Master Thesis. Do cash-rich firms undertake better acquisitions outside takeover waves in the U.S.: Evidence from Administration number:

Master Thesis Do cash-rich firms undertake better acquisitions outside takeover waves in the U.S.: Evidence from 1993-2008 Author: Administration number: Supervisor: Examination Committee: G.J.M. Menting s139746 Dr. M. Da Rin Dr. V. P. Ioannidou Dr. M. Da Rin Faculty: Tilburg School of Economics and Management Date: January 2011

2 Preface This thesis concludes my study Business Administration. The major I have done at Tilburg University, at the finance department, is Financial Management. The graduation will finish my life as a student at the Tilburg University. The last five and a half years were characterized with a lot of fun combined with times of hard work. During the last year I have worked on my master thesis, most of the time with pleasure, but sometimes with hard feelings. Firstly, I want to thank my supervisor Marco Da Rin for his support and useful comments on my work. Without his sharp remarks on my research, I would not be able to achieve my results. Secondly, I want to thank my parents Harry and Mathilde, my sister Lotte and her boyfriend Theo for believing in me. They played a huge role for me during my study here in Tilburg. Further, my friends are important for me and therefore I would like to thank them for the great time we had and still have in Tilburg. Moreover, I want to thank my study association Asset Accounting & Finance, ECCO and TSVV Merlijn for providing the opportunities to develop myself in a professional manner. As last I want to thank Tilburg University for the great time I had on this campus.

3 Abstract This study is an empirical research based on the existing evidence on cash-rich bidders. Previous research suggested that those bidders are associated with negative announcement returns due to the free cash flow hypothesis. Moreover, previous research provides evidence that the total announcement wealth effects of M&A s occurring in periods outside the takeover waves are always significantly lower than the gains earned during takeover waves. During takeover waves companies are better able to extract capital externally to finance their investments due to the favorable business cycle conditions. This study finds strong and significant evidence that investors will appreciate acquisitions of cash-rich companies more than other acquisitions during the years after the 5 th takeover wave. Furthermore, it provides evidence that high cash availability bidders make better acquisitions in the years after the 5 th takeover wave than similar companies during the 5 th takeover wave. Important remark is that it shows only weak evidence in the 11-day event period. Thus, this study argues that outside takeover waves the advantage of cheap corporate funds outweighs the costs of maintaining corporate funds. In other words, the free cash flow hypothesis is less strong outside takeover waves. Finally, this research finds signals that high cash availability bidders outside takeover waves tend to make better acquisitions than low cash availability bidders during takeover waves at announcement day.

4 Table of Contents Chapter 1... 6 1.1 Relevance and aim... 6 1.2 Problem indication... 7 Chapter 2 Introduction into the world of M&A... 8 2.1 Introduction... 8 2.2 Motives for M&A activity... 8 2.3 Method of payment... 9 2.4 Means of payment... 10 2.5 Demarcation... 11 Chapter 3 The financing decision of a takeover deal... 12 3.1 Introduction... 12 3.2 General information... 12 3.3 Why choose cash as method of payment?... 13 3.4 Why choose stock as method of payment?... 14 3.5 Source of financing... 16 3.5.1 Introduction... 16 3.5.2 Corporate Funds... 16 3.5.3 Debt financing... 17 Chapter 4 Benefits & costs for cash-rich firms... 19 4.1 Introduction... 19 4.2 What is financial slack?... 19 4.3 Benefits of cash-richness... 19 4.4 Costs of cash-richness... 21 4.4.1 Free Cash Flow Hypothesis... 21 4.4.2 Other costs... 21 4.5 Previous evidence on cash-rich bidders... 22 Chapter 5 Hypotheses... 24 Chapter 6 Methodology... 26 6.1 Introduction... 26

5 6.2 Sources of data... 26 6.2.1 Securities Data Corporation Platinum... 26 6.2.2. Wharton Research Data Services... 27 6.2.3 Datastream... 28 6.2.4. Websites... 28 6.3 Sample description... 28 6.4 Methodology... 29 6.5 Descriptive statistics... 33 Chapter 7 Results... 34 7.1 Introduction... 34 7.2 Results... 34 7.3 Other interesting results... 44 Chapter 8 Conclusions and Recommendations... 47 8.1 Introduction... 47 8.2 Summary... 47 8.3 Conclusions... 48 8.4 Recommendations for further research... 49 Appendix 1 : Tender-offers Dataset... 50 Appendix 2: Descriptive Data groups A... 54 Appendix 3: Descriptive Data groups B... 55 Appendix 4 Removed/Adjusted Observations... 56 Reference List... 57

