et al. (1995)
found evidence that executives manipulate earnings to maximize their compensation
based on the compensation contracts’ short term performance focus. Weisbenner (1998)
pointed out that managers use repurchased shares to fund option exercises and boost the
EPS, counteracting the negative effects of the discretionary accruals. In subsequent
periods, discretionary accruals are reversed to improve accounting results, leading to
higher stock prices. Phillips et al. (2003) found that deferred tax expense computed in
accordance with SFAS No. 109 (Accounting for Income Taxes) is a useful proxy for
differences between book and tax incomes and can identify the presence of earnings
management in the non-banking sector. They used deferred tax expense as a fraction of
assets (DTE), discretionary current accruals as a fraction of assets (DAC), and change in
119
cash flows as a fraction of assets (ACFO) as predictors for presence of earnings
management (EM) in non-banking firms.
Recent studies on banking firms have focused on specific discretionary accruals
such as loan loss provisions and deferred tax allowances, loan write-offs and gains on
securities portfolios to manage regulatory earnings and capital levels [Moyer (1990),
Collins, Shackelford and Wahlen (1995), Collins et al. (1995), Ahmed et al. (1999),
Beatty et al. (1995, 2002)]. Beatty et al. (2002) found that public banks manage earnings
to achieve increases in earnings or avoid reporting declines in earnings. They showed that
loan loss provision as a fraction of total loans (LLP ratio) can proxy for discretionary
current accruals in the banking sector.
Since banking firms are subject to regulatory capital requirements based on
accounting numbers, the potential incentive for them to engage in earnings manipulation
exists. Loan loss provision as a fraction of total loans (LLP) is used as a proxy for
discretionary current accruals, and to test Phillips’ model to see if banking firms use
repurchases as an earnings management tool to offset the effects of option exercises on
EPS. The influence of discretionary current accruals, deferred tax expense, executive
options and institutional ownership on the probability of managing earnings in
repurchasing banking firms is tested. Figure 13 shows the relationship between deferred
tax expense as a fraction of assets (DTE), loan loss provision as a fraction of total loans
(LLP), and change in cash flows from year t-1 to t as a fraction of assets (DCFO). It is
interesting to note the offsetting trends of DTE and LLP while DCFO remains constant
possibly pointing to earnings management in repurchasing banking firms.
120
Figure 13: Earnings management hypothesis

2.
1.
1.
Mean
%
0.
Def. Tax Exp.
- 1. Loan L o ss Prov.
- 1. _ _ _ _ _ _ _ _ _ _ _ _ Diff C ash Flow s

1989 1991 1993 1995 1997 1999
1990 1992 1994 1996 1998 2000
YEAR
Estimation model (5) is similar to the model used by Phillips et al. (2003) and
Beatty et al. (2002) for the non-banking sector and is now applied to the study data from
the banking sector. Hypothesis 7 is tested using logistic regression model (5) to see if the
earnings management hypothesis holds true in the banking sector.
management.
Ln (P/ 1-P) = p 0 +Pi LLP + p 2 DTE + /% ACFO + p 4 In EXECOP +
Ps In INSTL + £ (5)
LLP is the loan loss provision as a fraction of total loans, DTE is deferred tax
expense as a fraction o f assets, ACFO is the change in firm’s cash flows from continuing
121
operations from year t-1. Inclusion of both DTE and LLP in the model helps to determine
the incremental usefulness of each measure in detecting earnings management. ACFO is
included to control for the effect of change in cash flows on the firm’s inclination to
manage earnings. Coefficients Pi and P2 are expected to be positive indicating that a
positive relationship exists between earnings management, deferred tax expense and
discretionary accruals.
Since asset sizes are known to influence managers’ decisions [Beatty et al. (2002),
Hirtle (2003)], the model is tested using the full study sample as well as the individual
asset size groups (under $20 billion, $20-50 billion, and over $50 billion). The results
show that deferred tax, executive options and institutional ownership have significant
influence on earnings management, but loan loss provision (discretionary current
accruals) and change in cash flows (ACFO) do not.
The results are presented in Table 13 for the total sample, and in Table D- 13a in
Appendix D for the three asset size groups. The first number in each cell is the parameter
coefficient estimate (P), the second is the Wald test (t-ratio), and third number is the odds
ratio. The number in parenthesis is the maximum likelihood p-value. Logistic regression
analysis is performed on earnings management as outcome, and five performance and
compensation related predictor variables: loan loss provision ratio, deferred tax expense
ratio, change in cash flows, log of executive options, and log of institutional holdings.
After deletion of 750 cases with missing values, data from 453 repurchasing firms is
available for analysis-134 non-eamings-managed firms and 319 earnings managed firms.
The overall prediction success rate is at 73%, with 97% of earnings managed firms
correctly predicted. The regression coefficients, Wald test (t-ratio), and p-values for each
122
o f the five predictors are presented. Based on the Wald test, p-values and odds ratios,
deferred tax ratio, change in cash flow, executive options and institutional ownership
predict the repurchases reliably with t=7.23, 1.309, 12.86 and 18.1, and odds ratios of
1.243, 59.970, 0.690 and 1.440 respectively. The significant impact of change in
operating cash flows on the likelihood of earnings management is consistent with the
cash flow hypothesis.
Table 13; Probability of earnings management
All cases
N 453
Pseudo .101
(Nagelkerke)
R-sq
Predicted % 72.6
correct
Intercept -.626
.193
.535
(661)
LLP -.026
.332
.974
(564)
DTE .218
7.225
1.243
(007)
ACFO 4.094
1.309
59.970
(253)
Ln -.371
EXECOPTION 12.858
.690
( 000 )
Ln INSTL .365
18.096
1.440
( 000 )
123
N indicates cases included in analysis. LLP is loan loss provision as a fraction of total
loans, DTE is deferred tax expense as a fraction of assets, ACFO= change in firm’s cash
flows from continuing operations from year t-1, Ln EXECOPTION= log of executive
options, Ln INSTL= Institutional ownership. The first number in each cell is the
parameter coefficient estimate (B), the second is the Wald test (t-ratio), third is the odds
ratio. The number in parenthesis is the maximum likelihood p-value.
The negative sign of the coefficients (P) for loan loss provision and executive
options show that firms with high loan loss provision ratios and executive options have
lower odds of earnings management. However the odds ratios of 0.974 and 0.690 show
little change in the likelihood of earnings management on the basis of one unit change in
the loan loss provision ratio. Deferred tax and institutional ownership with odds ratios of
1.243 and 1.440 respectively, show significant impact on the likelihood of the outcome.
Table D-13a in Appendix D shows the results of applying the logit model to the
data from small, medium and large banking firms. Institutional ownership and the
deferred tax ratio have strong positive predictive ability in small firms, possibly
consistent with the cash flow hypothesis. Executive options exhibit a consistently
negative predictive capability of earnings management for banks of all sizes. These
results are in line with the trend of executive options reacting negatively to actions that
have a dampening influence on the stock price.
Overall results are consistent with hypothesis 7 on deferred tax expense (DTE),
but not on loan loss provision (discretionary current accruals). Deferred tax expense is
incrementally useful in predicting earnings management for repurchasing banking firms
of all sizes. The results confirm the findings from Phillips et al. (2003) that deferred tax
expense is incrementally useful in detecting earnings management in non-banking firms.
The loan loss provision ratio is a weak positive predictor for medium and large firms, but
124
has a weak negative relationship in the small firms. These results are in line with the
results of Beatty et al. (2002) that public (large) banks use discretion in their loan loss
provisions to avoid declines in earnings, and private (small) banks have lower propensity
to do so. The next chapter provides the summary of the findings, conclusions, and
limitations o f the study along with suggestions for future research.
125
CHAPTER V
SUMMARY AND CONCLUSIONS
This chapter provides a summary of the findings of the study. In the first section,
the empirical results are presented and reviewed in light of the hypotheses tested. The
second section discusses the conclusions, followed by the contributions of this study.
Some limitations and suggestions for future research and closing remarks are presented at
the end of the chapter.
Summary of Results
Corporate finance theory expects that managers’ decisions should lead to value
maximization for the firm’s shareholders. When firms have excess cash flow, managers
have to choose among several alternatives to deploy the cash to add value to the firm. In
the absence o f profitable investments, they have to choose the best method to payout the
excess cash flow to shareholders to avoid agency conflict. Previous empirical research
has focused on the effect of share repurchases on managers’ wealth and the decision
process leading to the choice of payout mechanism in non-financial firms.
126
The purpose o f this study is to provide empirical evidence relevant to the
application of existing hypotheses to financial firms, while considering the exponential
increase of management incentives during the study period. Two major themes are
pursued using financial firms’ data. First, management’s desire to signal the market about
future performance of the firm and agency conflicts are reviewed. Second, the impacts of
unprecedented growth in executive and employee options on share repurchase decisions
and earnings management strategies are addressed.
This study draws upon the rich tradition of management actions and firm
operating performance research in finance and accounting. It concentrates on
management behavior and information asymmetry relative to the size of the firm and
utilizes the methodology typical to capital market studies. Data were collected from
Compustat, Federal Reserve Bank Holding Companies database and SEC Disclosure
database. Multiple regression and logistic regression models are used to test the
hypotheses derived from prior empirical studies in the non-financial sector.
Operating Performance and Firm Characteristic related Hypotheses: Results
from the first part o f the study indicate confirmation of the cash flow and signaling
hypotheses. The average size of the repurchase program in banking firms (10.45%) is
higher than the size of programs in non-financial firms (5%) as reported by previous
empirical studies [Bartov (1991), Comment and Jarrell (1991) and Ikenberry, Lakonishok
and Vermaelen (1995)]. It appears that the repurchasing firms have marginally higher
average return on assets than their peers in the non-banking sector.
127
Size of repurchase and PRIORPCT (percentage of shares repurchased as a
fraction o f prior announcements) do not contribute significantly to the explanation of
excess return of firm (DROA). The results of the analysis directionally contradict
signaling and the time inconsistency hypotheses, but they are too weak to draw
conclusions. Total assets show a negative relationship to DROA contradicting the
signaling hypothesis.
Among the controlling variables, market to book ratio shows a strong negative
relationship to DROA, contradicting some of the previous studies cited. Debt to equity
ratio relates negatively to DROA, while institutional ownership and operating earnings
relate significantly and positively to the prediction of DROA, confirming the cash flow
hypothesis. The same pattern emerges when testing repurchase payout as a dependent
variable, and cash flow, market to book ratio, debt to equity ratio, total assets and
volatility o f operating earnings as independent variables. Cash flow relates positively and
assets relate negatively to repurchase payout, confirming the cash flow hypothesis and
