Does Debt Help Managers? Using Cash Holdings to Explain Acquisition Returns

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1 University of Colorado, Boulder CU Scholar Undergraduate Honors Theses Honors Program Spring 2017 Does Debt Help Managers? Using Cash Holdings to Explain Acquisition Returns Michael Evans Follow this and additional works at: Part of the Finance and Financial Management Commons Recommended Citation Evans, Michael, "Does Debt Help Managers? Using Cash Holdings to Explain Acquisition Returns" (2017). Undergraduate Honors Theses This Thesis is brought to you for free and open access by Honors Program at CU Scholar. It has been accepted for inclusion in Undergraduate Honors Theses by an authorized administrator of CU Scholar. For more information, please contact

2 Does Debt Help Managers? Using Cash Holdings to Explain Acquisition Returns Michael Evans

3 Abstract I study if managers make better investment decisions when required to use external capital providers by investigating cash acquisitions. Acquiring firms that held insufficient cash and short term investments to complete a documented cash acquisition between 1990 and 2016 are assumed to have been unable to finance the acquisition entirely with internal funds. Results show that bidder returns are 2.9 percentage points higher for acquisitions that could not be financed internally. The larger the size of a target relative to the combined firm, the more value investors perceive an acquisition as adding. These findings are consistent with the free cash flow theory, and show investors perceive debt as capable of reducing agency costs. Eight years removed from the worst of the financial crisis, U.S. firms are holding record amounts of cash. A recent article in The New York Times helps put into perspective the amount of cash U.S. firms are currently holding. 1 As of January 2016, U.S firms were holding $1.9 trillion in cash at a time when United States Treasury bonds earned about two percent. General Motors held about half of its value in cash, and Apple held more than a third of its value in cash. Google held enough cash to buy outright Goldman Sachs, Costco, ebay, or one quarter of Amazon. There are a variety of factors that contribute to how much cash firms choose to hold. Bates et al. (2009) finds the precautionary motive for cash holdings, that firms hold cash to protect themselves against adverse cash shocks, helps explain recent increases in cash holdings. Shareholders are inherently forward looking, and want to know what large cash holdings may mean for future earnings and economic growth. With larger cash holdings, managers may have more discretion over investment decisions, and less reliance on external capital providers. Here, I address how large cash holdings may affect firms by answering the question: Do managers make better investments 1 Davidson, Adam Why Are Corporations Hoarding Trillions? The New York Times, January 20. 2

4 when they cannot exclusively rely on internal financing? I answer this question by studying acquisitions, which are large observable outcomes of the investment decision process. According to the free cash flow theory, managers are expected to make better investments when they cannot exclusively use internally generated funds to finance new projects. Findings here from investigating cumulative abnormal returns in an acquirer s stock at the announcement of an acquisition paid for using cash support this hypothesis. Acquirers that must use external capital providers to finance a cash acquisition have announcement period stock returns that are 2.9 percentage points higher, significant at the ten percent level. In addition, investors are found to place more value on acquisitions in which the target makes up a larger percentage of the combined firms total assets, supporting theories of market signaling from the method of payment. To truly determine if managers make better investments when external capital providers are required, one would need to measure the effects an investment has on firm performance over time, holding all other factors constant that can effect firm performance. This approach is not practical empirically as there are many factors that may affect firm performance over an extended period of time. Here, an acquisition is defined as being value increasing for an acquirer if it produces positive cumulative abnormal returns in the acquiring firm s stock at the acquisition announcement. Absent any market signaling, the change in the value of an acquirer at acquisition announcement should equal the net present value (NPV) of the acquisition. The NPV of the acquisition is equal to the value of future cash flows generated by the target, minus the price paid for the target. To determine if managers make better acquisitions when external financing is required, acquisitions paid for with cash are exclusively studied. It is assumed that acquirers which did not hold sufficient cash and short term investments to pay for the entire acquisition likely utilized external capital providers. It is also assumed that investors were informed up to the extent that they knew the acquirer needed external financing to complete the acquisition. This paper contributes to research on the ability of debt to reduce agency costs as well as research on mergers and acquisitions (M&A). Research has not shown what value investors are willing to place on the use of external capital providers for acquisition financing. Acquirer stock returns for acquisitions paid 3