6 Chapter 1 Introduction 1.1 Relevance and aim The history of mergers and acquisitions (M&A s) characterizes itself with the existence of takeover waves. They will arise if there are significant changes in the business environment. The first one took place from 1897 till 1904 and was known as a Monopoly wave. The second wave occurred during 1916-1929 (Oligopoly). Next, there was a conglomerate takeover wave and this one took place between 1965 and 1969. The fourth took place during 1982-1989 and was characterizes by its governance nature. The fifth and last takeover wave during 1993 and 2000 was known as a globalization wave. During a takeover wave it is easier for companies to attract capital on the financial market due to the good financial prospects. As a consequence, the companies will have more liquidity (and freedom) to undertake their positive Net Present Value (NPV) projects. In general, the investment with the most significant impact on the company, and therefore on the value of the company, is a takeover of another company. Previous research has shown that the method of payment and the financing decision have an important impact on the stock price of a company. In other words, the market has an opinion about the investment decision of the company. A company will take an investors attitude into consideration when choosing the method and means of payment, because investors determine the price of their stock. Previous research has also shown that if the company uses their corporate funds to finance a cash offer, their stock have negative announcement return. This result indicates that the company could better attract debt to finance this takeover. The existing literature has given us many meaningful results, but the majority of this literature had their focus on acquisitions during a takeover wave. This makes the period after a takeover wave a less covered section of study, but not less interesting. During the fifth takeover wave the stock prices rose significantly and therefore it was not difficult for companies to take advance of these high stock prices to attract capital. The fifth takeover wave ended because of the collapse of the stock market bubble and the related underlying economic downturn. As a consequence, it became more difficult for companies to attract capital and therefore also more difficult to finance an acquisition. As a result, during this period the M&A market faced a downturn in the amount of transactions. According to the theory of deep pockets, companies who retained their profits (and therefore created large cash reserves) would have more liquidity and are therefore able to take advantage of companies with liquidity problems. Companies with liquidity problems can become an easy (and attractive) takeover target. During a takeover wave, the investors judged a takeover done by a

7 cash-rich company negatively, but will they have the same opinion about those takeovers outside takeover waves? If not, do cash-rich companies make better acquisitions outside takeover waves? 1.2 Problem indication Previous research suggests more negative shareholder returns will occur when tender offers are mostly financed with corporate funds. During a takeover wave it is easier for a company to attract capital, under the assumption that the company is healthy. But in the years after a takeover wave this situation changes. Banks become more reluctant to lend their money and therefore it becomes more difficult for companies to attract capital externally. Thus, liquidity can become an issue. In such situations, cashrichness of company can provide the manager the freedom to always be able to undertake their positive NPV projects (like an attractive takeover target). So, there is a possibility that the free cash flow hypothesis will not be applicable in this situation. Could cash-richness be a substitute for the easy accessible capital markets outside takeover waves? This research will focus on the underlying cash position of the company and the short term shareholder wealth creation of those deals. Further, the source of payment that a cash-rich company uses will be checked. This study argues that when liquidity is an issue in the market, bidders with higher cash reserves will generate more short term shareholder wealth outside takeover waves than similar bidders during takeover waves. Thus, cash-rich firms make better acquisitions outside takeover waves in the United States. This research will focus on the fifth takeover wave and the years 2001-2008. The problem statement of this research can be stated as follows: Do cash-rich firms undertake better acquisitions outside takeover waves in the U.S.: Evidence from 1993-2008

8 Chapter 2 Introduction into the world of M&A 2.1 Introduction In the corporate world investments are the core of creating value for the company. There are several forms of investments that a company can undertake to create value. From all these sorts of investments, a takeover has the most impact on the value of the firm. But in a perfect market, with no taxes, the financing of an investment is irrelevant for the total value of the company. This statement was first invented by the pioneers on the capital structure theory; Modigliani and Miller. 1 During the last decades the literature about capital structure had grown rapidly and also the literature on the financing decision of an investment. The majority of the existing literature focuses on the assumption that the market is efficient, which means that prices fully reflect the value of the firm. The rate of return investors receive on their securities provides a measure of how those resources are utilized. When a firm s stock price experiences a string of abnormally low returns, than the firm is not using its resources in the right way (Kummer & Hoffmeister 1978). Hence bad performers become potential targets, but when bidding firms act rationally they will pay no more for their target than the expected level of benefits. As a result, when maximizing the value of its shareholders, it will offer a bid premium less than the value of the expected benefits (Kummer & Hoffmeister 1978). Three decades of evidence on public takeovers, demonstrates that they are at best wealth neutral for bidding firm stockholders, and potentially wealth destroying (Officer, Poulsen & Stegemoller 2009). The question arises why managers want to take over another publicly traded company when the majority of the takeovers are value destroying for their own shareholders. Section 2.2 will outline the existing evidence on the manager s motives for M&A activity. In the sections 2.3 and 2.4, this study will elaborate the relevant information about the method and structure of the takeover deals. Finally, in section 2.5 a demarcation for this research is made. 2.2 Motives for M&A activity In the existing literature there are three leading motives for managers to undertake a takeover, namely; synergy, agency and hubris. The synergy motive suggests that takeovers occur because of economic gains that result by merging the resources of the two firms. The manager of the acquiring firm will undertake this takeover if both acquirer s and total gain is positive. This is under the assumption that 1 Modigliani and Miller argue this assumption in their 1958 paper.

