Anticipating the future from the past: the valuation implication of mergers and acquisitions 1

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1 Anicipaing he fuure from he pas: he valuaion implicaion of mergers and acquisiions 1 Ning Zhang Deparmen of Accouning, Fuqua School of Business Duke Universiy June, 2012 Preliminary and commens welcome Absrac I examine he long-erm valuaion consequence of over-invesmen on acquiring firms hrough he anicipaion effec, in which forward-looking firm values conain informaion abou possible upcoming M&As. I hypohesize and find ha invesors form expecaions abou he profiabiliy of fuure M&A invesmen decisions based on he realized performance oucomes of firms pas acquisiions and value hese firms accordingly based on he likelihood of engaging in fuure acquisiions. Empirical resuls are consisen wih sock marke valuaions embedding an anicipaion discoun for acquiring firms ha have over-invesed in valuedesroying acquisiions in he pas. 1 I am indebed o Qi Chen for his guidance. This research paper has benefied helpful commens from Frank Ecker, Per Olsson, Kaherine Schipper and seminar paricipans a Duke Universiy. All remaining errors are mine.

2 1. Inroducion In his paper, I examine he long-erm valuaion consequence of acquiring firms in mergers and acquisiions (M&As). Specifically, I examine wheher he sock marke valuaions embed an anicipaion discoun for acquiring firms ha have engaged in value-desroying acquisiions in he pas. This idea is ha pas valuedesroying acquisiions lower invesors expecaions abou he profiabiliy of hese firms fuure invesmens hrough an anicipaion effec, in which forward-looking firm values conain informaion abou possible upcoming invesmens in M&As. This research is moivaed by anecdoal references in he financial press abou he valuaion consequence of firms pas M&A aciviies. For insance, commening on Hewle-Packard s sock price performance, he analyss a Seeking Alpha wroe ha: Companies like Hewle-Packard may no be good invesmens for value invesors since hese companies will coninue o pay high valuaions for acquisiions 2. An implici assumpion underlying his saemen is ha a firm s pas invesmen hisory is informaive abou is fuure invesmens. Meanwhile, prior academic research also finds ha CEOs play a significan role in firms invesmen sraegies (Malmendier and Tae (2008)) and he average CEO enure is around seven years (Kaplan and Minon (2010)). Thus, wheher invesors revise heir expecaions abou firms fuure cash flows (or discoun rae) according o pas M&A hisory hrough anicipaion is an open empirical quesion. I sudy he long-erm valuaion implicaion in he conex of mergers and acquisiions for several reasons. Firs, mergers and acquisiions are among he larges capial expendiures. Oher invesmens including R&D expendiure, purchase of fixed asses, ec. are smaller in absolue magniude 3. Given he large size of M&As, i is very imporan o undersand he economic consequence of M&As no only in he shor run bu also in long horizons. Second, exising research has shown ha many M&As resul in bidders pos-acquisiion sock marke underperformance ha a leas parially sems from over-invesmen due o he agency problem. M&As hus provide an ideal and represenaive seing for me o examine he economic consequence of firms invesmen sraegy. Third, commercially available daabases provide exac M&A ransacion deails including daes and ransacion values. This allows me o evaluae he oucome of an acquisiion afer is compleion and hen use ha evaluaion as a proxy for fuure anicipaed invesmen oucomes. In his paper, I examine he hypohesis ha invesors form expecaions abou he profiabiliy of firms fuure M&A invesmen decisions based on he realized performance oucomes of pas acquisiions and value hese firms accordingly based on he likelihood of hese firms engaging in fuure acquisiions. I measure he 2 See he full ex from Seeking alpha a hp://seekingalpha.com/aricle/ glenview-capial-loves-expedia-and-hese-13-supersocks. 3 The mean values of M&A ransacion value and he cash porion of he ransacion value in my sample are 481 million and 326 million, respecively. The Compusa mean values of capial expendiure and R&D over he same period are 125 million and 63 million, respecively. 1

3 realized oucome of a firm s pas acquisiion by he one-year ahead abnormal sock marke reurn afer is compleion. I classify acquisiions wih posiive one-year pos-acquisiion abnormal reurns as value-enhancing acquisiions and acquisiions wih negaive one-year pos-acquisiion abnormal reurns as value-desroying acquisiions. I use he firms free cash flow as a proxy o capure invesors expecaion abou he likelihood of aemping fuure M&As. I designae firms as likely acquirers if hey have posiive free cash flows and designae firms as unlikely acquirers if hey have negaive free cash flows. This designaion is moivaed by he agency heory ha posis firms end o overinves in negaive NPV projecs when hey have posiive free cash flows (Jensen (1986)) and recen empirical findings by Richardson (2006). In paricular, Richardson finds ha firms wih posiive free cash flows end o over-inves and firms wih negaive free cash flows end o under-inves. I find ha he marke valuaions of firms wih prior hisory of M&A aciviies depend on boh wheher heir pas M&As are value-desroying or value-enhancing and wheher he firms have posiive free cash flows. When firms have posiive free cash flows (suggesing ha hey have he financial means o engage in fuure M&As), heir valuaions are lower if more of heir pas M&As are value-desroying acquisiions. On average, firms wih he wors hisory of value-desroying M&As 4 and posiive free cash flow experience a reducion in Tobin s Q of , consisen wih invesors pricing he poenial value-desroying acquisiion ha migh happen in he near fuure. In conras, firms wih a hisory of value-desroying M&As bu negaive free cash flow do no experience significan decrease in firm values, consisen wih invesors viewing he probabiliy of acquiring oher firms as much more remoe. All hese findings are robus o alernaive measures of firm values, o alernaive mehods o measure pas M&A performance. I also find ha a significan porion of he discoun is from invesors lowered valuaion of firms cash holdings. Among firms wih posiive free cash flows, each addiional dollar of cash a firms wih he wors hisory of value-desroying M&As is valued by invesors $0.84 less han he marginal cash a firms wih he bes hisory of M&As. This finding is consisen wih invesors viewing cash will be invesed sub-opimally, especially when firms have engaged in more value-desroying M&As in he pas. To furher esablish ha he discoun in firm value is relaed o invesors anicipaion of fuure invesmens, I examine wheher he discoun is associaed wih he uncerainy invesors have abou fuure earnings. I find for firms wih posiive free cash flows, informaion uncerainy, proxied by analys forecas dispersion, is posiively associaed wih he pas hisory of over-invesmen, consisen wih informaion uncerainy, a leas parially, conribuing o he low firm valuaions. 4 Throughou his paper, I use hisory of value-desroying M&As and hisory of over-invesmen inerchangeably. 5 As repored in Table 1, he averages of Tobin s Q in he full sample, posiive free cash flow sample and negaive free cash flow sample are 1.70, 1.81 and 1.52, respecively. 2

