The Combined Effects of Free Cash Flow and Financial Slack on Bidder and Target Stock Returns

Abstract

This article examines the extent to which takeovers mitigate the underinvestment problem of S. C. Myers and N. S. Majluf (1984) and the free-cash-flow problem of M. C. Jansen (1986). Using accounting data, bidders are classified as 'high free cash flow,' 'slack poor,' or 'other.' Bidder, target, and total returns are highest for acquisitions that combine slack-poor and free-cash-flow firms. The widely cited negative returns of bidders are concentrated among combinations where bidders and targets are similarly classified. Cross-sectionally, bidder returns are more positive when associated with capital structure and liquid asset changes that mitigate bidder slack or free-cash-flow problems. Copyright 1994 by University of Chicago Press.