9 the manager will follow the synergy motive; else he will not proceed with the planned takeover. The second motive is the agency motive; it suggests that takeovers occur because they increase the acquirer management s welfare at the expense of acquirer shareholders. Despite that this motive conflicts with the synergy motive, a manager wants to engage into takeovers for various reasons. For example, managers will use takeovers to diversificate their own personal portfolio at the expense of the shareholders (Amihud & Lev 1981). Also, a manager can use the free cash flow to increase the firm size to gain prestige in their business environment (Jensen 1986). In addition, managers want to entrench themselves to the firm by acquiring assets and increase the firm s dependence on them (Schleifer & Vishny 1989). Summarizing, acquisitions result in the extraction of value from the acquirer shareholders by the acquirer management, when the manager follows the agency motive. At last, there is the hubris hypothesis. This hypothesis suggests that managers undertake acquisitions while there are no synergy gains. But this motive is not the same as the agency motive, because no synergy gains will arise because the manager made mistakes in evaluating the target firm (Berkovitch & Narayanan 1993). Not all of those three motives will eventually lead to positive returns on the market. For example, an investor can judge that the motive is not the right and/or the valid one to engage in a takeover. The existing evidence underpins this point of view. According to the paper of Berkovitch and Narayanan (1993), the majority of the takeovers are motivated by the synergy motive and the agency motive seems to be the major reason for the existence of value-reducing acquisitions. This indicates that the market screens the motives of managers. From the three motives, the synergy motive appears to be leading motive for takeovers (Goergen & Renneboog 2004 and Gupta, LeCompte & Misra, 1997). 2.3 Method of payment This section will introduce the method of payment decision into the takeover process. After a manager decides to engage in a takeover, he has to decide which method of payment will be used. According to the existing literature, there are four methods possible; Cash Equity Mixed Undisclosed

10 Each of the four methods of payment has their own advantages and disadvantages. In the last decades there have been a growing number of researches on the consequence of choosing a particular method of financing. These consequences will be deeper outlined in chapter 3. The most common distinction in the method of payment is the following; cash or equity. When a company decides to finance the takeover with equity, they will exchange their own shares for the shares of the target company. When using cash as method of payment, the company can use multiple sources to finance the investment. These possible sources will be discussed in section 2.4. 2.4 Means of payment This section will dig deeper into sources of cash financing. In the existing literature means of payment is usually considered as synonymous to the sources of takeover financing. As earlier explained, a cashoffer can be financed with multiple sources. If the deal size increases, it becomes more likely that the amount of financing sources also increases. There are different sources of payment, like 2 : Corporate funds Bank loan Common stock issue Preferred stock issue Rights issue Debt issue Foreign provider of funds Junk bond issue Mezzanine financing Staple offering financing The choice for which financing source is subject to several variables. For instance, the economic conditions in the market are crucial. If there is uncertainty in the market about the upcoming future, banks and private investors are more reluctant to lend money to companies. As a consequence, the credit lines for companies will be narrower. Therefore, the probability that the firm can use bank loans as means of payment becomes smaller. Further, the chance that the company can raise money through a stock offering becomes less likely. In those financial times, it would be predictable that companies will 2 These different sources are given by the SDC Platinum database.

11 rely more on their corporate funds to finance a cash offer. On the contrary, if the economic conditions are favorable, the credit lines will be wider and investors are more willing to lend their money. Summarizing, the economic conditions can have an influence on the means of payment of a cash-offer. 2.5 Demarcation The financial market and their related variables are continuously changing. Thereby, each company has his own characteristics. To be able to perform a good analysis, it is crucial to make several assumptions about the financial market conditions. Underneath, this study will provide various assumptions about the financial market conditions which will give us a platform for the remainder of this research. First, this study will use the efficient markets framework. An efficient market is defined as one where the share price fully incorporates all available information on that security (Fama 1970). However, there is a growing body of research that disproves the functioning of this framework (Bernard & Thomas 1989; Sloan 1996; Hirshleifer, Hou, Teoh & Zhang 2004 and Agrawal & Jaffe 2000). One of the opponents argues that the given market price reflects the beliefs of attentive and inattentive investors, which disproves the existence of an efficient market (Griffin & Tverksy 1992; Hirshleifer & Teoh 2003 and Oler 2008). Despite this counter-argument, this study will use for the simplicity the efficient capital markets as basic platform. Second, the term free cash flow will frequently be used. In the existing literature there are various definitions of free cash flow, but this research will use Jensen s definition of free cash flow; free cash flow is the cash flow in excess of that required funding all projects that have positive net present values when discounted at the relevant cost of capital (Jensen 1986). Third, each company is unique and has their characteristics. All companies that are considered in this research will be labeled as a U.S. publically listed company. Therefore, this study will exclude all evidence given on cross border takeovers. As a result, this research will not face the problem of unequal access to the external capital markets for different companies. Each company has the opportunity to attract cash externally. As a result, there is no indifference about this opportunity.

