Why do firms repurchase stock to acquire another firm
Robin S. Wilber
Published online: 3 August 2007
Abstract:This study investigates firms that repurchase their stock to finance an acquisition. Since research shows that cash-financed acquisitions perform better than stock financed acquisitions, why do firms that have available cash initiate the extra transactional step. I find these firms are well compensated for their efforts, especially in the long run. On average, these firms have negative abnormal returns prior to their repurchase announcements and thus may choose repurchasing to signal undervaluation. Furthermore, the stock acquisition step allows these firms to share risk, counteract the negative effects of dilution,
and enjoy a tax advantage for their efforts.
Keywords: Acquisitions Method of payment Repurchases
1 Introduction
This study investigates the enigmatic decision by a firm to take on the extra transactional step to repurchase its shares with cash and then use those shares to finance an acquisition, rather than use the cash to directly finance the acquisition. It would seem to be far easier, if a firm has the cash available, to acquire the target firm with the cash. This is even more of an enigma when it is well known that cash offerings perform better than stock offerings.
I find that firms that in a sample of 96 firms that repurchase shares to finance an acquisition from 1995–2002 are well compensated for their efforts. The most compelling argument as to why firms would take on the extra financing step is to achieve the best of both the stock-financing acquisitions and cash-financing acquisitions. These firms experience risk sharing with the target firms, counteract the negative effects of dilution by repurchasing shares first, and enjoy a tax advantage for their efforts. This is important to firms that want to use stock financing but are concerned about the historical negative returns of firms acquiring another firm with stock. Also this is an important research topic that has not been addressed.
The organization of this paper proceeds as follows. The first part discusses merger and acquisition literature. The second section develops the hypotheses and methodology. The third section reports the empirical findings and the last section summarizes and concludes.
3 Prediction, data and methodology
3.1 Hypotheses
Based on previous research,9 if a repurchase is conducted in order to finance an acquisition it may also carry with it the poor stock return reactions that have been associated with bidder firms conducting acquisitions. However, researchers have made a clear distinction between cash-financed acquisitions and stock-financed acquisitions. If a firm uses cash to repurchase shares which are then used to acquire a target firm, this is not straight cash or straight stock-financed. Many researchers have documented losses to bidding firms that use stock. The use of repurchased shares to conduct an acquisition is stock-financed and may result in the negative abnormal returns associated with stock-financed acquisitions. On the other hand, using repurchased stock to finance an acquisition is just adding a step to a cash-financed acquisition and thus may act according to previous research and have no negative abnormal returns or possibly slightly positive returns.
Additionally, using a repurchase to facilitate an acquisition begs further investigation. Why would a firm go through such transactional gymnastics? It would be simpler and lesscostly in time and dollars to just conduct an acquisition with cash.10 Therefore, there must be some benefit to taking on this additio
nal cost. It may be that the premium to acquire is less with a stock-financed acquisition than with a cash-financed acquisition for the bidding firm will not need to compensate the target firm for its immediate tax consequences.
It is possible that the repurchase announcement gives managers the anticipated positive stock price return reaction which more than offsets the anticipated decrease in stock price with an acquisition announcement. In a sense, this may extinguish the negative return reactions associated with a straight stock offering and allow bidder managers to pay a smaller premium at the acquisition. If this is the case, I expect that these firms may have better long-term performance than firms that do not take the extra transactional step since they would be less likely to overpay for the acquisition.
Finally, purchasing accounting does carry a long term tax advantage. Normally stock offered acquisitions do not use purchase accounting. However, if the firm uses repurchased shares it can only proceed with purchase accounting. This is an advantage to the long-term cash flows of the combined firms.
In order to test, I will conduct a difference in means between firms announcing both a repurchase jointly with an acquisition and firms that announce an acquisition without a repurchase.
Hypothesis    1 Abnormal return (at the announcement date and long-term post
announcement) will be less negative for firms that announce repurchase intentio ns with an acquisition announcement than for firms that only announce the acquisition.
This test will be performed at the announcement date for announcement date effects and also 2-year and 3-year post-announcement.
译文翻译Table 1 summarizes the hypotheses put forth in the literature. Most of the hypotheses make predictions on the method of payment choice. I question why firms would use cash to repurchase shares in order to conduct a stock-financed acquisition. Since the bidder firm’s wealth is not hurt by cash acquisitions and the combined firm wealth is, on average, better with cash, it is perplexing as to why a firm would incur additional transactions fees and most likely incur labor costs to take this extra financing step that at first glance does not appear to carry benefits.
