Stock Repurchases and Executive Compensation Contract

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Stock Repurchases and Executive Compensation Contract Design The. Role of Earnings Per Share Performance Conditions, Compensation contracts that link payoffs to earnings per share EPS provide executives with. direct and potentially powerful incentives to manage EPS realisations Since stock repurchases. directly affect both the numerator and denominator in the EPS calculation we test whether. managers stock repurchase decisions are sensitive to explicit EPS related incentives Findings. reveal a strong association between stock repurchase activity and the presence of EPS based. compensation arrangements The predicted odds of a repurchase for firms where executive. compensation depends on EPS performance are almost twice the level observed for firms where. rewards are independent of EPS Repurchase likelihood is also increasing in EPS target difficulty. Bonus based EPS conditions are associated with the strongest effect on repurchase propensity. followed by share option plans with EPS based vesting conditions Further tests do not support. the hypothesis that EPS based contracts and associated stock repurchase activity represent an. efficient contracting solution to the agency problems of free cash by motivating self interested. executives to disgorge surplus cash to shareholders in a timely manner We conjecture that. executives may use repurchases opportunistically to maximise their compensation at the expense. of external shareholders and that such behavior persists either because it represents an. unavoidable agency cost associated with a second best contracting solution or because. management friendly boards successfully appease external monitors by adopting performance. targets that at the same time provide executives with ancillary earnings management. opportunities, Stock Repurchases and Executive Compensation Contract Design The Role of. Earnings Per Share Performance Conditions,I INTRODUCTION. This study investigates the link between firms stock repurchase activity and the presence. of earnings per share performance conditions in executive compensation contracts Our analysis. seeks to address the apparent disconnect between theory and practice regarding stock repurchases. One the one hand traditional academic theories identify factors such as signalling Vermaelen. 1981 agency costs Fenn and Liang 2001 and leverage Dittmar 2000 as important. determinants of repurchase activity On the other hand survey and anecdotal evidence highlights. earnings per share EPS as a primary driver of managers repurchase decisions Caster et al. 2006 Brav et al 2005 Badrinath and Varaiya 2000 Identifying why managers attached such. weight to the EPS impact of their stock repurchase decisions therefore represents an important. step toward a better understanding of this increasingly significant aspect of corporate payout. Stock repurchases affect both the numerator and denominator in the EPS calculation. Hribar et al 2006 Bens et al 2003 Guay 2002 Recent research has started to shed light on the. links between repurchase decisions and EPS related considerations Kahle 2002 Bens et al. 2002 and Bens et al 2003 focus on the dilutive impact of employee stock options ESOs. Their findings suggest that stock repurchases represent a managerial response to EPS dilution. concerns Evidence also suggests that managers use repurchases for benchmark beating purposes. including meeting or exceeding analysts EPS forecasts Hribar et al 2006 preserving a. sequence of EPS improvement Myers et al 2006 and maintaining historic EPS growth rates. Bens et al 2003 However neither the dilution nor benchmark beating explanations offer an. explicit link between EPS performance and managerial wealth For example precisely why. managers care about EPS dilution is unclear in a traditional corporate finance framework Guay. 2002 Kalhe 2002 And while prior research reveals a valuation premium to benchmark beating. Hribar et al 2006 find that such premiums are largely eliminated for positive earnings surprises. resulting from accretive stock repurchases, Our analysis builds on prior research by examining whether managers stock repurchase. decisions are sensitive to explicit EPS related incentives provided by executive compensation. contracts Compensation contracts linking rewards to EPS performance provide executives with. direct and potentially powerful incentives to manage reported EPS over and above any implicit. market based gains We therefore test whether stock repurchase activity is higher for firms that. condition executive compensation on EPS performance. Empirical tests employ data for a comprehensive sample of UK non financial firms over. the period January 1998 through December 2003 Several features make the UK a particularly. attractive setting in which to explore the link between stock repurchases and compensation. contract design First in addition to executive bonus plans that routinely condition rewards on. EPS performance executives long term incentives such as stock options and restricted stock. frequently employ EPS based vesting conditions Carter et al 2008 Main and Neate 2006. Conyon et al 2000 Explicit contractual arrangements linking both short and long term. elements of compensation to EPS performance create particularly strong incentives for UK. executives to manage EPS realisations through repurchases Second regulatory restrictions. governing the treatment of stock repurchases during our sample period help simplify our. empirical tests by tempering the link between repurchase activity and the dilutive effects of ESOs. In particular UK company law prior to December 2003 required repurchased shares to be. cancelled immediately As a result the cost of using repurchases to offset ESO related EPS. dilution was relatively high for UK firms because issuing new shares is administratively more. costly than re issuing treasury stock Accordingly UK firms with large ESO programs typically. established a wholly owned trust company to repurchase and re issue shares on behalf of the. firm Shares acquired by these ESO trusts do not meet the legal definition of a stock repurchase. and are excluded from our sample 1 Third UK firms are required to disclose the volume and. value of shares repurchased enabling us to construct accurate firm level measures of repurchase. activity This approach contrasts with the majority of extant US studies that employ proxies for. the level of repurchase activity e g Hribar et al 2006 Bens et al 2002 Fenn and Liang 2001. Dittmar 2000 Jagannathan et al 2000 Stephens and Weisbach 1998. Findings reveal a statistically and economically significant association between stock. repurchase activity and the presence of EPS based compensation arrangements The predicted. odds of a repurchase for firms where executive compensation depends on EPS performance are. almost twice the level observed for firms where rewards are independent of EPS Further the. odds ratio associated with EPS based compensation arrangements is similar to and in many cases. larger than odds ratios for more traditional determinants of repurchase activity such as excess. cash flow and scarce investment opportunities We also present evidence that repurchase. likelihood is increasing in EPS target difficulty for stock option plans Bonus based EPS. conditions are associated with the strongest effect on repurchase propensity followed by stock. option plans with EPS based vesting conditions Overall our results provide compelling evidence. that EPS contingent compensation arrangements represent an important determinant of UK. managers stock repurchase decisions, An obvious question raised by our findings is why firms continue to link executive.
