Mitigating the Negative Market Reaction Associated with Acquisition Announcements by Cash-Rich Firms

Abstract

Managers of cash-rich firms who are contemplating an acquisition face a dilemma. On the one hand, if they finance the acquisition with cash, the market could presume that they undertake the acquisition simply because the firm has excess cash (the free cash flow hypothesis). On the other hand, if they finance it with securities, the market could presume that they prefer to use securities, although they have excess cash, because the securities are overvalued (the substitution hypothesis). Consistent with these two hypotheses, we find that the association between excess cash and the market reaction to acquisition announcements is negative for both pure cash and pure noncash acquisitions. It would appear then that the managers of an average cash-rich acquirer have no good option - the market reacts negatively to an acquisition by the average cash-rich firm whether the acquisition is financed with cash or with securities. However, we find evidence suggesting that there is an optimal mix of cash and security financing that enables the average cash-rich firm to undertake acquisitions without eliciting negative market reactions, with the optimal mix tilted toward securities. The results also indicate that the market differentiates between acquirers that apparently opt for mixed financing as a means of distinguishing themselves and those that use mixed financing because of financing constraints.