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CHRISTINE BROWN, JOHN HANDLEY, AND JAMES O’DAY

The Dividend Substitution Hypothesis:Australian Evidence

In a perfect capital market firms are indifferent to either dividends orrepurchases as payout mechanisms, suggesting that the two payoutmethods should be perfect substitutes. Empirical research at the singlecountry level, as well as cross country studies, provide evidence that divi-dends and repurchases act as substitutes (the dividend substitution hypoth-esis), and that the tax treatment of dividends versus capital gains affectsthis relation. Australia, which operates under a full dividend imputationsystem, has two types of repurchases: on- and off-market. On-marketrepurchases are taxed as capital gains while off-market repurchases com-prise a large dividend component carrying valuable tax credits. Australiathus provides a natural setting to investigate how the tax treatment of proceeds affects the dividend substitution hypothesis. Dividend substitu-tion is found to exist for on-market repurchases but not for off-marketrepurchases, thus providing further support for the idea that the tax treat-ment of proceeds affects the substitutability of repurchases and dividends.

Key words: Buyback; Dividend imputation; Equal access; Franking;Off-market; On-market; Payout; Repurchase.

Share repurchases were not an important form of corporate payout when Lintner’s(1956) seminal research on dividend policy was conducted. However, in the US,which has the longest history of share repurchases, share repurchases grew tobecome the most important method of cash distribution to shareholders. Grullonand Michaely (2002) show that share repurchases in the US grew at an average rateof 26.1% over the period 1980–2000 and surpass ordinary dividends in the dollarvalue of cash distributed to shareholders in the years 1999 and 2000.

The theory of payout policy was established by Miller and Modigliani (1961).They

show that when capital markets are perfect and frictionless, dividends and sharerepurchases are perfect substitutes and that the size of the payout has no effect on

Christine Brown ([email protected]) is at the Department of Banking and Finance,MonashBusiness School, Monash University, Victoria. John Handley ([email protected]) is at theDepartment of Finance, University of Melbourne, Victoria. James O’Day was an honours student at TheUniversity of Melbourne when the first version of this paper was written. We thank Anne Ritter for herexcellent research assistance.We are grateful to Kevin Davis, Bill Griffiths, Krishnan Maheswaran, GarryTwite, Peter Swan, Glenn Boyle, and seminar participants at The University of Melbourne, The QueensUniversity Belfast, The University of New South Wales and Victoria University Wellington for helpfulcomments on earlier versions of the paper. This research was supported under the Australian ResearchCouncil’s Discovery Project funding scheme (project number DP0878537).

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ABACUS, Vol. 51, No. 1, 2015 doi: 10.1111/abac.12041

37© 2015 Accounting Foundation, The University of Sydney

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firm value. Whether introduction of market frictions in the form of agency costs,information asymmetries, and taxation affect the Miller and Modigliani propositionshas been the focus of numerous theoretical and empirical studies. Imperfections

could imply that the size of the distribution matters, the form of distribution matters,or that they both matter.Recent studies on payout policy integrate dividend and share repurchases as

alternative forms of cash disbursement, and attempt to answer whether these twomechanisms are complements or substitutes.Whether repurchases act as a substitutefor dividends is termed the ‘dividend substitution hypothesis’. Brav et al . (2005)conduct surveys and interviews with CFOs and conclude that dividends and sharerepurchases are not viewed as pure substitutes; managers value the flexibility inher-ent in share repurchases in contrast to the relative rigidity of dividends. The reti-cence to increase dividends found by Lintner (1956) is also reflected in the finding of

Brav et al . that managers would not use a hypothetical reduction in repurchases toincrease dividends. Empirically, a negative relation between changes in dividendsand changes in repurchases would suggest that dividends and repurchases are sub-stitutes. Grullon and Michaely (2002) conduct such an empirical test and find thatcompanies in the US are buying back shares with funds that would otherwise havebeen used to increase dividends. Skinner (2008) reports that US firms increasinglyuse repurchases to pay out earnings, while Floyd et al . (2012) confirm this findingusing more recent US data. These findings tend to support the view expressed inBrav et al . that once free of historical constraints on dividend payouts, managerswould substitute from dividends towards repurchases. Nevertheless the dividendpayout for large, mature industrial firms in the US continues to increase (Floyd et al .,2012).

Differential taxation treatment of capital gains and dividends is a significantdeterminant of the market reaction to share repurchase announcements (Grullonand Michaely, 2002). But these authors and others (for example Dittmar, 2000) haveargued that taxes alone do not explain the extent of repurchase activity in the US.Brav et al . (2005) find that in the US managers view tax considerations as of secondorder importance in the choice of disbursement mechanism. Nevertheless, evidenceprovided by Chetty and Saez (2005) and Julio and Ikenberry (2004) suggests thatdividend increases and initiations are on the rise in the US since the tax changesintroduced in the Jobs & Growth Tax Relief Reconciliation Act of 2003, whichlowered the tax rate on dividend income.1 Chetty and Saez conclude that when keyshareholders are affected by changes in taxation policy the corporate response to thechanges is greater. De Angelo et al . (2004) show that large, mature and profitablefirms dominate the group of US firms paying dividends. Hoberg and Prabhala (2009)find that risk explains over 40% of the decline in dividends and that, once risk iscontrolled for, the ‘disappearing dividend’ puzzle (Fama and French, 2001) is notexplained by Baker and Wurgler’s (2004a, b) suggestion that firms cater to transientfads for dividends.

1 The 2003 tax reform results in dividends being taxed at a rate of 15% instead of facing the regularincome tax schedule with a top rate of 35%.

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US evidence is mixed as to the extent to which differential taxation treatment of repurchases and dividends affects the payout decision. Jacob and Jacob (2013) arguethat single country studies provide mixed evidence, whereas cross-country studies

are likely to have sufficient variation in the tax rates across time and countries toderive robust conclusions. In their cross-country study they find that firms’ propen-sity to pay dividends or repurchase shares (and the amounts) are closely associatedwith the tax penalty on dividends relative to capital gains.

In Australia, Partington (1989) finds that managers consider the tax position of shareholders the least important of all variables examined that affect dividendpolicy. In more recent Australian evidence, Coleman et al . (2010) show that manag-ers do consider the ability to distribute imputation tax credits important whensetting payout policy. We therefore use the Australian tax environment, where divi-dends are not as tax-disadvantaged relative to capital gains, to further investigate the

extent to which dividends and repurchases act as substitutes. For certain sharehold-ers in Australia dividends are tax advantaged because they carry imputation taxcredits, which can be used to offset personal income tax liabilities. Consistent withthis, Pattenden and Twite (2008) find that dividend payouts in Australia increasedwith the introduction of the imputation tax system.2 Therefore, our primary objec-tive in this paper is to use the unique opportunity provided by the tax environmentin Australia to investigate the relation between repurchase activity and dividendpayout in a non-classical tax environment.

There are a number of inter-related factors that potentially affect firms in theirdecision to repurchase.We control for these firm characteristics in investigating therelation between repurchase yield (defined as dollar volume repurchased divided bymarket value of the firm in the previous period) and changes to dividend payout.Theaim of our paper is to test the hypothesis that firms are substituting repurchases fordividends in Australia.If increases in dividends are associated with lower repurchaseyield we take this as evidence in support of the substitutability of repurchases anddividends. If, on the other hand, firms that increase dividends do not decreaserepurchase yield we take this as evidence against the substitution hypothesis and infavour of treating the two forms of disbursement as complements.

