Excess cash flows and diversification discount

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

We first address this issue by using the subsample of identifiable bidder-target pairs. Panel A of Table VIII shows that there is a positive correlation between actual changes in excess cash flows and excess value. We also find a positive association between the actual and the predicted changes in bidders' excess value. The correlation between the actual change in excess value and the unanticipated change in excess cash flows (AECF-PAECF) is negative. This relation purports that our predicted change in excess cash flows was overly optimistic.

In cross-sectional regressions, reported in Panel B of Table VIII, we find that unrelated acquisitions have a negative and significant impact on the excess value of the bidder around the acquisition. Consistent with the correlation results, the actual change in excess cash flows enters the regressions with a positive sign. Similarly, the projected change in excess value and the unanticipated change in excess cash flows enter the regressions with the same signs of the correlation coefficients reported earlier.

Using the entire sample, we also examine this issue in a multivariate framework by regressing the change in actual excess cash flow and valuation of bidders on their projected changes. In this set of regressions, we introduce the interactive terms of the indicator variable for the subsample of identifiable bidder-target pairs with the projected change in excess cash flows (P[DELTA]ECF) and excess valuation (P[DELTA]EV). In regressions where the dependent variable is the change in actual excess cash flow and excess value of bidders around the acquisition, respectively, the interactive terms enter these regressions with insignificant coefficients, which suggest that the projected changes in both excess performance measures do not have a bearing on bidders' actual performance changes when we account for the characteristics of the identifiable targets. (11) More importantly, consistent with the evidence reported in Panel B of Table IV, we find the coefficient of the change in excess cash flows is 0.37 and statistically significant (with a t-value of 4.089). This result confirms that there is positive association between the change in excess cash flows and excess valuation. Finally, consistent with the subsample regression results, we find that unrelated acquisitions have a negative impact on bidders' excess cash flows and valuation one year after the acquisition.

V. Conclusion

In this article, we study the impact of diversification on firm cash flows and excess values. We examine whether there is a direct association between the discount to diversification and excess cash flows in related and unrelated acquisitions undertaken by multi-segment bidders over the 1991-1997 period. Our findings provide empirical evidence that supports a direct relation between excess valuation and cash flow changes subsequent to diversification. We find that a 10% decline in bidders' excess cash flows is associated with a 3.7% excess value loss. This relation between reductions in cash flows subsequent to the acquisition and declines in excess value is incremental relative to the diversification discount that has been previously identified in the literature. The evidence also shows that bidders acquiring unrelated targets experience larger excess cash flow decreases and valuation discounts than do bidders who buy related targets. These results are robust to the targets' excess cash flow and valuation characteristics. Overall, our results suggest that post-acquisition cash flow declines drive the diversification discount.