Company cash reserve may have unwanted informational effects

What is it about?

Corporate cash reserve has an adverse selection effect. Specifically, if investors know a company does not have to issue to invest, an attempt to do so sends a strong signal of overvaluation. This notion has not been explicitly studied in the extant empirical literature, despite its intuitiveness. Using a sample of acquisitions solely financed by stock to exclude the potential complications of free cash flow, I find that announcement returns are lower for a bidder with a higher excess cash reserve. This effect is stronger in hot equity market years or when a bidder's standalone value is more difficult to evaluate. I also find evidence supporting the idea that targets request cash payment to remove “lemon” bidders in normal (non-hot equity market) years, but accept too many stock offers in hot equity market years. After acquisitions, high-excess-cash-reserve bidders operationally outperform low-excess-cash-reserve bidders. Further, they spend more funds on reducing debt but not more on investments, compared with low-excess-cash-reserve bidders. Combined, these results show that cash reserve has information costs. Further, they highlight the importance of the two-sided information asymmetry framework of Rhodes-Kropf and Viswanathan (2004) in describing merger outcomes without resorting to behavioral or agency explanations.

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Why is it important?

When an acquiring firm has a large cash reserve but prefer to pay using its own stock, it sends a strong signal of overvaluation. We explain this phenomenon based on a two-sided information asymmetry framework, i.e., the target neither knows the true value of the acquiring frims' shares nor it knows the synergy to the acquiring firm of the proposed deal. When a stock offer is high, the target interprete part of it as from the high synergy, thus accept the offer. This article shows that cash has informational effects on company share prices. The acquiring firm's CEO should be aware of this issue when considering stock payment. This way, she is more prepared to avoid unwanted consequences on share prices.