Share repurchases have become an important capital management mechanism forsome Australian companies. Our study provides a comprehensive investigationbecause it covers virtually all firms that have undertaken repurchases over theperiod 1997 to 2009. When on-market repurchases and off-market repurchases areinvestigated separately, there is evidence for substitution only in the on-marketrepurchase sample.The proceeds from on-market repurchases in Australia are taxedas capital gains. So they are taxed as if in a classical tax system and the substitutioneffect is evident for these repurchases.

On the other hand off-market repurchases generally contain a substantial divi-dend component with associated tax credits. For these repurchases there is no

2 Currently Australia, Chile, Mexico, and New Zealand have a full imputation system where a tax creditis given to shareholders for the full corporate tax. Canada, the United Kingdom and South Korea havepartial imputation systems.

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evidence of substitution. In fact, increases in repurchase yield are significantly andpositively related to increases in dividends, consistent with the observation thatlarge, dividend paying companies tend to undertake off-market repurchases. Com-

panies buying back shares off-market are not using funds that would have otherwisebeen distributed as dividends. Using the demarcation between the tax treatment of the proceeds of on- and off-market repurchases facilitates a natural experiment, theresults of which show that taxes are an important determinant of a firm’s choice of payout method.

Furthermore, when the whole sample of repurchases is combined to investigatedividend substitution, the results show a negative relation between repurchase yieldand dividend changes, a finding that supports the notion that in Australia repur-chases and dividends in the aggregate act as substitutes.The paper makes an impor-tant contribution to the literature by providing direct empirical evidence that the

taxation treatment of the proceeds of a repurchase affects the substitutability of dividends and repurchases.

SHARE REPURCHASES IN AUSTRALIA

The study of repurchases in Australia3 is driven by two legislative issues: companylaw enabling buybacks, and legislation determining the tax treatment of the buybackprice for participating shareholders. In 1989 legislation was introduced that allowedcompanies to repurchase shares. But it was not until December 1995, when the ruleswere considerably simplified, that repurchase activity surged. Firms can now repur-

chase their shares through two main vehicles: on-market or off-market repurchases.4

Off-market repurchases can be categorized into equal access, selective, or minimumholding.TheAppendix describes these categories and gives details of the regulationsgoverning repurchases in Australia.

Australia changed from a classical tax system to a full dividend imputation systemon 1 July 1987. Under the imputation system, resident companies generate imputa-tion or ‘franking credits’ for the company tax paid. Part 3-6 of the Income Tax

Assessment Act 1997 (ITAA97) deals with the tax law pertaining to the dividendimputation system in Australia. The major influences on the franking accountbalance (FAB) are as follows.According to s. 205-15 ITAA97 Franking Credits, if the

company pays income tax and satisfies the residency requirement, it credits(increases) the franking account by the amount of tax paid. If the company receives

3 Early papers include Harris and Ramsay (1995) and Balachandran and Faff (2004) investigatingannouncement day effects; Lamba and Ramsay (2005) look at the impact of deregulation on repur-chases; Mitchell and Robinson (1999) provide a study of the regulatory environment and the motiva-tions for repurchases prior to the first Corporate Law Simplification Bill of December 1995, whichsimplified the process for firm undertaking buybacks. More recent papers are described in the text.

4 The terms ‘repurchase’ and ‘buyback’ are used inter-changeably throughout the paper. In the USon-market repurchases are generally referred to as open-market and off-market repurchases arereferred to as self-tender offers. In Australia, as in the US, in an off-market repurchase the buybackprice can be fixed or determined through a Dutch auction.

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a franked distribution and satisfies the residency requirement, it credits the frankingaccount by the amount of the franking credit attached to the distribution.Accordingto s. 205-30 ITAA97 Franking Debits, if the company pays a franked distribution, it

debits (reduces) the franking account by the amount of the franking credit attachedto the distribution. This includes franking credits attached to the dividend compo-nent of an off-market buyback. Under certain conditions an on-market repurchasewill also result in a reduction in the FAB.5

Resident shareholders declare the dividend (grossed up to equal the pre-company-tax profit from which the dividend was paid) as income, and then the taxcredit is used to offset personal income tax obligations.6 If D is the cash dividendpaid, the resulting taxable personal income is D/(1 − t c) where t c is the corporate taxrate. The tax levied on the investor is thus tD/(1 − t c), where t is the investor’smarginal tax rate, but the investor also receives a tax credit of t cD/(1 − t c) such that

the tax payable (or rebateable) is (t − t c)D/(1 − t c). Overseas investors cannot use thefranking credits.Australia’s capital gains tax (CGT) provisions operate to tax capital gains on the

sale of assets acquired after 20 September 1985 as assessable income in the year of disposal of the asset. Prior to September 1999 the capital gains tax liability wascalculated using the indexation method, whereby the inflation adjusted capital gainis included in ordinary income. Under the discount method for assets acquired afterSeptember 1999 (and which taxpayers can elect to use for assets acquired prior tothat date), 50% of the nominal capital gain accrued on assets held for longer thanone year is included as income. Capital losses are offset against capital gains in theyear of calculation or carried forward.

The major difference between on- and off-market repurchases for Australianshareholders is the tax treatment of the proceeds for the shareholder.As far as thetax liability of the company is concerned,a repurchase is tax neutral. Under the rulesgoverning off-market repurchases in Australia companies can split the repurchaseprice into capital and dividend components. This split must be confirmed by aruling from the Commissioner of Taxation subsequent to which companies with

5 ITAA s. 160AQCC, s. 160AQE(5). On-market share repurchases can result in a deduction to thefranking account of an equivalent amount of franking credits, in other words for tax purposes treatingthe company ‘as if’ it had conducted an off-market repurchase rather than an on-market repurchase.

This occurs if the on-market buyback is conducted using funds sourced from profits. Thus it is likelythat only those companies that have low FABs (those that have not generated excess franking creditsor those that have recently conducted an off-market buyback) will undertake on-market buybacks.Brown and Norman (2010) show that companies conducting on-market buybacks have significantlylower FABs than those conducting off-market buybacks. See http://www.ato.gov.au/Media-centre/Speeches/Current-taxation-issues-arising-out-of-capital-management-strategies/ where the ATOstates that companies could ‘[by undertaking off-market and on-market buy-backs in tandem, targetdifferent shareholder profiles. For instance, an off-market buy-back with a substantial dividend com-ponent would be attractive to resident shareholders and a subsequent on-market buy-back out of capital could be used to make distributions to non-resident shareholders.’

