Why Do Firms Repurchase Their Overpriced Shares?

Abstract:

Firms are commonly assumed to repurchase their shares to signal they are underpriced (undervalued) or to take advantage of underpricing to enhance share value. However, recent empirical evidence indicates that actual repurchases are often performed when the stock is overpriced. This paper explains why firms may repurchase overpriced shares and characterizes the situations in which this is likely to happen. We suggest that insiders' benefits from waste of free cash have a substantial impact on the decision to repurchase and highlight the importance of having good corporate governance in place when managers get approval from the board to repurchase stock.