rejecting the signaling hypothesis. In summary, the results do not support the signaling or
time inconsistency hypotheses, but strongly support the cash flow hypothesis.
Management Incentive Hypotheses'. Fenn and Liang (2001) found that multiple
regression of the determinants of payouts against the management incentives and
explanatory variables of non-financial firms produced dividend and repurchase payout
coefficients with similar sign and magnitude. The results of the analysis with banking
firms’ data show that the coefficients are similar in sign but different in magnitude,
suggesting that dividends and repurchases serve a similar function but they are not close
substitutes.
128
The results in the second part of the study show that dividend payouts increase
with firm size, and repurchase payouts decrease with size. Small firms keep a smooth
upward trend in dividends, while medium size firms adjust dividends during volatile
earnings periods. Both repurchase payouts and executive options have increased steeply
since 1992. Holding the volatility of income constant, the level of cash flow shows a
strong positive relationship with repurchase payouts, confirming the cash flow
hypothesis. Similar to the non-financial sector, banking firms show a strong positive
relationship between repurchase payout and volatility of operating earnings, pointing to
the substitution hypothesis. Lambert et al. (1989) suggested that the reduction in the
value o f executive options caused by dividends would cause managers to choose
repurchases over dividends for distributing the excess cash flow. The positive
relationship between executive options and repurchase payouts in banking firms shows
that option-induced reductions in dividends are offset by repurchases. The results from
the second part of the study show confirmation of the substitution hypothesis, and weak
support for the option funding hypothesis.
Looking at the payout patterns of the banking firms, some interesting trends
emerge. Dividend paying firms are larger and more profitable than repurchasing firms.
Repurchasing firms have higher non-operating income than dividend paying firms,
suggesting the existence of substitution. Grullon and Michaely (2002) found a negative
relationship between repurchase yield and dividend forecast deviation, showing that
funds are directed away from dividends to repurchases in non-financial firms. The
relationship of repurchase yield to dividend forecast deviation in banking sector was
insignificant, and too weak to confirm or reject the substitution hypothesis.
129
Analyzing by asset size, certain interesting trends emerge. Small banks increase
dividends as return on assets and leverage ratios rise, and lower dividends with increases
in volatility o f operating income and institutional ownership. Medium size banks increase
dividends as return on assets and leverage ratios rise. Return on assets plays a marginal,
positive role in the medium size banks’ dividend decision. Large banks increase
dividends as return on assets increases and lower dividends with increased volatility of
operating income. Leverage and institutional ownership do not have much impact on
dividends in large banks. In summary, the substitution hypothesis is directionally
confirmed, but the results are not robust enough to support or reject the hypothesis.
Kahle (2002) tested the non-financial firms to see if repurchases were used to
minimize the dilution of earnings per share from exercise of employee options. She found
a positive relationship between unexercisable executive options and repurchases, showing
that managers act in their own best interests by using repurchases to preserve the value of
outstanding executive options. Her results supported both the substitution and the option
funding hypotheses. When a similar logistic regression model is applied to the banking
data, the results show a significant positive impact of executive options on the likelihood
o f repurchase, confirming the substitution hypothesis. Total options show weak
predictive value but not enough to support or reject the option funding hypothesis.
The firm’s market value, 5-year total return and institutional ownership show
significant effect on the likelihood of repurchase. In summary, the results show that the
substitution hypothesis is confirmed in banking firms, but support for the option funding
hypothesis is inconclusive.
130
Using the loan loss provision ratio as a proxy for discretionary current accruals,
Beatty et al. (2002) showed that public (large) banks manage earnings to achieve an
increase in earnings, or to avoid reporting a decline in earnings from operations. Phillips
et al. (2003) showed that deferred tax expense would identify the presence of earnings
management in the non-banking sector. Using a logistic regression model with loan loss
provision, deferred tax expense and change in cash flow ratio as predictors of earnings
management in banking firms, this study finds that repurchasing banks engage in
earnings management regardless of size. Deferred tax is incrementally useful in
predicting earnings management in banking firms, similar to non-banking firms. Loan
loss provision is a weak positive predictor of earnings management as asset size
increases, in line with Beatty et al. (2002). Institutional ownership also shows significant
impact on the likelihood of earnings management in banks. Executive options exhibit a
consistently negative predictive capability of earnings management, showing that
executive options react negatively to actions that have a dampening influence on the
stock price.
The results lead to the following conclusions: (1) Cash flow and institutional
ownership have strong positive relationship to firm’s operating performance confirming
cash flow hypothesis: (2) Size of repurchase and performance in satisfying prior
repurchase commitments do not have an impact on the operating performance,
contradicting the results on signaling and time inconsistency from the non-financial
sector; (3) Executive options, transient cash flow, and institutional ownership play a
significant role in influencing management choice of repurchase over dividends in banks
o f all sizes, confirming substitution hypothesis; (4) Total options do not show predictive
131
ability of repurchases, contradicting option funding hypothesis; and (5) Deferred tax
expense and institutional ownership show significant positive impact on the likelihood of
earnings management in banks, consistent with results in the non-financial sector.
Contributions
This study contributes to the ongoing empirical research on stock repurchases in
corporate finance and accounting in several ways. It tests the existing share repurchase
hypotheses to banking firms while considering the exponential increase in management
incentives during the study period.
Much of the previous research concentrated on studying the impact of share
repurchases in a short time horizon surrounding the repurchase event in non-financial
firms. Several researchers [Bartov (1991), Comment and Jarrell (1991), Ikenberry,
Lakonishok and Vermaelen (1995)] reported support for the signaling hypothesis by
showing that excess return relative to industry had a positive relationship to the market to
book ratio. These conclusions have perpetuated management efforts to use share
repurchases as a signal to the market about the operating performance of the firm. An
important contribution of this study is the rejection of the signaling hypothesis in banking
firms, indicating that the repurchasing banking firm does not enjoy excess returns relative
to the industry. The results of this study also reject the time inconsistency hypothesis,
showing that the market does not punish banking firms if they do not fulfill prior
repurchase commitments.
Another important contribution of this study is examining the impact of the
exponential growth in management incentives on share repurchases in banking firms
132
during the study period. Management incentives play a significant role in determining
the repurchase payout decisions. Prior research [Grullon and Michaely (2002), Kahle
(2002)] in non-banking firms confirmed the incidence of substituting repurchases for
increased dividends during periods of transient earnings, and using repurchases for
funding option exercises. In testing the same hypotheses in banking firms, this study
finds significant support for the substitution hypothesis and weak support for the option
funding hypothesis. This confirms that the market can discriminate between true share
repurchases and the option funding needs in banking firms. Since banking firms have
consistently paid dividends in the past, the impacts of executive options and changes in
dividend tax rates on management behavior would afford interesting topics for future
research.
Limitations
Despite using a large pool of sample firms for a period of 13 years, the lack of
readily available data imposed certain limitations on the present study. Compustat
database excludes key data variables for regulated industries including financial firms.
When the sample was partitioned into sub-samples, the limited number of observations
precluded making statistical comparisons of groups.
Due to the limited data availability across the three databases- Compustat,
Federal Reserve and SEC Disclosure, the study sample was limited to banking firms with
assets over $2 billion. It would have been worthwhile to include banking firms of all
sizes. However, smaller banking firms do not seem to engage in stock repurchases.
A second component of management incentives, restricted stock awarded to
executives has been increasing along with the executive options. This study did not
133
examine the impact of restricted stock due to limited data availability. Joint analysis of
both components could reveal insight into the behavioral aspects of the managerial
decision process relating to share repurchases.
Suggestions for future research
Four major directions for future research emerge from this study. First, the study
population was limited to banking firms with assets over $2 billion. The population can
be expanded to include smaller banking firms to examine the applicability of the
hypotheses. It would also be interesting to study the impact of share repurchases on
operating performances of other types of financial institutions such as insurance and
brokerage firms to see if existing hypotheses apply to these firms similar to banks.
Second, the FASB and SEC are going to require U.S. firms to recognize the
expenses of stock options in their financial statements to give investors a better
understanding o f total executive compensation. The change will take effect by Fall of
2004. In February 2004, more than 500 large firms voluntarily adopted or disclosed the
expenses associated with stock options. It will be interesting to study how the reporting
changes influence management decisions on repurchase payout in future years.
Third, since the 1990’s did not have any major economic fluctuations or interest
rate changes, this study did not control for time. It would be worthwhile to examine the
results from using the same models for different periods. Future research could also
benefit from matched pair comparisons between repurchasing and non-repurchasing
banking firms.
134
Fourth, the management incentive hypotheses can be tested relative to the three
cash payout mechanisms to executives- repurchases, dividends, and restricted stock. The
present study did not consider restricted stock due to limited availability of data.
135
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APPENDICES
146
APPENDIX A
LIST OF VARIABLES
Variable Definition Compustat FRB SEC Calculated
ASSETS Total assets X X X
BHR Buy and Hold return (5 yrs) X
BV Book value of assets X X X
BVEQ Book value of equity X
CFO Cash flow from operations X
DEVIATION Dividend forecast deviation X
DIV Cash dividends per share X X
DIVPAYOUT Dividend amount/ EARN X X X
DIVYIELD Dividend amount/ MV X
DTE Deferred tax expense/ Assets X X
DROA ROA of firm- ROA of industry X
EARN Operating earnings X X X
EXECOP Executive options (proxy) X
INSTL Institutional ownership X
LLP Loan loss provision/ Total X X
Assets
147
LIST OF VARIABLES (Contdl
Variable Definition Compustat FRB SEC Calculated
LTD Long term debt/ BV o f Equity x
MB Market value/ Book value x
MV Market value of equity
NOPER Non operating income/

