This study analyzes whether the efficiency of investments, i.e., the extent to which a firm recovers it's cost of capital in an investment, is related to the source of the funds available for investment. For a sample of 285 takeovers, the abnormal announcement period return is used to proxy for the investment's NPV. Unlike previous papers, the actual source of financing rather than the form of payment is examined. The study documents that firms with poor investment opportunities, as measured by a proxy for Tobin's q, exhibit a negative relation between funds available for investments and bidder gains, regardless of the source of the funds. However, funds that are generated internally, exhibit the strongest negative relation with bidder gains. Funds raised through a debt issue exhibit a negative relation with bidder gains, but significantly less so than internally generated funds. Funds raised through an equity issue have no relation with bidder gains for low q firms. The debt-to-equity ratio, measured two years prior to the takeover announcement, has a significantly larger relation with bidder gains for low q firms than for high q firms. This is consistent with debt acting as a disciplinary role for low q firms. High q firms exhibit a strong (weak) positive relation between equity (debt) financing and bidder gains and no relation between internally generated funds and bidder gains. Overall, the free cash flow evidence is consistent with the managerial discretion hypothesis from Stulz (1990). The results are also consistent with the differential cost of capital hypothesis, derived from the pecking order theory from Myers and Majluf (1984). The differential cost of capital hypothesis predicts that the market expects a firm to have selected an investment with higher discounted cash flows if the project is announced after more costly forms of financing have occurred prior to the investment decision.
This study further documents that internal, equity, and debt financing, among other factors are positively related to the likelihood of a takeover announcement in the subsequent year. When the takeover is classified as expected versus unexpected, the relation between free cash flow and bidder gains for low q firms is negative for unexpected takeovers only. This result supports the notion of an efficient capital market. Furthermore, when both firm and industry level growth opportunities are considered the relation between free cash flow and bidder gains is particularly negative for takeovers by low q firms in low q industries. In contrast, the positive relation between equity financing and bidder gains is particularly strong for high q firms in low q industries.
Long-horizon stock price performance is not related to free cash flow, equity, or debt financing in the year prior to the takeover announcement. The sample displays some evidence of positive abnormal performance during the first two years after the takeover announcement and weak under-performance if the investment horizon is extended to five years.