Reacquisition of Common stock by United States Corporations

Although many countries forbid or severely restrict the acquisition of equity shares by the issuing corporation, the United States presents few barriers to firms seeking to buy back their shares. The legal restrictions which do exist largely represent attempts to protect investors and creditors from stock manipulation and fraud. These regulations, while frequently complex, are not generally prohibitive. Additionally, certain tax laws, particularly those allowing the treatment of reissued shares as an augmentation of the equity base and distribution of corporate earnings to shareholders at capital gains rather than ordinary income tax rates combine to make share reacquisition an attractive option among alternate uses of funds. This study addresses both the theoretical and empirical aspects of the role of reacquisition of common stock in financial decision making, most specifically considering its role in the investment decision. It offers a theory of rational investment behavior demonstrating that circumstances do exist when reacquisition represents the optimal use of corporate funds. A simple model isolates the main issues of share reacquisition and indicates that the relationship between the market value of the firm's assets and the supply price of identical new assets, a version of James Tobin's famous q, provides the basis for the firm's decision. While this model is not a formal asset model for the firm, it does make clear that even in a general equilibrium model, this relationship will dominate the reacquisition decision. In spite of the fairly open legal framework, most firms do not appear to adhere to the rational investment model. While many firms reacquire small amounts of their shares, observation of all New York Exchange firms over several years reveals that few firms seem to engage in the large scale reacquisitions indicative of investment. Direct statistical tests using the available aggregate data for reacquisitions and q find no measurable relationship between the two; although similar tests using samples of firms do find some weak evidence of the relationship. A secondary effort to capture the relationship between reacquisition and q by measuring the profitability of reacquisition confirms the results of the direct tests and the initial conclusion that firms in general do not carefully consider reacquisition as an investment option and that only a few firms behave as the rational investment theory suggests.