Corporate Debt Maturity and Acquisition Decisions

• Published date: 01 August 2016
• DOI: http://doi.org/10.1111/fima.12117
• Author: Xudong Fu,Tian Tang
• Date: 01 August 2016

Corporate Debt Maturity and Acquisition

Decisions

Xudong Fu and Tian Tang∗

This paper provides an empirical analysis of the effects of corporate debt maturity on firms’

acquisition decisions using a large sample of acquisitions from 1991 to 2010. We find that firms

with shorter debt maturity are less likely to undertake acquisitions. If they do,they are more likely

to undertake smaller deals, take more time to complete, are less likely to make all cash offers,

and tend to use less cash in the payment. These results support the predictions of the increased

liquidity risk hypothesis. We also find that acquirers with shorter debt maturity realize higher

announcement returns and experience better long-term stock returns and operatingperformance.

These results suggest that shortdebt maturity improves the efficiency of capital allocation through

acquisition decisions.

Over the past few decades, academics have made significant progress in understanding corpo-

rate capital structure beyond the basic leverage levelchoice. In particular, academics have focused

much interest in understanding the determinants and effects of corporate debt maturity structure.

This study is the first empirical investigation on the effects of corporate debt maturity on firms’

acquisition decisions.

Specifically, we examine the effectsof shor ter debt maturity on acquisition propensity, various

deal characteristics, and acquisition quality. We investigate two hypotheses through which short-

term debt can influence acquisition propensity. The reduced underinvestment hypothesis argues

that short-term debt increases equity holders’ investment incentivesdue to more frequent repricing

(Myers, 1977). The increased liquidity risk hypothesisargues that short-ter m debt creates liquidity

risk that can force firms to forgo investment opportunities due to excessive liquidation threats

from lenders (Diamond, 1991). In addition, short-term debt amplifies a firm’s rollover risk (He

and Xiong, 2012) leading to earlier firm default. The likelihood of earlier default reduces the

value of future firm growth opportunities thereby undermining equity holders’ current investment

incentives (Diamond and He, 2014).

To test these two hypotheses, we construct a short debt maturity variable as the fractional

amount of debt in current liabilities to the market value of the firm. In addition, we construct a

corresponding residual variable calculated as the firm-level deviation from its predicted short debt

maturity. We then analyze the effects of debt maturity structure on deal size, time to completion,

and method of payment in acquisitions using a sample of 10,561 completed acquisitions from 1991

to 2010. We find that firms with shorter debt maturity are less likely to undertake acquisitions in

We are especially grateful to Raghavendra Rau (Editor) and an anonymous referee for their valuable comments and

suggestions. Wealso thank Alan Douglas, Subramanian Iyer, Qin Lian, Han Yu, the participants at the 2013 Financial

Management Association Annual meeting,the 2014 Midwest FinanceAssociation Annual meeting, and the 2014 Southern

Finance Association Annual meeting for their helpful comments. All errorsare our own.

∗Xudong Fu is an Assistant Professor in the Department of Finance, Collegeof Business at the University of Louisville

in Louisville, KY and formerly an Assistant Professorin the Department of Economics and Finance, School of Business

at Southern Illinois University Edwardsville in Edwardsville, IL. TianTang is an Assistant Professor in the Department

of Finance, College of Business at the University of Louisville in Louisville,K Y.

Financial Management •Fall 2016 •pages 737 – 768

738 Financial Management rFall 2016

general. In addition, firms with shorter debt maturity than the optimal level are also less likely

to acquire. This evidence supports the notion that short-term debt is not a perfect solution to

the debt overhang problem and the liquidity risk arising from the use of short-term debt reduces

firms’ investment incentives. It is also consistent with the findings of Graham and Harvey (2001)

that financial practitioners view liquidity risk as the second most important concern in corporate

decision making.

Since short debt maturity affects the propensity with which a firm undertakes acquisitions,

we face a potential sample selection bias problem if we use an ordinary least squares (OLS)

methodology. Hence we employ a Heckman (1979) two-stage selection model. Specifically, we

use City-Industry Cluster, defined as the natural logarithm of one plus the number of Compustat

firms from the same two-digit standard industrial classification (SIC) industry headquar tered in

the same city, as our instrumental variable (IV) in the first-stage (Wooldridge, 2012) since City-

Industry Cluster has a positive effect on acquisition propensity (Almazan et al., 2010), but has no

direct relation with various deal terms or quality measures. We find that acquirers with shorter

debt maturity tend to undertake acquisitions of smaller relative size, take more time to complete

the transaction, are less likely to use all cash offers, and use a smaller cash component while

paying for the acquisition. These results provide additional evidence supporting the notion that

liquidity risk concerns arising from the use of short-term debt have effects on various acquisition

characteristics.

