Tutorial 5:Discuss the impact of CEO incentives on share buyback decisions.

Question 1

Why are managers incentivised to do share repurchases?

Answer 1

MANAGERIAL COMPENSATION TIED TO EARNINGS PER SHARE (EPS) –> share repurchases increases EPS –> if CEO’s bonus tied to higher EPS they will be incentivised to increase share repurchases –> increases likelihood of bonus payouts & increases size of bonuses awarded.

Question 2

What is the impact of managerial incentives to conduct share buybacks?

Answer 2

1) Firm more likely to conduct share buybacks when CEO bonus directly tied to EPS –> hence share repurchase magnitude also tends to be larger.

2) Probability of firms conducting
share repurchases increases when EPS is right below threshold EPS required to triggers bonus award –> FINDING: EPS just below threshold in absence of repurchase makes repurchase more likely.

3) Bonus-driven repurchasing firms do not exhibit +ve long-run abnormal returns –> could be attributed to potential conflicts of interest between managers & shareholders where managers may prioritise short-term EPS targets to max. their bonuses, whilst not prioritising generating long-term value for shareholders e.g. firm’s expansion & investment initiatives –> FINDING: on average, firms engaging in share repurchases have +ve abnormal returns, but those w EPS-based bonuses don’t –> focus on EPS-driven incentives may lead to decline in firm value compared to firms solely focused on share repurchases to increase growth & investment.

–> MANAGER-SHAREHOLDER CONFLICT OF INTEREST: STRATEGIC USE OF SHARE REPURCHASES BY FIRMS’ MANAGERS TO BOOST EPS & GAIN HIGHER BONUSES RATHER THAN GENERATE LONG-TERM SHAREHOLDER VALUE.