4 An implici assumpion in my analysis is ha invesors assess a lower likelihood of fuure M&A for firms wih negaive free cash flows. An implicaion is ha when firms wih negaive free cash flows acually announce M&As, he announcemens are more likely o be news o invesors. Consisen wih his predicion, I find a significanly higher absolue sock price reacion for acquisiion plans made by firms wih negaive free cash flows. The average absolue 5-day abnormal reurn around he announcemen window is Furher, he announcemen reurn is negaively associaed wih he pas over-invesmen hisory, consisen wih invesors forming expecaions abou he announced acquisiions based on hisorical realized M&A performance. This paper conribues o he lieraure by sudying he long-erm valuaion consequence of acquiring firms pas M&A aciviies hrough he anicipaion effec. Unlike prior lieraure ha focuses on evaluaing wheher he merger and acquisiion ransacions hemselves creae or desroy values, I emphasize he anicipaion effec, a channel via which pas M&A affec invesors expecaions abou fuure invesmens. The findings in his paper have several imporan implicaions. Firs, empirical sudies ofen use firm values (e.g., Tobin s Q) as a proxy for firms invesmen opporuniies (e.g., Lang e al. (1991)). The underlying assumpion is ha he observed sock price embeds expecaions abou firms fuure invesmen decisions. My findings provide evidence ha validaes his assumpion. In paricular, I argue ha he forward-looking firm value conains informaion abou he anicipaed M&As and as well as heir anicipaed performance. Second, my findings also shed ligh on he underlying mechanism for akeovers o funcion as a disciplinary role. Michell and Lehn (1990) find ha bad bidders are more likely o be acquired by oher firms in he fuure as ousiders end o correc he agency problem ha is manifesed in previous bad acquisiions. Their findings sugges ha akeovers are boh a sympom and a soluion in ha firms ha engage in value-desroying M&As exhibi sympoms of over-invesmen and he over-invesmen problem ges correced laer when hese firms are acquired by oher firms. The link, hrough which he sympom and he soluion are conneced, however, is no discussed. My findings shed ligh o his link in ha I find bad bidders experience low firm values in he fuure when hey have posiive free cash flows. Thus, he combinaion of boh bad invesmen hisory and posiive free cash flow hrough he anicipaion effec gives rise o a low firm value, which in urn, aracs ousiders o ake over he bad bidder in he fuure. In my sample, I do find ha firms wih posiive free cash flows and a hisory of over-invesmen are more likely o be acquired in he fuure, confirming he resuls in Michell and Lehn (1990) ha bad bidders are more likely o become akeover arges. This paper exends recen research on he valuaion effec due o invesors anicipaion of pending acquisiions on arge firms (Cremers, e al (2008), Edmans, e al. (2012)). Cremers e al. (2008) consider he impac of he akeover likelihood 6 on he arge firm s valuaion. They hypohesize and show ha firms exposed o akeovers have differen reurns han proeced firms and a rading sraegy of longing (shoring) firms wih a 6 They erm he akeover likelihood as akeover vulnerabiliy. 3

5 high (low) akeover likelihood creaes significan abnormal reurns. Edmans e al. (2012) also examine he valuaion of he arge and argue ha he observed valuaion is he combinaion of wo effecs: he rigger effec, a decrease in marke valuaion ha invies a akeover aemp, and he anicipaion effec, an increase in marke valuaion due o he reverse causaliy from akeover probabiliy o forward-looking marke price. My research differeniaes and complemens heir sudies by exploring he valuaion on he acquiring firms. Firs of all, concepually, he anicipaion effec on he acquiring firm provides more direc evidence on he consequences of firms invesmen sraegy. In conras, he anicipaion effec on he arge firm may come from many oher sources (e.g., gains from sraegic synergy, gains from disciplining arge firms; ec.) and is less specific o arge firms invesmen sraegies. Second, he anicipaion effec on he acquiring firm has imporan implicaions for he acquirer s long-erm valuaion. Unlike arge firms ha will cease o exis as separae eniies afer hey are acquired, acquiring firms coninue o operae and may inves in oher M&As in he fuure. Thus, undersanding pas invesmens in M&As is perinen o long-erm valuaions for acquiring firms. Third, he mechanism of how anicipaion works differs for acquiring firms from arge firms. My research moivaes he anicipaion effec for acquiring firms from he agency heory and examines how fuure firm values are relaed wih pas invesmens in M&As based on he anicipaed likelihood of fuure M&As. In oher words, I do no sudy he performance consequences of M&A deals per se; raher, I sudy he valuaion consequences due o invesors (revised) expecaions abou fuure invesmens. Lasly, his paper adds empirical evidence o he lieraure examining he value of corporae cash holdings. Exising research explores he value of corporae cash holdings wih respec o capial srucures. I show ha he anicipaed oucome of cash invesmen measured using realized invesmen oucomes is also relaed o invesors valuaion of cash holdings. The res of he paper is organized as follows. The nex secion reviews relaed work in his area and develops he hypoheses. Secion 3 describes he daa and sample selecion. Secion 4 oulines he empirical design and discusses he resuls. Secion 5 presens several addiional findings and robusness checks. Secion 6 concludes. 2. Hypohesis Developmen Mergers and acquisiions are arguably he mos imporan corporae invesmen decisions in oday s financial world. The pas decades have winessed several waves of mergers and acquisiions. Among hese, boh anecdoal and empirical evidence have shown ha a large number of mergers and acquisiions resul in bidders pos-acquisiion sock underperformance. Take he merger case from Hewle-Packard wih Compaq as an example. On May 3, 2002, when he deal was officially compleed, he sock ended a $ As of Nov. 1, 2002 and half a year afer he merger, he shares sood a $16.31, 6% down from he ransacion compleion day. On May 2, 2003, he shares closed a $16.65, sill 5% down from he ransacion compleion day. Viewing he 4