12 Chapter 3 The financing decision of a takeover deal 3.1 Introduction This chapter will elaborate the reasons behind the financing decision. First, a small introduction about the financing decision is given in section 3.2. Section 3.3 will point out which reasons drives managers to cash as exchange medium. Section 3.4 will outline the reasons for using equity to finance a takeover offer. Finally, in section 3.5 a small overview of the existing evidence is given on the consequences of using a particular source of financing. 3.2 General information According to Bruner (2003), abnormal returns to acquirer shareholders from M&A activity are essentially zero on average. A reason could be that buyers essentially break even. This can be explained by the size effect; on general, bidders are larger than targets. Other researches argue that only the acquiring firms directors will benefit (Firth 1980). Despite the excessive evidence on returns of the target shareholders, the focus will be on the returns of the acquirer in the following chapters. 3 Underneath, this study will give a review of the existing literature and the underlying implications for this research. In general, a bidding manager will always choose the method of payment that will generate the highest abnormal returns for his company. Besides the manager itself, the business cycle conditions can influences the manager incentives, and therefore influences the choice for an exchange medium. First, when there is an increase in overall economic activity more stock financing will be used in takeover deals. This is because firms face lower adverse selection cost, have more promising investment opportunities, and have less uncertainty about asset-in-place (Choe, Masulis, & Nanda 1993). Secondly, the total announcement wealth effects of M&A s occurring in periods outside the takeover waves are always significantly lower than the gains earned during takeover waves (Harford 2003 and Bhagat, Dong, Hirshleifer & Noah 2005). Further, the financing decision is also influences by the cost of external capital. The cost of external capital is subject to the bidder s pecking order preferences, its growth potential and its corporate governance environment. Moreover, Martynova & Renneboog (2008d) found that the payment decision 3 The focus of this research is on the wealth creation for the acquiring shareholders.

13 depends on the strategic preferences of the bidder s large shareholders. In the first place, it depends on to which degree they wish to retain control after the takeover. Second, it depends on the intention to share the risk of the transaction with the target s shareholder. For instance, if the shareholders are absolute certain that the takeover will be profitability then they will prefer to buy all the target shareholders out (Martynova & Renneboog 2008d). Next, the financing decision transmits a signal to the market about the quality of the bidding firm and profitability of the deal (Yook 2003 and Martynova & Renneboog 2008d). Furthermore, the payment method has an informational function to the market. It can indicate something about the bidder s assessment of the true value of the combined entity s assets, together with the bidder s assessment about the true value of assets in place (Yook 2003). As last, the amount of cash reserves held by the target firm can be important for the acquiring manager. These cash reserves can provide the bidder with part of the necessary money to finance the particular acquisition (Goergen & Renneboog 2002). Concluding, the choice for a particular method of payment is a combination of multiple factors. 3.3 Why choose cash as method of payment? In this section the first method of payment will be outlined, namely the cash method. The cash method is the predominant method of financing for tender offers (Gilson 1986 and Fishman 1989) and cash offers trigger much larger share price reactions than all-equity offers or combined offers (Goergen & Renneboog 2004). 4 The existing literature has a positive perspective about the cash method. But, there are also some disadvantages about cash as exchange medium. Therefore, in the next paragraph the different opinions about this method will be discussed. To start with, cash will be preferred as exchange medium if the manager values control. Using stock as exchange medium will dilute his holdings and increases the risk of losing control of the company (Martynova & Renneboog 2008d). In addition, the larger the managerial ownership fraction of the acquiring company, the more likely the use of cash financing (Amihud, Lev & Travlos 1990). Moreover, by using a cash-offer management ownership s fraction will not dilute and therefore the firm is less vulnerable for takeovers in the future. Those actions can act as a takeover resistance strategy (Harris & Raviv 1988). Cash will be the best option to use as exchange medium when the bidding firm believes 4 A combined bid consist of cash, equity and loan notes.

14 their own stock is undervalued by the market (Amihud et al. 1990). 5 Such an action sends a signal to the market that bidder s management thinks that their equity is undervalued. Besides it signals that the management has confidence that it will accomplish to achieve all the potential synergies after the takeover and they does not want to share it with the target shareholders (Fishman 1989; Berkovitch & Narayanan 1990; Eckbo, Giammarino & Heinkel 1990 and Goergen & Renneboog 2002). On the contrary, when their own stock is overvalued a common stock exchange offer will be preferred by the manager. During the negotiations of a takeover, the chance that both parties disagree about the actual value of the target company can be a possibility. The target company has an information advantage over the bidding company. In other words; there exists an informational asymmetry between the target and the bidder. The bidding company will prefer a cash offer if he expects to achieve high synergies. But when the bidder expects low synergy gains, he will prefer equity as exchange medium. The costs of collecting information about the target can be expensive when the bidder faces information asymmetry about the target value. When these costs will be too high, cash financing will be more likely. Furthermore, the characteristics of the bidding company are influencing the financing method. For example, when a firm has large amounts of cash, a high cash flow, or sufficient debt capacity they are more likely to use cash as exchange medium (Martin 1996). But also the characteristics of the target company can have an influence. In general, small takeover targets are financed with cash, because of the small amount of money involved in those deals. The chance the company has all this cash inside their corporation will be less likely if the deal size increases. The company will be forced to extract capital externally to complete the transaction. Summarizing, when the deal size increases firms has to rely on multiple sources to collect the required money for the transaction. Overall, the existing literature indicates that cash offers generate better returns than pure stockexchange offers. On average, with stock exchange offers bidding firms generate significant losses, while with cash offers they experience normal returns (Travlos 1987; Servaes 1991 and Bhagat et al. 2005). 3.4 Why choose stock as method of payment? The second method that will be discussed is the stock exchange method. The bidder will offer his own shares for the target s shares. The stock exchange method has his upsides but also his downsides. In this 5 Tax-consequences for target firm are removed from my literature-overview; the financing choice lies in the hands of the bidding company.