5 with cash are also a little researched topic. The goal of this paper is to determine if managers make better investments when they cannot exclusively use internal financing, with higher acquisition announcement period stock returns indicating a better investment. In the next section I will discuss relevant M&A literature on acquirer announcement period stock returns and theories related to cash holdings and capital structure. In section II I review the data on acquisitions. Section III presents empirical results and analysis, and section IV concludes. I. Literature Review To determine if managers make better investments when required to use external capital providers, we must first understand how investors interpret and place value on investment decisions. An extensive body of research has shown that acquisitions paid for with stock produce negative abnormal returns in the acquiring firm s shares at the announcement of an acquisition (Travlos (1987), Servaes (1991), Heron and Lie (2002)). These findings are consistent with Myers and Majluf (1984), who show that managers have incentive to issue stock when they believe their firm is overvalued. Negative abnormal returns for acquisitions paid with stock do not necessarily indicate that the targets in these acquisitions are value destroying investments for the acquirer. An acquirer may experience negative abnormal returns at the announcement of an acquisition with a positive NPV simple because investors perceive the method of payment as signaling shares in the acquirer are overvalued. These findings are significant because they show that investors consider motivating factors behind an investment in addition to the quality of an investment itself. Negative abnormal returns for acquisitions paid with stock show that investors believe managers have non-public material information regarding the fair value of their firm, and will act rationally in using this information asymmetry when determining what method of payment to use for an acquisition. Existing research has focused less on acquirer abnormal returns at the announcement of acquisitions paid for using cash. If managers use stock as the method of payment for an acquisition when they believe their firm is overvalued, then in the presence of information asymmetries between managers and shareholders, managers may use cash as the method of payment when they believe 4

6 their firm is undervalued. Acquisitions paid with cash should therefore signal to investors that the acquirer is undervalued, resulting in positive abnormal returns in the acquiring firm s shares at the announcement of an acquisition. But the same studies that find negative abnormal returns for acquisitions paid with stock, find no abnormal returns in the acquiring firm s shares for acquisitions paid with cash. Insignificant investor reactions to acquisitions paid with cash may be due to other signals these deals send regarding the quality and motivation of the acquisition not being controlled for in empirical studies. Existing research on agency theory, capital structure, and cash management may provide a framework for understanding investor reactions to cash acquisitions, and what these reactions say about manager s investment decisions. If investors view manager s discretionary use of cash reserves pessimistically, cash acquisitions could be viewed with distrust, offsetting other positive signals these deals would otherwise send. Jensen (1986) applies agency theory to manager s discretionary use of free cash flows to make specific predictions regarding when acquisitions are value destroying. Jensen s (1986) free cash flow theory predicts acquisitions paid for with cash are value destroying for shareholders of the acquiring firm when the acquiring firm has cash reserves greater than that which maximizes shareholder value. These acquisitions are predicted to be value destroying because of agency problems and the mechanisms by which free cash flows can result in excess cash reserves. Free cash flows are cash flows available for distribution to all investors. Calculated as after tax net operating profits minus investments in positive NPV projects, there are five ways managers can use free cash flows. They can 1) Pay interest on debt, 2) Pay off principle on debt, 3) Pay dividends to shareholders, 4) Repurchase stock, and 5) Buy nonoperation assets such as marketable securities, or hold more cash. As the free cash flow theory argues, managers could fail to use free cash flows in these five acceptable ways and instead continue to invest in new projects that, by definition, would be value decreasing. Jensen (1986) notes that managers are required to make interest payments on debt due to the threat of bankruptcy, but possess greater discretion over whether to pay out free cash flows to shareholders through dividends or stock repurchases. The distribution of free cash flows to shareholders 5