Operating earnings x
NUM Number of shares outstanding
PRIORPCT Shares to be repurchased/

Total # of shares authorized x
PURSIZE Shares to be repurchased/

Total # of shares outstanding x
RYIELD Repurchase amount/ MV X
REPO Purchase of Treasury stock- x X
Sale of Treasury Stock x
REPOP AYOUT Repurchase amount/ MV X
ROA Return on assets
SH Year end price per share
O roA Standard deviation of operating earnings X
SIZE Book value of total assets
Total payout Repurchase + Dividends X
TOTALOP Total options (proxy) X
148
APPENDIX B
Signaling and Time Inconsistency Hypotheses

Analysis of 1988-1991 and 1992-2000 periods
Due to the disproportionately large number of zero median values for PURSIZE
and repurchase yield during the early years of the study, the time period was split into
two sub-periods with 1992 being the break point. The year 1992 is chosen because of the
widespread consensus among economists that the U.S. economy started robust expansion
in 1992, leading to unprecedented corporate performance. Descriptive statistics and
multiple regressions were compared for the periods of 1988 to 1991, and 1992 to 2000.
The results from testing model (1) on data for the 2 periods did not show significant
changes from the previous results for the total study period. The only significant
difference was the confirmation of the time inconsistency hypothesis in the period of
1988 to 1991. The following tables present the summary statistics and results of testing
model ( 1 ).
Table B -l.l: Summary Statistics on perform ance measures, firm and payout characteristics.
Years: 1988 to 1991
Year DROA PURSIZE Assets Dividend yield Repurchase yield
1988 N 55 16 58 48 46
Mean -.0189 .0128 7713 2.983 5.408
Median .0000 .0000 3327 3.139 .0000
1989 N 58 17 58 48 46
Mean .2148 .00574 8397 3.1807 4.391
Median .1700 .0000 3968 3.2014 .0000
1990 N 66 16 58 48 46
Mean .3136 .00139 9177 3.1807 8.107
Median .2900 .0000 3919 3.2014 .0000
1991 N 69 16 58 51 49
Mean -.1661 .00619 10198 2.686 1.603
Median .2300 .0000 4065 2.7548 .0000
Total N 248 65 232 195 187
Mean .0833 .00652 8871 3.4114 4.8252
Median .0100 .00000 3776 3.2523 .00000
DROA= Return on assets of firm in year t minus the industry average return on assets in year t, PURSIZE=
Shares to be repurchased as a fraction of total outstanding shares, Assets= Book value of assets, Dividend
yield= Dividends/ market value of equity, Repurchase yield= Repurchase amount/ market value of equity.
Table B -l.l presents summary statistics for banking firms with repurchases
during the period of 1988 to 1991. It shows that the average difference between return on
assets of repurchasing firms and industry-wide return on assets is .0833%, average size of
repurchasing firm is $8.9 billion, and average size of repurchase program is .065%. It
appears that during the period of 1988 to 1991, the repurchasing banking firms had
higher average return on assets than their peers in the industry; and the average size of
repurchase program in the banking firms (0.65%) is almost negligible. It makes one
wonder if funding employee options that were coming into vogue at that time was the
only purpose of the repurchases. The topic is not pursued further in this study.
Table B-1.2: Summary Statistics on performance measures, firm and payout characteristics.
Years: 1992 to 2000
1992 N 74 10 23 22 22
Mean -.1931 .00566 16132 2.2917 3.9799
Median -.3650 .0000 10213 2.4844 .001574
1993 N 78 14 23 22 22
Mean -.0486 .01914 18117 2.711 14.994
Median -.1850 .0000 10476 2.785 3.931
1994 N 80 19 32 31 30
Mean -.0513 .00957 21653 3.6392 18.757
Median -.0450 .0000 10868 3.3247 3.882
1995 N 81 35 92 80 72
Mean .0791 .02515 12323 2.5502 9.346
Median .0300 .01458 3255 2.6186 .6914
1996 N 82 37 92 81 73
Mean -.0021 .022576 13592 2.4546 1.7908
Median -.0050 .01405 3771 2.4694 2.087
1997 N 82 38 79 70 63
Mean -.0033 .0279 16987 1.7239 11.459
Median -.0150 .00616 5307 1.7009 1.9617
1998 N 82 45 92 87 78
Mean -.2422 .3672 21509 2.127 1.340
Median -.2250 .0331 5920 2.094 6.394
1999 N 82 56 92 91 82
Mean .0498 .3672 24174 2.6896 3.848
Median .0500 .0331 6990 2.970 1.699
2000 N 82 52 92 91 83
Mean .1887 .2491 25897 2.845 24.503
Median .245 .0327 7763 2.686 12.085
Total N 723 306 617 575 525
Mean -.0115 .1253 19112 2.4937 18.6337
Median .0300 .01658 5861 2.4304 4.2591
DROA= Return on assets o f firm in year t minus the industry average return on assets in year t, PURSIZE=
Shares to be repurchased as a fraction o f total outstanding shares, Assets= Book value of assets, Dividend
yield= Dividends/ market value o f equity, Repurchase yield= Repurchase amount/ market value o f equity
150
Table B-1.2 presents summary statistics for banking firms with repurchases
during the period of 1992 to 2000, showing that the average difference between return on
assets of repurchasing firms and industry-wide return on assets is -.0115%, average size
o f repurchasing firm is $ 19.1 billion, and. average size of repurchase program is 12.5%.
It appears that during the period of 1992 to 2000, the repurchasing banking firms had
lower average return on assets than their peers in the industry. In spite of the later start of
repurchases, the average size of repurchase program in the banking firms (12.53%) is
much higher than the size of programs in non-financial firms (5%) as reported by
previous empirical studies [Bartov (1991), Comment and Jarrell (1991) and Ikenberry,
Lakonishok and Vermaelen (1995)], showing the impact of higher repurchase levels in
the banking firms. It is interesting to note that the average dividend yield decreased from
3.4114 to 2.4937, while the average repurchase yield increased from 4.8252 to 18.6337
during the two periods studied.
Table B-l .3 presents summary statistics for repurchasing banking firms during the
period of 1988 to 2000. It shows that the average difference between return on assets of
repurchasing firms and industry-wide return on assets is .0127%, average size of
repurchasing firm was $ 16.3 billion and average size of repurchase program was
10.45%. It appears that the repurchasing firms have marginally higher average return on
assets than their peers in the non-financial sector. In spite of the later start of repurchases,
the average size of repurchase programs in banking firms (10.45%) is higher than the size
o f programs in non-financial firms (5%) as reported by previous empirical studies
[Bartov (1991), Comment and Jarrell (1991) and Ikenberry, Lakonishok and Vermaelen
(1995)], showing the impact of higher repurchase levels.
151
Table B-1.3: Summary Statistics on performance measures, firm and payout characteristics.
Years: 1988- 2000
1988 N 55 16 58 48 46
Mean -.0189 .0128 7713 2.983 5.408
Median .0000 .0000 3327 3.139 .0000
1989 N 58 17 58 48 46
Mean .2148 .00574 8397 3.1807 4.391
Median .1700 .0000 3968 3.2014 .0000
1990 N 66 16 58 48 46
Mean .3136 .00139 9177 3.1807 8.107
Median .2900 .0000 3919 3.2014 .0000
1991 N 69 16 58 51 49
Mean -.1661 .00619 10198 2.686 1.603
Median .2300 .0000 4065 2.7548 .0000
1992 N 74 10 23 22 22
Mean -.1931 .00566 16132 2.2917 3.9799
Median -.3650 .0000 10213 2.4844 .001574
1993 N 78 14 23 22 22
Mean -.0486 .01914 18117 2.711 14.994
Median -.1850 .0000 10476 2.785 3.931
1994 N 80 19 32 31 30
Mean -.0513 .00957 21653 3.6392 18.757
Median -.0450 .0000 10868 3.3247 3.882
1995 N 81 35 92 80 72
Mean .0791 .02515 12323 2.5502 9.346
Median .0300 .01458 3255 2.6186 .6914
1996 N 82 37 92 81 73
Mean -.0021 .022576 13592 2.4546 1.7908
Median -.0050 .01405 3771 2.4694 2.087
1997 N 82 38 79 70 63
Mean -.0033 .0279 16987 1.7239 11.459
Median -.0150 .00616 5307 1.7009 1.9617
1998 N 82 45 92 87 78
Mean -.2422 .3672 21509 2.127 1.340
Median -.2250 .0331 5920 2.094 6.394
1999 N 82 56 92 91 82
Mean .0498 .3672 24174 2.6896 3.848
Median .0500 .0331 6990 2.970 1.699
2000 N 82 52 92 91 83
Mean .1887 .2491 25897 2.845 24.503
Median .245 .0327 7763 2.686 12.085
Total N 971 371 849 770 712
Mean .0127 .1045 16313 2.726 15.007
Median .0000 .00995 5372 2.580 .7449
DROA= Return on assets o f firm in year t minus the industry average return on assets in year t, PURSIZE=
Shares to be repurchased as a fraction of total outstanding shares, Assets= Book value of assets, Dividend
yield= Dividends/ market value of equity, Repurchase yield= Repurchase amount/ market value of equity.
152
Table B-2.2: Operating performance of firm relative to industry

Asset Group: All Cases; 2 1 8 _____ Period: 1992- 2000
Variable Correlation Adj. R2 p. t-stat p-value
Dependent variable
DROA - - - -
Independent variables .386

PURSIZE -.119 -.021 -.984 .326
PRIORPCT .020 .005 .120 .905
Ln ASSETS .208 -2.288** -8.859 .000
MB .223 .027 1.277 .203
LTD -.082 -.056** -2.379 .018
BHR .157 -.005 -2.049 .042
Ln INSTL .335 .122** 6.360 .000
Ln EARN .274 .885** 8.495 .000
** p <. 01
DROA= ROA of firm —ROA o f industry for year t, PURSIZE (shares to be repurchased as a percent of
total shares outstanding), ASSETS (book value o f assets), PRIORPCT (percent o f shares repurchased from
prior repurchase programs), MB (market value to book value ratio), INSTL (institutional ownership), LTD
(long term debt as a fraction of equity), EARN (operating income before depreciation), and BH R (total return over
5 years).
The cross-sectional regression of the excess return on assets of the firm relative to
the industry (DROA) on repurchase variables and firm characteristics for the whole
sample during the period of 1988 to 1991 is not presented due to the small number of
cases (15) selected. Table B-2.2 presents the cross-sectional regression (Model 1) of the
excess return on assets of the firm relative to the industry (DROA) on repurchase
variables and firm characteristics for the whole population during the period of 1992 to
2000.
Table B-2.3 presents the cross-sectional regression of the excess return on assets
o f the firm relative to the industry (DROA) on repurchase variables and firm
characteristics for the whole sample during the entire study period of 1988 to 2000.
Comparing the results from the period of 1992 to 2000 in Table B-2.2 to those for the
entire study period of 1988 to 2000 in Table B-2.3, the signaling hypothesis is rejected
due to the insignificant value of the coefficient for PURSIZE, and coefficient for In
ASSETS being significantly negative. These results are similar in both periods. The time
153
inconsistency hypothesis is rejected due to the insignificant relationship of PRIORPCT
with the excess return in both periods.
Table B-2.3: O perating perform ance of firm relative to industry

Asset G roup: All ____________ Cases: 233
Variable Correlation Adj. R 1 Pi t-stat p-value
Dependent variable
DROA - - - -

PURSIZE -.023 -.001 -1.062 .289
PRIORPCT .005 -.021 -.455 .650
Ln ASSETS .148 -2.047** -7.858 .000
MB -.039 -.050** -2.241 .015
LTD -.176 -.076** -3.091 .002
BHR .051 -.002 -.891 .374
Ln INSTL .319 .150** 7.889 .000
LnEARN .198 .764** 7.289 .000
* * p < . 01
DROA= ROA o f firm -ROA of industry for year t, PURSIZE (shares to be repurchased as a percent of
total shares outstanding), ASSETS (book value of assets), PRIORPCT (percent of shares repurchased from
prior repurchase programs), MB (market value to book value ratio), INSTL (institutional ownership), LTD
(long term debt as a fraction of equity), EARN (operating income before depreciation), and BHR (total
return over 5 years).
154
APPENDIX C
Empirical Analysis using Dummy Variables for Asset Size and Repurchases
To test the effect of small sample sizes for medium and large banking firms, size
o f share repurchases, dummy variables are used for asset size groups and size of
repurchases. Dummy 1 will assume value of 1 if medium size, 0 otherwise, Dummy 2
will assume value of 1 if large bank, 0 otherwise, Dummy 3 will assume value of 0 if
purchase size is 0, value of 1 otherwise. This chapter will present the results of the
empirical analysis using the 5 models to test the 7 hypotheses, using the dummy variables
instead of the asset size groups and size of repurchase.
Sisnalim and Time Inconsistency hypotheses: This analysis will use econometric
model ( 1 ) and banking firms’ data to examine if the results support signaling and time
inconsistency hypotheses. Model (1) tests signaling (hypothesis 1) and time inconsistency
(hypothesis 2), using dependent variable DROA- excess return on assets of firm relative
to industry in year t, and independent variables: DUMMY 1 (value of 1 if medium size, 0
otherwise), DUMMY2 (value of 1 if large size, 0 otherwise), DUMMY3 (dummy
variable=0 if PU RSIZE-0,1 otherwise), PRIORPCT (percent of shares repurchased from
prior repurchase programs), MB (market to book ratio), ln INSTL (institutional
ownership), LTD (long term debt as a fraction of equity), ln EARN (operating income
Since variables such as size of the firm, market to book ratio, institutional
ownership, debt to equity, operating income before depreciation, and 5-year total return
155
may be correlated to the firm’s operating performance, cross sectional regression is used
to examine the relationship between the firm’s excess return on assets and the size of the
repurchase program in a multivariate framework. Because the signaling hypothesis holds
that firms will increase the size of the repurchase as a signal for expected future
profitability, the relationship between excess return relative to industry, size of the
repurchase and firm size is examined while controlling for leverage, firm’s performance
in meeting previous repurchase program commitments and market-to-book ratio.
Hypothesis 2\ Banking firms that had fulfilled prior repurchase commitments will
experience better operating performance relative to the industry.
DROA = 0o + 0i DUMMY1 +02 DUMMY2+0 3 DUMMY3+04PRIORPCT + 0 5MB +
p 6 In INSTL+ + 0 7LTD + 0 8 In EARN + 0 9 BHR + £ (1)
Both hypotheses 1 and 2 are tested using model (1). If the predictions of the
signaling hypothesis hold, coefficients Pi, p2) and P3 are expected to be positive. The time
inconsistency hypothesis will be validated if coefficient P4 is positive.
156
Hoi: p i > 0 p2> 0 andp3 > 0 Ho2: p4 > 0
Hai: P i < 0 p2 < 0 and p 3 < 0 Ha2: |34 < 0
Table C-2.4 presents the results of cross sectional regression of the excess return
on assets of the firm relative to industry (DROA) on repurchase variables and firm
characteristics. A standard multiple regression is performed between return on assets for
firm relative to industry (DROA) as the dependent variable and operating performance
and firm characteristics related independent variables- repurchase size, percentage of
shares acquired from prior announced repurchases, market value to book value of firm,
debt to equity ratio, total return over 5 years, institutional ownership, operating earnings
and total assets. Results of the evaluation led to transformation of the variables to reduce
skewness, and improve the linearity and normality of residuals. Logarithmic
transformations are used on institutional ownership and operating earnings. Cases with
missing data were excluded leaving 243 cases for the analysis. Table C-2.4 shows the
ry
correlations between the independent and dependent variables, F, adjusted R , intercept,
non-standardized coefficients (B), t-statistics and p-values. Size of repurchase,
PRIORPCT and size of firm do not show high correlation to DROA. F for regression was
significantly different from zero F (9, 233)= 6.56, p< .001. Market value to book value
ratio, debt to equity ratio, institutional ownership, operating earnings and total assets
contribute significantly to the prediction of DROA. Altogether 20% (17% adjusted) of
the variability in DROA is predicted by these independent variables. Size of repurchase,
PRIORPCT and size of firm do not contribute significantly to the explanation of variance
157
of DROA. The relationship of size of firm to DROA contradicts the results of studies
cited above.
Table C-2.4: Operating performance of firm relative to industry