6 bearish rend in sock price afer he acquisiion, financial expers and Wall Sree analyss quesion he value of he mergers and HPQ s invesmen sraegy 7. From he academic side, a larger number of sudies in finance have sudied firm performance afer mergers and acquisiions (e.g., Loughran and Vijh (1997), Rau and Vermaelen (1998), ec.). They generally find ha while mergers creae shareholder value in oal, on average, acquiring firms experience lile or even negaive pos-acquisiion reurn wih mos of he benefis accruing o arge firms. While oher explanaions exis, researchers aribue his long-erm underperformance a leas parially o he agency problem beween corporae managers and equiy invesors. A sizeable body of research has explored he agency-relaed over-invesmen problem and esablished free cash flow as an imporan deerminan. Jensen (1986) proposes he free cash flow hypohesis ha posis ha managers wih posiive free cash flow will end o inves i in waseful (negaive NPV) projecs raher han pay i back o shareholders. In he mergers and acquisiions conex, Lang e al. (1991) show ha bidder reurns for firms wih bad invesmen opporuniies are negaively associaed wih cash flows, lending suppor o Jensen s argumen. Their analysis is based on pre-acquisiion valuaion of he acquiring firms, proxied by Tobin s Q, whereas a high Tobin s Q represens good invesmen opporuniies. They find ha if invesmen opporuniies are no valued by invesors (exhibied by a low Tobin s Q), he shor-window reurn around he acquisiion announcemen is inversely relaed o free cash flow. They inerpre he resuls as suggesing ha invesors believe he more cash managemen has, he more severe he problem of overinvesmen in value-desroying acquisiions becomes. Masulis e al. (2007) provide empirical evidence ha firms wih weak corporae governance srucures experience low announcemen reurns as invesors infer ha managers in hese firms are more likely o indulge in empire-building acquisiions. In addiion o invesigaing he pos-acquisiion performance, exising research also looks a firm fundamenals before he deal announcemen and esablishes several firm characerisics ha predic invesmens in acquisiions. Harford (1999) empirically documens ha cash-rich firms are more likely o aemp acquisiions especially when insider ownership is low and ha hese acquisiions are value-desroying 8. On he oher hand, using an accouning-based framework, Richardson (2006) consrucs an ex ane measure of free cash flow and provides empirical evidence ha is consisen wih Jensen s agency cos hypohesis. Firms wih posiive free cash flows end o over-inves and firms wih negaive free cash flows end o under-inves and cerain corporae governance srucures miigae he agency problem. An imporan bu generally overlooked quesion by researchers is he long-erm valuaion implicaion of pas M&As for acquiring firms hrough anicipaing fuure M&As. To undersand his, ake he anecdoe from 7 See he full ex from Knowledge@Wharon a hp://knowledge.wharon.upenn.edu/aricle.cfm?aricleid= There is also anecdoal evidence showing ha invesors predic acquisiions based on cash reserves. See he analysis from infocom analysis a hp://infocomanalysis.com/2012/03/27/10-of-he-mos-likely-acquirers-in-infocom/. 5

7 he Hewle-Packard case again for illusraion. A he end of firs quarer of 2011, HPQ s shares rade a a fairly low price of around $40. Given is srong forecased earnings and growh rae, he mean arge price esimae for HPQ is $53.88, more han 30% higher han he observed price. In addiion, HPQ s operaing cash flow is large and has been increasing over he pas few quarers. Financial analyss a Seeking alpha explain is low raded price by quoing is hisory of acquiring firms wih high valuaion. An implici assumpion underlying heir analysis is ha a firm s pas invesmen hisory is informaive abou is fuure invesmens. In his paper, I direcly es his assumpion in a large sample of merger and acquisiion firms and examine wheher fuure firm values are relaed o firms pas invesmen hisory. I hypohesize ha invesors form expecaions abou he profiabiliy of firms fuure M&A invesmen decisions based on he realized performance oucomes of firms pas acquisiions and value hese firms accordingly based on he likelihood of hese firms engaging in fuure acquisiions. When a firm s sock underperforms he marke afer is M&A, he poor performance and hus he value-desroying acquisiion will be remembered by invesors. In he long-run, when his firm, again in he fuure, has posiive free cash flow, I expec ha invesors will anicipae an upcoming value-desroying acquisiion. Thus, firm value will manifes iself lower as invesors will price he poenial value-desroying acquisiion ha migh happen in he near fuure even hough he managemen has no announced such an acquisiion plan. When a firm, insead, does no have posiive free cash flow, he possibiliy of over-invesmen is much lower. In his case, he associaion beween he firm value and pas hisory of value-desroying M&A is no expeced. Thus, my firs hypohesis is as follows: H1: The long-erm firm value is negaively associaed wih he pas hisory of value-desroying M&As for firms wih posiive free cash flows. Concepually, firm value measures he discouned all fuure cash flows generaed by all asses a presence. Since he over-invesmen problem is direcly relaed o cash expendiure, i is hen naural o invesigae how invesors value a firm s cash holdings differenially according o is anicipaed profiabiliy. H1 hypohesizes ha when a firm has posiive free cash flow, is firm value decreases wih a worse pas invesmen hisory. If his relaion is caused by invesors anicipaion of an upcoming over-invesmen in value-desroying M&A, I should expec a lower valuaion coefficien on he firm s marginal cash holdings as he cash held by managemen is more likely o be invesed wasefully raher han o increase shareholder value. In oher words, a low valuaion on he firms marginal cash holdings reflecs a discoun due o invesors expecaion of wasing he cash on hand by he curren managemen. On he oher hand, for firms wih negaive free cash flow, I do no expec a lowered valuaion coefficien on he marginal cash as he anicipaed likelihood of over-invesmen is much lower. 6

8 Opler e al. (1999) decomposes he level of cash holdings ino an expeced componen and an excess componen using firm characerisics. The expeced componen of cash is he cash level ha is needed for a firm s normal operaion and he excess componen is he cash level beyond wha is implied by he business model. As he discoun placed by invesors is due o invesors expecaion of he manager s ren exracion of excess cash, by he same logic, I hypohesize ha he discoun in marginal cash comes primarily from he excess par. Thus, my second se of hypoheses is as follows: H2a: The marginal value of cash is negaively associaed wih he pas hisory of value-desroying M&As for firms wih posiive free cash flows. H2b: The marginal value of excess cash is negaively associaed wih he pas hisory of value-desroying M&As for firms wih posiive free cash flows. Recen research by Erickson e al. (2012) examines he effec of informaion uncerainy, proxied by analys forecas dispersion, in acquiring firms sock underperformance. They find ha afer he acquisiion, he sock reurn performance is inversely associaed wih analys forecas dispersion, a proxy for informaion uncerainy. They inerpre his finding as indicaing ha informaion uncerainy is a leas a conribuing facor o he sock price underperformance as higher informaion uncerainy leads o a higher discoun rae for he firm s fundamenals (Wang (1993)). Since my H1 and H2 discuss firm value in he conex of invesors expecaion of fuure possible acquisiions, I furher invesigae a firm s informaion environmen ha may affec he discoun rae. The increase in informaion uncerainy associaed wih M&As may come from boh he probabiliy of such an acquisiion and he resul of combining wo separae business eniies. A firm wih a hisory of over-invesmen may no carefully choose is arge when i again has posiive free cash flow. This would make forecasing is fuure earnings harder for analyss, resuling in more informaion uncerainy. Thus, if Erickson e al. s argumen is also valid in expecing possible upcoming acquisiions, informaion uncerainy is posiively associaed wih he pas hisory of value-desroying M&As for firms wih posiive free cash flows. If a firm has negaive free cash flow, such relaion is no o be expeced as he likelihood of an acquisiion is much lower. Thus, my hird hypohesis is as follows: H3: The informaion uncerainy is posiively associaed wih he pas hisory of value-desroying M&As for firms wih posiive free cash flows. The previous hree hypoheses concern abou invesor s anicipaion of fuure upcoming acquisiions and heir valuaion of firms according o heir pas hisory of over-invesmen. An implici assumpion in my analysis is ha invesors assess a higher (lower) likelihood of fuure M&A for firms wih posiive (negaive) free cash flows. In he nex hypohesis, I examine he invesor pricing when a firm announces is acquisiion plan. If an acquisiion is expeced and informaion abou he anicipaed performance implied by pas hisory has already 7

