Corporate Cash Holdings and Acquisitions

Erik Lie and Yixin Liu

(Literature review prepared by: Enkhdelger Erdene - 606535008

. Delgermurun Battulga - 606535009
Steven Sebastian - 606535007

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TABLE OF CONTENTS

1. Research questions and prior studies.........................................................................3

2. Testable hypotheses, main variables, and data sources.............................................3
2.1 Testable hypothesis..........................................................................................3
2.2 Main variables..................................................................................................4
2.3 Data sources.....................................................................................................4
3. Empirical analysis.....................................................................................................5
A. Decision to Undertake Acquisitions.................................................................5
B. The Effect of Cash Holdings on Acquirer’s Announcement Returns..............5
C. Overvaluation Analysis....................................................................................6
D. Subsequent Operating Performance.................................................................7
4. Summary and contributions......................................................................................7
5. Critical comments.....................................................................................................8
6. References.................................................................................................................9
7. Appendix..................................................................................................................10

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1. RESEARCH QUESTIONS AND PRIOR STUDIES
During the recent years, non-financial firms are holding much more cash compared to
decade ago. According to Moody’s Investors Services, US non-financial firms rated
by Moody’s held $1.68 trillion in cash at the end of 2015 which is more than twice the
amount held in 2007. Average cash holdings of US firms also increased steadily
during the last few decades in accordance with Harford, Klasa, and Maxwell (2014).
Various studies were undertaken based on the concern that excess cash urge managers
to invest in value destroying or negative NPV projects. Jensen (1986) hypothesizes
that “managers of firms with unused borrowing power and large free cash flows are
more likely to undertake low-benefit or even value-destroying mergers”. Harford
(1999) predicts that firms with excess cash tend to make value-destroying acquisitions
and found that firms with excess cash are more likely to undertake acquisitions which
are associated with lower announcement returns.
This paper suggests that evidence found by previous studies (most prominently
Harford, 1999), may have changed mainly due to three reasons:
a) Harford’s (1999) sample consisted of relatively few observations (487
acquisitions) covering period 1977 to 1993 which may no longer be valid. Since
then, number of mergers and acquisitions and amount of cash holdings both
jumped significantly. There are also greater regulatory requirements imposed to
firms that constrain the ability of managers to undertake bad acquisitions.
b) Prior studies do not differentiate between cash and stock acquisitions. Harford
(1999) controls for the payment method in his analysis however; he did not
consider whether his results differ across cash and stock acquisitions. Gao (2011)
alike, finds that the negative relation between acquirers’ cash holdings and
announcement returns prevails for a sample of pure stock acquisitions but does
not examine the relation for cash acquisitions.
c) The authors hypothesize that cash holdings do not necessarily lead to more value-
destroying acquisitions. Several studies also suggested that an excess cash
holding is not associated with bad acquisitions. Moeler, Schlingemann, and Stulz
(2004), Savor and Lu (2009), and others find that acquisitions financed with stock
are associated with an average negative stock price reaction for acquirers. Gao
(2011), and Pinkowitz, Sturgess, and Williamson (2013) find that firms with
excess cash are less likely to finance their acquisitions with cash compared to
other firms. Savor and Lu (2009) also find evidence that overvaluation of
acquirers, rather than value destruction, leads to negative announcement returns.
This effect is even stronger when the firm has excess cash, but does not wish to
use those excess cash for acquisitions, and rather uses stock payments in
accordance with Gao (2011). This may explain negative relationship between
acquirers’ cash holdings and announcement returns.

2. TESTABLE HYPOTHESES, MAIN VARIABLES, AND DATA SOURCES

2.1 Testable hypothesis
The authors came up with four testable hypotheses:

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First, the authors examine whether excess cash leads firms to undertake more
acquisitions. The free cash flow theory suggests that excess cash leads to more
acquisitions. However, the authors find that there was no evidence cash holdings lead
to more acquisitions.
Second, the authors tested whether Harford’s (1999) result that announcement returns
for acquirers decline with their cash holdings. The authors find that there is negative
relationship between cash holdings and announcement returns which is consistent
with Harford’s (1999) result. However, differences arise when the analysis was run
separately for different payment methods. The negative relationship between cash
holdings and announcement return was even stronger for stock acquisitions whereas
there were no correlation for mixed acquisition and cash acquisition.
Third, the authors tested whether acquirer firms using stock acquisitions is overvalued
compared to firms using cash acquisitions. The authors find that acquirers using stock
payment are more overvalued than those using cash payment.
Fourth, the authors examined operating performance in order to find whether negative
announcement returns were due to value-destroying acquisitions or overvaluation of
the acquirer. The latter was true.