Asset Group: All with asset size and repurchase size dummies Cases: 243
i 11 ^
Variable Correlation F I* / A
/ Adj. R O
Pi
A nA nA
t-stat p-value
H . m l . . .
Dependent variable
DROA - - - -
Independent variables 6.56/.171

Constant -1.835 -6.411 .000
DUMMY 1 -006 -.035 -.407 .685
DUMMY2 .172 .064 .549 .584
DUMMY3 .059 .042 .722 .471
PRIORPCT .028 .048 .906 .366
MB .029 -.004 -.167 .867
LTD -.145 -.120** -4.285 .000
BHR .096 .004 1.419 .157
Ln INSTL .337 .112** 5.372 .000
Ln EARN .222 -.052 -1.326 .186
**p <.01
DROA= ROA of firm -R O A of industry for year t, DUMMY 1 (1 if asset size = medium, 0 otherwise),
DUMMY2 (1 if asset size = large, 0 otherwise), DUMMY3 (0 if PURSIZE=0, 1 otherwise), PRIORPCT
(percent of shares repurchased from prior repurchase programs), MB (market value to book value ratio),
INSTL (institutional ownership), LTD (long term debt as a fraction o f equity), EARN (operating income
Prior empirical studies cited above found that operating performance of non-
financial firms had a positive relationship to the size o f the repurchase consistent with the
signaling and cash flow hypotheses. The results from testing model (1) using banking
data show a negative (not significant) relationship between DROA and size of repurchase
directionally contradicting signaling hypothesis and contradicting the previous studies.
Because banking firms are highly regulated and followed closely by institutional
investors, information asymmetry about their operating performance and share valuations
is minimal. Hence management’s efforts to signal the market about hidden strengths by
launching share repurchases do not show the same positive relationship between
operating performance and repurchases as the non-financial firms. The above results are
158
almost identical to the results in Table 2 in Chapter IV, showing that the variables market
to book ratio and size are able to capture the effects of asset size without using dummy
variables. The addition of dummy variable for purchase size did not change the results.
Cash flow hypothesis
repurchase payout.
REPOP A YO UT= (3o + p t In CFO + p 2 In ASSETS + p3MB + p4LTD + p 5 LTD 2+
p 6 a(ROA) + p 7 a (ROA) 2 + p 8 In EXECOPTION+ p 9 DUMMY1 +
j6,o DUMMY2 + £ (2)
Table C-8.1 shows the results from model (2). A standard multiple regression is
performed between repurchase payout as the dependent variable and operating
performance and management incentive related independent variables- cash flow, market
value to book value ratio, debt to equity ratio, standard deviation of return on assets, and
executive options. SPSS regression and SPSS frequencies are used for evaluation of
assumptions. Results of the evaluation led to transformation of the variables to reduce
skewness, and improve the linearity and normality of residuals. Logarithmic
transformations are used on cash flow and executive options. Cases with missing data
were excluded leaving 481 cases for the analysis.
159
Table C-8.1 shows the correlations between the independent and dependent
variables, adjusted R2, intercept, non-standardized coefficients ((3), t-statistics and p-
values. Market to book ratio and debt to equity ratio did not show high correlation to
REPOPAYOUT. F for regression was significantly different from zero, F (9, 472) =
10.87, p < .001. Cash flow, asset size, standard deviation of return on assets and asset
size contribute significantly to the prediction of repurchase payout, confirming cash flow
hypothesis. Altogether 17% (16% adjusted) of the variability in repurchase payout is
predicted by these independent variables. Market to book and debt to equity ratios do not
contribute significantly to REPOP AYOUT.
Table C-8.1: Determinants of repurchase payouts

Asset Group: All with asset size dummy_______ Cases: 481
Correlation Adj. R2 Pi t-stat p-value
D ependent Variable
REPO PAYO UT
C on stan t .1 5 6 -.7 3 8 -3 .8 1 6 .0 0 0
Ln CFO .368 .0 5 0 * * 7 .1 4 3 .0 0 0
DUM M Y 1 -.0 8 7 -.0 8 0 * * -2 .0 0 4 .0 4 6
DUM M Y2 -.1 7 7 -.1 2 5 * * -2 .0 8 1 .038
MB .031 -.0 0 7 -.6 0 9 .543
LTD .0 5 2 -.0 1 9 -.4 2 7 .6 6 9
LTD2 .0 8 4 .0 1 2 .8 5 7 .3 9 2
-.0 4 6
441 * * 2 .3 5 5 .0 1 9
° (ROA)
_ 2 - 4 4 9 **
(ROA) -.0 6 0 -2 .8 2 6 .0 0 5
Ln EXECOPTION .011 .0 3 6 * * 2 .6 5 9 .008
** p < .01
Dependent: REPOP AY OUT (Repurchase/ (Repurchase + Dividends)). L n C F O ( lo g o f c a sh f lo w ), L n S IZ E (lo g
o f total a ss e ts ), D U M M Y 1 an d D U M M Y 2 are d u m m y v a r ia b le s for m e d iu m and large b a n k s, M B (m ark et
to b o o k ra tio ), L T D (d e b t to e q u ity ratio), o (ROa ) (stan dard d e v ia tio n o f return o n a ss e ts o v e r 13 y ea rs),
R O A (o p era tin g in c o m e d iv id e d b y total a ss e ts ), and L n E X E C O P T IO N (lo g o f e x e c u tiv e o p tio n s).
The above results are identical to the original results shown in Table 8 in Chapter IV,
showing that_cash flow and asset size variables capture the impact of asset size groups
without the addition of dummy variables to control for sample sizes.
160
Substitution hypothesis
Hypothesis 4: Share repurchase yield negatively relates with the dividend forecast
deviation.
DEVIATION = fio + P i RYIELD++P2 In M V + p 3ROA + p 4(J roa + P s c tr o a 2 + p 6Ln CFO+
PjLTD + p 8LTD 2+p 9Ln INSTL + p 10DUMMYl+ p n DUMMY2+ £ (3)
T ab le C - l l . l : D eterm in an ts o f d ividend su bstitu tion

A sse t G roup: A ll w ith asset size du m m y____________ C ases: 603
C orrelation A dj. R2 Pi t-stat p-value
Dependent
variable
DEVIATION - - - - -
Independent .236
variables
Constant .006 -.06270 .951
RYIELD .036 .0 0 0 -.629 .530
Ln M V .145 .025** 1.336 .182
RO A .265 . 1 0 1 ** 5.822 .0 0 0
Ln CFO .099 .008** 2.259 .024
( ctr o a ) .245 -.422** -4.801 .0 0 0
(O ro a )2 .308 .543** 7.293 .0 0 0
LTD .131 .097** 4.363 .0 0 0
LTD2 .077 -. 0 2 2 ** -3.227 .001
©
CO
Ln INSTL -.013** -2.618 .009

i*
DUMM Y 1 -.042 -.05123 -.0 0 2 .998

DUMM Y2 .095 .041 1.100 .272
* * p <.01
Dependent variable: dividend forecast deviation (DEVIATION). Independent variables: repurchase yield (RYIELD=
repurchase amount/ market value o f equity), market value o f firm (M V ), return on assets (RO A), standard deviation o f
return on assets over 13 years (ctROa), Log cash flow s (Ln CFO), L og Institutional ownership (Ln IN STL), debt to
equity ratio (LTD). Square o f standard deviation o f ROA ( o R O a 2 ) and square o f debt to equity (LTD2) adjust for the
non-linearity o f the data, DUM M Y1 and D U M M Y 2 denote dummy variables for m edium banks and large banks.
Results of the evaluation led to transformation of the variables to reduce skewness, and
161
improve the linearity and normality of residuals. Squares of standard deviation of return
on assets and debt to equity ratios are included to improve linearity. Logarithmic
transformations are used on market value, cash flow and institutional ownership. Cases
with missing data were excluded leaving 603 cases for the analysis.
Table C-11.1 shows the correlations between the independent and dependent
variables, adjusted R2, intercept, non-standardized coefficients (B), t-statistics and p-
values. Repurchase yield did not show high correlation to dividend forecast deviation. F
for regression was significantly different from zero, F (11,591) = 17.93, p < .001. Return
on assets, cash flow, standard deviation of return on assets, debt to equity ratio and
institutional ownership contribute significantly to the prediction of dividend forecast
deviation. Altogether, 25% (24% adjusted) of the variability in dividend forecast
deviation is predicted by the independent variables. The results in Table C-l 1.1 show that
market value and cash flow variables capture the impact of asset size, making the use of
dummy variables redundant in the analysis. Repurchase yield did not contribute
significantly to the dividend forecast deviation as predicted by the substitution
hypothesis.
Option fundins hypothesis
Hypothesis 6 a \ Total exercisable options and un-exercisable executive options
162
Hypotheses 5, 6a and 6b are tested using the logistic regression model (4).
Ln (P/l-P) = p 0 + Pi Ln M V + p 2 Ln CFO+ fc MB+ p 4 LTD+ p 5 BHR+ p 6Ln TOT OP +
P 7 Ln EXECOP + p 8 Ln INSTL + p 9 DUMMY I + p l0 DUMMY2 + £ (4)
Table C-12.1 shows the results of logistic regression analysis performed on
repurchases as outcome, and eight performance and compensation related predictors:
market value, cash flow, market to book ratio, debt to equity ratio, 5-year total return,
institutional holdings, total employee options and asset size dummy variable. Executive
options are added in the second column, and total and executive options are split into
exercisable and unexercisable parts in the third column. SPSS LOGIT regression is used
for the analysis. After deletion of 669 cases with missing values, data from 534
repurchasing firms is available for analysis- 177 non-repurchasing firms and 357
repurchasing firms. The overall prediction success rate is at 74%, with 94% of
repurchasing firms and 34% of non-repurchasing firms correctly predicted. The
regression coefficients, Wald test (t-ratio), odds ratios, and p-values for each of the eight
predictors for each of the three compensation scenarios are presented.
Based on the Wald test from Column 1, only the log of market value, 5-year total
return and institutional holdings predicted the repurchases reliably, t=26.7, 11.8 and 5.1
respectively, p< .001. The negative sign of the coefficients (P) for 5-year return and
institutional ownership shows that firms with high historical returns and firms with high
institutional ownership have lower odds of repurchasing shares, confirming the signaling
163
hypothesis. However the odds ratios of .970 and .776 for these variables point to little
change in the likelihood of repurchase on the basis on one unit change in total return or
institutional holdings. Log market value with an odds ratio of 7.097 shows a significant
positive impact of the size of firm on the likelihood of repurchase. Total outstanding
options have minimal predictive value, which is not enough to support or reject the
option funding hypothesis.
The results in Column 2 show the impact of both total and executive options. The
t-ratio of 8.784 and odds ratio of 1.453 for log executive options show the positive impact
of executive options on the likelihood of repurchase, confirming the substitution
hypothesis. Total options have a minimal moderating negative predictive value. Column
3 shows the results with total and executive options split into exercisable and
unexercisable portions. The results show that only the log of market value, 5-year total
return, unexercisable total options and exercisable executive options predicted the
repurchases reliably, t= 6.20, 17.8, 2.51,and 2.71 respectively, p< .001. The negative sign
o f the coefficient for 5-year total return shows that firms with high historical returns have
lower odds of repurchasing shares. But the odds ratio of 0.946 for 5-year return shows
little change in the likelihood of repurchase on the basis of one unit change in total return.
Table C-12.1: Probability of repurchases: All firms with asset size dummy
The first number in each cell is the parameter coefficient estimate (P); the second is the W ald test
(t-ratio); the third is the odds ratio. The number in parenthesis is the maximum likelihood p-value.
(2) Total and (3) Total and

