Determinants of Cash Distribution Options: History
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Contributor:
Ntungufhadzeni Freddy Munzhelele
,
Ayodeji Michael Obadire

The purpose of this text was to examine the determinants of cash distribution options by critically considering the effects of earnings, dividends, firm size, and economic value added. The distribution of cash dividends to shareholders serves as a basic means by which shareholders receive returns on their investments, so it is essential to examine share repurchases alongside dividends to enhance management’s efforts in maximising shareholder value. 

  • dynamic panel data
  • payout flexibility
  • share repurchases
  • dividend payout

1. Introduction

The prudent management of finances and resources is a key component of financial management for businesses (Kontuš 2018). In order to accomplish the organisation’s short- and long-term goals, this entails making strategic decisions on the acquisition, allocation, and utilisation of financial resources. Options for cash distribution are essential in this process because they let businesses distribute surplus money to different stakeholders. Pidun (2019) asserted that choosing the best cash distribution is crucial because it has a big impact on the business’s success and financial health. For a company to be sustainable and successful, it is essential to strike a balance between retaining appropriate financial reserves, rewarding investors, and reinvesting surplus funds (Lazonick 2014). Effective financial management and ensuring the company’s long-term growth and stability depend on careful consideration of these variables.
According to Feito-Ruiz et al. (2020) and Lazonick (2014), dividends, share repurchases, and other payout mechanisms are probable choices available for a firm’s cash distribution and payout policy. Pidun (2019) suggested that share repurchasing has become an integral part of companies’ financial strategy. The recognition of share repurchases as a payout alternative places them alongside cash dividends, and together, they are a means by which wealth can be distributed to shareholders during normal corporate operations (Benkert 2020).
The flexibility inherent in share repurchases, that is the choice they provide as to how much should be paid, although relatively non-binding, enhances their recognition with respect to managers’ endeavours to maximise value for shareholders (Brav et al. 2005). The utilisation of share purchases with respect to payout policy dates back several decades. For example, share repurchases have been allowed in the United States (U.S.) since the 1970s, although they only became more popular in the 1980s, and the United Kingdom (U.K.) legalised them in 1981 (Dittmar 2008; Wesson et al. 2015); they have since become a global phenomenon. Share repurchases were only permitted in South Africa beginning on 1 July 1999 (Wesson and Botha 2019). Share repurchases are now a global phenomenon, to the point where they occasionally outnumber cash dividends and new share issuance in some economies, namely the U.S. and U.K. (Wesson et al. 2015). Numerous studies such as those of Sakinç (2017), Sodhi and Mateus (2018), and Chen and Liu (2021) have drawn from the robustness of theories such as agency, signaling, pecking order, trade-off, and behavioural finance theory to fully understand the dynamics of cash distribution options determinants.
The popular debate among scholars (Brav et al. 2005) is that share repurchases are flexible as opposed to cash dividends as managers can decide to make them or not, as well as the fact that they can be made to serve several purposes. Iyer and Rao (2017) and Wesson et al. (2018) supported this notion by arguing that repurchases are more flexible; thus, some managers prefer them over cash dividends. According to Chivaka et al. (2009), research on share repurchase has been conducted for a few reasons such as the enhancement of value, a change in shareholding and control, and administrative- and compensation-related reasons. In the following, the first two sections will cover the empirical trends and motivation for share repurchases in developed and emerging markets, respectively. The last two sections will elicit empirical evidence of the extent to which share repurchases are used as a payout choice and the determinants of the payout decision and flexibility.