6 Australian resident individuals, complying superannuation (pension) funds, registered organizationsand life assurance companies may use distributed franking credits to offset their tax liabilities. If all thefranking credits are distributed, and all recipients are able to fully utilize them, then the imputationsystem effectively eliminates the double taxation of dividends (Officer, 1994).



http://www.ato.gov.au/Media-centre/Speeches/Current-taxation-issues-arising-out-of-capital-management-strategies/http://www.ato.gov.au/Media-centre/Speeches/Current-taxation-issues-arising-out-of-capital-management-strategies/http://www.ato.gov.au/Media-centre/Speeches/Current-taxation-issues-arising-out-of-capital-management-strategies/http://www.ato.gov.au/Media-centre/Speeches/Current-taxation-issues-arising-out-of-capital-management-strategies/


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accumulated tax credits can fully frank the dividend component of the repurchase.The capital amount is calculated as the deemed tax value7 of the offer price minusthe dividend.The participating shareholder benefits from the imputation credits and

may also benefit if the cost base for calculation of CGT implies that the sale resultsin a capital loss.8 This structure has resulted in many off-market repurchases occur-ring at a discount to the market price. Brown and Efthim (2005) find that the size of the discount of the offer price to the current share price is significantly related to theproportion of the repurchase price offered as a franked dividend. Brown and Davis(2012) estimate that equilibrium, market clearing discounts in tenders averagedaround 20% for the buybacks in their sample, but actual discounts were constrainedby the Australian Tax Office to 14%.9 The dividend/capital gains breakdown of theoffer price means that the sum of the tax gains from any capital losses on the sale andthe imputation tax credits attaching to the dividend component may be of greater

value to certain shareholders than the loss involved in selling shares at a price belowthe market price.From the shareholder’s perspective, on-market repurchases are treated in the

same way as any sale of shares, and the proceeds are subject to CGT. Underpinningour empirical approach is the stark comparison of the tax treatment applying to on-and off-market repurchases. Several changes to the tax treatment of income, capitalgains, and imputation credits over the sample period10 have not affected the funda-mental outcome that off-market repurchases carry large tax benefits for some resi-dent shareholders, while the proceeds of on-market repurchases are taxed as capitalgains.

Institutional investors such as Australian superannuation funds, on a marginal taxrate of 15% compared to the company tax rate of 30%, benefit from selling sharesinto off-market repurchases (Brown and Efthim, 2005). Low tax paying institutions

7 The deemed tax value of shares under TD2004/22 (Tax Determination) is calculated as volumeweighted average price on the ASX over the last five trading days before the first announcement of thebuyback, adjusted for the movement in the S&P/ASX200 Index from the opening of trading on theannouncement date to the close of trading on the day the buy back.

8 The following example provides an illustration of the breakdown between dividend and capitalcomponents. On 11 April 2003 Woolworths completed an off-market buyback at a price of $11.40, of

which $8.52 was designated a fully franked dividend and $2.88 the capital amount. Participatingshareholders use $2.88 as the sale price for calculation of CGT. The share price on announcement of the repurchase was $11.04; many participating shareholders could have claimed a capital loss on thesale.

9 In late 2007,theATO released a Practice Statement (PSLA 2007/9) stating that the maximum discountallowed in an off-market repurchase is 14% calculated by reference to the volume weighted averageprice on the five days leading up to and including the closing date of the repurchase. In practice theATO had been applying this maximum discount in private rulings for some years prior to its officialannouncement.

10 In terms of changes to the value of the imputation credits that investors receive, the corporate tax ratehas been 30% since July 2001, was 34% in the preceding fiscal year and was 36% for the prior fiveyears. Additionally, since July 2000 Australian resident investors have been able to receive a refundfrom the tax office if taxable income is insufficient to use all franking credits received.

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form a very important part of the shareholder base for most companies. For examplein the UK, Rau and Vermaelen (2002) argue that firms are influenced by largeinstitutional investors such as pension funds when setting their payout policy.

Coleman et al . (2010) use management surveys and interviews to show that Austra-lian CFOs are impacted in their financial decisions by pressure from expectations of different stakeholder groups. AuYong et al . (2014) highlight the importance of taxmotivations in explaining abnormal trading volumes around key dates for off-market repurchases.

PAYOUT POLICY

Are dividends and share repurchases inter-changeable payout methods? The theo-retical answer to this question begins with the seminal work of Miller and Modigliani

(1961), who first argued that the value of a firm is entirely determined by itsinvestment policy and is consequently unaffected by the mix of retained earningsand payout. This result relies on perfect capital markets, in which dividends andshare repurchases are equivalent.The introduction of market frictions in the form of taxes, information asymmetries and agency costs may affect the equivalence of dividends and repurchases in a number of ways. The following subsections reviewthe theoretical and empirical research on the motivation for repurchases and therelation between repurchases and dividends.

Taxation

The US operates under a classical company tax system where dividends are paid outof after company tax income. This results in dividends being taxed twice. Until theintroduction of the Jobs & Growth Tax Relief Reconciliation Act of 2003 dividendincome was taxed at the marginal tax rate of the receiving shareholder.

Repurchases (both open-market and self-tender offers) in the US are taxed on acapital gains basis. Since the tax rate on capital gains is generally lower than that ondividend income, most investors would prefer the company to disburse cash viashare repurchases rather than dividends (Black, 1976; Barclay and Smith, 1988). So,in an otherwise perfect capital market, the effect of taxation in the US is to inducea preference for payout in the form of repurchases. Grullon and Michaely (2002) find

that differential taxation is also important in market reactions to share repurchaseswith the reaction to repurchases being more positive when tax gains on repurchasesrelative to dividends are larger. They suggest, as do Jagannathan et al . (2000), thatdifferential taxation is, however, not sufficient to fully explain the observed increasein share repurchase activity, since the upsurge in repurchases coincided with legis-lation that made repurchases less tax effective.11 In support of this argument,Dittmar (2000) finds that repurchasing firms do not have lower dividend payoutratios and argues that it is not the tax benefits of repurchases that cause firms torepurchase stock.

11 The 1986 Tax Reform Act eliminated the preferential tax treatment for realized capital gains.




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Australia operates a full dividend imputation system as discussed in the previoussection. Companies accumulate tax credits in the franking account and must decidewhen and how these ‘franking credits’ are to be distributed to shareholders. Prior to

legislation enabling share repurchases, the primary method of distributing the taxcredits to shareholders was through the payment of fully franked ordinary dividends.Brown and Howard (1992) argue that the Australian imputation tax system is biasedtowards high dividend payouts. Monkhouse (1993), in deriving the CAPM under animputation system, finds that the optimal dividend policy is for a firm to distribute allits imputation credits because they lose value as time passes.12 Many resident share-holders would prefer to receive returns in the form of fully franked dividends as thetax rate on this form of distribution is lower than that on capital gains. 13 Thusdividends in Australia are not tax disadvantaged to the same extent as they were inthe US prior to 2003.

On-market repurchases in Australia are taxed as capital gains. So assuming thattax treatment of proceeds affects the substitutability of dividends and repurchases(Jacob and Jacob, 2013), we expect to find the substitution hypothesis supported foron-market buybacks in Australia.

Australian firms that have accumulated imputation tax credits in excess of needsunder ordinary dividend policy will be influenced in their choice of buyback bytax-related factors such as the size of the franking account,how the payment is taxedwhen received by shareholders and whether the cash distributed via a repurchasehas franking credits attached (Brown and Norman, 2010). Off-market repurchasesoffer a mechanism for firms to distribute these ‘excess’ franking credits. In support of this, 54% of respondents in the survey conducted by Coleman et al . (2010) indicatedthat the level of franking credits available to be paid out to shareholders wasconsidered important in the decision to undertake a buyback.

Firms may be reluctant to use off-market repurchases as a substitute for ordinarydividends, because this action will disadvantage a group of shareholders who do notfind it advantageous to participate in the buyback (Brown and Efthim, 2005; Brownand Davis, 2012). But suppose that firms follow an optimal dividend policy anddistribute franking credits through ordinary dividends to the maximum extent pos-sible, given the current dividend policy. This suggests that while Australian firms areunlikely to substitute from ordinary dividends towards off-market repurchases they

12 The IncomeTax Assessment Act (ITAA s.160AQE) governs the extent to which companies can franka dividend distribution. Entities may frank dividends subject to a benchmark rule,which provides thatall dividends paid within a franking period must be franked to the same extent. Breaches may resultin penalties.