15 section, an overview of the existing literature about the motivations of the managers for choosing the stock exchange method and their valuation consequences will be given. First, recent empirical evidence shows that equity has become an increasingly popular source of financing in M&A s (Andrade 2001 and Martynova & Renneboog 2008d). Despite that stock financing is related to a significantly negative share price revision following the announcement of a takeover (Martynova & Renneboog 2008d). 6 The reason of using more equity financing in takeover deals are the growing deals sizes of takeovers. Companies are not able anymore to finance their deals only with cash and must therefore also rely on stock financing. In addition, managers will tend to use more stock financing when the bidder has a low cash balance relative to the transaction value (Martin 1996). But, it decreases with a higher cash availability of the acquirer. Second, information asymmetry can cause valuations differences. When the company s stock is overvalued by the market, the bidding manager prefers to use the company s stock as exchange medium (Myers & Majluf 1984). In this situation, the cost of stock financing will be lower than the cost of cash financing and as a result the manager will use stock as exchange medium (Amihud 1990). Stock has a contingent-pricing effect that, for the same costs to the acquirer, induces the target to accept the offer in all states for which it would have accepted at equal cost a cash offer. However, the acquiring firm will not offer his own shares when the target underestimates the value of the offer (Hansen 1987). Consequently, information asymmetry can cause serious trouble when the bidding company wants to use stock financing. When the target manager has an informational advantage, the bidding manager will prefer stock as exchange medium to force the target to share any post-acquisition revaluation effects (Martin 1996). Consistent with this statement are the findings of Officer, Poulsen & Stegemoller (2009); they found higher acquirer announcement returns when acquirers used equity to acquire difficult-tovalue targets. Third, the debt/equity ratio has an influence on the financing decision. The probability of a stock exchange increases with the acquirer s debt. 7 On the contrary, the probability of a stock exchange decreases with the target s debt level (Hansen 1987). Further, the likelihood of stock financing will 6 Value reduction will be smaller in periods of stock market booms, than in normal stock market circumstances. 7 This is consistent with the Pecking Order Hypothesis and the cost of capital U-curve.

16 increase when the firm has higher growth opportunities, a higher pre-acquisition market return or a higher acquiring stock return (Myers 1977 and Martin 1996). 8 Because, the equity method gives them more discretion over the funds rose than with debt financing (Jung, Kim & Stulz 1995). Moreover, an equity-offer could be interpreted as a signal of a profitable investment opportunity (Cooney & Kalay 1993). A downside of an equity-offer is that it signals that the bidding management thinks their shares are overvalued. As a consequence, investors will adjust the bidding firm s share price downwards when equity financing is announced (Myers & Majluf 1984). This phenomenon is known as the equity signaling hypothesis. 3.5 Source of financing 3.5.1 Introduction This section will elaborate the method of cash financing. Managers can use their own corporate funds to finance an acquisition, especially for small size deals this is an achievable opportunity. But when the deal size increase it will become more difficult to finance the whole deal with corporate funds. As a consequence, the company must go to the external capital markets to attract capital to finance their cash-offer. Debt could be a substitute for corporate funds (Myers & Majluf 1984). Besides attracting debt, the company can choose to undertake a share issuance. There are more constructions than those mentioned above to attract capital, but for the simplicity of this study only debt financing and corporate funds as means of payment will be considered. 3.5.2 Corporate Funds The first source of fund is the corporate funds of the company. When the deal size is small, the firm will be better able to finance it with only their corporate funds. When the deal size grows, this becomes harder for the company. But small deals are not the only motivation to use corporate funds to finance an acquisition. There are multiple reasons and motivations for the usage of corporate funds. For instance, managers who fear to lose control after a takeover prefer cash as exchange medium (Stulz 1988 and Jung, Kim & Stulz 1995). Thus, managers with a large ownership stake will not be in favor of using stock as exchange medium. Counter-evidence given by Martin (1996) argues that managers only care about the impact of dilution if their own stake is in the middle. In addition, companies with high cash balances will be more tempted to use their corporate funds (Crawford 1987). 8 Jung, Kim and Stulz (1995) found also evidence that higher investment opportunities, whether measured using Tobin s q-ratio or historical sales growth, lead to a greater probability of stock financing.