7 reduces a manager s power by decreasing resources under their control. Over time, firms which are reluctant to return cash to shareholders can accumulate cash reserves above the level which maximizes shareholder value. Further, firms which generate large free cash flows but possess few positive NPV investment opportunities are more susceptible to the accumulation of excess cash reserves. Opler et al. (1999) finds that firms with large amounts of excess cash acquired it through the accumulation of internal funds. Because excess cash reserves can arise from a combination of agency problems and a lack of good investment opportunities, excess cash reserves are at risk of being used in value destroying ways. Jensen (1986) theorizes that managers may use excess cash reserves to further increase operating assets under control, potentially through value destroying acquisitions. Fama (1980) notes that manager s wealth is less diversified than shareholder s because managers have both stock and human capital invested in the firm. For these reasons, managers can be incentivized to both increase and diversify operating assets under their control through acquisitions. Morck et al. (1990) and Harford (1999) find that diversifying acquisitions produce negative returns in the acquiring firms stock. Martin (1996) finds that acquirers with higher cash balances tend to prefer cash-financed acquisitions. Martin (1996) studies how bidders choose a given method of payment, and does not address bidder returns as is the focus here. These previous findings support the possibility that documented normal returns in the acquiring firm s shares at the announcement of acquisitions paid with cash are the result of a combination of market signals, including investor perceptions of agency problems at the acquiring firm. Testing predictions by the free cash flow theory regarding how cash reserves and debt may affect acquisition returns requires determining the optimal level of cash reserves which maximizes shareholder value. Using inventory management and buffer-stock theories of cash management, Harford (1999) develops a baseline model to identify what constitutes normal cash reserves for a given firm. Using a sample of 430 observations from 1977 to 1993, Harford (1999) finds that acquisitions by firms with above normal cash holdings are value decreasing and more likely to be diversifying acquisitions, after controlling for method of payment. He views these results as supportive of the free cash flow theory s agency cost explanation of acquisitions by cash-rich firms. Consistent with previous studies, Harford 6

8 (1999) finds that cash-rich firms have higher cumulative abnormal returns at acquisition announcement for cash offers compared to stock offers. These relatively positive returns for cash offers however do not make up for negative reactions shareholders have when the bidder is cash-rich. These results indicate that investors believe managers make worse investment decisions when they have excess cash reserves, and that these poor investments are an agency cost. Not controlled for in these results is the expected source of cash for cash offers. By the pecking order theory of financing, as described by Myers (1984), firms with excess cash reserves are less likely to use external capital providers, leaving these managers with more discretion over investment decisions. Harford recognizes the importance of the source of cash, stating there is a difference between using cash as a method of payment and paying with internal funds, and that firms which are not cash rich can still pay with cash by using external funds. Under the free cash flow theory, cash offers which require external capital providers should have significantly higher returns than cash offers which use internally generated funds. This is because the free cash flow theory states that debt reduces agency costs associated with free cash flows by requiring managers to use these cash flows to make interest or principle payments, rather than accumulating excess cash. In addition to reducing excess cash, debt provides monitoring of managers through the threat of bankruptcy. Harris and Raviv (1991) survey early literature on capital structure as it relates to agency costs. Grossman and Hart (1982) demonstrate how higher levels of debt can incentivize managers through the threat of bankruptcy. As Maloney et al. (1993) describes, debtholders have the legal standing to review and replace managers during bankruptcy. Shareholders in contrast are bound by the business judgement rule, which requires they meet a higher standard to remove managers in court. Absent serious violations by managers, such as a clear breach of fiduciary duty, shareholders must remove managers by the same means they appointed them. For these reasons, debtholders can better monitor and hold managers accountable compared to shareholders. The threat of bankruptcy may deter managers from taking on more debt, resulting in an underinvestment problem in which firms do not pursue positive NPV projects. Other underinvestment problems relating to capital structure are discussed by Myers and Majluf (1984). In the presence of 7

9 information asymmetries, firms that require external financing to undertake positive NPV projects may not have sufficient liquidity to do so. Market imperfections can thus make it beneficial for firms with ample positive NPV investment opportunities to hold large cash reserves. In such conditions, and by the pecking order theory of financing, firms with large cash reserves would not be expected to seek external financing for cash acquisitions, and these firms would prefer to use internal funds over stock as the method of payment due to negative signaling associated with equity financing. Under these assumptions, the announcement of a cash acquisition could be expected to produce abnormal returns in the acquiring firm s stock equal to the assumed NPV of the acquisition. This is because the acquirer is expected to use internally generated cash reserves to finance the acquisition, eliminating any question as to the motivation behind the acquisitions. Cash reserves based on market imperfections as described by Myers and Majluf (1984) and the free cash flow theory described by Jensen (1986) are not mutually exclusive. Myers and Majluf (1984) do not discredit the possibility that investors place value on the independent monitoring of managers associated with debt. The free cash flow theory and the market imperfections argument for cash holdings differ in their emphasis on under or overinvestment problems. Whereas the free cash flow theory views large cash reserves as a reasons managers may invest in negative NPV projects, the market imperfections argument emphasizes that without these large cash reserves, managers may be unable to take advantage of value increasing projects. Which theory investors believe is a statement on when managers are perceived as making value increasing investment decisions. Both theories rely on the assumption that there is an optimal level, or at least a beneficial level of cash holdings for which under or overinvestment problems are minimized. Determining this level of cash holdings, and assuming investors know what this level of holdings is, underscores the difficulties of studying manager s investment decisions by identifying cash rich firms as Harford (1999) does. This problem is avoided here by not attempting to measure cash holdings against a theoretical model, but rather using the size of an investment to scale a firm s cash holdings, enabling the standardized comparison of cash holdings and investments performance across many firms. 8

