Operating performance and free cash flow of asset buyers

Financial Management (Financial Management Association), Winter, 2003 by Steven Freund, Alexandros P. Prezas, Gopala K. Vasudevan

A second theory is the focus hypothesis. Berger and Ofek (1995), and Comment and Jarrell (1995), find that firms that divest unrelated lines of business and focus on their core lines tend to see increases in market value. John and Ofek (1995) examine the focus hypothesis for asset sales, and find that focus-increasing firms tend to experience improvements in operating performance following the sales.

Lang et al. (1995) provide a third explanation for the positive stock price reaction to asset sales announcements: the management discretion hypothesis. It is based on the assumption that managers value firm size and control. This suggests that the proceeds from asset sales retained by the firm represent free cash flow that managers can use to pursue their objectives. Hence, the announcement of asset sales would be good news to the market when the proceeds are paid out rather than reinvested within the company. Lang et al. (1995) find that asset sales follow poor operating performance and the associated stock price reaction is positive only when the asset sales proceeds are paid out. (3)

Kruse (2002) examines the factors that influence asset sales by financially distressed firms. He finds that asset sales are more likely by firms in industries with higher growth rates, firms with higher debt levels, or those that have made acquisitions prior to their performance decline. Lasfer, Sudarsanam, and Taffler (1996) examine the stock price reaction to asset sales by both healthy and financially distressed firms. They find that announcement period returns are positive for both types of firms. The announcement period returns are higher for asset sales by distressed firms, possibly because they can avoid the direct and indirect costs of bankruptcy by selling assets and meeting debt repayments.

A complementary explanation for the announcement period returns to the seller may be attributable to the buyer's willingness to overpay. The buyers could be purchasing the assets because of managerial incentives to add to their private benefits. Jenson (1986) argues that firms with large amounts of free cash flow can purchase an asset for a price above its true economic value. In findings consistent with this argument, Lang, Stulz, and Walking (1991) document that bidders with high free cash flow and poor investment opportunities have negative returns when they announce acquisitions.

In a contrary assumption, Emery and Switzer (1999) hypothesize that managers acting in the best interests of shareholders choose the acquisition method that maximizes the announcement period returns; their evidence supports this hypothesis. They find that the choice of acquisition method depends on taxes and the extent of asymmetric information between the firm and outsiders.

Sicherman and Pettway (1992) examine the wealth effects of divestitures for both sellers and buyers. They find that announcement period returns are positive for both sellers and buyers. Abnormal returns depend on both the seller's financial condition and disclosure of the price of the asset purchased.