13 Compare $1 received as a fully franked dividend versus $1 paid as a capital gain using the ‘discountmethod’ to calculate CGT. Assume personal tax rate p and company tax rate t .After-tax income froma dividend payment is [1/(1 − t )] * (1 − p) while after-tax income from a $1 capital gain is 1 − 0.5 p.Shareholders prefer dividends provided p


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may use off-market repurchases as a mechanism to distribute franking credits excessto the requirements of ordinary dividend policy. We therefore do not expect thesubstitution hypothesis to hold for off-market buybacks.

Other Motivations for Share Repurchases

Grullon and Michaely (2004) argue that the two predominant theories explainingfirms’ motivations for undertaking repurchases are the information/signallinghypothesis and the free cash flow hypothesis.The information/signalling hypothesishas its root in the information asymmetries that exist between managers and outsid-ers. It is based on the idea that managers use share repurchases to signal betterprospects for the company. Dann (1981), Vermaelen (1981)and Comment and Jarrell(1991) find that the market reacts positively to the announcement of a repurchase, aresult which is consistent with the information/signalling hypothesis. However,

Stephens and Weisbach (1998), Nohel and Tarhan (1998), Ikenberry et al . (2000) andGrullon and Michaely (2004) provide more recent empirical evidence that does notsupport the signalling hypothesis. Mitchell and Dharmawan (2007) find strongsupport for signalling incentives in their empirical study of Australian buybacks.

The free cash flow hypothesis is based on the work of Easterbrook (1984) andJensen (1986). Repurchases and dividends are mechanisms to distribute excess cashto shareholders and lower the agency costs of free cash flow. Based on this hypoth-esis one would expect firms with large excess free cash flow to repurchase moreshares. Stephens and Weisbach (1998), Dittmar (2000),Grullon and Michaely (2004)find support for the free cash flow hypothesis.

There are a number of other explanations for firms’ repurchasing behaviour.Firms with high leverage are less likely to repurchase (Bagwell and Shoven, 1988;Lie, 2002). In addition, cross-sectional analysis shows that dividends are used to payout cash flow that is likely to be permanent whereas share repurchases are used formore volatile cash flows (Jagannathan et al ., 2000; Guay and Harford, 2000).

Grullon and Michaely (2002) directly explore the substitutability of dividends andshare repurchases by examining the correlation of share repurchases with deviationsfrom expected payout policy. Using the Lintner (1956) model of expected dividendsand controlling for firm characteristics they find strong evidence that for the periodfrom 1972 to 2000 US firms completed repurchases using funds that would otherwisehave been used to increase dividends. Importantly, market participants are aware of this substitution, as evidenced by the insignificant impact of the announcement of dividend decreases on the share price of repurchasing firms.

Summary

The tax environment is a key component in the relation between dividends andshare repurchases (Lie and Lie, 1999; Jacob and Jacob, 2013). In a classical taxenvironment such as the US where the proceeds of both on- and off-marketbuybacks are taxed as capital gains there are clear incentives for companies todistribute cash via repurchases. If tax treatment of the proceeds matter, one mightexpect on- and off-market repurchases in Australia to have different effects on

the relation between dividends and repurchases. While dividends are, for many




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shareholders, preferred over capital gains, it remains an empirical issue as to whetherdividend substitution will be present for the whole sample of buybacks. Neverthe-less, we have argued that it is unlikely that dividend substitution will be found for

off-market repurchases.While our central concern is to study the substitutability of repurchases anddividends in Australia we control for other variables affecting the firm’s repurchasedecision.

DATA AND DESCRIPTIVE STATISTICS

We collect data for firms that undertook repurchases over the years 1997 to 2009;prior to 1997 there were few repurchases (Lamba and Ramsay, 2005). A databaseconsisting of all on- and off-market share repurchases completed between 1997 and

2009 (inclusive)14 is constructed using data sourced from SIRCA (Securities Indus-try Research Centre of Asia-Pacific), backed up by the Securities Data Company(SDC). We believe that we have managed to identify all repurchases undertakenover this period. The total number of repurchases collected is 899. Companiespurchasing shares on-market make daily statements to the Australian SecuritiesExchange detailing the previous day’s repurchase activity, including the number of shares repurchased and the average price paid. This rigorous disclosure regime hasalso been described by Mitchell and Dharmawan (2007) and Holub and Mitchell(2012). The on-market repurchase data are aggregated and cross-checked withcompany final buyback announcements in order to calculate accurately on-market

repurchase activity over each financial year. The off-market sample is constructedfrom the SDC database and supplemented with searches of DatAnalysis.15

Initially we filter out only those transactions where the repurchase yield cannot becalculated.This results in deletion of 12 observations and a dataset consisting of 887firm-year observations. We provide descriptive statistics on this dataset, as it pro-vides a comprehensive description of buyback activity in theAustralian market sincethe relaxing of the rules governing buybacks.

The relevant historical financials16 between 1 January 1996 and 31 December 2009are obtained from FinAnalysis17 supplemented with information from the AGSM

14 The starting date for the sample period was chosen to avoid any confounding effects of the introduc-tion of the First Corporate Law Simplification Bill in December 1995. The introduction of this Billreduced the previously stringent regulations governing share buybacks and consequently lowered thehigh transactions costs associated with initiating a share buyback. Prior to the introduction of the billonly 32 repurchases were undertaken over the period 1989–1995 (Lamba and Ramsay, 2005).

15 DatAnalysis is provided by Aspect Huntley and contains financial data for all companies listed on theASX from 1997 onwards. The search is conducted on the keywords ‘off-market’ or ‘equal-access’,‘selective’ and ‘buyback’.

16 Financial items and buyback activity are collected on a firm-specific, financial-year-end basis.

17 FinAnalysis is provided by Aspect Huntley and contains financial data for all companies listed on theASX from 1997 to present.

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database.18 Financial data at the end of the financial year preceding the year of therepurchase are collected: market capitalization (MV ), book value of shareholders’equity (BV ), net profit after tax (NPAT ) pre abnormal items, book value of totalassets (TA), cash on the balance sheet (Cash), dividends (Div), and a measure of leverage (Lev). While the FAB has been disclosed in the annual reports since 1999,

it is not available electronically.19

Given the large number of observations in thesample the FAB has not been collected for this project. Definitions of the financialmetrics are given in Table 1.

Our full sample of repurchases (denoted as Rep = 1) consists of firms that haveundertaken either an on- or off-market buyback over the period 1997 to 2009.

18 The Australian Graduate School of Management (AGSM) Centre for Research in Finance SharePrice and Price Relative Database is now managed by SIRCA.

19 AASB 1034 was introduced in October 1999,with section 5.3(f) mandating the disclosure of frankingaccount balances.The adoption ofAASB 101, to replace AASB 1034 in July 2004 as part ofAustralia’sadoption of International Financial Reporting Standards, maintained this requirement in Aus 126.5.However, the information is disclosed in the notes to the accounts and so must be hand collected.

Table 1

This table provides a description of financial items. Firm statistics collected from FinAnalysis,supplemented by the AGSM database for firms delisted between 1995 and 1997.

Item Description

MV Market Value of Equity:Market capitalization of the firm.

BV Book Value of Shareholders’ Equity

TA Total Assets:Book value of total assets of the firm.