9 been impounded in he firm value, he shor-window cumulaive reurn around he announcemen should no be significanly relaed wih he pas hisory. In conras, if a firm s pas invesmen hisory is informaive abou is fuure invesmens, when a firm wih negaive free cash flows acually announces is acquisiion plan, invesors can immediaely form expecaions abou he announced acquisiions according o is pas hisory in he shorwindow around he announcemen. A worse hisory of over-invesmen should be associaed wih a lower announcemen reurns. Thus, my las hypohesis is as follows: H4: The shor-erm announcemen window reurn is negaively associaed wih he pas hisory of valuedesroying M&As for firms wih negaive free cash flows. 3. Daa and Sample Selecion 3.1 Sample I obain mergers and acquisiions daa from SDC (Securiies Daa Company) daabase from 1979 o Similar o Edmans e al. (2012), I remove bids classified as acquisiions of parial sakes, minoriy squeeze-ous, buybacks, recapializaions, and exchange offers. Since my main research quesion requires sock price and reurn daa on acquirers, I examine only U.S. domesic public acquirers. To calculae he pas hisory of mergers and acquisiions, I include only compleed ransacions wih arge firms being public, privae, subsidiary or join venure firms. In addiion, I require ha he acquirer own less han 50% of he arge s shares prior o he acquisiion announcemen and own a final holding of more han 50% of he arge s shares afer he acquisiion has compleed. As my main hypohesis is closely cenered on cash invesmen, I include M&As where cash paymen accouns for a leas 1% of he ransacion value as candidaes for calculaing a firm s he pas M&A hisory 9. Lasly, I remove all small ransacions wih deal value less han 1 million and all acquiring firms in he financial (SIC code ) and uiliy (SIC code ) indusries. I merge he SDC daabase wih sock reurn daa from CRSP and accouning fundamenal daa from Compusa. For each firm-year observaion wih available free cash flow measure (FCF, defined in Secion 3.2), I calculae a firm s pas M&A hisory over a rolling en-year window. In addiion, o avoid a mechanical relaion beween he firm value and is mos recen M&A, o be included in he final sample, a firm-year observaion mus be a leas hree years old from he mos recen M&A s compleion dae o ensure he performance consequences from pas M&As have fully realized. Therefore, he final sample sars from 1989 and conains 6283 firm-year observaions. As my main hypoheses H1 o H3 concern abou invesors expecaion and pricing of possible upcoming acquisiions, I furher require ha a firm-year observaion should no be associaed wih an acquisiion. This procedure makes sure ha he resuls are no driven by invesors pricing of a concurren 9 I obain very similar resuls if I alernaively require cash paymen o be a leas 5%, 10% or 20%. Unabulaed resuls show, however, ha firm value is no sysemaically associaed wih he pas M&A hisory if I conduc he analysis using compleely sock-financed deals. This is consisen wih he agency heory explanaion of over-invesmen in M&A. 8

10 acquisiion announcemen. Therefore, he sample for he main ess consiss of 6211 firm-year observaions. To es H4, I examine a smaller sample of firm-year observaions ha are acually associaed wih an acquisiion announcemen. The exac imeline is described in Figure 1. Years of ineres wih FCF>=0 or <0 Collec one-year BHCAR 1, 2,, n as performance merics a leas hree years M&A (1) M&A (2) M&A (n) The en-year rolling window Figure 1: The Timeline 3.2 Main Variable Consrucion To capure M&A performance, I calculae one-year ahead long-erm buy-and-hold cumulaive abnormal reurns (BHCAR) since he compleion dae of acquisiions o assess wheher M&As are value-enhancing or value-desroying. Following Rau and Vermaelen (1998), I calculae abnormal reurns as buy-and-hold reurns adjused by he Fama-French (1992, 1993) 5*5 size and book-o-marke benchmark porfolios. If he inerval beween wo neighboring M&As is less han a year, I collec reurns since he las M&A s compleion dae o 14 days before he nex M&A in calculaing BHCAR. I classify pos-merger performance ino value-enhancing if BHCAR is posiive and value-desroying if BHCAR is negaive. I hen calculae he main independen variable Incidence as he weighed average negaive performance incidence. Specifically, Incidence is defined as he raio of number of value-desroying M&As o he oal number of M&As over he en-year rolling window, using en minus disance in ime as weighs. An old M&A back in hisory is assigned wih a smaller weigh. For insance, if over he pas en years, one acquisiion ook place in year -8 and anoher ook place laer in year -2, hen he firs acquisiion is given a weigh of 0.2 and he laer one is given a weigh of 0.8. Since I use a rolling en-year window, Incidence is firm-year specific, ime-varying and bounded beween 0 and 1. A higher Incidence (more owards o 1) indicaes a worse pas hisory 10. The use of pas over-invesmen hisory in M&A aciviies as a proxy for anicipaed fuure invesmen oucome is predicaed on he assumpion ha he firm s managemen mainains a seady invesmen sraegy and invesors learn he sraegy over years. However, inferring anicipaed fuure invesmen oucome from a firm s pas hisory also creaes some limiaions. For example, empirical research has shown ha he average CEO enure for a lised firm is around seven years (see Kaplan and Minon (2010) among ohers). As a new CEO akes 10 I also calculae Incidence as a simple average of pas negaive performance incidence. Resuls based on he simple average are very similar o resuls repored in ables using weighed average incidence. 9

11 office, he firm s invesmen sraegy can be subsanially differen from he one adoped by he previous CEO. Thus, wheher and when a firm s pas over-invesmen hisory would affec is fuure firm value is an open empirical quesion. I calculae free cash flow (FCF) as he pariioning variable. Following Richardson (2006), FCF is defined as he cash flow beyond wha is necessary o mainain asses in place (including servicing exising deb obligaions) and finance expeced new invesmens. FCF = CF AIP, I * new, = CFO - Depreciaion & Amorizaion Expense + RD - I * new, [1] I new, V 1 / P Book Leverage Cash Age Size I u new, [2] I new is new capial invesmen defined as he difference beween oal capial invesmen and invesmen o mainain asses in place. Toal capial invesmen is calculaed as R&D expendiure plus capial expendiure plus acquisiion expendiure less cash receips from PP&E disposal. Invesmen o mainain asses in place is proxied by depreciaion and amorizaion expense. CFO is cash flow from operaions. I * new is he expeced new capial expendiure. All variables in equaion [2] are predicors of new capial expendiure and are defined in he same way as in Richardson (2006). Specifically, V/P is a measure of growh opporuniies and is calculaed as he raio of he Ohlson model (1995) firm value (V AIP ) 11 o he marke value of equiy. Book Leverage is measured as he sum of curren deb and long-erm deb deflaed by he sum of book value of oal deb and book value of equiy. Cash is measured as cash and shor-erm invesmens. Age is he log of number of years he firm has been lised on CRSP. Size is he log of oal asses. is he change in marke value of he firm from he prior year. I new, -1 is he new capial invesmen from las year. Equaion [2] is esimaed wih indusry and year fixed effecs. FCF is hen calculaed as in [1] and used as a pariioning variable in he main ess 12. Specifically, I classify firms wih posiive FCF as likely acquirers and firms wih negaive FCF as unlikely acquirers. I use Tobin s Q as my primary dependen variable o capure firm value. Tobin s Q is he raio of marke valuaion of he firm o he replacemen cos. As originally proposed in Tobin (1969) and discussed in Hayashi (1982), Tobin s Q measures a firm s invesmen opporuniies valued by is invesors under he curren managemen. Thus i is an appropriae dependen variable o ascerain wheher marke valuaions embed informaion abou anicipaed fuure invesmens. 11 Same as in Richardson (2006), V AIP is esimaed as (1-αr)BV+α(1+r)X-α r d, where α=. ω is he abnormal earnings 1 r persisence parameer and akes a value of d is annual dividends. X is operaing income afer depreciaion. r is he discoun rae and akes a value of 12%. 12 Esimaion resuls are very similar o ha in Richardson (2006) and are available upon requess. 10