(1) Total options Executive options Executive Options-
outstanding outstanding Exercisable and
Unexercisable
N 534 460 359
R-sq
Intercept .391 -1.069 -.694
.042 .241 .081
1.478 .343 .500
(838) (.343) (.776)
Log o f M V 1.960 1.639 1.118
26.715 13.923 6.197
7.097 5.149 3.059
(.000) (.000) (.013)
L og o f Cash flo w -.071 -.029 -.051
1.637 .204 .480
.932 .651 .951
(201) (.971) (.488)
Market to B ook -.033 -.114 .048
.104 .955 .113
.967 .328 1.049
(747) (855) (.737)
D ebt/ Equity -.095 -.156 -.130
.575 1.364 .720
.909 .243 .878
(448) (855) (.396)
11.760 10.231 17.801
.970 .001 .946
(001) (.969) (.000)
L og o f Institutional -.254 -.214 -.0 1 2
shares 5.142 2.698 .005
.776 .808 .989
(023) (.100) (.944)
L og o f Total options .0 2 0 -.214
.059 2.835
1 .020 .806
(.809) (.092)
L og o f Total options .262
exercisable 1.304
1.299
(.254)
Log o f Total options -.332
unexercisable 2.513
.717
(113)
Log o f Executive .373
options 8.784
1.453
(.003)
L og o f E xecutive .277
1.319
(.100)
165
L og o f Executive -.229
options 1.653
unexercisable .796
(199)
DUM M Y1 .040 .497 .468
.0 1 0 1.249 .987
1.040 1.644 1.597
(.922) (264) (.320)
DUMM Y2 -.720 -.358 .0 1 2
1.341 .282 .0 0 0
.487 .699 1 .012
(247) (596) (.987)
The log market value with odds ratio of 3.058 shows that market value of the firm
increases the likelihood of repurchase. The results show support for the substitution
hypothesis, but are not robust enough to accept or reject the option funding hypothesis.
The addition of dummy variables does not seem to improve the original results as
reported in Table 12 in Chapter IV, possibly because market value and total return values
act as proxies for asset size groups.
Earninss Management hypothesis
management.
Ln (P/ 1-P) = p 0 +Pi LLP + p 2 DTE + p 3 ACFO + p 4 Ln EXECOP +
p 5 LnIN STL+ p5DUMMY 1+ p 5 DUMMY2+ % (5)
LLP is loan loss provision / total loans, DTE is deferred tax expense / assets,
ACFO is change in firm’s cash flows from continuing operations from year t-1. Inclusion
of both DTE and LLP in the model helps to determine the incremental usefulness of each
measure in detecting earnings management. ACFO is included to control for the effect of
166
change in cash flows on the firm’s inclination to manage earnings. Coefficients pi and p2
are expected to be positive indicating that the positive relationship exists between
earnings management, deferred tax expense and discretionary accruals.
H 07: P i >0 a n d P 2 > 0
Ha?: pi < 0 and p2 < 0
Hypothesis 7 is tested using logistic regression model (5) to see if the earnings
management hypothesis holds true in the banking sector. The results show that deferred
tax, executive options and institutional ownership have significant influence on earnings
management, but loan loss provision (discretionary current accruals) and change in cash
flows (ACFO) do not. The results are presented in Table C-13.1. The first number in each
cell is the parameter coefficient estimate (P), the second is the Wald test (t-ratio), and the
third number is the odds ratio. The number in parenthesis is the maximum likelihood p-
value.
As shown in Table C-13.1, logistic regression analysis is performed on earnings
management as outcome and six performance and compensation related predictor
variables: loan loss provision ratio, deferred tax expense ratio, change in cash flows, log
o f executive options, log of institutional holdings, and asset size dummy variables
(DUMMY1 for medium size firms and DUMMY2 for large banking firms). After
deletion of 750 cases with missing values, data from 453 repurchasing firms is available
for analysis- 134 non-eamings-managed firms and 319 eamings-managed firms. The
overall prediction success rate is at 73%, with 97% of earnings managed firms correctly
167
predicted. The regression coefficients, Wald test (t-ratio), and p-values for each of the
five predictors are presented. Based on the Wald test, p-values and odds ratios, deferred
tax ratio, change in cash flows, executive options and institutional ownership predict the
repurchases reliably with t=7.30, 1.27, 10.94, and 14.275 respectively, and odds ratios of
1.245, 57.03, 0.706 and 1.532 respectively. The significant impact of change in operating
cash flows on the likelihood of earnings management is consistent with the cash flow
hypothesis. The negative sign of the coefficient ((3) for loan loss provision shows that
firms with high loan loss provision ratios have lower odds of earnings management.
However the odds ratio of 0.969 shows little change in the likelihood of earnings
management on the basis of one unit change in the loan loss provision ratio. Deferred tax
and institutional ownership with odds ratios of 1.245 and 1.532 show significant impact
on the likelihood of the outcome.
Table C-13.1: Probability of earnings management

The first number in each cell is the parameter coefficient estimate (B),
second is the Wald test (t-ratio), third is the odds ratio. The number
in parenthesis is the maximum likelihood p-value.
All cases with asset size dummies

N 453
Pseudo (Nagelkerke) R-sq .105
Predicted % correct 73.3
Intercept -1.930
.947
.145
(331)
LLP -.031
.499
.969
(480)
DTE .219
7.304
1.245
(007)
ACFO 4.044
1.273
57.032
(259)
Ln EXECOPTION -.349
10.941
.706
(001)
168
Ln INSTL .427
14.275
1.532
(.000)
DUMMY 1 -.097
.072
.907
(788)
DUMMY2 -.547
1.361
.579
(243)
The addition of dummy variables for asset size groups does not seem to have any
impact on the results reported in Table 13 in Chapter IV. The variable cash flow seems to
be acting as a proxy for asset size. Overall results are consistent with hypothesis 7 on
deferred tax expense (DTE), but not on loan loss provision (discretionary current
accruals). Deferred tax expense is incrementally useful in predicting earnings
management in repurchasing banking firms of all sizes. The results agree with the results
from Phillips et al. (2003) that deferred tax expense is incrementally useful in detecting
earnings management in non-banking firms. The loan loss provision ratio shows an
insignificant relationship, contradicting the results of Beatty et al. (2002) that public
(large) banks use discretion in their loan loss provisions to avoid declines in earnings, and
private (small) banks have lower propensity to do so.
169
APPENDIX D
Empirical Analysis Using Asset Size Groups
This appendix presents the empirical results from applying the models used in the
study to test the seven hypotheses using the banking data split into three asset size
groups- small (under $20 billion), medium ($20- 50 billion), and large (over $50 billion).
The asset size cutoff points are based on Federal Reserve Bank studies and Office of
Comptroller of the Currency definitions. The asset size floor is set at $2 billion because
only banks over that asset size threshold undertake share repurchases. The research
results in this chapter are presented by the applicable hypotheses, with brief comments on
the results. Relevant parts of the comments are included in the body of Chapter IV to
point out the differences in relationships due to asset sizes.
The first section presents the results of testing three hypotheses- signaling, time
inconsistency and cash flow hypotheses that relate to firm characteristics and operating
earnings. The second section contains the results of tests of the remaining three
hypotheses relating to management incentives and their impact on strategic decisions on
the payout mechanism. The management incentive hypotheses deal with substitution of
repurchases for dividends, repurchases to fund option exercises and earnings
management. The main purpose of the latter part of this study is to investigate managers’
choice of payout mechanism relative to its potential effect on their own wealth.
170
Operating Performance and Firm Characteristics Hypotheses
Signaling hypothesis states that repurchasing firms will experience improvement
in their future operating performance following the repurchase announcement, and the
changes in operating performance will be positively related to both the market reaction
(measured by stock price movements), and the magnitude of the repurchase program.
Time inconsistency hypothesis states that the market reaction (measured by the
stock price movement) will be based on the firms’ track record of repurchasing shares
satisfying the commitments from prior repurchase programs before announcing the new
program. The common practice in the banking industry is to announce repurchase
programs before the previous program has been completed and accounted for.
To analyze the impact of asset size, model (1) is applied to the three asset size
groups, and results are presented in Tables D-3 to 5 showing variations in the relationship
of DROA with predictor variables as asset sizes change. Tables D-3 to 5 show the
correlations between the independent and dependent variables, adjusted R2, intercept,
non-standardized coefficients (B), t-statistics and p-values for the 3 asset size groups. The
positive relationship of DROA to PRIORPCT (percentage of repurchased shares as a
fraction of prior announcements) is significant in large firms, confirming the time
inconsistency hypothesis. Both PURSIZE and INSTL are significant in small firms only.
The coefficients for PURSIZE show negative relationship to DROA for all sizes of firms,
directionally contradicting the signaling hypothesis. The magnitudes of the relationship
are too weak to draw any conclusions about the signaling hypothesis in banking firms.
Institutional ownership exhibits a strong positive relationship to DROA in small firms,
171
and a weak positive relationship in medium and large banks showing the influence of
information symmetry.
Small firms show the predictable pattern of excess returns relating positively with
institutional ownership, and negatively with the leverage ratio, confirming the signaling
and cash flow hypotheses. Medium size banking firms’ excess return shows a strong
positive relationship to 5-year total return confirming the cash flow hypothesis. In
summary, the results support the signaling hypothesis in small banks only. The time
inconsistency hypothesis is confirmed in large banks only.
Table D- 3: O perating perform ance of firm relative to industry- Group 1

Asset Group I: <$20 billion______________ Cases:148 _______
Variable Correlation B t-stat p-value
Adj. R2
Dependent
variable
DROA
Independent .204
variables
Constant -1.741 -5.543 .000
PURSIZE -.182 -.081** -2.197 .030
PRIORPCT -.013 .125 1.349 .179
MB -.027 .027 .809 .420
_ 147**
LTD -.234 -3.937 .000
BHR -.013 .000 .081 .936
Ln INSTL .339 .109** 4.820 .000
Ln EARN .183 -.053 -1.221 .224
** P<. 01
(D R O A = R O A o f firm -R O A o f industry for year t), PU R SIZ E (shares to b e repurchased as a p ercen t o f
total shares outstanding), P R IO R PC T (percent o f shares repurchased from prio r repurchase program s), M B
(m arket value to book value ratio), IN S T L (institutional ow nership), LTD (long term d eb t as a fraction o f
equity), EARN (operating income before depreciation), and BHR (total return over 5 years).
172
Table D-4: Operating performance of firm relative to industry- Group 2

Asset Group 2: $ 20-50 billion ___________ _________________ Cases:48
Variable Correlation Adj. R2 t-stat P-value
B
Dependent
variable
DROA - - - - -
Independent .326
variables
Constant -5.256 -2.766 .009
PURSIZE -.024 -.040 -1.212 .233
4^
PRIORPCT -.070 -.694 .492
l
o
MB -.318 -.163** -3.342 .002
LTD -.301 -.052 -1.046 .302
BHR .035 .015** 2.245 .030
Ln INSTL .401 .181 1.418 .164
LnEARN .363 .273 1.597 .118
** p<. 01
(DROA= ROA of firm -ROA of industry for year t), PURSIZE (shares to be repurchased as a percent of
total shares outstanding), PRIORPCT (percent of shares repurchased from prior repurchase programs), MB
(market value to book value ratio), INSTL (institutional ownership), LTD (long term debt as a fraction of
Table D-5: Operating performance of firm relative to industry- Group 3

Asset Group 3:>J150 billion Cases: 47
Variable Correlation Adj. R2 B t-stat p-value
Dependent
variable
DROA
Independent .233
variables
Constant -.654 -.440 .663
PURSIZE -.232 -1.923 -.913 .367
PRIORPCT .445 .425** 2.194 .034
MB .232 .012 .299 .766
LTD .037 .063 .774 .443
BHR .399 .012 -1.627 .112
Ln INSTL .182 .046 .404 .689
LnEARN -.145 -.096 -.636 .529
* * p<. 01
(DROA= ROA of firm -ROA o f industry for year t), PURSIZE (shares to be repurchased as a percent of
total shares outstanding), PRIORPCT (percent of shares repurchased from prior repurchase programs), MB
(market value to book value ratio), INSTL (institutional ownership), LTD (long term debt as a fraction of
173
Based on the results, the first two hypotheses relating to firm characteristics and
operating earnings- signaling and time inconsistency hypotheses, are rejected. The study
will now look at the cash flow hypothesis
conflict between the shareholders and managers. The firm’s marginal investment
opportunities should guide the decision to enhance firm value by using excess cash flows
to finance investments or payout to shareholders to reduce the agency conflict between
the shareholders and managers (Jensen, 1986). The cash payout can occur in the form of
dividends or repurchases, or both. If the firm has unexpected excess cash flows in a year,
any increases in dividend payouts to mitigate agency conflicts will provide an implicit
commitment to keep future payouts at the same or higher level. Tables D-6 a to 6 c show
the descriptive statistics of the variables for the three asset size groups. Mean repurchase
payout percentage decreases from 24.6% to 11.7%, as the asset size increases from $5.2
billion to $107.3 billion. Medium size banks have the highest mean dividend and
repurchase yields, while small banks have the highest mean repurchase payout ratio.
174
Table D- 6a: Distribution of payouts and firm characteristics - Group 1