MBt Market to Book ratio:

MV TA BV

TA

t t t

t

+ −( )

The ratio of market value of firm to book value.

Casht Balance sheet cash:

Cash

TA

t

t

+( )short term investmentst

The ratio of cash plus short term investments to total assets.

NPAT NPAT is reported Net Profit after Tax (pre Abnormal items).

Levt Balance sheet debt:

short term debt long term debtt t+( )

TAt

The leverage of the firm defined as the ratio of short term plus long term debt to total assets.

All figures are measured at the firm’s balance date (commonly 30 June).




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Sample firms are initially categorized on the basis of whether they paid at least oneordinary dividend (denoted as Div = 1). Table 2 Panel A reports the descriptivestatistics for repurchasing firms that did not pay dividends over the sample period

(denoted as Div = 0, Rep = 1), for firms that did pay dividends (denoted as Div = 1,Rep = 1) and for the complete sample (denoted as Div = 0, 1, Rep = 1).Table 2 gives a comprehensive representation of the dividend and repurchase

behaviour of the sample of firms that have conducted repurchases over the dataperiod. It is of interest to note that, for our sample, the combined dollar payout viarepurchases is similar to that disbursed through dividends.20 Repurchases haveclearly become an important mechanism for some Australian companies to returncash to shareholders. However, repurchases have not overtaken dividends as thedominant payout method as Grullon and Michaely (2002) find for US firms.Although we have captured all repurchases, our sample of repurchasing companies

is a small subset of the complete universe of companies listed on the AustralianSecurities Exchange (ASX), and dollars paid out through repurchases constitute asmall proportion of the overall payout of Australian firms.

As highlighted by the work of Guay and Harford (2000), Jagannathan et al . (2000)and Stephens and Weisbach (1998), the financial characteristics and performance of a firm may influence its payout policy choices, particularly in the choice betweenincreasing dividends and undertaking a share repurchase. From Table 2 Panel A, weobserve that the dividend-paying firms in our sample are on average larger, moreprofitable and hold less cash than non-dividend paying firms. They have higher MBratios, which in combination with their larger size, suggests that they are less likelyto be undervalued (Dittmar, 2000; Ikenberry et al ., 1995;Vermaelen, 1981, 1984).Forthe overall sample the mean market value of equity is $2.6b while the mean totalassets are $7.7b with mean leverage at 19.1%.This compares to an average reportedleverage of 21.7% for all listed companies on the ASX at end 2008. Comparingmeans and medians in Panel A, it is clear that the data are skewed.There are a largenumber of small companies in the sample.21

Off-market repurchases, although fewer in number, are important in the choice of payout mechanism. As shown in Table 2 Panel B, the full sample of 83 off-marketrepurchases disbursed $25,879.1m to shareholders while the 823 on-market repur-chases disbursed $43,865.4m.22 It is also clear that firms undertaking off-marketrepurchases are larger on average than those undertaking on-market repurchases.

We investigate companies that make repeat repurchases, defined as companiesundertaking three or more repurchases over the sample period (485 observations

20 Because we do not have all listed firms in our sample this does not imply that repurchases havereplaced dividends in the Australian market as the dominant payout method.

21 Note that in later analysis repurchases buying back more than 10% are removed from the sample, andthe analysis is performed on financial and non-financial companies. This approach removes theextreme outliers and is a robustness check of the results.

22 A number of companies undertook both on- and off-market repurchases, so the sum of off-marketand on-market repurchases is greater than the total number of repurchases.

A BA C U S



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Table 2

This table provides a summary of financials for all firms completing buybacks between years 1997–2009.Financial statistics for the same financial year that the buyback occurred are obtained from the

FinAnalysis database, supplemented by the AGSM database. Share repurchases calculated fromcompany announcements to the ASX, sourced from SIRCA and backed up by IRESS’s Signal Gdatabase. Div represents the dollar value of ordinary dividends paid during the firms’ respective financialyears. Rep is the dollar value of both on- and off-market repurchases made during the firms’ financial year.Σ Div represents the total dollar value of dividends paid by all repurchasing firms in the sample and Σ Repis the total dollar value of repurchases paid by all firms over the period. Other variables are defined inTable 1.Panel A: There are 368 companies (with necessary financial data) in the sample completing 887repurchases over the sample period (Div = 0, 1, Rep = 1). Of those, there are 256 companies completingrepurchases, that also paid dividends over the period (Div = 1, Rep = 1). There are 167 companiescompleting 269 repurchases that did not pay dividends (Div = 0, Rep = 1).Panel B: The same statistics are presented for the on- and off-market samples separately.

Panel A

Div = 0, Rep = 1 Div = 1, Rep = 1 Div = 0, 1, Rep = 1

No. of companies 167 256 368No of observations 269 618 887Σ(Div)($m) 0 69601.2 69601.2Σ(Rep)($m) 4726.5 65036.3 69744.5

Mean Median Mean Median Mean Median

MV($m) 309.3 28.2 3521.1 213.5 2559.7 117.3TA($m) 318.3 37.9 10875.1 249.5 7673.5 136.7

MB 1.34 1.01 1.57 1.13 1.50 1.11Cash (%) 29.5 19.2 16.0 7.7 20.1 10.4Lev (%) 14.8 5.4 20.9 15.8 19.1 12.9NPAT($m) 13.9 0.7 241.3 15.7 172.3 8.1Divs($m) 0 0 112.6 9.9 78.5 3.6Reps($m) 17.5 0.8 105.2 2.9 78.6 1.7

Panel B

Off-market On-market

No. of companies 61 333No of observations 83 820Σ

(Div)($m) 20603.0 51986.1Σ(Rep)($m) 25879.1 43865.4

Mean Median Mean Median

MV($m) 10415.2 914.6 1830.9 109.7TA($m) 21949.6 628.7 6402.0 121.3MB 1.37 1.09 1.51 1.11Cash(%) 17.5 6.4 20.1 10.6Lev (%) 23.0 16.1 18.7 12.2NPAT($m) 695.1 58.2 122.0 7.5Divs($m) 248.2 20.5 63.4 3.2Reps($m) 311.8 113.1 53.5 1.42




14/26

and 118 companies). Untabulated results show that these companies have loweraverage values of Cash (16.5% versus 20.4%), higher NPAT ($272.8m versus$172.3m), higher MV ($3.9b versus $2.6b) and higher Div ($120m versus $78.5m).

These comparisons are significant at the 1% level. Companies making repeat repur-chases also have significantly higher (at 5%) average repurchase amount ($80.8mversus $78.6m), and leverage (20.8% versus 19.1%).

The dataset represented in Table 2 is not suitable for an investigation of thesubstitution hypothesis for a number of reasons. Under the Corporations Act 2001(see the Appendix) an Australian company is entitled to buy back its shares withoutshareholder approval provided that the total number of shares bought back does notexceed 10% of the smallest number of shares on issue over the previous 12 months.We therefore restrict the sample to repurchase yields less than or equal to 10%.23

Companies that buy back more than 10% are often subsequently wound up or

delisted; others are very small companies such as CTEs.

24

Our sample constructiontherefore tends to remove the outliers.We first construct the on-market repurchase sample, which consists of 773

announced and completed on-market repurchases by 323 companies. This facilitatesa direct comparison of our results with those for open-market repurchases from theUS (Grullon and Michaely, 2002).25 We also restrict the sample to non-financialcompanies (722 firm-year observations and 310 companies).26 Given support for thesubstitution hypothesis in the US where the proceeds are taxed as capital gains, weexpect substitution to hold for the Australian sample of on-market buybacks.