12 4. Empirical Tess and Resuls Table 1 Panel A describes he descripive saisics of M&A deals. The mean values of he M&A ransacion value and he cash porion of ransacion value in my sample are 481 million and 326 million, respecively. On average, he size of he deal (he cash paymen porion) represens 27% (19%) of an acquirer firm s pre-acquisiion marke capializaion. This is consisen wih he noion ha acquisiions are one of he mos significan invesmens in erms of boh ransacion size and cash expendiure. Table 1 Panel B presens he descripive saisics for he main ess. Tobin s Q is defined as he sum of marke value of equiy, liquidaion value of preferred equiy and book value of oal liabiliies scaled by oal asses. Size is he logged oal asses. MTB is he raio of marke value of equiy o book value of equiy. Sales is he logged annual sales number. RD is he annual research and developmen expendiure scaled by PP&E. Adv is he annual adverising expense scaled by PP&E. Capex is he annual capial expendiure scaled by PP&E. PP&E is he propery, plan, and equipmen scaled by sales. Incidence is he main variable of ineres and is defined in Secion 3.2. Posiive FCF is a dummy variable and akes one if he free cash flow measured as in Richardson (2006) is posiive and zero oherwise. As I conduc mos analyses separaely for posiive FCF and negaive FCF samples, I also repor descripive saisics in wo subsamples. As shown in Table 1 Panel B, he sample mean of Tobin s Q is The subsample means of Tobin s Q are 1.81 and 1.52 for he posiive FCF sample and negaive FCF sample, respecively. The difference is saisically significan (=10.63, unabulaed), consisen wih idea ha firms generaing posiive free cash flows are valued higher. The sample mean of Incidence is The subsample means of Incidence differ only marginally (=1.78, unabulaed). Table 2 presens he sample correlaions for variables used in he main firm value es. Pearson correlaions are presened in he upper corner for he posiive FCF sample and in he lower corner for he negaive FCF sample, respecively. P-values are presened underneah he correlaions. Incidence is negaively correlaed wih Tobin s Q in he Posiive FCF sample bu is insignificanly correlaed wih Tobin s Q in he negaive FCF sample. This observaion provides some preliminary insighs o H1 in ha for firms wih posiive free cash flows, firm values are negaively relaed o he pas hisory of value-desroying M&As. To validae he poin ha firms wih posiive free cash flows are likely o announce acquisiion plans, I firs esimae a Logi model ha predics acquisiions wih Posiive FCF and oher firm characerisics. The Logi model is similar o ha in Harford (1999). The dependen variable Merger akes 1 if a firm-year observaion is associaed wih merger and acquisiion announcemen [-183, 183] around he earnings announcemen dae. Size is he logged oal asses. Growh, MTB, PE, Lev, NWCAP are sales growh, marke-obook raio, price-o-earnings raio, marke leverage raio (defined as oal deb over he sum of oal deb and marke value of equiy), non-cash working capial scaled by oal asses, all averaged over he pas four years, 11

13 respecively. Posiive FCF is defined same as before. I include year fixed effecs in all panel daa regressions hroughou his paper. In addiion, o avoid boh cross-secional and ime-series dependence, all sandard errors are clusered boh by firm and by year (Peersen (2009), Gow e al. (2010), Cameron e al. (2011)). As I hypohesize ha a firm year wih posiive free cash flow is likely o aemp acquisiions, Posiive FCF is expeced o have a posiive sign. Merger =α+β 1 Size +β 2 Growh +β 3 MTB +β 4 PE +β 5 Lev +β 6 NWCAP +β 7 Posiive FCF +u [3] Table 3 presens he esimaion resuls. The dummy variable Posiive FCF (β=0.282, z=2.52) is posiively and saisically significanly associaed wih he likelihood of aemping an acquisiion. Coefficiens on oher firm characerisics are as prediced. Consisen wih Harford (1999), he coefficiens on Size and Growh are posiive and significan, meaning ha large firms and firms wih subsanial recen growh rae are likely o aemp acquisiions. Lev is esimaed wih a negaive sign, suggesing ha highly leveraged firms are less likely o acquire oher firms. Coefficiens on oher variables are no significan. I conclude from his able ha firms wih posiive free cash flows are more likely o announce acquisiions. Therefore, i is appropriae o use free cash flow (i.e., he dummy variable Posiive FCF) as our main pariioning variable o group firms ino likely acquirers and unlikely acquirers. 4.1 Tes of H1 To es H1, I esimae firm value using he equaion proposed by Himmelberg e al. (1999). Prior sudies also use a similar equaion o examine firm value (e.g., Edmans e al. (2012), Habib and Ljungqvis (2005)). The main variable of ineres is Incidence, defined in Secion 3.2. Firm characerisics are defined earlier. Equaion [4] is esimaed in Table 4 panel A on hree samples, firms wih posiive FCF, negaive FCF and he full sample. Incidence is expeced o have a negaive sign on he posiive FCF sample. Q =α+β 1 Sales +β 2 Sales 2 +β 3 RD +β 4 Adv +β 5 Capex +β 6 Margin +β 7 Leverage +β 8 PPE +β 9 PPE 2 + β 10 Incidence +u [4] Table 4 panel A presens he OLS regression resuls. As prediced, in Model (1) Incidence is negaively and saisically significanly associaed Tobin s Q in he posiive free cash flow sample (β=-0.18, =-3.42). This resul indicaes ha on average, when firms are assessed wih a high likelihood of aemping fuure M&As (suggesed by having posiive free cash flows), invesors place a higher discoun on firm value for firms wih a pas hisory of value-desroying M&As. On average, among firms wih posiive free cash flows, firm value decreases by 0.18 when moving from firms wih he bes hisory achievable (Incidence=0) o firms wih he wors hisory (Incidence=1). In conras, in Model (2) Incidence is insignifican from 0 in he negaive free cash flow sample (=-0.28). This suggess ha when firms are assessed wih a low likelihood of aemping M&As, firm values are no sensiive o heir pas over-invesmen hisory. When he regression is esimaed on he full 12

