Excess cash flows and diversification discount

Financial Management (Financial Management Association), Summer, 2004 by John A. Doukas, Ozgur B. Kan

One possible explanation for the divergence between excess cash flows and the discount to diversification is that the market may attach greater value on the bidder's growth and/or its industry prospects. If the diversification decision loads more on the firm's future prospects or its industry growth opportunities, that might explain why these bidders trade at a discount despite having positive excess cash flows prior to the acquisition year.

We use logistic regression analysis to determine whether industry growth opportunities drive unrelated acquisitions. (5) Our findings indicate that the bidder's decision to diversify is affected by industry growth opportunities rather than their excess cash flows. Bidders' industry growth opportunities, for which the imputed value of their Tobin's Q serves as a proxy, have a negative, significant impact on the decision to diversify. This finding provides additional support for the important role played by bidders' industry growth opportunities. Our findings also suggest that diversifying investments are more pronounced in firms with lower insider and institutional ownership, and that the tendency to acquire targets outside the core business of the bidder increases with firm size. To the extent that institutional ownership and size reflect agency costs, this result is consistent with the view that diversification is influenced by bidders' agency costs. (6)

III. Change in Bidders' Excess Performance

Here, we examine the change in the excess performance of multi-segment bidders that undertake related or unrelated acquisitions. We do so to gain additional insights about the cash flow and valuation effects of these investment decisions. We are interested to see if there is a direct link between the change in the diversification discount and the decline in cash flows.

A. Univariate Results: Change in Multi-segment Bidders' Excess Cash Flow and Excess Value

Table III reports bidders' mean [median] change in the excess cash flow and valuation measures from year -1 to 1. The excess cash flow results demonstrate that bidders' excess operating cash flows deteriorate from year -1 to 1. This decline is more pronounced for bidders that conduct unrelated acquisitions. The mean [median] decline is 2.12% [0.22%] and statistically significant at the 10% level. Furthermore, the change in the excess cash flows of multi-segment bidders that acquire unrelated targets is significantly below that of bidders buying core-related targets.

The excess valuation results show that bidders do not experience any significant excess value declines. Surprisingly, while diversifying bidders realize a mean excess value decline of 4.05% it is not statistically significant at any conventional level. In general, multi-segment bidders experience marginal cash flow declines and shareholder value losses when they engage in diversifying acquisitions.

The difference in excess cash flow changes between related and unrelated investment strategies indicates that unrelated acquisitions do not necessarily result in improved cash flow performance. The evidence also shows that diversifying acquisitions fail to enhance shareholder value. Overall, these findings support that the change in the diversification discount reflects bidders' declining cash flows.