Asset group; $0-20 billion N is number of cases for each variable._________
N Variable Mean Median Standard Minimum Maximum
Deviation
a. P a y o u t va ria b les
596 DYIELD .2578 .2492 .1525 0.000 1.335
538 RYIELD .1557 .0185 .3360 -.3864 3.651
563 REPOPAYOUT .2459 .0634 .3393. -1.253 1.90
b. R e la te d va ria b les
486 Ln CFO 10.802 11.033 1.543 4.39 14.00
673 MB 1.44 1.540 1.345 .0 0 0 9.120
586 LTD .7052 .2958 .989 -.395 7.291
675 Total assets 5169 3642 4669 .0 0 0 19992
Payout variables: REPOPAYOUT (repurchase amount/ total payout), RYIELD (repurchase/ market value
o f equity) and DYIELD (dividends/ market value o f equity), and explanatory variables: CFO (cash flow),
Total assets, MB (market to book ratio), LTD (debt to equity). N is number of cases for each variable.
Table D- 6b: Distribution of payouts and firm characteristics- Group 2

Asset group: $20-50 billion N is number of cases for each variable________
Variable Mean Median Standard Minimum Maximum
N Deviation
a. P a y o u t varia b les
113 DYIELD .3349 .3026 .1862 .0686 1.1871
113 RYIELD .1616 .0335 .3538 .0 0 0 3.057
109 REPOPAYOUT .2082 .0232 .2639 .0 0 0 .8 8 8 8
b. R e la te d varia b les
104 LnCFO 9.539 8.048 3.466 3.76 14.09
113 MB 1.832 1.863 1.74 .0 0 0 8.074
113 LTD .9715 .7313 .800 .1 1 0 3.945
113 Total assets 33750 32507 8183.57 20254 48879
Payout variables: REPOP AYOUT (repurchase amount/ total payout), RYIELD (repurchase/ market value
of equity) and DYIELD (dividends/ market value of equity), and explanatory variables: CFO (cash flow),
Total assets, MB (market to book ratio), LTD (debt to equity). N is number o f cases for each variable.
Table D-6c: Distribution of payouts, and firm characteristics- Group 3

Asset group: >$50 billion N is number of cases for each variable
Variable Mean Median Standard Minimum Maximum

N Deviation
a. P a y o u t va ria b les
61 DYIELD .3014 .2742 .1242 .1183 .6230
61 RYIELD .0790 .0042 .1979 .0 0 0 .1189
61 REPOPAYOUT .1166 .0017 .2277 .0 0 0 .7840
b. R e la te d va ria b les
52 LnCFO 7.822 7.4167 2.045 5.35 15.10
61 MB 2.939 2.535 1.420 1.109 8.846
61 LTD 1.365 1.177 .717 .255 2.772
61 Total assets 107338 83395 66286.91 50364 272426
Payout variables: REPOP AYOUT (repurchase amount/ total payout), RYIELD (repurchase/ market value
of equity) and DYIELD (dividends/ market value of equity), and explanatory variables: CFO (cash flow),
Total assets, MB (market to book ratio), LTD (debt to equity). N is number of cases for each variable.
175
Jensen (1986) targeted excess cash flow as a factor leading to severe agency
conflicts between the interests of managers (agents) and shareholders (owners). Managers
seem to deploy cash flow to projects that maximize their own wealth, thus raising the
question o f whether better alignment of management incentives and shareholder interests
reduce agency conflicts. Lambert et al. (1989) suggested that the reduction in the value of
executive options caused by dividends would cause managers to choose repurchases over
dividends for distributing the excess cash flow. The relationship between executive
options and repurchase payouts is analyzed to see if option-induced reductions in
dividends are offset by repurchases in the three asset size groups, using econometric
model (2 ).
repurchase payout.
REPOP A YO UT= p 0 +Pi In CFO +p2 In ASSETS + p 3 MB + p 4LTD + p 5 LTD 2 +
p 6 O (ROA) + p 7<y(ROA) + Ps In EXECOPTION+ £ (2)
Since large firms are regarded as having more stable cash flows and less
information asymmetry, firm size measured as the log of assets is used as proxy for
external financing costs along with debt. The relationship between cash flow volatility
and payout policy is tested to see if the behavior of financial services firms is similar to
the results from Jagannathan, et al. (2000) and Fenn and Liang (2001) studies on non-
financial firms. The cross sectional regression model estimates how the firm
176
characteristics affect the dependent variable (repurchase payout). Coefficients Pi, p 3 , P6
and pg are expected to be positive showing that a positive relationship exists between
repurchase payouts and cash flows, market-to-book ratio, standard deviations of
operating income and executive options. Coefficient P4 is expected to be negative
showing the relationship between debt to equity ratio and repurchases.
H o 3: p i > 0 p3 > 0 p6 > 0 p8 > 0 p4< 0
H a 3: Pi < 0 p3 < 0 p6 < 0 p8 < 0 p4 > 0
Tables D- 8 a- 8 c show the correlations between the independent and dependent variables,
adjusted R2, intercept, non-standardized coefficients (P), t-statistics and p-values for the
three asset size groups.
Table D-8a: Determinants of repurchase payouts

Asset Group 1: < $20billion_________ Cases: 347
Dependent variable
Repopayout - - - - -

Constant -.925 -3.718 .000
LnCFO .209 .0493** 4.205 .000
MB .061 -.0171 -1.035 .301
LTD .122 -.003 -.052 .959
LTD2 .120 .0091 .534 .594
° (ROA) -.013 .728** 2.951 .003
_ 2
-.050 -.638** -3.210 .001
° (ROA)
Ln EXECOPTION .139 .0455** 2.836 .005
** p < 01
Dependent: Repopayout (Repurchase/ (Repurchase + Dividends)). Ln CFO (log o f cash flow from operations),
MB (market value to book value ratio), LTD (long tem debt divided by equity),
o (roa) (standard deviation of return on assets over 13 years), ROA (operating income divided by total
assets), and Ln EXECOPTION (log of executive options).
177
Table D-8b: Determinants of repurchase payouts

Asset Group 2: $20- 50billion_______ Cases: 91
Correlation Adj. R 2 Pi t-stat p-value
Dependent variable
Repurchase payout - - - -
Independent variable .396

Constant -.943 -2.107 .038
LnCFO .589 .040** 4.906 .000
MB .087 -.0131 -.798 .427
LTD .209 -.113 -1.336 .185
LTD2 .237 .0287 .1.193 .236
° (ROA) -.363 1.290** 2.641 .010
_ 2
° (ROA) -.426 -1.901** -3.054 .003
Ln EXECOPTION .139 .0537 1.630 .107
** p< .01
Dependent: REPOPAYOUT (Repurchase/ (Repurchase + Dividends)). Ln CFO (log of cash flow from
operations), Ln SIZE (log of total assets), MB (market value to book value ratio), LTD (long tem debt
divided by equity), a (ROA) (standard deviation of return on assets over 13 years), ROA (operating income
divided by total assets), and Ln EXECOPTION (log of executive options).
Table D- 8c: Determinants of repurchase payouts

Asset Group 3: > $50billion__________ Cases: 44
Correlation Adj. R 2 Pi t-stat p-value
Dependent variable
Repopayout - _ - - -
Constant .343 .859 .396
LnCFO .662 .058** 4.904 .000
MB -.007 .055** 1.994 .054
LTD -.130 -.184 -1.118 .271
LTD2 -.109 .064 1.231 .226
° CROA) -.501 -.376 -.583 .563
_ 2 -.459 .089 - .1 1 1 .912
° fROA)
Ln EXECOPTION -.342 -.039 -1.481 .147
** p <. 01
Dependent: Repopayout (Repurchase/ (Repurchase + Dividends)). Ln CFO (log of cash flow from operations), Ln
SIZE (log of total assets), MB (market value to book value ratio), LTD(long tem debt divided by equity), o
( r o a ) (standard deviation o f return on assets over 1 3 years), ROA (operating income divided by total assets),
and Ln EXECOPTION (log of executive options).
The results show some interesting variations in the relationship of repurchase
payout with the predictor variables with the asset size groupings. A strong positive
relationship exists between the repurchase payout and cash flow in all asset size groups.
The significant positive coefficients of cash flow in all groups are consistent with the
178
cash flow hypothesis, showing that firms with excess cash flows will engage in
repurchase payouts to mitigate agency conflicts.
Volatility o f operating income as shown by the standard deviation of return on
assets has a significant positive relationship with repurchase payout in small and medium
size firms. This relationship is consistent with the substitution hypothesis that transient
excess cash flows will encourage repurchases. The relationship is not significant in the
large firms, possibly due to their ability to manage volatility through diversification.
Interestingly, the relationship of repurchases with volatility of operating income reverses
direction and turns negative at an equilibrium point for firms of all sizes (shown by the
results for o ( r o a )2) , showing that the volatility of cash flow will cause the managers to
reduce or eliminate repurchases after reaching a threshold.
Market to book ratio exhibits an inverted U-shaped relationship to repurchase
payout as the asset size increases. It relates marginally negative in groups 1 and 2, and
turns strongly positive for group 3. Management of small and medium banks use
repurchases to signal to the market the firms’ operating performance characteristics, and
stock undervaluation. Since large firms do not have the information asymmetry, their
repurchases are caused by the desire to mitigate agency conflicts, confirming the cash
flow hypothesis.
Executive options show a horizontal S-shaped relationship to repurchase payout
as asset size increases. The significant positive relationship in group 1 firms confirms the
substitution hypothesis. The relationships in groups 2 and 3 are not significant. Overall
the results indicate that repurchase payouts show a strong positive relationship to
operating cash flow confirming the cash flow hypothesis across all banking firms.
179
Among the hypotheses relating to firm characteristics and operating earnings,
only the cash flow hypothesis is confirmed by testing the models with banking data. In
the next section the three hypotheses relating to management incentives- substitution,
option funding and earnings management are examined for their influence on the
repurchase decisions by banking firms.
Management Incentive Hypotheses
Empirical studies by Ofer and Thakor (1987) Choi and Chen (1997), Bartov et al.
(1998), Fenn and Liang (2001), Jagannathan et al. (2000) and Kahle (2002) looked at the
impact of uncertainty (volatility) o f cash flows upon managers’ choice of repurchases
over dividends in non-financial firms. The volatility of operating cash flows and
uncertainty about future trends can encourage firms to use repurchases rather than
increasing the dividends.
Table D-10 shows the results of analysis similar to the above studies, using the
data from the banking firms in the study sample. It shows the relationship between cash
flow volatility and payout method for the three asset size groups.
180
Table D-10: Cash flow volatility and payout decisions