14 sample in Model (3), he ineracion beween Posiive FCF and Incidence is negaive and saisically significan (=-3.56), emphasizing ha i is he combinaion of boh anicipaed likelihood and over-invesmen hisory ha maer in he firm value discoun. To summarize, hese findings are consisen wih invesors forming expecaions abou he profiabiliy of fuure M&A invesmen decisions based on he realized performance oucomes of heir pas acquisiions and valuing hese firms accordingly based on he likelihood of hese firms engaging in fuure acquisiions. To furher ensure ha he observed relaion beween Incidence and Tobin s Q is no driven by a mechanical relaion beween previous sock marke performance and firm values laer, I conduc a mached sample analysis. Specifically, I mach each M&A firm wih a non-m&a firm wih he closes marke capializaion in he same Fama-French (1997) 48-indusry from he enire Compusa daabase a he ime of is firs M&A. I use he acual M&A announcemen dae and compleion dae as he pseudo-daes for he mached non-m&a firm. For each non-m&a firm, I calculae Incidence exacly he same way as described in Secion 3.2 bu using pseudo daes. Finally, I esimae equaion [4] on his mached sample and presen resuls in Columns (4)-(6). Srikingly differen from Model (1), Incidence is insignifican in Model (4). The ineracion beween Posiive FCF and Incidence in Model (6) is no significan. These resuls reassure ha my findings in Model (1)- (3) are due o he anicipaion effec of fuure upcoming invesmens. Firm characerisics in Model (1) o (6) are esimaed consisenly wih prior lieraure. Capex is generally posiively and significanly associaed wih Tobin s Q and Leverage is negaively and significanly associaed wih Tobin s Q. Margin is posiively associaed wih Tobin s Q in he posiive FCF sample bu no in he negaive FCF sample. In Models (3) and (6), he coefficien on Posiive FCF is posiive and srongly significan (=5.28 and 4.80, respecively), suggesing ha firms wih posiive free cash flows are valued higher han firms wih negaive free cash flows. In Table 4 Panel B, I sor firm-year observaions by FCF ino five quiniles and re-esimae equaion [4] for each FCF quinile. All firm characerisics are included in he regression bu I only repor he coefficien on Incidence for he sake of breviy. As seen from he able, Incidence is insignificanly relaed o he firm value for he hree low FCF quiniles, bu is significanly and negaively relaed wih firm value in he wo high FCF quiniles. The coefficien on Incidence almos decreases monoonically as moving from he lowes FCF quinile o he highes FCF quinile. In he highes FCF quinile, a one uni change from he firm wih bes hisory achievable (Incidence=0) o he firm wih wors hisory (Incidence=1) resuls in an implied decrease in Tobin s Q of These resuls again emphasize he anicipaion channel: firm values embed anicipaed profiabiliy of fuure M&A invesmens according o he perceived fuure M&A likelihood. Pas invesmen hisory is more perinen o firm valuaions when he anicipaed likelihood of fuure acquisiions is high. Prior lieraure has esablished ha good corporae governance srucures miigae he agency problem associaed wih over-invesmen (Richardson 2006). In addiion, Biddle e al. (2008) find ha good earnings 13

15 qualiy enhances invesmen efficiency by limiing boh under-invesmen and over-invesmen. Therefore, I consider he effecs of corporae governance and earnings qualiy in he relaion beween firm values and pas over-invesmen hisory. In Table 4 Panel C, I inerac indicaors of corporae governance index and earnings qualiy wih he main independen variable Incidence. Governance akes a value of 1 if he firm-year value has a BCF index 13 (Bebchuk e al. (2009)) below he annual sample median. Qualiy akes a value of 1 if he firmyear s accruals qualiy is below he annual sample median. Accruals qualiy is esimaed cross-secionally as in Francis e al. (2005) 14. In Models (1) and (2), I inerac Incidence wih Governance. The coefficien on he ineracion beween Incidence and Governance is posiive for he posiive FCF sample bu is no significan. The coefficien on he ineracion for he negaive FCF sample is insignifican from 0. As before, he coefficien on Incidence iself is negaive and saisically significan in Model (1) bu insignifican from 0 in Model (2). In Models (3) and (4), I inerac Incidence wih Qualiy and obain very similar resuls as in Models (1) and (2). Taken ogeher, I find ha he srong corporae governance srucure or good earnings qualiy, a mos, very weakly miigaes he discoun caused by pas over-invesmen for posiive FCF firms hrough he anicipaion effec. 4.2 Tes of H2 The previous discussion examines he relaion beween fuure firm values and pas M&A performance. H2 direcly assesses invesors valuaion on firm s cash holdings. I esimae he marginal value of cash using he framework proposed by Faulkender and Wang (2006). r b r Cash 1 Div 8 Cash 2 9 NF * Incidence Leverage 10 Cash 3 11 Cash 4 Cash E NA Leverage RD Cash * Ineres 7 Incidence 13 u [5] The dependen variable r - r b is he compounded size and book-o-marke adjused realized reurns from fiscal year -1 o. Cash is change in cash. Cash -1 is cash balance from las year. E is change in earnings before exraordinary iems plus ineres, deferred ax credis, and invesmen ax credis. NA is change in ne asses where ne asses are defined as oal asses minus cash holdings. Ineres is change in ineres expense. Div is change in common dividends paid. Leverage is he marke leverage defined as oal deb over 13 The corporae governance index from Bebchuk e al. (2009) is consruced from Invesor Responsibiliy Research Cener (IRRC, now RiskMerics). Specifically, hey consruc heir index based on 6 ou of he 24 aniakeover provisions. Higher index indicaes weaker corporae governance. As discussed in Masulis e al. (2007), IRRC publishes volumes every six years from I assume ha beween each consecuive IRRC publicaion, a firm s corporae governance provision remains he same as he previous publicaion year. Empirical resuls, however, are no sensiive o his assumpion. 14 I esimae accruals qualiy following Francis e al. (2005). Specifically, I esimae TCA j, = φ 0 +φ 1 CFO j,-1 +φ 2 CFO j, +φ 3 CFO j,+1 + φ 4 Rev j, +φ 5 PPE j, + v j, in each Fama-French 48-indusry. TCA is oal curren accruals. CFO is cash flow from operaions. Rev is change in revenues. PPE is propery, plan and equipmen. Accruals qualiy is he five-year rolling sandard deviaion of firm j s residuals, v j, calculaed over years -4 hrough. Larger sandard deviaions of residuals indicae poorer accruals qualiy. 14