We next construct the off-market repurchase sample, which consists of 50 firm-year observations27 conducted by 34 companies. When financial companies areremoved, the off-market non-financial firm sample consists of 41 firm-year observa-tions and 30 companies. Given the different tax treatment of off-market buybacks,and the likelihood of these buybacks being used to distribute ‘excess’ tax credits, wedo not expect substitution to hold for this sample.

A sample is also constructed that combines the shares bought back each financialyear via each method for each company. This ‘aggregate’ sample consists of 805firm-year observations and 341 companies (745 firm-year observations and 324

23 We experiment with different thresholds for repurchase yield. Our results are not changed materiallyby the application of different thresholds around 10%.

24 A Commitment Test Entity (CTE) is a small unprofitable company listed on the ASX based oncommitments to spend the funds raised under an Initial Public Offering (IPO).

25 Note that US studies have tended to use open-market repurchases to investigate substitution (e.g.,Grullon and Michaely (2002) and Skinner(2008)) largely because open-market repurchases dominateself-tender offers in both volume and value. In Australia,there are many more on-market repurchasesbut off-market repurchases are economically important, so we include both in our analysis.

26 Financial firms that are constrained in various ways by regulations may have different payoutbehaviour. We follow Dittmar (2000) and Grullon and Michaely (2002) to create a sub-sample thatomits banks and other financial companies.

27 Note that both Minimum Holding and Employee Share Scheme repurchases were excluded from thisanalysis.

A BA C U S



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companies for the non-financials), and is used to answer the question as to whetherin aggregate buybacks are being used by Australian companies as a substitute fordistributing the cash via dividends. We have no prior expectations as to whether

substitution will be found for the full sample, because it consists of a mixture of on-and off-market repurchases with the resulting mix of tax treatments. Neverthelessthis exploration provides important insights concerning company payout behaviour.

MEASURING DIVIDEND CHANGES

There are few studies on the explanatory power of models to estimate dividends inan Australian setting. Early studies include Shevlin (1982). The major difficulty inusing the standard estimation approach of the Lintner (1956) model for forecastingdividends with Australian data is obtaining a long enough time series of firms with

continuous dividend payments to estimate firm-specific variables.28 Instead we con-struct a measure of dividend changes as follows.29 We measure the dividend pershare for firm i in period t −1, di,t − 1, and use this to estimate the total dividend payoutin period t. The estimated dividend payout for firm i at time t , Ei,t is given by

E d Number of shares outstanding at time t i t i t , ,= ×−1 (1)

We then use this estimate to measure the change in dividends as

DDiv Div E

MV

i t i t i t

i t

,, ,

,

= −( )

−

1

(2)

where MV i,t −1 is the market capitalization of the firm in the previous period, Ei,t is theestimated dollar value of dividends as given in equation (1) and Divi,t represents theactual (total) dollar value of dividends paid in period t . DDivi,t therefore simplyrepresents the change in the dividend per share from period t –1 to period t .

We combine firm characteristics that have been found to affect repurchase activitywith the change in dividends as measured by equation (2) into the regression modeldescribed in equation (3).The dependent variable, repurchase yield, is defined as thedollar value of repurchases in the financial year divided by the market value of equity at the end of the previous financial year.This variable is estimated accurately

from our data, but is observed only if the firm undertakes a repurchase so theregression is estimated as a truncated regression model of the form,

28 One approach could be to use a panel regression as in da Silva et al . (2004) to estimate the coefficientsof the Lintner model. This approach was used in an earlier version of this paper and gave realisticpayout ratios. It was not used for this dataset because it gave an unrealistic overall payout ratio.

29 This is a simple model but is not unrealistic. In the survey and interviews conducted by Brav et al .(2005) 88% of managers very strongly or strongly agree that they consider the level of dividends pershare paid in recent quarters when choosing current dividend policy. 94% strongly or very stronglyagree that they try to avoid reducing dividends. Together, these two results provide strong support forour simple model.




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RYield Cash MB TAi t i t i t i t , , , ,ln= + + + ( )

+

+( )−

−( )−

−( )−

β β β β 1 2 1 3 1 4 1

β β β β 5 1 6 7−( )

−

−( )

+ + +Lev DDiv Tax ui t i t t i, , , (3)

where we have indicated the expected signs on the coefficients of the independentvariables. Our primary focus is the relation between repurchase yield and DDivi,t . Apositive coefficient (or a non-significant negative) on DDivi,t (positive β 6) will resultin the rejection of the substitution hypothesis.

Table 3 summarizes how each of the control variables in equation (3) is measured.Cash is used to proxy for free cash flow and is expected to have a positive coefficient(Jensen, 1986; Grullon and Michaely, 2004; Nohel and Tarhan,1998). If the market tobook ratio (MB) is used to represent the market’s assessment of growth opportu-nities for the firm, it is expected to have a negative coefficient (Grullon et al ., 2002;

Grullon and Michaely, 2004). The natural logarithm of total assets ln(TA) has beenused as a proxy for information asymmetry; large firms are less likely to be under-valued (Vermaelen, 1981). Therefore, if firms are using buybacks as a signal to themarket that the firm is undervalued the coefficient on this variable should benegative. Finally, firms with high debt levels are likely to repurchase less (Bagwell

Table 3

This table explains the variables used in the truncated regression model:

RYieldi,t = β 1 + β 2Cashi,t −1 + β 3MBi,t −1 + β 4ln(TA)i,t −1 + β 5Levi,t −1 + β 6DDivi,t + β 7Taxt + ui

Variable Description and expected sign

RYield The repurchase yield, defined as the dollar value of repurchases in a firm’s financial yeardivided by the market value of equity at the end of the previous financial year. This is thedependent variable in the regression and is only observed if a firm undertakes arepurchase, that is, if repurchase yield is positive.

Cash Cash is used to test the free-cash-flow hypothesis. As defined in Table 1 cash is measuredusing balance sheet data. Cash should be positively associated with repurchase yield.

MB As previously defined in Table 1, this is used to test the investment and informationsignalling hypotheses, as it represents the market’s assessment of growth opportunities forthe firm. MB should be negatively related to repurchase yield.

Ln(TA) The log of the book value of total assets of the firm, measured at the end of the previousfinancial year to that of the repurchase.This measure is commonly used to test forinformation asymmetry so that ln(TA) should be negatively related to repurchase yield

Lev As previously defined in Table 1, this is used to test the leverage hypothesis. Lev should benegatively related to the repurchase yield

DDiv DDiv is the change in dividends measured as the difference between the total dividendspaid in period t and period t −1, divided by the market value of equity at the end of period t – 1. If firms are substituting share repurchases for dividends DDiv should benegatively related to share repurchase yield.

Tax Tax is a time dummy used to investigate whether changes to the tax rates had an effect onrepurchase yields.

Tax1 = 0 for years before 1999 and 1 from 1999 onwards (CGT change)

Tax 2 = 0 for years before 2000 and 1 from 2000 onwards (Franking credit rebate change)

A BA C U S



17/26

and Shoven, 1988; Lie, 2002), so the coefficient on the leverage variable is expectedto be negative.We investigate whether tax changes have had an effect on repurchaseyields with the use of the Tax dummy.

