How Do Firms Value Debt Capacity? Evidence from Mergers and Acquisitions

Abstract

We examine how capital structure considerations affect acquisition pricing and valuation. We find that debt capacity improvement is value-enhancing for all acquirers when they gradually reveal their growth opportunities to the market. This is reflected in the long-run stock market returns, both 12- and 24-months after acquisition announcement. While both overlevered and underlevered acquirers benefit from an increase in debt capacity resulting from the merger, only overlevered acquirers pay higher premiums to increase debt capacity. Underlevered acquirers do not pay a premium for it; instead they consider market timing opportunities. Results are robust for alternative definitions of leverage and debt capacity improvement.