2. Empirical Trends and Motivation for Share Repurchases in Developed Markets

The practice and trends of share repurchases in developed nations have been more noteworthy than for emerging markets (Wesson et al. 2018). In their research, Dedman et al. (2022) investigated the share price patterns of U.S. companies engaged in share repurchases. The study findings indicated that these companies tend to buy back their shares at a higher price, using this strategy as a signal of anticipated favourable future earnings.
Furthermore, a study by Abraham et al. in 2018 surveyed managers’ views on share repurchases, particularly with respect to tender offer premiums. In the end, they proposed several factors that may determine the size of the tender offer premium, namely the dividend substitution hypothesis, leverage, the capital adjustment hypothesis, the price pressure hypothesis, the anti-takeover hypothesis, and the signalling hypothesis. Consistent with Dedman et al.’s (2022) work, Abraham et al. (2018) revealed that managers use share repurchases to signal their confidence in the prospects of the company. Additionally, a study by Olasiuk et al. in 2020 confirmed the signalling hypothesis as a key driver of share repurchases (Olasiuk et al. 2020). The interviewed respondents also provided additional motivational drivers, namely the best use of excess cash, boosting the share price and earnings per share.
In a trend-setting investigation, Varma et al. (2011) contributed to the debate on the drivers of share repurchases. Firstly, they confirmed information signalling as a key driver with respect to tender offers. They, however, cautioned that this phenomenon may not be generalised with respect to the open market offers, as the empirical evidence does not seem to be clear with respect to these offers. They also lent support for other drivers, namely the agency costs of free cash flow, capital reallocation, the dividend substitution hypothesis, and capital structure adjustment.
Tsetsekos et al. (2011) provided support for the signalling hypothesis as a key driver for share repurchases. They also confirmed other hypotheses, namely capital structure adjustments and the best use of excess free cash flow. Voss (2012) confirmed the somewhat less-popular driver of repurchasing, managerial incentives, thereby stressing that they are key factors that influence share repurchase decisions.
Although share repurchases were legalised in 1981 in the U.K., related activities took off in the 1990s (Wang et al. 2021). It is important to note that Rees (1996) was the first researcher to empirically show the share price impact of repurchases in the U.K. He revealed a positive reaction of share price to repurchases, on the announcement date. This evidence suggests that the U.K.’s corporate situation supports the signalling hypothesis as a reason for repurchases. Wang et al. (2021) scrutinised the effect of regulations and taxes on share repurchase activities, also in the U.K. setting. Furthermore, Wang et al. (2021) stated that the tax system in the U.K. is the key determinant of share repurchases. As such, Wang et al. (2021) found that, although applicable regulations seem to discourage open market repurchase activity with respect to undervalued shares, under-pricing is observed as a key driver of share repurchases in the U.K.
Furthermore, Alghamdi (2018) investigated the motivations for and determinants of share repurchase activity in Saudi Arabia. It was noted that companies undertake share repurchase activities to signal that share prices are undervalued. Similarly, Andriosopoulos and Hoque (2013) evaluated the determinants of share repurchases of three developed European countries, namely the U.K., Germany, and France. Andriosopoulos and Hoque (2013) revealed that, in all of these countries, large companies whose shares are widely held and those that pay dividends prefer announcing share repurchases through the open market option, and in the U.K., excess cash flow seems to be a key determinant of share repurchases; thirdly, the dividends and share repurchases in the U.K. and Germany seem to be complementary, but they serve as substitutes in France.
Furthermore, a study by Ota et al. was conducted in 2019 on the impact of open share repurchases in Japan (Ota et al. 2019). The research supported the signalling hypothesis, indicating that companies repurchasing shares were sending positive signals about their future performance. Additionally, they found evidence supporting the investment hypothesis, suggesting that the announcement of open market repurchases provided insights into managers’ private benefits related to new investments. The Oceanian developed markets also contributed to share repurchase activity, as highlighted by Ann Wheeler and Garrick (2020) in their study on share repurchases in Australia. Ann Wheeler and Garrick (2020) recognised the differences between the applicable regulations in the U.S. and Australia and revealed that share repurchases were allowed in Australia from 1 November 1989, but it took more than five years for effective repurchase activities to gain momentum.
Moreover, Anwar et al. (2018) discovered that enhancing earnings per share and net asset backing per share are motivations for share repurchases in India. They observed that, approximately five years after the reluctance period (that is, from 1995 onwards), Indian managers have become aware of the potential benefits and the legislative matters of repurchases. Worryingly, as Anwar et al. (2018) noted, shareholders seem not to understand or are not favourably placed to understand share repurchase events. Dedman et al. (2022) also highly recognised the signalling hypothesis as a key motive for repurchases.