10 Little research has been done studying the effects of debt on acquisition performance, whether measured by short term market reactions around acquisition announcement or long term operating performance after an acquisition. Maloney et al. (1993) studies the effects of debt on manager s investment decisions. Using multiple samples of acquisitions from 1962 to 1982, Maloney et al. (1993) finds that there is a statistically significant positive relationship between leverage of the acquiring firm and the three day abnormal returns of the acquirer s stock at merger announcement, controlling for method of payment. The size of this positive relationship is fairly small. A one standard deviation increase the acquirer s debt-to-equity ratio would increase the acquirer s abnormal return at acquisition announcement by less than one percent. Maloney et al. (1993) interprets these results as supportive of the argument that capital structure in the form of higher leverage can help reduce agency costs. The results in Maloney et al. (1993) are supportive of the free cash flow theory. Harford (1999) tests the free cash flow theory by focusing on cash-rich firms, whereas Maloney et al. (1993) less directly tests the free cash flow theory by evaluating predictions that debt can reduce agency costs. Interestingly, Harford finds no evidence of the leverage effect documented in Maloney et al. (1993). A large amount of research on acquisitions has found that acquirers communicate negative information about the firm s value when choosing to pay for an acquisition with stock. This research shows that investors consider motivating factors behind a manager s choice to acquire another firm at the announcement of an acquisition. Knowing investors consider management s motivation at acquisition announcement, we can use acquisitions to study theories that relate agency problems to cash management and capital structure. The free cash flow theory suggests managers should make better investment decisions when using external capital providers. Under the free cash flow theory, debt can reduce the likelihood manager s will engage in value decreasing acquisitions both by reducing managers discretionary use of cash reserves, and through the threat of bankruptcy. If investors are aware that an acquisition will likely require external capital providers, they should consider what this information signals about management s motivation in pursuing the acquisition, and the quality of the investment. This study tests the free cash flow theory and attempts to place a value on the use of external capital 9

11 providers by focusing on abnormal returns in the acquiring firm s shares around the announcement of a cash acquisition likely requiring external capital providers. II. Data and Descriptive Statistics To investigate the relationship between cash holdings and an acquiring firm s announcement period stock returns, I use a sample of 227 cash acquisitions from January 1, 1990 to January 1, Acquisition data, including the total amount paid for the target and the announcement date, comes from the Securities Data Corporation s (SDC) U.S. Mergers and Acquisitions database. Only acquisitions in which a U.S. publically traded firm acquired another U.S. publically traded firm using cash are considered. Firm specific financial data comes from the COMPUSTAT database. Cash is defined as cash plus short term investments from COMPUSTAT moving forward. To insure an acquisition would have had a material impact on the acquiring firm, only acquisitions in which the target was larger than two percent of the combined firm s size as measured by total assets are considered. A firm s relevant sector is determined by its first level in the hierarchy of the Global Industry Classification Standard (GICS). Acquirer s which have a sector classification of Financials, including banks, insurance companies, and diversified financial firms are not included in this study. Acquirers of the Financials sector are not considered because these firms hold cash for different reasons than all other sectors. Data on a firm s stock price, holding period return, shares outstanding and other securities related measures come from the Center for Research in Securities Prices (CRSP). An acquirer likely could not have exclusively financed an acquisition internally if it held cash reserves at the end of the quarter prior to the acquisition that would have been insufficient to cover the full amount paid for the target. An acquirer s cash holdings relative to the amount paid for the target can be described by the following cash to value ratio: S = cash i / deal value i (1) where cash i is cash (defined as cash plus short term investments) held by the acquirer at end of the quarter prior to acquisition i, and deal value i is the total amount paid for the target for acquisition i. When S is equal to one, the acquirer could have paid for the target using only internal funds, but would have had no 10