compensation to EPS targets despite the additional earnings management opportunities that such. arrangements create particularly given the evidence in Bens et al 2002 that managers may. divert resources away from potentially value increasing investments to fund EPS driven stock. repurchases We propose and test an efficient contracting explanation for this apparent paradox. Specifically because EPS targets incentivize managers to manipulate reported performance by. Consistent with the absence of ESO related motives for stock repurchases in the UK none of our sample. firms mentioned the dilutive impact of stock based compensation plans among the list of repurchase. repurchasing stock we conjecture that EPS based contracts may help overcome agency problems. of free cash flow by motivating self interested executives to disgorge surplus cash to shareholders. in a timely manner We explore this hypothesis in two ways First if conditioning executive. compensation on EPS performance helps overcome the agency costs of surplus cash then the link. between stock repurchases and EPS based contractual incentives should be more pronounced for. firms with excess cash This prediction is tested by examining the interaction between the. presence of EPS targets and proxies for surplus cash Second if the decision to tie executive. compensation to EPS is an endogenous response to the agency problems of excess cash then the. strength of the association between stock repurchases and EPS based compensation arrangements. should diminish once this endogeneity is accounted for We test this prediction by estimating a. system of equations that includes separate models for the probability of a stock repurchase and. the incidence of EPS targets in executive compensation contracts. Neither our interaction tests nor our recursive simultaneous equations bivariate probit. model analysis reveal any support for the efficient contracting hypothesis We therefore speculate. on alternative explanations for the observed link between repurchase activity and EPS based. compensation arrangements One possibility is that opportunistic executives use repurchases to. maximise their compensation at the expense of external shareholders and such behavior persists. either because it represents an unavoidable agency cost associated with a second best contracting. solution or because management friendly boards successfully appease external monitors by. adopting performance targets that at the same time provide executives with ancillary earnings. management opportunities, Our study contributes to prior research in several ways First we document an important. determinant of stock repurchase activity in the form of EPS based executive compensation. contracts that is new to the academic literature but which is entirely consistent with an. reasons disclosed in their annual reports In contrast 66 percent of US managers surveyed by Brav et al. explanation frequently proffered by management to justify their repurchase decisions Second. our findings help reconcile evidence regarding the manipulation of EPS using stock repurchases. Bens et al 2002 Bens et al 2003 Hribar et al 2006 Myers et al 2006 with the apparent. absence of an equilibrium incentive structure to support managers myopic focus on short term. EPS Guay 2002 405 Larcker 2003 46 Compensation contracts based on EPS targets provide. executives with explicit incentives to manage EPS realisations via stock repurchases Third our. analysis speaks to prior work on performance measure choice in managerial compensation. contracts While prior research highlights the relative merits of accounting versus market based. measures Sloan 1993 the choice between unscaled accounting metrics versus per share scaled. metrics has been largely overlooked Our results provide one reason why managers may prefer. per share based performance measures and why shareholders should think twice before. acquiescing to such preferences, The remainder of this paper is organized as follows Section II develops the link between. stock repurchase activity and executive compensation arrangements and reviews the structure of. executive compensation plans in the UK Section III provides details of our sample data and. research design Section IV reports results of tests examining the association between stock. repurchases and EPS based executive compensation arrangements Section V presents tests of the. efficient contracting hypothesis and discusses managerial opportunism as an alternative. possibility Section VI concludes,II LITERATURE REVIEW AND INSTITUTIONAL OVERVIEW. Stock Repurchases Earnings Management and Executive Compensation. Despite being largely overlooked in the corporate payout policy literature managers and. financial commentators have long recognized the EPS implications of stock repurchases Caster. 2005 cited stock options as an important or very important factor influencing their repurchase decision. et al 2006 Badrinath and Varaiya 2000 The impact of stock repurchases on reported EPS. represents the net of both numerator and denominator effects The numerator effect which works. to reduce EPS represents the decline in earnings caused by an increase in borrowing for. repurchases financed with debt or a reduction in investment returns for repurchases financed. using cash reserves The denominator effect serves to increase EPS by reducing the number of. shares outstanding Repurchases have a positive net effect on EPS when a firm s earnings to. price ratio exceeds its opportunity cost of funds i e either the after tax return on short term cash. investments or the cost of debt Conversely repurchases reduce EPS if the earnings to price ratio. is less than the opportunity cost of funds Guay 2002 Bens et al 2003 Hribar et al 2006. Survey evidence reported by Brav et al 2005 highlights the central role that EPS considerations. Earnings Per Share Performance Conditions I INTRODUCTION This study investigates the link between firms stock repurchase activity and the presence of earnings per share performance conditions in executive compensation contracts Our analysis seeks to address the apparent disconnect between theory and practice regarding stock repurchases

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