Does leveraged stock buyback improve firms’ profitability?

ABSTRACT

We provide a structural explanation about how and when leveraged stock buyback improves firms’ profitability. We find operating profit on equity and operating profit sensitivity on debt are crucial factors to consider when determining the source of stock repurchase. Our theoretical reasoning and empirical tests show that companies with high operating profit on equity and low operating profit sensitivity on debt have a higher chance of improving profit through leveraged buyback. We also suggest a structural form to estimate leveraged buyback and cash buyback based on financial variables instead of companies’ disclosure.

KEYWORDS:

• Leveraged Stock Repurchase
• buyback
• credit worthiness
• common stock

JEL CLASSIFICATION:

• G31
• G32

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ For example, Lei and Zhang (2016) analyse leveraged buyback with less than 400 samples. Kahle and Stulz (2020) computed stock repurchase utilizing financial variables.

² Assuming that a company uses retained earnings to repurchase common stocks, we obtain the year-end retained earnings as RE_t = RE_t-1+ NI_t-DIVt-REP^c_t, where REP^c_t represents stock repurchase using retained earnings or cash.:

³ We confirm that our research data includes most of the firms announced leveraged stock repurchase in Securities Data Company and SEC’s DGAR.

⁴ Similar results are observed if market capitalization is controlled instead of total equity.