3. Empirical Trends and Motivation for Share Repurchases in Emerging Markets

Emerging economies’ contribution to share repurchase research has been noteworthy, although far less compared to that of developed economies. In South Africa, share repurchase activity and related research followed their legalisation in 1999 (Wesson et al. 2015). Through investigating share price reaction to open market repurchases, Alghamdi (2018) provided support for the signalling hypothesis, suggesting that South African managers use share repurchases to signal that shares are undervalued and that a company’s prospects are promising. Chivaka et al. (2009) were the first scholars to investigate reasons for share repurchases in South Africa, in detail. Their study specifically pointed out that the vast interest and significance of repurchase activity warrant some considerable research in South Africa. They found three major reasons for share repurchases, namely enhancement of shareholder value, changes in shareholding and control, and administrative matters.
Lee et al. (2005) conducted a study on the long-term performance of share prices in response to open market repurchases in Korea. Their research provided strong support for the efficient market hypothesis, suggesting that share prices are generally accurately valued, making it unlikely for managers to buy overvalued shares or sellers to sell overvalued shares. However, this evidence did not support the dynamics of the signalling hypothesis.
On the other hand, Isa and Ghani (2011) observed that Malaysian managers use share repurchases to signal their confidence in their companies’ prospects. They also noted that Malaysian managers employ share repurchases to stabilise share prices. Firth et al. (2010) focused on specific accounting ratios and deduced motivations for share repurchases. His findings showed that variables such as return on equity, return on assets, earnings per share, and the market-to-book value of equity demonstrated some improvements in the operating performance of companies engaging in share repurchases.
In contrast, Jiang et al. (2013) identified different trends in the Chinese context, where they found that share repurchases and cash dividends served as substitutes. Wang et al. (2021) assessed the real effects of share repurchases and their impact on a company’s profitability in Hong Kong. Their findings supported the signalling hypothesis, which was also corroborated by Zhang (2005) and Firth et al. (2010) in the same country.

4. Empirical Review of Share Repurchases as a Substitute of and or Complement to Cash Dividends

The recognition of share repurchases as a payout choice, that is as a cash distribution alternative to shareholders, and relatively alongside cash dividends suggests that share repurchases have become an effective means through which companies can maximise shareholders’ wealth. The popularity and growth in repurchase activity have been attributed to their flexibility (Brav et al. 2005). Jagannathan et al. (2000) researched companies’ decisions to distribute cash flows and the reasons for the choice between cash dividends and share repurchases. Firstly, they recognised the growing repurchase activities and that repurchases are more volatile than cash dividends. They then noted that repurchases are complements to dividends, not substitutes. Secondly and lastly, they interpreted their results as confirming the flexibility inherent in share repurchases. Guay and Harford (2002) gave full support for the above findings as they concluded that companies increase dividends to distribute permanent cash flow shocks, while repurchases are for the distribution of transitory shocks and that share repurchases are flexible.
Through a survey methodology, Brav et al. (2005) also scrutinised, among others, the choice between dividends and repurchases, as well as the flexibility of the latter. They confirmed repurchases’ flexibility, that i, repurchases help managers time the market, thereby responding to share undervaluation. Some increase in share repurchases has been occurring at the expense of a decrease in dividends. Grullon and Michaely (2002) examined several issues with respect to dividends and repurchases, namely the trend of repurchases and the substitution hypothesis and the motives for companies not substituting for repurchases earlier. They noted that, firstly, in the 15 years preceding their report, cash distribution to shareholders was initiated more through repurchases than cash dividends. Secondly, the rate of growth in dividends was observed as being significantly lower than before, while companies’ spending on repurchases was shown to have increased since the mid-1980s. Lastly, companies finance their repurchase programmes through funds that would otherwise be used to finance cash dividends, and large and more-mature companies only use part of this financial option. In another study, Skinner (2008) examined the relationship between earnings, share repurchases, and cash dividends. The results revealed that companies continue to pay dividends because of their history, that is they feel obliged to do so (for a small group that pays dividends and makes repurchases). Skinner (2008) also observed that much of the companies’ earnings are absorbed by repurchases rather than by dividends, thus explaining the substitution hypothesis, and that repurchases adjust quicker to earnings than dividends do, thus confirming the flexibility of repurchases. Furthermore, he noted that some companies have no significant history of paying dividends; hence, for these companies, paying dividends was no longer economically important (for a small group that does not pay dividends, but makes share repurchases and a large group that occasionally makes repurchases). Bonaimé et al. (2014) reported that a more-flexible distribution favours repurchases. Rapp et al. (2014) found that companies for which shareholders advocate for flexibility pay lower dividends and prefer repurchases. This is consistent with both the substitution hypothesis and the complementary nature of share repurchases. Che-Yahya and Alyasa-Gan (2020) found past dividends and company size to be among the key determinants of payout choices in Malaysia. Kaźmierska-Jóźwiak et al. (2022) noted cash dividends as the dominant payout option over share repurchases in South Africa and Poland.