2.2 Sample selection and Data sources

The sample size covers the acquisitions announced between January 1985 to
December 2015 which was initially derived from the Securities Data Company’s
(SDC) M&A database that were later supplemented by information from various
sources. Total sample size was 2,785 observations which were derived using 5 criteria:
a) Acquiring firm sought 100% of the shares of the target firm,
b) The status is known and not pending,
c) Both the target and the acquiring firm are publicly traded and have available
information in the Center for Research in Security Prices and Compustat
databases,
d) The target shares are ordinary common shares,
e) The payment includes only cash, only stock or mixed.
The sample size is relatively high compared to that of Harford (1999) since Harford
covered periods until 1993 and M&A activities rose significantly during later periods.
This rise may have been due to economic, technological, and regulatory factors
(Harford, 2005), but only if there is sufficient capital liquidity. Due to this logic,
excess cash may have contributed to increasing mergers and acquisitions due to
overinvesting during the last few decades.

2.3 Main variables

The main variables used in the analysis are stated in Table 1, Descriptive Statistics.
These variables are then estimated by three categories in our analysis: cash payments,
stock payments, and mixed payments. Market capitalization is estimated five days
before the acquisition announcement. The book value of assets, debt ratio, cash ratio,
and market-to-book ratio are measured at the end of the fiscal year before the
acquisition announcement. The announcement return is the abnormal stock return
measured from the day before through the day after the acquisition announcement

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using a one-factor model. The prior one-year return is the year ending five days
before the acquisition announcement.
As can be seen from the table, acquisitions undertaken using stock payments or mixed
payments has negative relation with announcement return whereas acquisitions
undertaken using cash payments has positive relation with announcement returns
which is in consistent with prior studies such as Moeller et al, (2004) and Savor and
Lu (2009).

3. EMPIRICAL ANALYSIS
A. Decision to Undertake Acquisitions
This first section of the analysis reviews the decision to undertake acquisitions. The
main question is whether holding excess cash leads firms to make acquisitions.
In Table II, Regressions of the Acquisition Decision, firms in Panel A consists of all
Compustat firms that were not involved in M&A transaction in the past three years
whereas firms in Panel B consists of firms that were not involved in M&A
transactions in the past three years and belonged to the same industry, size, market-to-
book, and momentum four factor portfolios in the prior year.
The results suggested that there is no evidence that high cash levels lead to
acquisitions, not even cash acquisitions since none of the cash coefficients in Panels A
and B differs statistically from 0. In contrary, Harford (1999) reports that there is
strong and positive relationship between adjusted cash ratio and acquisition likelihood.
However; since his payment methods were not divided into cash and stock payments,
it is unclear that which payment method contributed to the positive relationship.
If excess cash leads to acquisitions, the effect of cash on acquisition decisions to
primarily be present in the sample of acquisitions with cash payment. However; there
was no evidence in the authors’ analysis.
Furthermore, Pinkowitz et al. (2013) studied whether firms with excess cash use those
cash to pay for acquisitions. Their results suggested that firms with excess cash are
more likely to finance acquisitions with stock than with cash which is consistent with
this paper’s result that excess cash does not lead firms to make acquisitions. However;
it should be mentioned that our authors and Harford (1999) used samples involving
only public targets whereas the sample in study by Pinkowitz et al. (2013) involved
mainly private firms and subsidiaries so it is not suitable to directly compare them.

B. The Effect of Cash Holdings on Acquirer’s Announcement Returns

The objective of this section is to examine whether announcement returns are
negatively related to the cash holdings of acquirers, as in Harford (1999). Harford
(1999) divided acquisition payment method into 2 categories: cash or other payments
whereas the authors further divided the other payments into stock or mixed payments.
All other things equal, cash payments are associated with around 3% to 4% higher
announcement returns, on average, than stock and mixed payments (Table III).
Harford’s (1999) studies on the same analysis suggested that cash payments are
associated with approximately 1% higher announcement return than other payments.