17 Further, companies with financial slack will prefer to use their corporate funds to finance the acquisition, because it is the least expensive financing source. This assumption is in line with the pecking order hypothesis. As last, when the manager believes that their shares are undervalued they will use their corporate funds to finance the acquisition (Yook 2003). 9 On the contrary, there will be a lack of outside monitoring when using corporate funds as financing source. According to Martynova & Renneboog (2008d) acquisitions financed with corporate funds will underperform those that are financed with debt. They argue that investors judged such acquisitions as pure managerial empire building. 3.5.3 Debt financing When corporate funds are insufficient, the manager will opt for debt financing if the shares of the firm are undervalued or if there is a high risk that an equity issue will trigger a substantial share price decline (Martynova & Renneboog 2008d). According to the evidence found by Bharadwaj & Shivadasani (2003), debt financing will lead to significantly positive acquirer announcement returns. An explanation for the positive returns can be that bank financing can overcome the information disparity between the company and the external capital markets (Bharadwaj & Shivadasani 2003). Banks are typically regarded as financial intermediaries with superior information and evaluation capabilities (Leland & Pyle 1977 and Diamond 1984). Thereby, the disciplining function of debt provides the company with an incentive to undertake value-enhancing investment project (Diamond 1994). Moreover, bank debt has a screening function. This implies that the bank will screen all the proposed projects of the firms on their profitability. As a result, the negative NPV-projects are screened out and this will have a positive certification effect (Boyd & Prescott 1986 and Diamond 1991). This view is supported by James (1987), Lummer & McConnell (1989) and Billett, Flannery & Garfinkel (1995), they all found empirical evidence that the market appreciates the monitoring and screening role of the bank. An important advantage of bank debt is that bank debt contracts place restrictions on manager s future investment choices (Bharadwaj & Shivadasani 2003). This disciplining function can create incentives to only undertake positive NPV-projects, but on the contrary it can place restrictions on the freedom of the managers in such manner that less known but certainly attractive investment opportunities will be overlooked (Martin 1996). However, firms with poor investment opportunities will experience positive 9 Stock-exchange will destroy value for the bidding firm s shareholders when the stock is undervalued in the market.

18 returns when using bank debt as financing source. Furthermore, bank debt transmits a positive signal to the market about the valuation of the firm s own shares and that the takeover is profitable. The positive view of bank debt is supported by the evidence of Bharadwaj & Shivadasani (2003); firms with poor performance and high information asymmetry experience positive CAR s when they used bank debt in their tender offer. Next, attracting debt has as consequence that the firm will create a larger debt burden. The manager has to make sure that the firm will not go bankrupt due to the increased interest costs. In other words, the higher leverage makes managers to work harder. The higher leverage also mitigates the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers (Yook 2003). Furthermore, the discipline function of debt is appreciated by the market participants (Bharadwaj& Shivadasani 2003 and Yook 2003) Besides the positive effects, debt financing has also some downsides. The bank will receive information about the firm s business and their financial statements if they lend the company money. As a result, the bank creates an information advantage over other parties. This information advantage of the bank can be detrimental to the firm s shareholders, because this information monopoly can result in a surplus that is appropriable by the bank. Consequently, the firm s incentive to pursue shareholder valuemaximizing investments will decrease (Rajan 1992). The bank can become less objective over the profitability of the firms investment opportunities, when an officer of a bank is also a member of the borrower s board of directors. Kracaw & Zenner (1998) found that a bank loan announcement is associated with significantly negative announcement returns. This phenomenon is due to the redeeming discipline function of debt and bankruptcy costs. It is possible that the bank stimulates the company to choose for negative NPV-projects but with stable cash flow, to guarantee that the firm will be able to pay back the debt to the bank. Understandable, this will not be in favor of the firms shareholders. In such scenario, corporate funds will be preferred as financing source above debt financing (Bharadwaj & Shivadasani 2003).

