Are Cash Acquisitions Better?

Written by Scott C. Linn and Jeannette A. Switzer

Summarized by George S. Mellman, CFA

Edited by Constantinos Papanastasiou, CFA

President CFA Society of Cyprus

 

The authors examine the relationship between changes in post-acquisition operating income and the bidder’s use of cash or equity in the acquisition offer. They study accounting information for more than 400 U.S. corporate acquisitions from 1967 to 1987.

The overall results show that when all-cash financing is used, the combined entity delivers significantly greater increases in operating performance than when equity financing is used. The authors suggest that this measurable increase in performance from all-cash offers may be the result of these acquirers having private information about the potential for major post-acquisition synergies.

Corporate acquisitions can be made with cash or securities or some combination of both.

Research has shown that U.S. business combinations resulting from all-cash offers tend to earn excess stock market returns. To understand this phenomenon, the authors review the current literature and investigate potential relationships between the types of acquisition financing used and the combined company’s five year post-acquisition net operating income.

The data used in this study come from a compilation of all completed U.S. tender offers during the 1967–87 period for which published tender offer and pre- and post-combination operating performance information exist. For consistency and uniformity, the authors exclude acquisitions from the study if the method of payment involved a security other than cash, common stock, or a combination of the two, thus leaving a sample research universe of more than 400 acquisitions —much more than had been used in previous research in this area.

The authors use pre-tax operating income to represent company performance because, in their view, measures of performance based on bottom-line net income may be artificially influenced by the accounting method (purchase or pooling) and the financing tools used in the acquisition. Their definition of company performance is based on after-tax income before extraordinary items and adds back depreciation and amortization charges, net interest expense, and total income taxes. To the extent possible, the operating income amounts reflect performance for the five years before and after the business combination.

Overall, their analysis shows that cash-only tenders result in greater increases in industry-adjusted, pretax operating profit than combined cash–equity tenders and that equity-only tenders lead to the lowest increases. These conclusions are supported by an assortment of statistical significance tests, and the results are not sensitive to whether the acquisition resulted from a tender or negotiated offer.

In their analysis of all-cash, all-equity, and mixed acquisitions, the authors apply regression tools to control for the potential interference caused by several added company-specific variables. In particular, they control for tender offers versus negotiated mergers, the leverage of the bidding company, the relative size of the target company versus the bidding company, and the industrial similarity between the paired companies. The authors’ primary conclusion that all-cash mergers have led to higher pre-tax operating profits is not particularly sensitive to any of these control variables.

Why do cash offers appear to outperform stock offers by so much? The authors suggest that this outcome is related to acquiring companies’ motivations for making all-cash offers in the first place. Essentially, they believe that companies use cash offers to deter competing bids when they have favorable private information about potential synergies. The greater the perceived synergies, the higher the likelihood that a cash offer will be used.

 

The CFA Society of Cyprus is a member society of CFA Institute, an international, non-profit member organization of more than 88,000 investment practitioners and educators in 129 countries. CFA Institute awards the Chartered Financial Analyst (CFA) professional qualification, the designation of professional excellence within the global investment community. For more information on the CFA designation, visit the CFA Institute web page on www.cfainstitute.org or CFA Society of Cyprus web page on www.cfacyprus.com , e-mail: [email protected] .