12 cash remaining after the acquisition. Given using all cash holdings for an acquisition isn t realistic, it is assumed an acquisition can be internally financed when S is greater than or equal to Other thresholds for S are explored in the results section. Table I shows the distribution of acquisitions by GICS sector, including when firms likely did and did not utilize external capital providers. The entire sample of 227 acquisitions has over twice as many deals likely requiring external financing as those which could be financed internally. The GICS sectors Consumer Discretionary, Health Care, Industrials, and Information Technology make up 81 percent of all acquisitions. The Health Care and Information Technology sectors had roughly the same number of acquisitions that could be exclusively financed internally as those which could not. The Consumer Discretionary sector had about four times as many acquisitions that could not be financed internally compared to those which could be financed internally, and the Industrials sector had about seven times as many acquisitions that could not be financed internally. The summary of acquisitions by sector and financing demonstrates how cash holdings can vary across industries. Table I supports the view that cumulative abnormal returns in the acquiring firms stock at acquisition announcement may be best 11

13 compared within a given GICS sector to account for correlations between an acquirer s sector and cash holdings. Abnormal returns will be calculated here using a market model that assumes a given stocks expected return over one day is equal the return on the overall market. Abnormal returns are calculated as: AR it = R it - K t (2) where AR it is the abnormal return in the acquirer s shares for acquisition i over time period t, R it is the actual return in the acquirer s shares, and K t is the return on the Standard & Poor s Composite Index over time period t. The effect of the acquisition announcement on the acquiring firms stock is defined as the cumulative abnormal return (CAR) in the acquiring firm s shares over a period of ten days before to one day after the acquisition announcement. Thus, CAR is the summation of (2) over an 11 day period. Betton et al. (2008) show how a target s stock experiences a runup beginning 40 days ahead of the announcement of an acquisition as information of the deal is leaked. A large portion of this runup occurs beginning ten days prior to the acquisition announcement. To fully capture the effect of the acquisition announcement, it is assumed here a similar pattern of abnormal returns can be expected for the acquiring firm. Table II shows descriptive statistics for acquirer CARs over three ranges of the cash to value ratio S. Acquiring firms across the sample of 227 acquisitions had a median CAR of 1.3 percent, consistent with findings that cash acquisitions produce no or small positive abnormal returns in the acquiring firm s shares at acquisitions announcement. Acquisitions for acquirer s which held the lowest range of the cash to value ratio, at most 75 percent of the total amount paid for the target, experienced the largest and only positive median CAR of 1.7 percent. Given CAR is relative to the bidder s value, a CAR of 1.7 is quite large relative to the size of a target. For example, a target that is ten percent the size of a bidder, and has a ten percent return on investment, would add only one percent to the bidder s value. Firms within the low cash to value ratio range had a median cash to value ratio of 21.9 percent, well below the range s upper bound of 75 percent. In contrast, firms in the highest cash to value ratio range, above 150 percent, had median cash to value holdings of 322 percent, supporting findings by Opler et al. (1999) that some firms 12

14 hold more cash than predicted. Acquirer s in the high cash to value ratio range had a median CAR of -0.3 percentage, with slightly less variation in returns. While low cash to value ratio acquisitions had exceptionally high CARs, high cash to value ratio acquisitions for the most part do not experience exceptionally low CARs. The largest CAR for the high ratio range was 16 percent, and the smallest was -21 percent. The ten acquisitions in the sample which had the highest cash to value ratios had a median CAR of -1 percent, with a median size of the target relative to the combined firms of 2.5 percent. Table II provides preliminary evidence that managers could make better investments when required to use external financing. Other factors however may be influencing the higher median CAR for acquirers in the low cash to value ratio range. For example, acquisitions for acquirers with low cash to value ratios could be leverage increasing events in the acquirer s capital structure. Leverage has the ability to increase a firm s return on equity (ROE), and thus it would not be surprising to see an increase in a firm s stock price around a leverage increasing event. M&A literature suggests that acquisitions in which the target and acquirer are in the same industry produce larger CARs in the acquirer s stock at announcement. If firms with lower cash to value ratios are more likely to pursue non-diversifying acquisitions, this could explain the higher CARs seen in the data for low cash to value ratio acquirers. Not shown here, the full distribution of acquirer s CARs from ten days before to one day after acquisition announcement reveals no single abnormally large or small CAR outlier above or below the 1.25 threshold for the cash to value ratio S that could influence results. 13

