Free Cash Flows and the Wealth Effects of Stock Repurchase Announcements

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The free cash flow hypothesis predicts that repurchasing firms with free cash flows will have larger announcement-period abnormal returns than repurchasers that do not have free cash flows. We test the free cash flow hypothesis by examining the announcement-period abnormal returns of repurchasing firms sorted by their available investment opportunities, as measured by the Tobin's q ratio and cash flows. Firms with low q (less than one) and high cash flows are identified as firms with free cash flows. We find that firms with free cash flows earn significantly higher abnormal returns than all other firms. Cross-sectional regression analyses provide robust empirical support for the free cash flow hypothesis even after controlling for other variables that can affect the announcement-period abnormal returns.
stock repurchase program, free cash flow theory, G30, G20, G35, wealth effect