We further investigate the impact of debt maturity on acquisition quality by examining the

relation between acquirers’ debt maturity and acquirers’ announcement returns, long-run stock

performance, and long-run operating performance. Short-term debt could influence the quality of

an acquisition through two mechanisms. First, firms use short-term debt to signal the quality of

their firm or favorable private information of future profitability to the market (Flannery, 1986;

Kale and Noe, 1990). In addition, it is the high rated borrowers who are willing to bear the risk of

refinancing short-term debt, and they will only undertake value-enhancing acquisitions with the

knowledge that they will refinance the maturing debt subject to the arrival of new information

(Diamond, 1991). We find that acquirers with shorter debt maturity realize higher announce-

ment returns and have better long-term stock and operation performance postacquisitions. These

findings indicate that capital markets interpret acquisitions undertaken by shorter debt maturity

firms as value-enhancing investments. They also suggest that short debt maturity improves the

efficiency of capital allocation through acquisition decisions. The continuation of positive re-

turns observed in the long term is consistent with the notion that short-term measurements of

abnormal performance do not fully capture the effects of the markets’ reaction to an event (Rau

and Vermaelen, 1998) and investors tend to underreact (Kadiyala and Rau, 2004).

This study contributes to the literature in three ways. First, we extend the literature regarding

debt maturity by investigating the effects of debt maturity on firms’ acquisition decisions. Pre-

vious studies find that corporate cash reserves (Harford, 1999), growth opportunities (Officer,

2003), executivecompensation str ucture (Datta, Iskandar-Datta, and Raman, 2001), firm location

(Almazan et al., 2010), and target leverage deviation (Uysal, 2011) have an impact on a firm’s

likelihood of undertaking an acquisition. We move beyond the influence of the basic leverage

level on firms’ acquisition decisions by examining firms’ f inancing choices through a finer lens,

namely, their debt maturity structures. Our results indicate that a firm’s debt maturity structure

has a significant impact on its propensity to undertake an acquisition. Therefore, corporate debt

maturity is an important factor that should be taken into consideration in understanding a firm’s

acquisition decisions.

Second, this paper enhances the understanding of acquirers’ bidding behavior. Despite the

connection between a firm’s debt maturity and deal size, completion time, and payment method

Fu & Tang rCorporate Debt Maturity and Acquisition Decisions 739

of acquisition, no research has been conducted to investigate the effects of a large amount of

debt maturing within a short period of time on the deal characteristics of these acquisitions.

Our findings lend support to the notion that liquidity risk is a major concern for acquirers when

determining the deal details in acquisitions.

Finally, this study provides large sample empirical evidence to enhance the understanding of

the costs and benefits of using short debt maturity when implementing investment opportunities.

On the cost side, being exposed to excessive liquidation threats from debtholders and earlier

defaults triggered by rollover risks reduce firms’ incentives to undertake profitable investment

opportunities. On the benefit side, short debt maturity serves as a signal of quality to the market

and improves the efficiency of firms’ capital allocation through acquisitions. Collectively, our

findings provide empirical evidence suggesting that firms with shorter debt maturity are less

likely to make an acquisition due to increased liquidity concerns. They will only select those

acquisitions whose quality provides them with greater benefits.

The remainder of the paper is organized as follows. Section I discusses the related literature and

hypotheses development. Section II explains the samples and explores debt maturity measure-

ments. Section III presents our empirical designs, while Section IV provides the empirical results.

Section V reports the robustness test results from two-stage least square (2SLS) estimation.

Section VI provides our conclusions.

I. Related Literature and Hypotheses Development

Debt maturity is an important attribute of debt in a firm’s capital structure that is closely related

to various corporate decisions. In this section, we explore the motivationfor our empirical analysis

of the relation between debt maturity and firms’ acquisitions by reviewing the related literature

and discussing the development of the hypotheses.

A. Relation between Debt Maturity and Acquisition Propensity

Myers (1977) proposes that firms with outstanding debt may forgo investment opportunities

with positive net present value (NPV) since the benefits from the investments will be shared

between the stockholders and debtholders. Reduced incentive to undertake profitable investments

is referred to as “debt overhang.” Myers (1977) suggests that short-term debt is a possible solution

to the debt overhang problem. If all of the debt matures prior to the investment opportunity, a

firm without debt in place can make investment decisions as if it is an all equity firm. In addition

to the discussion in Myers (1977), many studies considering the effect of debt maturity on debt

overhang use settings in which investment decisions are made after debt issuance and before debt

refinancing (Gertner and Scharfstein, 1991; Titman and Tsyplakov, 2007). Moreover, financial

markets are not always efficient (Cooper, Dimitrov,and Rau, 2001) and it could take time for the

quality of the investmentto be fully revealed suggesting that debt that matures soon, although after

relevant investment decisions, as opposed to before, should have reduced overhang (Diamond

and He, 2014).

Following their logic,we discuss the mechanisms through which debt maturity could influence

debt overhang. Short-term debt is less sensitive to changes in firm value arising from a new

investment due to more frequent repricing. As such, it would receive less benefit from any new

investment taken. Consequently, equity holders set lowerinvestment thresholds with shorter term

debt. If this force of reduced underinvestment dominates, we predict a positive relation between

short-term debt and a firm’s acquisition propensity.

Alternatively, shorter debt maturity can have several disadvantages. Some quantitative studies

suggest that short debt maturity is not a perfect solution to the overhang problem (Diamond,1991;