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Furthermore, there is negative relationship between acquirer’s cash holdings and their
announcement returns according to the regression result for all payment types which
is consistent with Harford’s (1999) result. However; this negative relationship was
mainly due to acquisitions financed with stock and there was no statistically
significant relationship between announcement returns and cash.
Harford (1999) and free cash flow theory states that acquisitions occurring when
acquirers have excess cash leads to value destroying behavior. However; the
regression result suggests that acquisitions financed with cash tend to be associated
with positive announcement returns for acquirers. It may be because the market views
that excess cash is better spent on acquisition even if it is value-destroying because
alternative uses of excess cash may be even worse. However; operating performance
results discussed later in this paper suggest that these acquisitions are not value
destroying.
Savor and Lu (2009) find that firms financing acquisitions with stock are overvalued
and that market reacts to it with decline in post announcement stock prices. Based on
the analysis, the authors further added that firms with excess cash has the option of
making payments via cash or stocks whereas firms with limited cash only has the
option of making payment via stocks. Thus; when firms with excess cash decides to
make payments by stocks, it signals that the firm’s stocks are overvalued which
causes post-announcement stock prices to decline.

C. Overvaluation Analysis
There are two general approaches to examine the overvaluation of a firm. The first
one is a method by Fu et al. (2013) which is using the refined version of an approach
where public data (such as residual income model) is being used to estimate the
fundamental value, and it will be compared to the actual market value. The second
approach is the method used by Savor and Lu (2009) which examines the subsequent
stock returns, with the presumption that the capital market corrects any overvaluation
over time.
From Table IV Panel A, it can be concluded that all categories of the acquirers are
overvalued (0.359 average overvaluation) no matter when they are using cash
payment (0.250), stock payment (0.471), or mixed payment (0.307).
From Table IV Panel B, it can be concluded that the targets of acquisitions financed
with stock and mixed payment are overvalued (00166 and 0.132 average
overvaluation respectively). The one with cash payment, however, are less overvalued
compared to the other categories. Furthermore, it can also be concluded from Panel A
and Panel B that on average the overvaluation of acquirers are about three times
greater than the average overvaluation of targets in stock acquisitions.
Table IV Panel C shows the regression result of acquirer overvaluation estimates
against indicator variables for stock and mixed payments, cash holdings, and
interaction variables between payment indicator variables and cash holdings. Model
(a) and (c) are assuming that the high cash indicator equals to 0, while model (b) and
(d) are assuming that the high cash indicator equals to 1, or in other words the cash
ratio is in the fourth quartile. Furthermore, model (a) and (b) are using OLS standard
errors, while model (c) and (d) are using clustered standard errors.

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It can be concluded that acquirers who pay with stock tend to be more overvalued
than acquirers who pay with cash or mixed payment (all of the indicator variables for
stock payment are positive and significant, or a little bit under 0.2 with p-values less
than 0.01). On the other hand, the mixed payment indicator variables are not
statistically significant. Another result from examining the interaction variables
between stock payment indicator variables and cash holdings is that stock acquirers
are more overvalued when they have large cash balances (0.257 and 0.146
respectively), but it is supported only when we use OLS standard errors in model (a)
and (b). When clustered standard errors is being used in (c) and (d), the result
becomes not statistically significant.
As an alternative way to analysis the overvaluation, long-term abnormal stock returns
are being examined. Table V Panel A indicates that average long-term abnormal
returns are negative and statistically significant for acquisitions with stock and mixed-
payment deals. On the other hand, cash deals’ average long-term abnormal returns are
positive for four factors model and negative for three factors model, which means
Carhart’s momentum factor makes a difference for the long-term abnormal return
estimates.
Table V Panel B indicates that the coefficients for stock payment indicator variables
are all negative and significant for model (b) and (d), in which both models are
referring to the high cash level indicator. Furthermore, the coefficients of interaction
between stock payment and cash are always negative and significant, which supports
the result in previous table.
To conclude, acquirers that pay with stock are founded to be more overvalued,
especially when the acquirers’ cash holdings are large.

D. Subsequent Operating Performance

This section examines how pre-acquisition cash holdings affect post-acquisition
operating performance by estimating the operating performance before and after the
acquisitions using a prediction model similar with Hardford (1999). The linear
regression model is assuming there is a linear relationship between pre-acquisition
adjusted performance and post-acquisition adjusted performance. Finally, cash
holdings variable is also added to the regression model.
From Table VI, it can be seen that the coefficients on pre-acquisition performance is
approximately equal to 0.5 for cash payment and stock payment, and both of them are
statistically significant which means past performance is a strong predictor for future
performance. Next, the cash ratio coefficients are also positive for all kind of
payments (0.092, 0.185, and 0.762 respectively for cash, stock and mixed payment)
but only statistically significant at 0.05 level for stock and mixed payment method. It
can also be concluded from the table that there is no evidence that acquirers with high
cash holding will result in worse post-acquisition operating performance because even
for the acquirers who pay with stock or at least a part of the acquisitions with stock
have a better post-acquisition performance.