5. Empirical Review of the Determinants of Payout Choices’ Flexibility

Empirical evidence has shown several variables as having an impact on payout decisions; such variables include earnings, dividends, profitability, the level of cash holding, and the company’s size. Notably, the dividend relevance models (Moreland and Madsen 2017; Harakeh et al. 2019; Singh and Tandon 2019; Paolone and Paolone 2020) show that earnings and dividends are key determinants of payout decisions. Although these models advocate for a smoothing pattern of dividends by companies over time, a relatively positive correlation exists between earnings, dividends, including respective lagged variables, and payout decisions. That is, a higher level of earnings and dividends results in higher next dividends or more value-adding dividend decisions. Thus, a positive correlation is expected between these explanatory variables and payout flexibility.
The past decades have witnessed the emergence of value-based measures of financial performance, notably the economic value added (EVA), as key in determining value created for shareholders. These measures have been noticeable as early as the 1980s when Marsh and Merton (1987) argued that economic earnings are better determinants of payout decisions than accounting earnings. Consistently, through net present value (NPV) analysis, Stewart (2014) found, among others, that EVA has an impact on payout decisions. Thus, a relatively positive correlation is expected between EVA and payout flexibility. That is, the more value created for shareholders may result in more utilisation of share repurchases as payout choices.
The level of cash holdings has some implications for company managers. Holding large amounts of cash may be advantageous as this allows managers to respond in a value-adding manner to future or unexpected investment needs. Tong (2011) and other researchers argued that holding large amounts of cash in companies can lead to agency costs of free cash flow. This means that managers may be tempted to invest the excess cash in low-return or value-reducing projects. To address this, companies should consider their structures, such as managers’ compensation plans, in a way that encourages managers to distribute excess cash as dividends. Furthermore, there is an anticipated positive correlation between the level of cash holdings and payout flexibility. In other words, when a company has more available cash, there is a higher likelihood of utilising it for share repurchases.
Furthermore, the size of the company plays a key role with respect to the company’s operations. Grullon et al. (2002) and Banyi and Kahle (2014) noted that larger and more-mature companies are more likely to pay dividends. De Mortanges and Van Riel (2003) also argued that mature companies can consistently generate excess cash and, hence, pay more dividends. Thus, a positive correlation is expected between company size and payout flexibility, that is larger companies still pay out a higher fraction of their total payout as cash dividends.
According to Bonaimé et al. (2014), payout flexibility is the value of share repurchases to the total payout. This definition was adapted for this study in line with the major aim of the company’s existence, which is the maximisation of value for shareholders, also shown by the adoption of EVA as one of the determining factors of payout flexibility. The global trend in repurchases is that open market repurchases have been widely used to an extent of 90% of total repurchases (Moreland and Madsen 2017; Harakeh et al. 2019). Studies from emerging nations that examine the trends and practices of share repurchases do so with respect to open market share repurchases, a phenomenon that is relatively like that of global practice.
Several studies have looked at different trends and practices related to share repurchases. Some of these studies include Bhana (2007), who examined the market reaction to open market share repurchases, Chivaka et al. (2009), who explored the reasons for share repurchases, Krige (2012), who studied the market reaction to open market share repurchases, and Punwasi (2012), who analysed the market reaction to share repurchase announcements.
Other studies such as Wesson et al. (2015) focused on actual share repurchases in South Africa and whether they follow global practices. This study acknowledged that open market share repurchases have been particularly noticeable and more common than other forms of repurchases, especially with their public announcements through the Johannesburg Stock Exchange (JSE) and Securities News Services (SENS). Additionally, Wesson et al. (2018) and Nyere and Wesson (2019) conducted studies on factors influencing payout decisions. It is worth noting that the study by Wesson et al. (2015) primarily explored the trends of actual share repurchases in South Africa, making it more of an exploratory study.
In line with the study of Wesson et al. (2015), this study acknowledged that SENS may not necessarily report all open market repurchase information since the JSE listing requirements are that if share repurchases do not exceed 3% of shares in issue in a specific year, they cannot be reported. It is nonetheless argued, in line with studies, such as those of Bhana (2007), Krige (2012) and Punwasi (2012), that the SENS announcements have more ability to prompt market reaction than repurchases that could not necessarily be made public (that is, share repurchases not reported because they do not exceed the 3% cut-off rule) and, hence, have some influence on the corporate value.

