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Corporate Cash Reserves And Acquisitions

Jarrad Harford

University of Washington

January 30, 1997

The acquisition behavior of cash-rich firms is examined for evidence of free cash flow-related behavior. A model of cash management is developed and used to identify a sample of cash-rich firms. The model provides a benchmark "normal" level of cash reserves based on industry characteristics and dynamic cash management over time. Cash-rich firms are found to be more likely to begin acquisitions, increase current acquisition spending, and engage in large acquisitions than the rest of the population of firms. In a multivariate setting, cash- richness is a strong predictor of acquisition likelihood, even controlling for sales growth and stock price performance. Additional tests support the free cash flow hypothesis over a hypothesis in which managers optimally stockpile cash before an acquisition. Among cash- rich firms, the decision to spend the cash on an acquisition rather than pay it out is strongly related to how well the agency conflict between managers and owners is controlled. Further, the abnormal return from an acquisition announcement is decreasing in the deviation of a firm's cash reserves from its predicted optimal level. Cash-rich firms are more likely to make diversifying acquisitions and their targets are less likely to attract other bidders. Overall, the evidence supports the explanatory power of the free cash flow hypothesis for the investment decisions of cash-rich firms.

Number of Pages in PDF File: 46

JEL Classification: G31, G34

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Date posted: April 7, 1997  

Suggested Citation

Harford, Jarrad, Corporate Cash Reserves And Acquisitions (January 30, 1997). Available at SSRN: http://ssrn.com/abstract=2109 or http://dx.doi.org/10.2139/ssrn.2109

Contact Information

Jarrad Harford (Contact Author)
University of Washington ( email )
Box 353226
Seattle, WA 98195-3226
United States
206-543-4796 (Phone)
206-543-7472 (Fax)
HOME PAGE: http://faculty.washington.edu/jarrad/
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