SHARE REPURCHASES AND FIRM PERFORMANCE - NEW EVIDENCE ON THE AGENCY COSTS OF FREE CASH FLOW

In this paper we examine tender offer share repurchases to differentia te between the information signaling and free cash flow hypotheses. Pr evious work in this area has focused on announcement period returns. W hile we also examine announcement returns, our primary emphasis is on operating performance changes surrounding repurchases. We argue that t he information contained in changes in operating performance, and its determinants, enables us to differentiate between the two hypotheses. Our primary finding is that operating performance following repurchase s improves only in low-growth firms, and that these gains are generate d by more efficient utilization of assets, and asset sales, rather tha n improved growth opportunities. Thus, repurchases do not appear to be pure financial transactions meant to change the firm's capital struct ure but are part of a restructuring package meant to shrink the assets of the firm. This evidence leads us to conclude that the positive inv estor reaction to repurchases is best explained by the free cash flow hypothesis. (C) 1998 Elsevier Science S.A. All rights reserved.