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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 additional 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

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