Capital Structure, Equity Mispricing, and Stock Repurchases

Abstract

We evaluate motives for share repurchases using a unified framework where a firm has a target capital structure and has equity that can be mispriced. We document that capital structure adjustments are a value-increasing motive for repurchases and that the extent to which adjusting capital structure through a repurchase creates value depends on the undervaluation of the firm. Underlevered and undervalued firms enjoy the greatest economic gains from a repurchase, as evidenced by the stock price reaction to the repurchase announcement, and these firms are more likely to announce a share repurchase program.

Keywords: Target Leverage, Residual Income Model, Capital Structure, Equity Mispricing, Market Timing, Share Repurchase

JEL Classification: G30, G32, G35