Deviation from the Target Capital Structure and Acquisition Choices

In the paper, Deviation from the Target Capital Structure and Acquisition Choices, forthcoming in the Journal of Financial Economics, I explore the effects of a firm’s leverage deficit on its acquisition choices. In particular, I examine the extent to which a firm’s leverage deficit affects the likelihood of the firm making an acquisition as well as the effect of its leverage deficit on the payment method and on the premiums paid for the target firm. Because managers are likely to anticipate the constraints of overleverage on acquisition choices, I also analyze managerial decisions on capital structure in the light of potential acquisitions. Specifically, I test whether managers of overleveraged firms reduce their leverage deficits when they foresee a high likelihood of making acquisitions. Finally, I examine how capital markets react to the acquisition announcements of firms that deviate from their capital structures. Managers of overleveraged firms will face constraints on the form and level of financing and are more likely to be selective in their acquisition choices if they fail to decrease their leverage deficits substantially. Therefore, I hypothesize that managers of overleveraged firms will pursue only the most value-enhancing acquisitions, which, in turn, will foster favorable market reactions to the news of their acquisitions.

This paper contributes to studies on interdependence of capital structure and investment decisions by documenting the relationship between corporate leverage deficit and acquisition choices. I find that the likelihood of a firm undertaking an acquisition decreases with its leverage deficit. However, the effect of its leverage deficit on the likelihood of making an acquisition is asymmetric. While the effect of overleverage is negative and significant, underleverage has an insignificant effect on the probability that the firm will make the acquisition. I also find that overleveraged acquirers have lower premiums and lower cash components in their acquisition offers. Finally, I find that capital markets react favorably to announcements of acquisitions from overleveraged acquirers. These findings collectively suggest that managers of overleveraged acquirers are more selective in their acquisitions while lending support to the view that a firm’s capital structure influences its investment choices.

The evidence presented in this paper also suggests that the nature of investment opportunities may influence the capital structure decisions (DeAngelo et al., 2010). The lower likelihood of undertaking an acquisition and higher announcement returns for overleveraged firms documented in this paper suggests that a higher likelihood of forgoing valuable acquisition opportunities may generate quicker leverage adjustments for overleveraged firms. I find further evidence confirming this prediction: overleveraged firms reduce their leverage deficits and issue equity when they have a high probability of undertaking an acquisition. These findings are consistent with the view that building up spare debt capacity is valuable for firms with investment opportunities while suggesting that the nature of investment opportunities has a role to play in the capital structure decisions. These findings also provide a potential explanation for why firms adjust their debt ratios more quickly when they are overleveraged than when they are underleveraged (e.g., Leary and Roberts, 2005; Frank and Goyal, 2009). Finally, by documenting that deviations from firms’ target capital structures influence both their acquisition choices and the way the acquisitions are structured, this study also illustrates the usefulness of the concept of the target capital structure in managerial decisions.

The full paper is available for download here.