I review the hypothesis with this question in mind. My sample is of firms which either have the cash available at the repurchase announcement or did not make a credible repurchase announcement. If they have the cash available, then according to the cash availability hypothesis they will prefer to use it if they are undervalued. Since the firm has chosen not to use the cash for the acquisition, but rather for the repurchase, the cash-availability hypothesis suggests that the firm is overvalued. However, if the firm is overvalued it is not likely it would choose to repurchase its own stock as suggested by Travlos (1987). Thus, it is feasible that using cash directly to purchase another firm or using cash
indirectly with repurchased share financing is inconsequential to the cash availability hypothesis in that both announcements are indicative of undervaluated bidder shares.
The investment opportunity hypothesis predicts that a high-growth bidder will prefer stock because it will afford the high-growth firm with future financial flexibility. This hypothesis is not applicable to cash flush firms with moderate growth. The signaling hypothesis is a little problematic in that the repurchase signals undervaluation and the subsequent stock-financing signals overvaluation. Although it is unlikely that a firm sets out to send mixed signals, it is possible that a firm prefers to use stock (i.e., for risk sharing and future tax benefits) and plans to mitigate the bad news of overvaluation indicated with a stock financing by offsetting with the undervaluation signal of the repurchase announcement.
The risk-sharing hypothesis is consistent with the extra financing. If a firm is concerned about the post-merger performance of the target firm then stock financing will mitigate this concern. Thus, if the target firm will represent a significant portion of the combined firm, it may be the preference of the bidder firm’s managers to share the risks, even if evidence of poor stock-financed acquisitions is predominant.
The target firm managers may have a preference for stock financing in order to maintain some control in the merged firm. Ghosh and Ruland (1998) show a strong, positive association between managerial ownership of target firms and the likelihood of acquisitions for stock. They suggest that target firm managers’ have preferences for control rights and want to enhance their chances of retaining jobs in th
e combined firm. Thus, if the target is large enough in comparison to the bidder and the target firm’s managers have some control, they may be in the position to influence the financing decision. In the extreme, the target may be able to influence the bidder to first repurchase its shares and then to pass the shares on to the target firm’s shareholders. T his argument may hold for the target manager shareholders; however, the argument fails for all the other target shareholders who should prefer cash due to the higher premium. It has also been suggested; however, that the higher premium is nothing more than compensation for the forced tax consequences and thus the high premium quickly disappears net of taxes.
The control hypothesis states that if a manager desires to maintain his ownership position in the firm, he or she will prefer stock to finance an acquisition in order to maintain control. A repurchase decreases the total outstanding shares and thus serves to increase the ownership position of the non-tendering shareholders. Thus, managers with a high concern for their ownership position would favor repurchase of shares first to mitigate the loss in ownership position if a stock-financed acquisition was pursued over the preferable cash acquisition.
Pooling accounting (stock financing) and repurchasing activities are both consistent with
manager objectives of increasing earnings per share. Thus, if a manager’s compensation were tied to earnings per share, both repurchasing shares and stock-financed acquisitions would supplement the manager’s compensation. Thus, the pooling versus purchasing hypothesis would be consistent with the doubled transactions. Furthermore, the doubled transactions may create favorable tax results. Purchase accounting creates a tax burden on the target firm. Thus, stock financing is beneficial for both risk-sharing and tax consequences. Cash financing has historically better returns. Thus, it is possible that by taking on the extra transactions the firm is taking advantage of both types of financing and entering into a win–win situation.
Finally, if it is not the method of payment that matters but only whether the acquisition is a good fit and increases the focus of the firm, then the transactions that preceded the acquisition may not be the important issue. This argument suggests that although it appears inefficient to use cash to repurchase shares to be used for the acquisition of another firm, this method of payment may not be predictive of poor post-merger stock price returns that have been documented by numerous researchers. If the bidder acquires a firm that increases its focused line of business then value should be enhanced and the method of payment is immaterial. Similarly, if the bidder attempts a diversifying acquisition, the market would be expected to respond negatively.
These studies suggest that a viable control for a value-enhancing merger versus a valuedecreasing merger could be determined by whether the merger increases or maintains its focus or decreases its focus in diversification attempts. Flanagan and O’Shaughnessy (2003) use primary SIC codes to classify transactions core-related in their paper that explores which firm characteristics influence the size of acquisition premiums. Flanagan and O’Shaughnessy classify an acquisition as core-related if both the acquiring and target firms share the same three or four digit SIC code. I will separate my firms that announce repurchase intentions to conduct an acquisition as value enhancing if the firms have the same three or four digit SIC code and are thus core-related focus increasing or preserving firms. Firms will be considered focus decreasing if the acquiring and target firms do not share three or four digit SIC codes and appear un-related.
3.2 Sample
The sample of firms announcing a repurchase in order to facilitate an acquisition are collected from Securities Data Corpor ation’s Mergers and Acquisitions database and Repurchases database. I begin by collecting all repurchase offers with an acquisition (ACQ) purpose. Financial firms (SIC codes 6000-6999) and regulated utilities (SIC codes 4910-4949)