19 Chapter 4 Benefits & costs for cash-rich firms 4.1 Introduction In the presence of capital market imperfections deriving from asymmetric information between managers and capital providers, liquidity can take on a strategic role. By managing the cash balances of the firm in a right manner, the manager will be able to create firm value. For example, a cash buffer enables the manager to finance investments even when the credit lines will be tight (Harford 1999). He creates value by avoiding the underinvestment problem. Besides the benefits, large cash reserves can create large costs. In section 4.2, a short description of financial slack will be given. In section 4.3, this research will outline the motivations for creating cash reserves. In section 4.4, the potential costs will be discussed. Finally, the previous evidence about cash-rich acquirers will be discussed in section 4.5. 4.2 What is financial slack? First, it is important to know the creation process of financial slack. Logically, cash reserves can be considered as primarily buffer stock and the value of cash reserves is driven by three prime factors; the degree of information asymmetry faced by the managers, the volatility and level of the firm s cash flows (Harford 1999). In addition, cash reserves are positively related with market-to-book ratios (Opler, Pinkowitz, Stulz & Williamson 1999). If the cash flow is greater than the amount required to fund the firm s positive NPV projects, the cash reserves of the company grows and the firm become cash-rich. When the manager will continue this process for a while, the firm will create large cash reserves. 4.3 Benefits of cash-richness This section will elaborate the motivations of managers for creating large cash reserves. First, cash reserves provide benefits for shareholder by reducing the underinvestment problem (Harford 1999). Excess cash will give a manager the freedom to undertake projects that will be good for his welfare but perhaps not for the shareholders welfare. Thus, when the manager only cares about his own utility maximization, he will not be in favor of paying out the excess cash to the shareholders. The cash reserves can be used to fund large expenditures, such as a planned acquisition, instead of using the costly external markets to raise the required amount of money for an acquisition (Harford 1999). 10 Due to the capital market imperfections and the pecking order hypothesis, this is a costly trip. The cash reserves will provide them with sufficient internal financial flexibility in this situation. In addition, they 10 Imperfect capital markets make external capital costly.

20 are better able to respond to risks in their industry and can better take advantage of the opportunities in the market (Myers & Majluf 1984). Besides, paying out the free cash flow can be costly, because replacing the funds later when they need the funds can be more expensive (Myers & Majluf 1984). 11 For those reasons, the manager will be reluctant to payout the excess cash to the shareholders. Further, more cash in the firm s pocket is desirable because it increases the firms financial flexibility (Kieso, Weygandt & Warfield 2004 and Oler 2008). Moreover, the manager thinks that it is value increasing, because equity holders will suffer the loss from underinvestment (Harford 1999). Besides, the manager will want to hold the cash to bridge the gap between disbursements and receipts (Keynes 1936). Another point of view is that cash availability has value during times when it is harder for companies to attract external capital. During an economic downturn, companies credit lines of banks will not be renewed by the bank and therefore companies will cut their investments and start witch accumulation of cash (Ivashina & Scharfstein 2009). These firms will create large cash reserves to avoid the underinvestment problem in the future. Firms that engage in this stockpiling of cash in an earlier stage than other companies can take advantage of the opportunities that other firms must forego due to the lack of financial flexibility. Furthermore, cash reserves can function as a takeover defense mechanism. It enables the manager to defend the company against an unwanted bid (Faleye 2004). For example, the cash from the buffer can be used to engage in bidder-specific negative NPV-projects. As a result, the value of the company for the bidder will be reduced. Summarizing, cash reserves can increase the uncertainty about the target s value for the bidder and thus cash availability can serve as a takeover defense tool (Faleye 2004). Finally, maintaining a high cash reserve can convince the market that the company runs their business superior and are able to generate cash (Oler & Picconi 2009). 12 Therefore, creating large cash reserves can be seen as a strategic choice. Such an action can be effective to win back the investor s confidence, especially during economic downturns. 11 This is due to the market imperfections. 12 Business includes operations and financing activities.

21 4.4 Costs of cash-richness 4.4.1 Free Cash Flow Hypothesis One of the leading theories about the costs of having large cash reserves is the free cash flow hypothesis. 13 The free cash flow hypothesis will occur only when the organization generates substantial free cash flow. In such situations, the manager will have more cash available than he can reinvest in the available positive NPV-projects. As a consequence, he will face the problem of choosing between paying out the cash to the company s shareholders or to stockpile the excess cash. By stockpiling the cash, he will have access to a cheap financing source in the future and can avoid the costly external capital market. However, due to the lack of external monitoring, conflicts of interest will arise between shareholders and managers over the payout policy (Jensen 1986). Instead of paying out the excess cash to their shareholders, the manager will engage in low-benefit or value-destroying mergers (Lang, Stulz & Walking 1991). This phenomenon is also known as the free cash flow hypothesis. In other words, there is a possibility that agency issues will arise when a firm has excess liquidity. 4.4.2 Other costs First, the value of cash holdings is subject to the market opinion. For instance, the market places a lower value for firms with large cash holdings for distressed firms and firms with fewer growth opportunities (Pinkowitz & Williamson 2001). Second, large cash reserves will give the manager the freedom to invest it in their way without external monitoring. Therefore, the freedom for managers of not making costly trips to the external capital market can be valuable for the shareholders, but in the same time this freedom can be abused by the managers. However, frequent trips to the external capital market helps to control the agency conflict between the manager and the firm s shareholders (Easterbrook 1984). Thereby, the agency conflict will be more severe when the manager has access to more internal generated funds (Jensen 1986). 14 This statement underwrites the importance of the trips to the external capital markets. Equity holders will prefer paying out the cash above the optimal buffer level, while the manager will enjoy the freedom and the related lack of active monitoring. This cash buffer will protect the company against an economic downturn, but when the cash buffer becomes too large it can hurt the company in the way that the undertaken projects will not be screened well enough on their 13 The Free Cash Flow Hypothesis was first defined by Jensen in 1986. Latter researches as Lang et al. 2001 and Richardson 2006 provide also empirical evidence that confirms the results of Jensen. 14 This is generated by free cash flow.