Since observations of zero repurchases are not included in our sample we use thetruncated regression approach pioneered by Hausman and Wise (1976, 1977). Thisapproach is also used by Dittmar (2000). The repurchase yield model is estimatedusing maximum likelihood estimation.We use a quadratic hill-climbing optimizationalgorithm with the OLS estimates as the initial starting values for our differentsamples. Maximizing the log-likelihood function with respect to the parametersyields coefficients that capture two effects: an effect on the mean of the dependentvariable (modelled using a latent variable approach) given that it is observed, and aneffect on the probability of the dependent variable being observed. We decomposethese two effects and concentrate on the former because we are interested in

examining substitution in firms that actually undertake repurchases. This approachcan be summarized as follows.We observe the repurchase yield onlywhenthe firm has repurchased shares(Ryield

> 0) and so the dependent variable is left truncated at zero. Neglecting the truncationcan lead to biased estimates of the coefficients.The general model is given as yi = β 0 +β 1 xi + ε i where yi > 0 and ε i → N (0, σ 2) and in this case we are interested in thedistribution of yi given that yi > 0. (Greene, 2012) shows that,

E y y x x

xi i i

i

i

>[ ] = + + − +( )( )

− − +( )( )0

10 1

0 1

0 1

β β σ ϕ β β σ

β β σ Φ. (4)

The last term on the right-hand side of equation (4) is called the Mills ratio, and canbe used to obtain the marginal effects in the population where yi > 0.

RESULTS

Before analyzing the regression results we first calculate the simple correlationbetween repurchase yield and changes in dividends for each firm over the sampleperiod. The correlation across the whole sample is -2.7%.The small negative corre-lation gives some weak preliminary evidence that the substitution hypothesis mayhold in the Australian market. In order to control for other variables that areexpected to influence repurchase activity we estimate equation (3). Note that inter-pretation of the marginal effects from the truncated regression model requires atransformation of the coefficient estimates.

Because we have different expectations regarding the sign of the coefficient on thedividend change variable DDiv we run the regression given by equation (3) sepa-rately for on- and off-market repurchases, restricting the repurchase yield to be lessthan or equal to 10%. Heteroscedasticity in the errors can cause significant problemswith truncated regression model estimation (Greene, 2012). We therefore useHuber-White standard errors and covariances.

Table 4 Panel A documents the results for the on-market repurchase sample (773

observations) and Panel B for the same sample excluding banks and other financial




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T a b l e 4

T h

i s t a b l e p r e s e n t s t r u n c a t e d r e g r e s s i o n r e s u l t s f o r o n - m a r k e t r e p u r c h a s e s w i t h r e p u r c h a s e y i e l d s e t t o b e l e s s t h a n o r e q u a l t o 1 0 % . P a n e l A

i n c l u d e s a l l

fi r m - y e a r o b s e r v a t i o n s s a t i s f y i n g t h e s e r e s t r i c t i o n s ( 7 7 3 O b s e r v a t i o n s ) , w

h i l e P a n e l B r e m o v e s fi n a n c i a l fi r m s a n d c o n t a i n s 7 2 2 o b s e r v a t i o n s . T h e r e g r e s s i o n

t a k e s t h e f o r m d e t a i l e d i n T a b l e 3 a n d

e q u a t i o n ( 3 ) . C o e f fi c i e n t s a r e e s t i m

a t e d u s i n g M a x i m u m L i k e l i h o o d E s t i m a t i o n ( Q u a d r a t i c h i l l - c l i m b i n g o

p t i m i z a t i o n

a l g

o r i t h m ) w i t h c o n v e r g e n c e a c h i e v e d i n 3 i t e r a t i o n s . P r e d i c t e d s i g n s l i n k t o t h e a r g u m e n t s i n S e c t i o n 3 . Z

- s t a t i s t i c s a r e r e p o r t e d i n p a r e n t h e s i s a n d a r e

c a l c u l a t e d f r o m H u b e r / W h i t e h e t e r o s c e d a s t i c c o n s i s t e n t e r r o r s . C o e f fi c i e n t s s i g n i fi c a n t a t 1 0 % , 5 % a n d 1 % l e v e l s a r e r e s p e c t i v e l y m a r k e d w i t h *

, * * a n d * * *

i n

s u p e r s c r i p t s . M a r g i n a l e f f e c t s a r e c

a l c u l a t e d a s a v e r a g e a n d m e d i a n o f t h e t r u n c a t e d s a m p l e .

V a

r i a b l e

P r e d i c t e d

P a n e l A : O n - m a r k e t r e p u r c h a s e s

( 7 7 3 o b s e r v a t i o n s )

P a n

e l B : O n - m a r k e t r e p u r c h a s e s e x c l u

d i n g

fi n a n c i a l fi r m s ( 7 2 2 o b s e r v a t i o n s )

C o e f fi c i e n t

M a r g

i n a l e f f e c t s


M a r g i n a l e f f e c t s

S i g n

A v e r a g e

M e d i a n

A v e r a g e

M e d i a n

I n t e r c e p t

?

2 . 3 7 1 5 * * *

2 . 3 6 6 8

2 . 3 5 4 7

3 . 0 0 9

5 * * *

2 . 3 5 0 0

2 . 3 4 6 8

( 2 . 8 7 2 9 )

( 3 . 2 6 8

6 )

C a

s h

+

0 . 6 0 9 9 *

0 . 7 8 6 4

0 . 7 7 9 2

0 . 5 0 2

8

0 . 7 7 2 9

0 . 7 7 4 5

( 1 . 6 5 1 5 )

( 1 . 3 0 7

5 )

M B

−

− 0 . 1 4 1 8 * *

− 0 . 2 1 4 8

− 0 . 2 1 4 0

− 0 . 1 4 6

3 * *

− 0 . 2 1 2 5

− 0 . 2 1 2 4

( − 2 . 1 0 2 2 )

( − 2 . 1 4 0

7 )

l n ( T A )

−

− 0 . 0 0 4 4

− 0 . 0 4 2 1

− 0 . 0 4 1 8

− 0 . 0 3 4

0

− 0 . 0 4 1 8

− 0 . 0 4 1 9

( − 0 . 1 0 1 1 )

( − 0 . 6 9 1

6 )

L e

v

−

0 . 0 1 9 5

1 . 6 1 3 7

1 . 6 0 0 6

− 0 . 3 7 5

0

1 . 5 9 9 7

1 . 6 0 3 1

( 0 . 0 4 0 3 )

( − 0 . 5 1 4

9 )

D D i v

−

− 1 . 8 3 2 9 * * *

0 . 1 0 8 3

0 . 1 0 7 3

− 1 . 8 4 2

8 * * *

0 . 1 0 7 1

0 . 1 0 7 1

( − 3 . 3 9 8 3 )

( − 3 . 5 5 7

3 )

L i k e l i h o o d r a t i o

1 3 . 6 7 0 0

L i k e l i h o o

d

r a t i o

1 5 . 6 5 3 2

L R p - v a l u e

0 . 0 1 7 8

L R p - v a l u e

0 . 0 0 7 9

A BA C U S



19/26

companies (722 observations). The size of the coefficients and the levels of signifi-cance are approximately the same in the two panels. The coefficient on dividendchanges is negative and significant providing support for the dividend substitution

hypothesis.Thatis,companiesengagingin on-marketrepurchases tendto reduce theirdividends. The coefficient on MB is significant at 5%; firms with greater growthopportunities repurchase less. The tax dummy (Tax1 ) used in this regression is foundto be insignificant and is not included in the Table.The results documented inTable 4are robust to running the regressions on a sample restricted to companies that paydividends.