15 Table III shows descriptive statistics for six deal characteristics that M&A literature indicates are likely to influence acquisition returns. These statistics are spread across both the GICS sectors seen in Table I, and the cash to value ranges used in Table II. Before controlling for factors that can affect acquisition returns, Table III provides insight into trends across an acquirer s GICS sector and cash to value ratio. Unlike Harford (1999), Table III does not support the view that firms with excess cash are more likely to make diversifying acquisitions. The lowest range of the cash to value ratio has the largest percent of its acquisition that are diversifying. Firms with excess cash, as defined by Harford (1999), could still pursue cash acquisitions which require external capital providers, and the cash to value ratio should not be considered a substitute for excess cash measures as the two metrics test different aspects of the free cash flow theory. The probability an acquisition is diversifying varies more by acquirer sector than cash to value ratio. Acquisitions for acquirers in the Industrials sector appear twice as likely to be diversifying than for acquirers in the Information Technology sector. This could be expected if acquirers in the Industrials sector have more extensive supply chains that offer more vertical integration opportunities compared to the Information Technology sector. Because M&A literature shows diversifying acquisitions have lower returns, Table III suggests acquisitions for acquirer s in the Industrials sector could have lower CARs. Such comparisons across GICS sectors underscores the conclusion from Table II that acquisitions may best be compared within an acquiring firm s GICS sector to better measure the effect of external capital providers on cumulative abnormal returns. Table III also emphasizes the need to control for an acquirer s capital structure when studying acquisition returns. The assets/equity column shows the leverage an acquirer uses in its capital structure. This ratio increases as a firm s liabilities make up a larger portion of its capital structure, and is measured at the end of the quarter prior to an acquisition. The lowest cash to value ratio range has three times as large a standard deviation in leverage compared to the other ranges. These leverage figures indicate that the relatively positive reaction investors had to the announcement of an acquisition as seen in table II 14

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17 for low cash to value ratio acquirers could be driven by differences in capital structure rather than the use of external capital providers for an acquisition. The ratio of assets to equity is negative for one acquirer on one acquisition in the Real Estate sector. Though rare, this can occur when firms engage in large share repurchases leading to negative balances in the equity section of their balance sheet. This phenomena can make it difficult to interpret a firm s capital structure, but is limited to only one acquisition across the entire sample. The last major indicator in Table III that demonstrates how acquirer CARs may depend on factors other than the use of external capital providers is seen in the Percent of Combined Firm column. Measured as the book value of the target scaled by the combined firms total assets, this variable measures the relative size of an acquisition. Unlike diversifying acquisition measures, relative size deviates more with respect to an acquirer s cash to value ratio than its sector. Because cash acquisitions signal more confidence in the valuation of the target than acquisitions paid for using stock, and the fact that cash acquisitions lack the negative signaling of stock acquisitions, it could be expected that CARs should increase with relative size for cash acquisitions. If relative size increases CARs, then the fact that relative size is three times larger for low cash to value ratio acquirers than high cash to value ratio acquirers could cause acquisitions requiring external capital providers to have higher cumulative abnormal returns. Descriptive statistics reveal it is plausible that managers could make better acquisitions when they cannot finance projects internally and must use external capital providers to some extent. However, there are numerous other variables that can effect cumulative abnormal returns in an acquiring firms shares at the announcement of an acquisition, some of which appear correlated with the acquirer s GICS sector. To measure the ceteris paribus effect of cash holdings on an acquirer s cumulative abnormal returns at the announcement of an acquisition, a multivariate model is required to control for other variables that influence acquisition returns. 16

18 III. Methodology and Empirical Analysis To determine if managers make better investments when required to use external capital providers, I run the following cross sectional regression for acquisition i: CAR i = β 0i + β 1Cash-to-Value 1i + β 2RSize 2i + β 3SameIndustry 3i + β 4PCAR 4i + β 5Leverage 5i + β 6AcquirerB/M 6i + β 7TargetB/M 7i + β 8Premium 8i + β 9TAssets 9i (3) where the dependent variable is the cumulative abnormal return in the acquirer s stock from ten days before to one day after the announcement of an acquisition. Independent variables in (3) are mostly those from Table III based on M&A literature. The variable of interest, Cash-to-Value, is a dummy variable that takes the value of one when the acquirer for acquisition i likely required external capital providers to finance the acquisition. As described in section II, an acquirer likely would have needed to utilized external capital providers when the cash to value ratio S is less than RSize is the relative size of the acquisition, measured as the book value of the target scaled by the total assets of the combined firm for acquisition i. To control for if an acquisition is diversifying for the acquirer, SameIndustry is a dummy variable that take the value of one when both the target and acquirer are in the same GICS sector. PCAR is a cumulative abnormal return like CAR, only measured prior to the acquisition announcement. PCAR is the sum of abnormal returns in the acquirer s stock over the range 252 days before to 40 days before the acquisition announcement. PCAR is included to control for recent abnormal performance in the acquiring firms stock. For example, lower input prices for a given GICS sector could increase the likelihood that an acquirer in that sector has positive abnormal returns at acquisition announcement. PCAR helps control for such conditions not related to the acquisition that could affect announcement period returns. Leverage is the acquirer s ratio of total assets to total equity, as previously described. AcquirerB/M and TargetB/M are the acquirer s and target s book to market ratios, calculated as the book value of a firms assets over its market capitalization. Smaller book to market ratios can be interpreted as investors believing a firm has more NPV positive investment opportunities that will produce future growth for the firm. Very large book to market ratios could be a sign of financial distress. In the sample of 227 acquisitions used here, a bankrupt Frontier Airlines had a book to market ratio of 299, the largest of 17