6. Result and Implications

Researchers utilised panel data from 52 companies listed on the Johannesburg Security Exchange (JSE) that engaged in open market share repurchases for at least 2 years between 2000 and 2019. The data were extracted from the IRESS database. The panel data regression model was fitted with the ordinary least squares (OLS), difference generalised moment method (Diff-GMM), system generalised moment method (Sys-GMM), and least-squares dummy variable correction estimator (LSDVC). The findings revealed that there was a positive and significant relationship between the earnings per share and the payoff flexibility, implying that there was an inherent flexibility of repurchases as a payout option in the sampled firms. Additionally, the study revealed a significant negative relationship between the firm size, economic value added, and payoff flexibility. This suggests that larger companies tend to distribute a lower proportion of their earnings as share repurchases and opt for higher cash dividends instead. The implications of these findings provide financial managers with valuable insights into the role of share repurchases as a cash distribution choice. By recognising share repurchases as a viable option, financial managers can enhance their efforts to create and maximise shareholder value, particularly in emerging market settings. This evidence should encourage financial managers to recognise share repurchases more as a distribution choice, diffusing the tension regarding share repurchases replacing the payment of cash dividends and some doubt that they may not possess attributes complimentary to cash dividends. The study recommended relevant academic, industry, and policy implications in the South African context.

The study noted the inherent flexibility of share repurchases for South African listed firms indicating that share repurchases’ announcements were not always acted upon eventually. The study findings showed a positive and significant relationship between the earnings per share and payoff flexibility, implying that there was an inherent flexibility of repurchases as a payout option in the sampled firms. The study also showed a positive relationship between dividends per share and the payoff flexibility that was statistically insignificant. Moreover, the study findings showed a negative relationship between firm size, economic value added, and payoff flexibility. This is because larger companies pay out a lower fraction of the payout as repurchases and are more likely to distribute higher dividends because larger companies have more-profitable opportunities in engaging in new investments, which defeats the purpose of the companies retaining excess earnings for foreseeable investments. This shows that the attitude of managers of larger companies is different from that of smaller ones regarding payout choices between cash dividends and share repurchases. This phenomenon may not be surprising given the features’ differences between these groups of companies, particularly with respect to stability and growth prospects. Another important thing to note is that the study pointed to evidence of share repurchases serving both substitute and complementary roles to cash dividends based on the dual relationship between the variables tested.
The research has some important academic, industry, and policy implications, as it adds the voice of Africa to the repurchase debate literature and fills the gap in examining the determinant of payoff flexibility in South Africa. Firstly, the findings of this study contribute significantly to the academic literature on corporate finance, particularly in the context of cash distribution options in South African firms. The identification of both the complementary and substitute roles played by share repurchases and dividends provides valuable insights for researchers. This study encourages further research in emerging markets such as South Africa, shedding light on the nuanced nature of cash distribution decisions. Academics can explore similar patterns in other emerging economies, deepening our understanding of corporate finance dynamics. Moreover, the positive relationship between lagged earnings per share (L_EPS) and payout flexibility aligns with signaling theory. Researchers can delve deeper into how profitable firms strategically use share repurchases as a signaling mechanism. This opens avenues for studies exploring the signaling effects of share repurchases in different contexts. The negative relationship between economic value added (EVA) and payout flexibility offers insights into agency conflicts. Future research can investigate how managerial incentives and shareholder interests influence payout decisions when firms generate a substantial EVA.
Secondly, these findings have practical implications for firms, especially in South Africa, where cash distribution decisions play a crucial role in financial management. For strategic payout choices, South African firms should recognise that share repurchases serve both as a complementary and substitute options for cash dividends. Financial managers should strategically assess their earnings, size, and economic value added when deciding on payout options. For managerial attitudes, larger firms should be aware that their payout choices signal different attitudes compared to smaller firms. Management in larger companies might need to communicate their financial strategies effectively to shareholders to avoid misconceptions related to payout preferences. Furthermore, firms with substantial economic value added should carefully weigh the benefits of internal investments versus external payouts. This balance can help align managerial incentives with shareholder interests.
Lastly, policymakers in South Africa can consider these findings when formulating regulations related to corporate finance and cash distribution. Regulators should recognise the dual role of share repurchases in South African firms. Regulatory frameworks can provide flexibility for firms to make payout choices that align with their unique circumstances. Furthermore, this encourages transparency in communication between firms and shareholders, which can help clarify the reasons behind payout decisions. This transparency can foster investor confidence and reduce information asymmetry. In sum, the study recommends that financial managers should recognise share repurchases more as a distribution choice, which diffuses the tension regarding share repurchases replacing the payment of cash dividends and some doubt that they may not possess complimentary attributes to the same, thus enhancing the decision alternatives for financial managers in their endeavours to create and maximise value for shareholders, particularly in an emerging market setting.

This entry is adapted from the peer-reviewed paper 10.3390/risks11100181

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