Table 5 documents the results for off-market repurchases. Here the results aremarkedly different from those for on-market repurchases and as expected do notsupport the dividend substitution hypothesis.The positive and significant coefficienton DDiv for both samples (Panel A the full sample and Panel B excluding financial

firms) indicates that the repurchase yield for off-market repurchases is positivelyand significantly related to changes in dividends. In other words, changes in repur-chase yield and dividends move in the same direction. This is consistent with theprevious argument that companies are using off-market repurchases to distributeexcess franking credits, and the observation that large dividend paying companiestend to undertake off-market repurchases. To the extent that a company has frank-ing credits over and above those needed for ordinary dividend policy, off-marketrepurchases and increases in dividend payments are possible mechanisms to distrib-ute the franking credits. Large companies in Australia undertaking off-market repur-chases often do so to distribute franking credits to shareholders (Brown andNorman, 2010; Brown and Davis, 2012). The results also show that off-marketrepurchase yield is negatively related to size of the company; larger companies buyback a smaller proportion.The tax dummy (Tax 2 ) used in this regression is found tobe insignificant and is not included in the Table.

Overall results on control variables in both Tables 4 and 5 are consistent withother studies. Summing up, we find evidence consistent with previous studies con-ducted in the US that on-market repurchase yields tend to be negatively related tochanges in dividends. However, we find no evidence of substitution for off-marketrepurchases. We argue that this result is driven by the need for these companies todistribute ‘excess’ imputation tax credits. In this case changes in dividends andrepurchase yields tend to move in the same direction.

Because there are a number of companies that undertake both types of buybackin the fiscal year, in order to investigate whether in aggregate a substitution effectexists for Australian repurchases the total dollars repurchased via the two types needto be combined.Table 6 Panel A summarizes the results for repurchases (combiningon- and off-market total for each company for each financial year restricting repur-chase yield to be less than or equal to 10%), and also gives the marginal effects. PanelB reports the results when the sample excludes financial firms.

In both panels we find that repurchase yield is negatively and significantly relatedto dividend changes, after controlling for firm characteristics that influencerepurchase yield, suggesting that there is an overall substitution effect forAustralian

firms. The results are also robust to running the regressions only on the sample of




20/26

T a b l e 5

T h

i s t a b l e p r e s e n t s t r u n c a t e d r e g r e s s i o n r e s u l t s f o r o f f - m a r k e t r e p u r c h a

s e s w i t h r e p u r c h a s e y i e l d s e t t o b e

l e s s t h a n 1 0 % . P a n e l A i n c l u d e s a l l fi r m - y e a r

o b

s e r v a t i o n s s a t i s f y i n g t h e s e r e s t r i c t i o

n s ( 5 0 o b s e r v a t i o n s ) , w h i l e P a n e l B

r e m o v e s fi n a n c i a l fi r m s a n d c o n t a i n

s 4 1 o b s e r v a t i o n s . T h e r e g r e s s i o n t a k e s t h e f o r m

d e t a i l e d i n T a b l e 3 a n d e q u a t i o n ( 3 ) .

C o e f fi c i e n t s a r e e s t i m a t e d u s i n g M

a x i m u m L i k e l i h o o d E s t i m a t i o n ( Q

u a d r a t i c h i l l - c l i m b i n g o p t i m i z a t i o n

a l g o r i t h m )

w i t h c o n v e r g e n c e a c h i e v e d i n f o u r i t e

r a t i o n s . P r e d i c t e d s i g n s l i n k t o t h e

a r g u m e n t s i n S e c t i o n 3 . Z - s t a t i s t i c s

a r e r e p o r t e d i n p a r e n t h e s i s a n d a r e c a l c u l a t e d

f r o

m H u b e r / W h i t e h e t e r o s c e d a s t i c c o n s i s t e n t e r r o r s . C o e f fi c i e n t s s i g n i fi c a n t a t 1 0 % , 5 %

a n d 1 %

l e v e l s a r e r e s p e c t i v e l y m a r k e d w i t h * , * *

a n d * * * i n

s u p e r s c r i p t s . M a r g i n a l e f f e c t s a r e c a l c

u l a t e d a s a v e r a g e a n d m e d i a n o f t h e t r u n c a t e d s a m p l e .

V a

r i a b l e

P r e d i c t e d

P a n e l A : O f f - m a r k e t r e p u r c h a s e s

( 5 0 o b s e r v a t i o n s )

P a n e l B : O f f - m a r k e t r e p u r c h a s e s

e x c l u d i n g fi n a n c i a l fi r m s ( 4 1 o b s e r v a t

i o n s )


M a r g i n a l e f f e c t s

C o e f fi

c i e n t

M a r g i n a l e

f f e c t s

S i g n

A v e r a g e

M e d i a n

A v e r a g e

M e d i a n

I n t e r c e p t

?

1 9 . 0 9 4 3 * * *

2 3 . 0 4 4 4

2 3 . 0 5 3 7

1 7 . 3 8 7 9 * * *

2 3 . 0 4 8 9

2 3 . 0 5 5 2

( 3 . 9 1 4 8 )

( 3 . 5 0 1 0 )

C a

s h

+

− 1 8 . 2 3 1 7

1 3 . 0 5 0 4

1 3 . 0 5 1 7

− 1 9 . 4 6 5 1

1 3 . 0 5 2 3

1 3 . 0 5 8 9

( − 1 . 2 7 6 2 )

( − 1 . 3 0 1 9 )

M B

−

− 0 . 3 7 6 8

− 2 . 1 3 8 3

− 2 . 1 3 9 4

− 0 . 4 3 8 3

− 2 . 1 3 8 5

− 2 . 1 3 9 5

( − 0 . 6 7 4 1 )

( − 0 . 7 5 2 1 )

l n ( T A )

−

− 0 . 5 8 7 7 * * *

− 0 . 6 0 0 0

− 0 . 6 0 0 3

− 0 . 4 9 2 7 * *

− 0 . 6 0 0 1

− 0 . 6 0 0 3

( − 2 . 6 4 7 4 )

( − 2 . 0 8 3 3 )

L e

v

−

0 . 5 5 8 9

− 3 . 0 5 9 3

− 3 . 0 6 0 7

− 0 . 1 7 6 5

− 3 . 0 5 8 9

− 3 . 0 6 0 9

( 0 . 2 9 4 6 )

( − 0 . 0 4 7 7 )

D D i v

−

3 3 . 7 1 5 0 * * *

3 8 . 1 6 6 2

3 8 . 1 9 2 1

3 4 . 2 5 6 2 * * *

3 8 . 1 6 3 7

3 8 . 1 9 8 8

( 2 . 9 6 2 1 )

( 2 . 9 7 6 3 )

L i k e l i h o o d

r a t i o

1 5 . 5 1 6 8

L i k e l i h o o d

r a t i o

9 . 2 6 6 7

L R p - v a l u e

0 . 0 0 8 4

L R p - v a l u e

0 . 0 9 8 9

A BA C U S



21/26

T a b l e 6

T h

i s t a b l e p r e s e n t s t r u n c a t e d r e g r e s s i o n r e s u l t s f o r t h e c o m b i n e d r e p u r c

h a s e s a m p l e r e s t r i c t e d t o r e p u r c h a s e y i e l d l e s s t h a n o r e q u a l t o 1 0 % c

o n s i s t i n g o f

brown et al 2015 abacus

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