19 all targets in the sample, when it was acquired in Premium is defined as the percent the acquirer paid above or below a recent average of the targets market value. If Premium is very large for an acquisition, investors may believe the acquirer overpaid, producing negative cumulative abnormal returns in the acquirer s shares at acquisition announcement. TAssets is the book value of the targets total assets measured in billions. TAssets is controlled for to account for situations in which investors react to the size of an acquisition not as a function of the targets relative size, as measured with RSize, but as a function of the targets book value of assets. Table IV shows three versions of the cross section regression (3). Column (1) in Table IV is exactly the regression as given in (3). The variable of interest, Cash-to-Value, is positive and economically significant, consistent with the free cash flow theory. When an acquirer s GICS sector is controlled for in Column (2), the coefficient on Cash-to-Value becomes larger and increases in statistical significance, reflecting the importance of comparing acquisitions within the acquirers industry. Column (2) shows that an acquirer which could not finance a project internally has a 2.7 percentage point higher CAR at the announcement of an acquisition. Not shown here, adjustments to the cash to value ratio threshold of 1.25 for determining if external capital providers were utilized slightly changes the statistical significance of the Cash-to-Value variable, and produces no significant changes in the size of its coefficient. The relative size variable is statistically significant at the.1 percent level, and also increases in size and statistical significance when an acquirer s GICS sector is controlled for. A one standard deviation increase in an acquisition s relative size produces a 2.9 percentage point higher CAR. For acquirer s with a cash to value ratio below.7, the effect of the relative size of an acquisition and the use of external capital providers on CAR is about equal when using the median relative size for this group. Unlike most M&A literature, acquisitions for which the target and the acquirer are in the same industry have a statistically insignificant 70 basis point lower CAR. While other studies do not exclusively use 18

20 cash acquisitions, acquisitions that are not diversifying are shown to consistently produce significant positive returns for the acquirer, all else held constant. The size of a target, as measured by total assets, has a negative effect on an acquirer s CAR. This may be because size is already controlled for in the relative size variable. Not shown here, when relative size is measured using market capitalizations of the target and the acquirer, the coefficient for a targets total assets remains negative, but becomes economically insignificant. Also not shown here, when the regression in column (2) is run with the Cash- 19

21 to-value dummy variable replaced with the continuous cash to value ratio S, the cash to value ratio has a small negative effect on CAR and is not statistically significant. These results using the continuous cash to value ratio are not surprising. The relationship between an acquirer s cash to value ratio and its CAR is not expected to be linear, and its negative effect matches the sign of the Cash-to-Value dummy, which takes a value of one when an acquirer had insufficient cash to complete the acquisition. Column (3) of Table IV adds a variable to the regression in column (2) called Leverage Change. Leverage Change is measured as the percent change in an acquirer s assets to equity ratio at the end of the quarter prior to an acquisition, to the end of the quarter after the acquisition has been completed. As described in Opler et al. (1999), the transaction costs model for cash holdings states that firms may avoid making frequent trips to outside capital markets when there are fixed costs in doing so. In the presence of such fixed costs, an acquirer could use an acquisition requiring external capital providers to borrow more than is needed to complete the acquisition, benefitting from economies of scale. Also, if an acquirer views the target as being an especially strong investment, it could borrow more than needed to magnify ROE. In either situation, an increase in leverage is predicted by the free cash flow theory to have a positive effect on CAR. While the coefficient on Leverage Change is positive in Column (3), it has virtual no effect on CAR. The coefficient on the Cash-to-Value variable becomes slightly larger and statistically significant at the ten percent level when Leverage Change is added, although this may be due to a reduction in the sample size to 220 acquisition. The insignificant effect of the acquirer s change in leverage from before to after the acquisition could be due to investors pricing in changes in capital structure at the announcement of the acquisition, which would be captured by the Cash-to-Value variable. An acquirer s beginning leverage and its change in leverage have a positive effect on its CAR, similar to Maloney et al. (1993). The lack of statistical significance in these variables however supports findings in Harford (1999) that the effect of cash holdings on CAR is not a leverage effect. 20