16 he sum of oal deb and he marke value of equiy. NF is he oal equiy issuance minus repurchases plus deb issuance minus deb redempion. RD is change in R&D expendiures. All independen variables excep Leverage and Incidence are deflaed by he lagged marke value of equiy ( 1 ). This deflaion has an advanage of inerpreing coefficien esimaes as he marginal value of righ-hand-side independen variables. As before, equaion [5] is esimaed over he full sample, posiive FCF sample and he negaive FCF sample. To furher sudy invesor s differenial pricing of marginal value of cash. I decompose he change in cash balance ino an expeced par and an unexpeced par in Model (4). To predic he nex-year cash balance, I adop he modified Opler e al. (1999) model o esimae he opimal cash balance using las year s financial variables. This equaion is mos recenly applied in Hwang and Zhang (2012). Cash ln( ) ln( 1 7 RD ) Growh 2 DDiv 8 u 3 CF NWCAP 4 CAPX 5 Deb 6 [6] is he marke value of equiy; Growh is he sales growh; CF is he operaing income less ineres, axes, and common dividends; NWCAP is ne non-cash working capial; CAPX is capial expendiures; Deb is oal debs calculaed as he long-erm deb plus he curren porion; RD is research and developmen expenses; DDIV is a dummy variable ha is se o 1 if he firm pays dividends and 0 oherwise. Equaion [6] is esimaed by each of Fama-French 48 indusries (1997) on he enire Compusa sample. The fied value from equaion [6] is he prediced value of nex-year s cash balance. The difference beween prediced cash and observed cash balance is he change in unexpeced cash. The difference beween prediced cash and las period s cash is he change in expeced cash. I hen re-esimae equaion [5] by decomposing Cash ino change in expeced cash ( Cash Expeced ) and change in unexpeced cash ( Cash Unexpeced ). Table 5 presens he OLS regression resuls. The main variable of ineres is he ineracion erm beween Incidence and Cash. In Model (1), he coefficien on Cash is posiive and saisically significan. This means ha on average, each addiional dollar held by a firm wih zero cash and no leverage is valued by invesors a $1.764 in absence of pas over-invesmen hisory 15. The coefficien on he ineracion beween Incidence and Cash is negaive and saisically significan, suggesing ha he marginal value of cash for a firm wih he wors over-invesmen hisory is 51 cens lower han a firm wih he bes hisory. Coefficiens on NA and E are posiive and significan, consisen wih invesors assigning higher values for firms wih srong balance shee and ne earnings. The coefficien on Div is posiive and significan, consisen wih firms wih srong dividend growh experiencing higher realized reurns. The coefficien on Cash -1 * Cash is negaive, 15 Faulkender and Wang (2006) esimae he marginal value of cash for a firm wih zero cash and no leverage a In my sample, he sample mean of Incidence is Therefore, he marginal cash from an average firm wih sample mean Incidence bu zero cash and no leverage is valued a *0.514=1.476, very close o he resul repored in Faulkender and Wang (2006). 15

17 consisen wih he diminishing marginal value of cash when a firm s cash posiion improves. The coefficien on Leverage * Cash is negaive, consisen wih he noion ha as he leverage raio becomes higher, some value of cash will accrue o deb holders. Resuls for oher conrol variables are also very similar o findings in Faulkender and Wang (2006). In Models (2) and (3), I esimae equaion [5] separaely for he posiive FCF and negaive FCF samples. Firs of all, he coefficien of Cash in Model (2) is bu only in Model (3). This conras is consisen wih our sample pariion. On average, wih zero cash and no leverage, firms generaing posiive free cash flows have much higher marginal value of cash han hose generaing negaive free cash flows in absence of pas over-invesmen hisory. Mos imporanly, he coefficien on he ineracion beween Incidence and Cash is negaive and saisically significan in Model (2) bu is insignifican from 0 in Model (3). This indicaes ha among firms wih posiive free cash flows, an addiional dollar of cash is valued 84 cens less for firms wih he wors hisory of over-invesmen compared wih firms wih he bes hisory. The analysis in Table 4 panel A shows ha in he posiive free sample, moving from a firm wih he bes pas hisory o a firm wih he wors hisory resuls in a decrease in Tobin s Q of Assuming he marginal value of cash is a good proxy for he average value of cash, resul in Column (2) indicaes ha around 80% ((0.84*( Cash +Cash -1 )*/Toal asses)/0.18, all expressed in he posiive FCF sample average) of he discoun in Tobin s Q documened in Table 4 is due o he discoun in cash holdings. This is consisen wih H2 in ha when he likelihood of acquisiion is high, invesors place a discoun a valuing is marginal cash for firms wih anicipaed unprofiable M&As. I decompose Cash ino Cash Expeced and Cash Unexpced and re-esimae equaion [5] in Model (4). As prediced, he coefficien on Incidence* Cash Unexpeced is negaive and saisically significan. The coefficien on Incidence* Cash Expeced is no significan from 0. This suggess ha he discoun on he marginal value of cash mainly comes from he unexpeced porion of change in cash. In Models (5) and (6), I furher esimae he decomposed version of equaion [5] on he posiive FCF and negaive FCF samples, respecively. The coefficien on Incidence* Cash Unexpeced is negaive and saisically significan only in he posiive FCF sample. Cash Unexpeced in Model (4) is he residual erm from equaion [6]. As i can be boh posiive (excess cash) and negaive (shorage in cash), I make sure ha my resuls capure he invesors discoun on excess cash. I pariion my sample ino firms ha have excess cash and firms ha have cash shorage and re-esimae he decomposed version of equaion [5]. Resuls are presened in Models (7) and (8). As prediced, he coefficien on Incidence * Cash Unexpeced is only negaive and saisically significan for he excess cash sample, consisen wih invesors placing a discoun a firms wih manager exracing rens from he cash posiion ha is beyond wha is expeced for he firm. Firm characerisics in Models (2) hrough (8) are esimaed similarly as in Model (1). In all models, he coefficien of Incidence iself is no significan from 0. Taken ogeher, I find ha invesors place a discoun on a firm s marginal value of cash for firms wih a hisory of over-invesmen when he likelihood of fuure 16

