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

The method of payment variable is a dummy variable that equals 1 if the buyer used cash to purchase the asset, and zero otherwise. Travlos (1987) finds stock price reactions of bidding firms to the announcement of a takeover to be related to the method of payment. The reaction is more negative for mergers paid with stock, as this signals that the bidder is overvalued. Loughran and Vijh (1997) find that firms that pay for a merger with stock have significantly poor returns during the five-year period following the acquisition, while firms that make purchases with cash have positive excess returns. We expect to find a positive coefficient for this variable.

Our industry-relatedness variable is a dummy variable that equals 1 if the asset purchased has the same SIC code as one of the buyer's three main lines of business. The focus hypothesis predicts that firms with fewer lines of business are valued more highly than conglomerates (Berger and Ofek, 1995). It is presumably easier for buyers to manage a new asset if they have knowledge of the business. This hypothesis implies that firms that purchase related assets should perform better than firms that purchase unrelated assets. If the focus hypothesis holds, we would expect to find a positive coefficient for this variable. Information on the main lines of business of the buyer and the asset purchased is obtained from Dun & Bradstreet's Million Dollar Directory for the year of the acquisition.

The free cash flow theory predicts a negative relationship between the free cash flow of the firm during the purchase year and the announcement period returns to the buyers. The market perceives that buyers with high free cash flow may be wasting shareholder wealth by engaging in asset purchases. Our free cash flow variable is the ratio of the buyer's operating free cash flow (FCF) over the book value of its assets in year -1. We define:

FCF = OI - TAX - INTEX - PFDIV - COMDIV

where:

OI       = Operating income before depreciation,
TAX      = Total taxes,
INTEX    = Interest expense on debt,
PFDIV    = Dividends paid to preferred stockholders, and
COMDIV   = Dividends paid to common stockholders.

A similar measure for operating free cash flow is used by McLaughlin, Safieddine, and Vasudevan (1996), Lang and Litzenberger (1989), and Lehn and Poulsen (1989). Median free cash flow-to-book value ratios for each sample year are shown in Table I. The median free cash flow-to-book value ratio is 0.055 in 1984, increasing to 0.077 in 1994, 0.080 in 1995, and 0.087 in 1996.

The size variable is the natural log of the book value of assets of the buyer. Others have found stock price reaction to be related to firm size (e.g., John and Ofek (1995)), so we use it as a control variable.

Since the free cash flow problem may be more prevalent among mature firms with fewer growth opportunities, we use a proxy for growth opportunities: the ratio of the market value of equity plus the book value of debt, to the book value of assets. This is a proxy for Tobin's q and has been used by Jung, Kim, and Stulz (1996) and Lang et al. (1991), among others. Table I reports median Tobin's q for each sample year, based on the year prior to the asset purchase. The median Tobin's q is 1.05 in 1984, the first year of our sample, and increases to 1.57 in 1996. Table II reports that, in the year prior to the purchase, the mean Tobin's q was 1.585 (median 1.313), suggesting valuable growth opportunities for the buyer firms.