22 In the same way acquisition characteristics differed over an acquirer s GICS sector and cash to value ratio, these characteristics can also differ over time. Further, business confidence can change with economic cycles, which could affect how acquisitions are perceived by investors. Such arguments support the need to compare acquisition within a given time period. Roughly 54 percent of acquisitions in the sample of 227 acquisitions were announced before 2001, 36 percent from 2001 to 2008, and 10 percent after A noticeably higher ratio of acquisitions between 1996 and 1999 would have required external capital providers compared to other periods, as seen in Figure I. Although there is insufficient variation in the data due to sample size to control for both an acquirer s GICS sector and the year an acquisition was announced, time related effects can be controlled for by grouping acquisitions into four periods of about five years from 1990 to Such grouping also aligns well with major market events including the technology bubble and the financial crisis. Running the cross sectional regression (3) controlled for acquirer GICS sector and the time period of an acquisition s announcement produces the results seen in Table V. 21

23 No major changes occur across all variables. The coefficient on Cash-to-Value increase slightly from 2.7 percentage points, as seen in Table IV, to 2.9 percentage points, and becomes statistically significant at the ten percent level. When the regression in Table V is run using a threshold of 1 for the Cash-to-Value dummy, the statistical significance for Cash-to-Value decreases slightly to 11 percent and the coefficient decreases to 2.6 percentage points. In general, changes in the Cash-to-Value threshold result in small changes in the statistical significance of the Cash-to-Value variable, while the coefficient remains relatively constant. As the threshold approaches 1.5, the standard error for Cash-to-Value begins to increase and the statistical significance decreases. This could happen because it becomes increasingly less clear if the acquirer was required to use external capital providers for financing as the cash to value ratio S increases above one. PCAR remains positive, indicating that acquirer s which have had positive cumulative abnormal returns prior to an acquisition have higher CARs at acquisition announcement. 22

24 PCAR is not economically significant however. The median value of PCAR across the sample is about one percentage point, which would add less than one basis point to an acquirer s CAR at acquisition announcement. The variables Cash-to-Value and Relative Size have the largest impact on an acquirer s CAR. An acquirer that utilizes external capital providers for financing and announces an acquisition one standard deviation above the median relative size, will have a 7.94 percentage point higher CAR, all else held constant. Harford (1999) predicts firms with excess cash are more likely to make diversifying acquisitions. Not shown here, a linear probability model using the regression in Table V without the PCAR variable reveals that acquirer s which can finance an entire acquisition internally are not more likely to make diversifying acquisitions, however no variables are statistically significant for this regression. IV. Conclusion Agency theory indicates that debt can be beneficial in monitoring managers and reducing overinvestment problems. After studying 227 acquisition from 1990 to 2016, I find that bidder returns are 2.9 percentage points higher for acquisitions that could not be entirely financed with internal funds. These results support the free cash flow theory, and show that managers make better investment decisions when they cannot rely on internal financing. It is not distinguished whether debt s ability to reduce managers discretionary use of free cash flows, or its monitoring effect provided by the threat of bankruptcy, are driving these results. Consistent with theories regarding method of payment signaling, a one standard deviation increase in the size of a target relative to the size of the post-acquisition combined firm produces a 2.9 percentage point higher return in the bidder s shares at the announcement of an acquisition. Whether an acquisition is diversifying does not play a major role in acquirer returns for the cash acquisitions studied, and firms that are able to finance an acquisition internally are not found to pursue significantly more diversifying acquisitions. In addition to showing the beneficial effects external capital could have on manager performance, the results here indicate that cash holdings and the availability of internal financing are important determining factors in how investors interpret an acquisition at its announcement. These results indicate 23

25 that investors place value on the role external capital providers play in the investment decision process. How an acquirer s board of directors composition or differing manager compensation structures effects these results requires further study. Statistically significant results indicate that M&A research can benefit by considering market signaling related to agency costs. 24

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