18 M&As is high and his discoun is mainly on he firm s excess cash ha is unexpeced from he firm s business model. 4.3 Tes of H3 To es H3, I examine he relaion beween a firm s informaion environmen wih is pas overinvesmen hisory on a subsample of firms followed by a leas hree analyss. Same as in Erickson e al. (2012), I use analys forecas dispersion as a proxy for informaion uncerainy. I follow Lehavy e al. (2012) and esimae analys forecas dispersion as a funcion of firm characerisics and Incidence. Dispersion =α+β 1 Incidence +β 2 Size +β 3 RD +β 4 Adv +β 5 MF +β 6 Volailiy +β 7 Bea +β 8 News +β 9 Complexiy +u [7] The dependen variable Dispersion is he sandard deviaion of IBES analyss one-year ahead annual EPS forecass scaled by he median forecas 16. Size is he logged oal asses. Growh is he sales growh. MF is he number of managemen earnings guidance as repored in he Firs call daabase. Volailiy is he sandard deviaion of he firm s monhly sock reurns from he previous fiscal year. Bea is he CAPM bea esimaed using monhly reurns over he en-year rolling window. News is he absolue value of he cumulaive markeadjused reurns around he 10-K filing even window [-1, 1]. Complexiy is he logged number of operaing segmens repored in Compusa. RD, Adverising and Posiive FCF are defined same as before. Table 6 presens he esimaion resuls. The coefficien on Incidence is posiive and saisically significan in he posiive free cash flow sample bu is insignifican from 0 in he negaive free cash flow sample. This indicaes ha when a firm has posiive free cash flow, financial analyss exhibi a higher degree of uncerainy abou fuure earnings for firms wih a hisory of over-invesmen. A possible upcoming acquisiion will aler a firm s fuure earnings sream. Analyss are more uncerain abou he earnings generaing process of he new combined firm for firms wih a hisory of over-invesmen. This could be due o analyss percepion ha firms wih previous value-desroying M&As may no carefully selec arge firms. MF is negaively associaed wih dispersion, consisen wih firms wih more managerial earnings guidance having less informaion uncerainy. News is posiively associaed wih dispersion, consisen wih more earnings surprise leading o more uncerainy. Volailiy is posiively associaed wih dispersion, consisen wih firms wih higher idiosyncraic risks having more informaion uncerainy. Oher conrol variables exhibi similar resuls as in Lehavy e al. (2012). These findings sugges ha he argumen in Erickson e al. (2012) also applies in anicipaing possible upcoming acquisiions. Likely acquirers wih a hisory of over-invesmen have high informaion uncerainy, which in urn leads o a higher cos of capial (Wang (1993)). Thus, informaion 16 I scale he sandard deviaion of EPS forecass by he median forecas. An alernaive is o scale he sandard deviaion by share price. However, my previous analysis shows ha share price is lower for firms wih bad hisory if i has posiive free cash flow. Therefore, o make sure ha he relaion beween he dispersion variable and pas hisory is no driven by he scaling variable, I use he median forecas as he scalar. 17

19 uncerainy is a leas a conribuing facor in he low valuaions hrough anicipaion for firms wih pas valuedesroying M&As. 4.4 Tes of H4 My previous analysis argues ha invesors assess a lower likelihood of fuure M&As for firms wih negaive free cash flows. An implicaion from his is ha when firms wih negaive free cash flow acually announce M&As, he announcemens are more likely o be news o invesors. To validae his, I sudy a smaller sample of firm-year observaions ha are acually associaed wih an acquisiion during he long window of [- 183, 183] around he earnings announcemen dae. I examine he five-day shor-window cumulaive abnormal reurn (CAR) around he acquisiion announcemen window [-2, +2] adjused by he marke model. The marke model parameers are esimaed over he long window [-210, -11] prior o he acquisiion announcemen. Table 7 panel A presens he descripive saisics for he 5-day CAR. The means of he absolue 5-day CAR are and 0.056, for he posiive FCF and negaive FCF groups, respecive. The difference in mean is significan (=3.17). Furher, unabulaed resuls show ha he 5-day CAR for he posiive FCF sample is no significan from 0 (=-0.49) and he 5-day CAR for he negaive FCF sample is marginally significan from 0 (=1.72). On average, firms wih negaive free cash flows experience higher announcemen reurns and he difference is saisically significan a 5% level (=1.98, unabulaed). This is consisen wih findings in Cai e al. (2011) ha less anicipaed bids earn significanly higher announcemen reurns. Taken ogeher, hese findings sugges ha he acquisiion announcemens from firms wih negaive free cash flows conain more news o invesors, measured in he announcemen window reurns, To es H4, I follow he specificaion in Masulis (2007) and esimae CAR as a funcion of firm characerisics and Incidence. CAR[-2,+2] =α+β 1 Incidence +β 2 Size +β 3 Leverage +β 4 Sock price runup +β 5 Deal value +β 6 Governance +β 7 Sock + β 8 Public Targe +β 9 Sock *Public Targe + β 10 Privae Targe +β 11 Sock*Privae Targe +β 12 FCF +u, The dependen variable is cumulaive abnormal reurn (CAR). Sock Price Runup is he marke-adjused buy-and-hold marke-adjused sock reurn over he window of [-183, 183] around he earnings announcemen dae. Deal value is he size of he deal defined as he ransacion value divided by he acquirer s marke value of equiy. Sock akes 1 if he deal is a leas parially sock-financed and 0 oherwise. Public Targe akes 1 if he arge is a public firm and 0 oherwise. Privae Targe akes 1 if he arge is a privae firm and 0 oherwise. Size, Leverage, Governance, Posiive FCF are defined same as before. Incidence is he main variable of ineres and is hypohesized wih a negaive sign for he negaive FCF sample. 18

20 Table 7 panel B presens he OLS regression resuls. Firs of all, his subsample consiss of 277 and 113 firm-year observaions for he posiive free cash flow and negaive free cash flow groups, respecively. This again poins o he fac ha an acquisiion is much more likely o happen if a firm has posiive free cash flow. In Model (1), he coefficien on Incidence is insignifican from 0 in he posiive free cash flow sample. In conras, in Model (2), he coefficien on Incidence is negaive and saisically significan (β=-0.259, =-2.21) in he negaive free cash flow sample. This suggess ha when invesors are surprised a acquisiion announcemens made by firms wih negaive free cash flows, shor-erm sock reurns reac negaively o Incidence. Firms wih a hisory of over-invesmen experience immediae sock reurn drops during he 5-day announcemen window. This is consisen wih invesors forming expecaions abou he newly announced acquisiions based on hisorical M&A performance. On he oher hand, when an acquisiion announcemen is anicipaed beforehand, he anicipaed profiabiliy of fuure M&As has already been gradually impounded ino he price prior o he announcemen and he announcemen window reurn is no sysemaically associaed wih pas M&A hisory. Oher coefficiens are esimaed consisenly wih findings in Masulis e al. (2007). 5. Addiional Analyses Michell and Lehn (1990) find ha firms ha made value-desroying acquisiions are more likely o become akeover arges in he nex five years afer heir bad acquisiions. They explain heir findings as marke aking a disciplinary role o promoe economic efficiency by reallocaing he resources from value-losing acquiring firms o fuure higher-valued uses. They inerpre akeovers as boh a sympom and a soluion. Firms ha engage in value-desroying M&As exhibi sympoms of over-invesmen in M&As and he overinvesmen problems ge correced laer when hese firms are acquired by oher firms. The link beween he sympom and a soluion, however, is no discussed in heir paper. My previous analysis suggess ha firms wih posiive free cash flows and a hisory of over-invesmen experience lower firm values in he long erm hrough he anicipaion effec. I exend my analysis o explore wheher firms wih posiive free cash flow and a hisory of over-invesmen are more likely o be aken over. This idea makes inuiive sense as he marke values of hese firms are lowered due o invesors expecaion of fuure valuedesroying over-invesmen. Meanwhile, hese firms are generaing posiive free cash flows. Poenial acquirers can ge conrol of cash-generaing businesses for lower prices. Therefore, I hypohesize ha firms wih posiive free cash flows and a hisory of over-invesmen are more likely o be aken over. I esimae a LOGIT regression as specified below. Acquired 1Incidence 2Size 3Leverage 4BTM 5ROA u [9] 19