The variables used in the analysis show end of year values: ctroa2- square of the standard deviation of
return on assets over the study period, NOPER- non operating income/ net income, Dividend payout-
dividend amount/ net income, REPOPAYOUT- repurchase amount/ total payout. _________________
~
O roa
2 NOPER Dividend payout REPOPAYOUT
Group 1: $2 to
$ 20billion
Mean .30629 1.3705 30.408 24.589
Median .21673 .69689 32.085 6.3366
N 603 604 610 563
Group 2: $20 to
$ 50billion
Mean .17569 1.0064 39.944 20.819
Median .11313 .72536 35.980 2.318
N 113 113 113 109
Group 3: over
$50 billion
Mean .21274 .74300 42.0716 11.655
Median .2306 .603 40.7100 .16528
N 61 61 61 61
The results show that the average dividend payout increases with the size of assets,
while average non-operating income and repurchase payout decrease. The cash flow
volatility follows a U-shaped curve relative to the size of assets.
Hypothesis 4: Share repurchase yield negatively relates with the dividend
forecast deviation.
DEVIATION= po+ pi RYIELD ++@2 In M V + p3ROA + p 4a ROA +Ps a ROA2+ fh L n CFO+
PjLTD + p 8LTD2+p 9Ln INSTL + £ (3)
The hypothesis can be statedin symbolic form as:
H o 4: pi < 0
Haq; Pi > 0
181
Cases with missing data were excluded leaving 447, 104 and 52 cases for asset size
groups 1,2 and 3 respectively for the analysis.
Tables D- l l b to l i d show the same results for the three asset size groups. The
results show some interesting variations in relationship between dividend forecast
deviations and the predictor variables with changes in asset size. Repurchase yield does
not show a significant relationship to dividend forecast deviation in any asset size group.
Return on assets shows a significant positive relationship to dividend forecast deviation
in the small and large asset size groups showing that higher dividends result from better
operating performance for these groups, confirming cash flow hypothesis. Medium size
banks show a weaker positive relationship.
Volatility of operating income as shown by standard deviation of ROA shows a
horizontal S-shaped relationship to dividend forecast deviation as the asset size increases.
It relates significantly negatively in group 1, shows a weak positive relationship for group
2, and turns significantly negative for group 3. This phenomenon can be explained by the
ability o f the medium size banks to maintain dividend trends in the face of volatility of
cash flows as the size (diversity of businesses) grows, but only to a certain point.
Debt to equity or leverage shows a significant positive relationship to dividend
forecast deviation for groups 1 and 2 showing that leverage contributes to increased
dividend payouts. Large banks do not exhibit a significant relationship between debt to
182
equity and dividend forecast deviation, possibly because of high leverage is their normal
operating pattern. One interesting point to note is the relationship of dividend forecast
deviation with the leverage ratio turns negative at an inflection (equilibrium) point for
small and medium size banks, as evidenced by the results for the square of the debt to
equity ratio. This shows that cash flows from increased leverage lead to increased
dividend payouts until an equilibrium point is reached, when the effects of increased risk
override the positive effects of leverage-induced operating performance.
The institutional ownership variable shows a significant negative relationship to
the dividend forecast deviation for small firms, possibly indicating the preference of
institutional shareholders to have the cash flow deployed into building profitable
businesses. The relationship is not significant in medium and large banks, showing that
the institutional shareholders pay less attention to dividend forecast deviation for these
groups.
Overall, the substitution hypothesis is directionally supported in small and
medium banks, but the results are weak. Small banks increase the dividends as return on
assets and leverage ratios rise, and lower the dividends with increases in volatility of
operating income and institutional ownership. Medium size banks increase dividends as
cash flow and leverage ratio increase. Return on assets ratio plays a marginally positive
role in the medium size firms’ dividend decision. Large banks tend to increase dividends
as return on assets increase and decrease dividends with increased volatility of operating
income. Leverage and institutional ownership do not seem to have much impact.
183
Table D-llb: Determinants of dividend substitution

Asset Group: 1__________ Cases: 447
Correlation Adj. R2 P. t-stat p-value
Dependent variable
DEVIATION - - - - -
Constant .008 .065 .948
RYIELD .028 .000 -.921 .358
Ln MV .161 .037 1.570 .117
ROA .251 .097** 4.618 .000
LnCFO .067 .003 .534 .593
(CtROA) .342 -.383** -3.536 .000
( ctROA> .386 .521** 5.953 .000
LTD .146 .084** 3.268 .001
LTD2 .108 -.014** -1.741 .082
Ln INSTL -.011 -.012** -2.215 .027
** p < .01
repurchase amount/ market value o f equity), market value of firm (MV), return on assets (ROA), standard deviation of
return on assets over 13 years (O roa ), Log cash flows (Ln CFO), Log Institutional ownership (Ln INSTL), debt to
equity ratio (LTD). Square of standard deviation of ROA ( a R 0 A2) and square of debt to equity (LTD2) adjust for the
non-linearity o f the data.
Table D -llc: Determinants of dividend substitution

Asset Group: 2 ____________________ ^ >____________ Cases: 104
Dependent
variable
DEVIATION - - - - -
Independent .265
variables
Constant .181 .316 .753
RYIELD .114 .000 -.572 .568
Ln MV .174 .018 .494 .622
ROA .205 .062 1.562 .122
LnCFO .360 .013** 2.009 .047
( CTROAi
-.340 .297 .907 .367
( O r OA!
-.347 -.492 -1.193 .236
LTD .010 .162** 3.136 .002
LTD2 -.114 -.061** -3.872 .000
Ln INSTL -.381 -.025 -.940 .350
** p < .01
repurchase amount/ market value of equity), market value o f firm (MV), return on assets (ROA), standard deviation of
return on assets over 13 years ( o ROa), Log cash flows (Ln CFO), Log Institutional ownership (Ln INSTL), debt to
equity ratio (LTD). Square of standard deviation of ROA ( ctROa 2) and square of debt to equity (LTD2) adjust for the
non-linearity of the data.
184
Table D -lld : Determinants of dividend substitution

Asset Group: 3 Cases: 52
Dependent
variable
DEVIATION - - - -
Independent .236
variables
Constant .509 1.033 .307
RYIELD .072 .001 .694 .492
Ln MV .007 -.031 -.391 .698
ROA .474 .107 2.416 .020
LnCFO .051 .003 .330 .743
(Ct r o a )
.228 -.669 -1.426 .161
(CTROA)
.309 1.022** 1.754 .087
LTD .052 .111 .944 .350
LTD2 .015 -.031 -.807 .424
Ln INSTL -.105 -.023 -.782 .439
p < .01
repurchase amount/ market value of equity), market value of firm (MV), return on assets (ROA), standard deviation of
return on assets over 13 years (ctroa), Log cash flows (Ln CFO), Log Institutional ownership (Ln INSTL), debt to
equity ratio (LTD). Square of standard deviation of ROA ( G r o a 2 ) and square of debt to equity (LTD2) adjust for the
non-linearity of the data.
The above results do not support the substitution hypothesis in banking firms. The
option funding hypothesis testing the total employee options and executive options using
a logistic regression model is examined for the repurchasing banks.
payout policy o f non-financial firms and found a positive relationship between the
executive stock options and the choice of repurchases over dividends. Kahle (2002)
found that unexercisable executive options have additional explanatory power on the use
o f repurchases. The results of the above studies were consistent with the substitution and
the option funding hypotheses suggesting that managers act in their own best interests by
using repurchases to preserve the value of the outstanding executive options, and try to
minimize the dilution of earnings per share from exercise of employee options.
exercise of outstanding executive and employee stock options and to minimize dilution to
185
existing shareholder interests. Firms announce repurchase programs when they need
shares to fund option exercises by employees (option funding). If the markets are
operating efficiently, repurchase announcements by firms for funding employee option
exercises should not experience any significant positive stock return. The banking firms
started paying out significant portions of compensation to executives in non-salary
components such as executive options and restricted stock in the 1990’s. An estimation
model similar to the models used by Kahle (2002) and Grullon and Michaely (2002) for
the non-banking sector is applied to the data from the banking sector. The regression
model observes the coefficients considering total executive options outstanding and total
options outstanding, as well as the exercisable and unexercisable segments of the total
and executive options. Hypotheses 5 and 6 are tested using logit regression model (4) to
see if the substitution and the option funding hypotheses hold true in the banking sector
also.
Hypothesis 6a: Total exercisable options and to un-exercisable executive options
Hypotheses 5 and 6 are tested using the logistic regression model (4).
Ln (P/l-P) = p 0 + Pi Ln M V + p 2 Ln CFO+ fa MB+ p 4 LTD+ fa BHR+ (36Ln TOT OP +
p 7 Ln EXECOP + /% Ln INSTL + £ (4)
186
A positive relationship between the banking firms’ repurchase decision,
exercisable executive options and unexercisable total options is expected. Coefficients p 2 ,
p 6 , p7 and P§ are expected to be positive consistent with substitution and the option
funding hypotheses.
H0 5 : P2 > 0 P7 > 0 and P8>0 H0 6 : P6 , > 0
Has: P2 —0 P7 ^ 0 and Ps^O Has'. P6 ^ 0
Employee compensation is decomposed into employee options and executive
options, and each of them split further into exercisable and unexercisable components to
see if they cause differences in the probability of repurchases. Since asset sizes have been
shown to influence managers’ decisions, the model is tested using the three asset size
groups. The results are shown in Table D-12b tol2d with Column 1: outstanding total
options, Column 2: outstanding total options and executive options, and Column 3:
outstanding total and executive options split into exercisable and unexercisable portions.
Wald test (t-ratio). The number in parenthesis is the maximum likelihood p-value.
Table D-12b shows regression coefficients, Wald statistics, and p-values for each
o f the seven predictors for group 1 firms for each of the three compensation scenarios.
Column 1 including total options shows that log of market value, 5-year total return and
institutional holdings predicted the repurchases reliably, t=46.3, 13.6 and 11.5
respectively, p< .001. The negative sign of the coefficients for 5-year total returns and
institutional ownership shows that firms with high historical returns and firms with high
187
institutional ownership have lower odds of repurchasing shares. The log of market value
with an odds ratio o f 21.257 shows significant impact on the likelihood of repurchase.
Executive options show positive predictive ability with Wald test of 3.758. These results
confirm the signaling and substitution hypotheses.
Table D-12c shows regression coefficients, Wald statistics, and p-values for each
of the seven predictors for group 2 firms for each of the three compensation scenarios.
When total executive options were used, the results show that log institutional holdings
and executive options predicted the repurchases reliably with t= 5.09 and 5.9, and odds
ratios o f 9.29 and 3.83 respectively. When the executive and total options were split into
exercisable and unexercisable portions, log institutional holdings and exercisable
executive options predicted the repurchases reliably with t= 4.5 and 2.8, and odds ratios
of 37.173 and 3.036 respectively. The results confirmed the substitution hypothesis.
Interestingly, medium size firms differ from the others in the effect of institutional
holdings, which has a positive coefficient, signaling that high institutional ownership
increases the odds of repurchases in medium firms. Medium size banking firms can be
using repurchases to distribute excess cash flows to institutional investors due to lack of
investment opportunities, confirming the cash flow hypothesis.
Table D-12d shows the results of logistic regression for each of the seven
predictors for group 3 firms for the three compensation scenarios. Column 1 including
total options shows that log of market value, market to book ratio, debt to equity and total
options predicted the repurchases reliably with t=2.2, 3.3, 3.16 and 5.4, and odds ratios of
0,14.99, 5.65 and 9.08 respectively.
188
Table D-12b - Probability of repurchases- Group 1 Ismail) firms

