Excess cash flows and diversification discount

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

B. Diversification and Change in Bidders' Excess Operating Cash Flows and Excess Valuation

To the extent that both the excess cash flows and the excess valuation of diversifying multi-segment bidders show similar degrees of deterioration around acquisitions, we assume that the change in the bidders' diversification discount is related to the change in cash flows. We investigate this relation around the acquisition.

Panel A of Table IV shows that the Pearson correlation coefficient between the change in excess value and excess cash flows is positive and significant at the 1% level in all cases. As we expected, these results show that an increase (decrease) in excess cash flows around the acquisition is followed by a similar change in bidders' excess value.

To gain additional insights about the cash flow and valuation effects of related and unrelated acquisitions, we regress the change in the excess performance measures from year -1 to 1 against the type of acquisition (related or unrelated) while controlling for the relative size of target, method of payment, whether the target firm or asset is divested or not, and the change in the market for corporate control using calendar year dummies.

Panel B of Table IV presents the regression results. The first regression, as the insignificant intercept points out, indicates that related acquisitions do not have an adverse impact on the excess cash flow of bidders. The negative and statistically significant coefficient estimate of the unrelated acquisition dummy (-2.70%, significant at the 10% level), however, shows that diversifying acquisitions lead to significant reductions in bidders' excess cash flows. Consistent with our previous findings, this result indicates that unrelated acquisitions hurt bidders' excess cash flow performance.

In the second regression, the positive but insignificant intercept suggests that core related acquisitions do not cause significant declines in bidders' excess value. The coefficient estimate of the unrelated acquisition indicator variable is -5.12 (with a t-value of -1.325). This negative coefficient implies that bidders acquiring unrelated targets do not experience dramatic excess value declines relative to a comparable portfolio of stand-alone firms. The relative size of the target enters the regression with a positive and significant coefficient, implying that larger targets have a greater impact on bidders' excess valuation. The indicator variable for the stock method of payment is -20.81% and statistically significant at the 1% level (with a t-value of -3.897), which suggests that when bidders pay with equity they incur significant declines in their excess value. This result is consistent with Rappaport and Sirower (1999), who argue that riskier acquisitions are more likely to be settled in stock rather than in cash.

In the third regression, we include the change in bidders' excess cash flows as another independent variable to explain the change in their excess values. The coefficient estimate of the change in excess cash flows is 0.37 and statistically significant at the 1% level (with a t-value of 4.245). This result is also economically significant, suggesting that a 10% decline in bidders' excess cash flows translates into 3.7% excess value loss. This finding provides additional evidence to support the hypothesis that the change in the diversification discount is positively related to the declining cash flows of the bidder after the acquisition. (7) The rest of the variables enter this regression with similar signs and statistical significance, as in the second regression.