4. SUMMARY AND CONTRIBUTIONS

The main background of this study is highly related with the main finding by Harford
(1999) which concludes that firms with cash hoards undertake value-destroying

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acquisitions, as evidenced by lower announcement returns for acquirers with high
cash holdings. Based on this previous finding, this literature is trying to use a much
larger and more recent sample.
The result is inconsistent with Hardford’s (1999) conclusion above, in which the
negative relation doesn’t present in the sample of acquisitions with cash, and it
presents on the acquisitions financed with stock which can be undertaken even with
limited cash holdings.
Another result is based on Savor and Lu (2009), in which stock acquirers are
overvalued and that the overvaluation is more pronounced when the acquirers choose
to pay with stock despite substantial cash holdings. The main reason is because capital
market will react to the overvaluation and rectifies it, which will result in lower
returns for stock acquirers especially the one with large cash holdings.
The last finding is that based on the measurement by Fu et al. (2013), stock acquirers
are more overvalued than cash acquirers, in which abnormal long-term stock returns
are more negative after stock acquisitions than after cash acquisitions and the
overvaluation increase with their cash holdings.
To conclude, while Harford (1999) said that cash holdings induce worse acquisitions,
this literature suggest a different point of view in which high cash holdings do not
induce value destroying acquisitions, but it is related to overvaluation, and this
overvaluation is corrected upon the announcement which leads to misconception that
those acquisitions destroy value for shareholders.

5. CRITICAL COMMENTS
This literature presents a different point of view for the negative relation between
announcement returns and cash holdings of stock acquirers. While previous literature
by Harford (1999) suggests that the negative relation is because cash holdings induce
value-destroying acquisitions, this literature argues that there is not enough evidence
to support that argument, and it is actually caused by greater overvaluation of stock
acquirers with high cash holdings which makes the market react and correct it upon
the announcement instead.
Furthermore, previous studies such as Harford did not differentiate his payment
methods in detail while the authors divided it into only cash, only stock, and mixed
which played major factor in reaching several of the conclusions which ultimately led
to different results compared to Harford’s result.
Finally, this argument is more relevant because when conducting this research, the
authors use much larger and more recent sample compared to the previous research so
the probability of error and misconception should be lower. Therefore, the conclusion
of this literature is arguably more reliable.

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6. REFERENCES
Fu, F., L. Leming, and M.S. Officer, 2013, “Acquisitions Driven by Stock
Overvaluation: Are They Good Deals?” Journal of Financial Economics 109, 24–
39.

Gao, N., 2011, “The Adverse Selection Effect of Corporate Cash Reserve: Evidence
from Acquisitions Solely Financed by Stock,” Journal of Corporate Finance 17,
789–808.

Harford, J., 1999, “Corporate Cash Reserves and Acquisitions,” Journal of Finance
54, 1969–1997.

Harford, J., 2005, “What Drives Merger Waves?” Journal of Financial Economics 77,
529–560.

Harford, J., S. Klasa, and W.F. Maxwell, 2014, “Refinancing Risk and Cash
Holdings,” Journal of Finance 69, 975–1012.

Jensen,M., 1986, “Agency Costs of FreeCash Flow, Corporate Finance,

andTakeovers,” American Economic Review 76, 323–329.

Lie, E., & Liu, Y. (2017). Corporate Cash Holdings and Acquisitions. Financial
Management,47(1), 159-173. doi:10.1111/fima.12185.

Moeller, S., F. Schlingemann, and R. Stulz, 2004, “Firm Size and the Gains from
Acquisitions,” Journal of Financial Economics 73, 201–228.

Pinkowitz, L., J. Sturgess, and R.Williamson, 2013, “Do Cash Stockpiles Fuel Cash
Acquisitions?” Journal of Corporate Finance 23, 128–149.

Savor, P.G. and Q. Lu, 2009, “Do Stock Mergers Create Value for Acquirers?”
Journal of Finance 64, 1061–1097.

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7. APPENDIX
Table I. Descriptive Statistics

Table II. Regressions of the Acquisition Decision

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Table III. Regressions of Bidder Returns

Table IV. Analysis of Long-Run Abnormal Stock Returns

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Table V. Analysis of Long-Run Abnormal Stock Returns

Table VI. Operating Performance

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