The first number in each cell is the parameter coefficient estimate ((1); the second is the Wald test (t-ratio).
The number in parenthesis is the maximum likelihood p-value. Odds ratios are not shown_____
(1) Total options (2) Total and (3) Total and
outstanding Executive options Executive
outstanding options-
Exercisable and
unexercisable
N 383 326 238
R-sq
Intercept 1.671 1.225 2.225
.645 .264 .604
(.422) (.608) (437)
Log of MV 3.057 2.930 2.673
46.280 31.668 16.093
(.000) (.000) (.000)
Log of Cash flow -.115 -.001 -.062
1.726 .000 .247
c m (.994) (619)
Market to Book -.195 -.227 -.181
2.640 2.838 1.093
(104) (.092) (■296)
Debt/ Equity -.162 -.189 -.167
1.207 1.443 .849
(.272) (.230) (.357)
13.596 12.067 14.627
(.000) (.001) (.000)
Log of Institutional -.435 -.480 -.281
shares 11.534 10.004 11.694
(.001) (.002) (193)
Log of Total options -.004 -.221
.002 2.259
(.966) (.133)
Log of Total options .171
exercisable .350
(.554)
Log of Total options -.228
unexercisable .810
(.368)
options 3.758
(.053)
options exercisable .855
(355)
Log of Executive -.333
options 2.353
unexercisable (.125)
The results show that large banks are able to use leverage to generate cash flows
and payout the excess cash flow in repurchases. Total outstanding options relate
189
positively to the probability of repurchase, confirming option- funding hypothesis. An
interesting difference with the large firms is the significant, negative coefficient for log
market value, t=6.68, showing that higher market values lower the odds of repurchases by
large banking firms. Higher market values could be the result of investors rewarding
large firms for their diversity of products and markets. If managers are deploying cash
flows into profitable investments, investors will expect the managers to continue to
increase the value of the firm rather than payout in repurchases, confirming cash flow
hypothesis. None of the other predictors are significant. In summary, the analysis results
show that the substitution hypothesis is confirmed in the total sample, and in small and
medium size firms. The option funding hypothesis is confirmed in the total sample and
large firms.
Table D-12c: Probability of repurchases- Group 2 firms
Odds ratios are not shown.
Exercisable and
unexercisable
N 99 90 71
Pseudo .072 .241 .397
(Nagelkerke)
R-sq
Intercept -7.286 -58.803 -84.719
.261 5.390 4.586
(610) (020) (.032)
Log of MV -.671 .234 -1.389
.196 .067 .136
(658) (796) (712)
Log of Cash flow .014 .215 .374
.013 2.096 1.910
(910) (148) (.167)
Market to Book .501 -.043 .435
2.267 .015 .323
(132) (903) (.570)
Debt/ Equity .132 -.839 -.898
.083 2.141 1.504
(773) (143) (.220)
5-year total return -.033 .007 -.011
.884 .023 .040
(347) (.879) (.841)
Log of Institutional .496 2.229 3.616
shares .662 5.088 4.508
(416) (024) (.034)
Log of Total options .089 -.120
.111 .046
(.739) (.830)
Log of Total options 1.292
exercisable 1.706
(.192)
Log of Total options -1.175
unexercisable 1.576
(.209)
Log of Executive 1.343
options 5.893
(.015)
(.094)
options .433
unexercisable (511)
191
Table D-12d: Probability of Repurchase- Group 3 firms

The first number in each cell is the parameter coefficient estimate ((3); the second is the
Odds ratios are not shown.
Exercisable and
unexercisable
N 52 44 50
Pseudo .627 1.00 .766
(Nagelkerke) R-sq
Intercept 1.102 1383.24 13.017
.002 .000 .045
(967) (991) (832)
Log of MV -13.279 -52.206 -22.826
6.668 .000 2.806
(010) (997) (094)
Log of Cash flow 1.315 28.327 2.494
2.227 .000 2.496
(136) (990) (114)
Market to Book 2.707 74.956 5.614
3.305 .000 2.099
(069) (990) (147)
Debt/ Equity 1.732 41.846 .920
3.164 .000 .269
(075) (993) (604)
5-year total return .023 -.347 -.222
.077 .000 1.153
(781) (998) (283)
Log of Institutional .119 -122.314 1.953
shares .006 .000 .681
(939) (989) (409)
Log of Total options 2.206 -.74.977
5.411 .000
(.020) (990)
exercisable .928
(335)
unexercisable .486
(.486)
options .000
(988)
options exercisable .993
(.319)
Log of Executive -7.783
options 1.443
unexercisable (.230)
The results of model (4) show the positive relationship of total and executive
options with the probability o f repurchases, confirming substitution. Option funding is
192
weakly confirmed. Since executive options are shown to influence management decisions
about share repurchases, the presence of earnings management in repurchasing banking
firms can provide avenues for behavioral research. The last hypothesis in the group of
management incentive hypotheses- earnings management hypothesis is now examined.
analysts on accounting based information to value stocks, creating the incentive for
companies to manipulate earnings and influence the stock price valuation. Burgstahler
and Dichev (1997) found evidence that firms manage reported earnings to avoid earnings
decreases and losses, and cash flow from operations to achieve increases in earnings.
Phillips et al. (2003) found that deferred tax expense computed in accordance with SFAS
No. 109 is a useful proxy for differences between book and tax incomes, and can identify
the presence of earnings management in the non-banking sector. They used deferred tax
expense as a fraction of assets (DTE), discretionary current accruals as a fraction of
assets (DAC), and change in cash flows as a fraction of assets (ACFO) as predictors for
presence of earnings management (EM) in non-banking firms. Beatty et al. (2002) found
that public banks manage earnings to achieve increases in earnings or avoid reporting
declines in earnings. They showed that the loan loss provision as a fraction of total loans
(LLP ratio) can proxy for discretionary current accruals in the banking sector.
Since banking firms are subject to regulatory capital requirements based on
accounting numbers, the potential incentive for them to engage in earnings manipulation
exists. Loan loss provision as a fraction of total loans (LLP) is used as a proxy for
discretionary current accruals, and test Phillips’ model to see if banking firms use
193
repurchases as an earnings management tool to offset the effects of option exercises on
EPS.
The influence o f discretionary current accruals, deferred tax expense, executive
options and institutional ownership on the probability of managing earnings in
repurchasing banking firms is tested. Estimation model (5) similar to the models used by
Phillips et al. (2003) and Beatty et al. (2002) for the non-banking sector is applied to the
study data from the banking sector.
management.
Ln (P/ 1-P) = p 0 +0i LLP + 02 DTE + 0 3 ACFO + 0 4 In EXECOP +
0 5 In INSTL + ^ (5)
LLP is loan loss provision as a fraction of total loans, DTE is deferred tax expense
as a fraction o f assets, ACFO is the change in firm’s cash flows from continuing
operations from year t-1. Inclusion of both DTE and LLP in the model helps to determine
the incremental usefulness o f each measure in detecting earnings management. ACFO is
included to control for the effect of change in cash flows on the firm’s inclination to
manage earnings. Coefficients Pi and P2 are expected to be positive indicating that a
positive relationship exists between earnings management, deferred tax expense and
discretionary accruals.
194
H07: pi > 0 and P2 > 0
Ha7: pi < 0 and P2 ^ 0
Hypothesis 7 is tested using logistic regression model (5) to see if the earnings
management hypothesis holds true in the banking sector. Since asset sizes are known to
influence managers’ decisions, the model is tested using the full study sample as well as
the individual asset size groups (under $20 billion, $20-50 billion, and over $50 billion).
The results show that deferred tax, executive options and institutional ownership have
significant influence on earnings management, but loan loss provision (discretionary
current accruals) and change in cash flows (ACFO) do not. The results are presented in
Table D-13a for the total sample, and asset size groups 1, 2 & 3. The first number in each
cell is the parameter coefficient estimate (p), the second is the Wald test (t-ratio), and
third number is the odds ratio. The number in parenthesis is the maximum likelihood p-
value.
As shown in Table D-13a, logistic regression analysis is performed on earnings
management as outcome, and five performance and compensation related predictor
variables: loan loss provision ratio, deferred tax expense ratio, change in cash flows, log
o f executive options, and log of institutional holdings. Table D-13a shows the results of
applying the logit model to the data from small, medium and large banking firms.
Institutional ownership and deferred tax ratio have strong positive predictive ability in
small firms, possibly consistent with cash flow hypothesis. Executive options exhibit a
consistently negative predictive capability of earnings management for banks of all sizes.
These results are in line with the trend of executive options reacting negatively to actions
that have a dampening influence on the stock price.
195
Overall results are consistent with hypothesis 7 on deferred tax expense (DTE),
but not on loan loss provision (discretionary current accruals). Deferred tax expense is
incrementally useful in predicting earnings management in repurchasing banking firms of
all sizes. The results agree with the results from Phillips et al. (2003) that deferred tax
expense is incrementally useful in detecting earnings management in non-banking firms.
Table D-13a: Probability of earnings management

N indicates cases included in analysis. LLP is loan loss provision as a fraction of total loans, DTE is
deferred tax expense as a fraction of assets, ACFO= change in firm’s cash flows from continuing operations
from year t-1, Ln EXECOPTION= log of executive options, Ln INSTL= Institutional ownership. The first
number in each cell is the parameter coefficient estimate (B), the second is the Wald test (t-ratio), third is
the odds ratio. The number in parenthesis is the maximum likelihood p-value.______ __________________
All Cases Group 1 Group 2 Group 3
N 453 315 88 50
Pseudo (Nagelkerke) .101 .109 .193 .168
R-sq
Predicted % correct 72.6 72.4 78.4 72.0
Intercept -.626 -2.318 -3.612 -3.701
.193 1.198 .124 .119
.535 .098 .027 .025
(661) (274) (725) (.730)
LLP -.026 -.226 .108 .067
.332 1.702 .204 .558
.974 .798 1.114 1.069
(564) cm (.652) (455)
DTE .218 .243 .193 .076
7.225 6.574 .939 .045
1.243 1.276 1.213 .1.079
(007) (.010) (.332) (831)
ACFO 4.094 4.356 -4.879 32.992
1.309 1.309 .116 .751
59.970 77.943 .008 large
(253) (.253) (.733) (.386)
Ln EXECOPTION -.371 -.260 -.667 -.710
12.858 5.089 3.907 2.441
.690 .771 .513 .491
(.000) (024) (.048) (U 8 )
Ln INSTL .365 .383 .743 .761
18.096 10.067 2.530 1.644
1.440 1.467 2.102 2.141
(.000) (.002) (.112) (.200)
The loan loss provision ratio is a weak positive predictor for medium and large
firms. These results are in line with the results of Beatty et al. (2002) that public (large)
banks use discretion in their loan loss provisions to avoid declines in earnings,
private (small) banks have lower propensity to do so.

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PERFORMANCE IN BANKING FIRMS: AN EMPIRICAL STUDY

KAMALA RANGASWAMY RAGHAVAN

Master of Business Administration

Northeastern University, Boston, MA

Submitted in partial fulfillment of requirements for the degree

DOCTOR OF BUSINESS ADMINISTRATION

CLEVELAND STATE UNIVERSITY

Copyright 2005 by ProQuest Information and Learning Company.

All rights reserved. This microform edition is protected against

unauthorized copying under Title 17, United States Code.

ProQuest Information and Learning Company

for the College o f Business Administration

and the College of Graduate Studies by

Dr Heidi Hylton Meier

With gratitude, I thank the members of my dissertation committee. Dr. Heidi

interpretation of the results.

My special thanks go to Mr. Chanda Sichinsambwe, doctoral candidate at

OPERATING PERFORMANCE IN BANKING FIRMS: AN EMPIRICAL STUDY

KAMALA RANGASWAMY RAGHAVAN

impact on the choice o f cash payout mechanism.

The purpose of this study is to provide empirical evidence relevant to the

application of existing share repurchase hypotheses to the banking firms while

repurchase decisions and earnings management strategies are addressed.

performance research in finance and accounting. It concentrates on management behavior

institutional ownership have a strong positive relationship to firm’s operating

(2) Size o f repurchase and performance in satisfying prior repurchase commitments do

influencing management choice of repurchase over dividends in banks of all sizes,

management in banks, consistent with prior research in the non-financial sector.

characteristics relative to share repurchases in banking firms.

Organization o f Subsequent Chapters 16

II. LITERATURE REVIEW

Share Repurchase Hypotheses 18

Operating Performance and Firm Characteristics

Management Incentive Related Hypotheses 36

Selected previous Empirical Research Studies 52

Selected previous Survey studies 57

III. HYPOTHESES AND RESEARCH DESIGN

Hypotheses, Research design 58

IV. ANALYSIS OF EMPIRICAL RESULTS

Data and Sample selection 71

V. SUMMARY AND CONCLUSIONS

Summary o f Results 125

Suggestions for future research 133

VI. REFERENCES 134

Appendix A: List of Variables 146

Appendix B: Signaling and Time Inconsistency Hypotheses:

Appendix C: Empirical Analysis using Dummy Variables for

Appendix D: Empirical Analysis using asset size groups 169

2. Operating performance of firm relative to industry 80

6. Distribution o f payouts and firm characteristics 91

7. Multiple regression of the determinants of payouts 92

8. Determinants of repurchase payouts 95

9. Firm characteristics by payout decision 99

10. Cash flow volatility and payout decision 101

11. Determinants of dividend substitution 105

12. Probability o f repurchases 115

13 Probability o f earnings management- All firms 122

B -l.l Summary Statistics- Years 1988 to 1991 148

B-1.2 Summary Statistics- Years 1992 to 2000 149

B-1.3 Summary Statistics- Years 1988 to 2000 151

B- 2.2 Operating performance of firm relative to industry-1992-2000 152

measures affected by option exercises, and if better financial performance in post