22 profitability anymore (Harford 1999). As a result, an agency conflict over the disposition of the cash reserve at the cost of the company s shareholders could arise (Harford 1999). Because the manager experiences more freedom in cash-rich firms, the chance that he will make a mistake is bigger due to the lack of external monitoring (Harford 1999). Unless the lack of monitoring gives the manager more freedom to be creative, the negative impact of cash hoarding on the future firm performance will outweigh any potential benefits gained from increased operational flexibility (Oler & Picconi 2009). 15 Third, problems over the destination of the generated free cash flow could arise if the interests of the manager not correspond with those of the shareholders. Empirical evidence of Jensen (1986), Harford (1999) and Oler (2008) shows a high cash level will contribute to the agency problems between managers and shareholders. Further, because a manager of a cash-rich firm faces less external monitoring, he will be tempted to make investments that will maximize his own utility instead of the company s shareholders (Oler & Picconi 2009). Thereby, managers will have incentives to continuously spend cash in such ways so they can increase their power and prestige, like making acquisitions, even if such investments will not maximize the firm value. Finally, despite cash accumulation signals to the market that the firms current investments are successful in generating cash, it also signals that the firm has not any significantly good investment opportunities left to invest in (Oler & Picconi 2009). Furthermore, cash-rich firms with limited set of investment opportunities are penalized by the market for holding excess cash by a downturn in their share price. 4.5 Previous evidence on cash-rich bidders In the past decades, there has been a growing body of literature on takeovers and their deal characteristics. As a result, there has also been research on cash-rich acquirers. Underneath, the most important views of the literature on cash-rich acquirers will be described. The leading research on cash-rich acquirers is done by Harford (1999). Logically, cash-rich firms have more corporate funds compared to other comparative companies. This enables them to finance their takeovers with their corporate funds. As a consequence, they would not have to make the costly trip to the capital market too often in contrary to cash-poor firms. In addition, the acquisitions are less monitored on their possible profitability. As a result, cash-rich firms will have more freedom to 15 Their paper was published in 2009.

23 undertake acquisitions. As a consequence, the chance that the acquisition is value-reducing will be higher. Harford (1999) provides empirical evidence which supports the agency costs of free cash flow explanation for cash-rich acquirers. The market will react with a negative stock price reaction at announcement, when a cash-rich firm makes an acquisition which is subject to the free cash flow hypothesis (Harford 1999). An explanation can be found in that large cash balances remove an important monitoring component from the investment process. Cash-rich firms will engage in diversifying acquisitions. Theory explains that diversifying acquisitions are in general value-destroying. Managers will engage in those value-destroying activities because they prefer to spend the excess cash instead of paying it out to their shareholders. This is in line with the free cash flow hypothesis. The investors anticipate partially to this behavior by a negative stock market reaction to cash stockpiling activity. Next to the negative evidence found on cash-rich acquirers, there are also some researchers that found positive features about cash-rich acquirers. If firms with financial problems combine with firms with financial slack, the market will acknowledge that there are gains that can be achieved (Hanson 1992, and Smith & Kim 1994). Under this market imperfection hypothesis, cash-rich firms are no more likely to make bad investments than other comparative firms.

24 Chapter 5 Hypotheses In this thesis the main topic of study is to find out if cash-rich firms undertake better acquisitions outside takeover waves in the United States during the time period 1993-2008.In order to answer this research question, several hypotheses will be tested. The existing literature tells us if cash-rich companies make acquisitions, they will generate negative abnormal announcement returns on average. A common explanation for this result is the existence of the free cash flow hypothesis. This hypothesis indicates that the company suffers a lack of external monitoring and as a result the manager will have too much freedom over the available free cash flow. Following this hypothesis, cash-rich companies will under achieve companies with a normal cash level. But when banks are reluctant to lend money to companies, the internal resources can become a valuable financing source. In this situation cash-rich companies can create an advantage over cash-poor companies. Hypothesis 1 is to test if cash-rich companies will achieve higher abnormal returns than cash-poor companies during the time period 1993-2008. The investment activities that will be used to check hypothesis 1 are corporate acquisitions. Hypothesis 1: Cash-rich companies will make better acquisitions than cash-poor firms during 1993-2008 according to the market participants. A downside of Hypothesis 1 is that the time span is too long and it includes a takeover wave. The long time period leaves the chance that takeovers during the fifth takeover wave will dominate those of the years after. By focusing on the takeovers after the fifth wave, this study is able to see if cash-rich companies make better acquisitions than cash-poor companies when the capital markets are tighter. If cash-rich companies achieve higher abnormal returns, this study can conclude that cash-richness is appreciated by the market in the years after a takeover wave. This result can indicate that companies can create an advantage over other companies by building cash reserves in the years after a takeover wave. Hypothesis 2: Investors will appreciate acquisitions of cash-rich companies more than other acquisitions during the years after the 5 th takeover wave.