Aurora Borealis
14 March 2019 CFA Institute Journal Review

How Do Firms Value Debt Capacity? Evidence from Mergers and Acquisitions (Digest summary)

  1. Michal Szudejko, CFA

Capital structure may affect valuation and pricing in the acquisition process. Overlevered acquirers may benefit from an increase in the debt capacity following the acquisition and are willing to pay higher premiums for this benefit. Underlevered acquirers will also pay higher premiums, but such behavior is consistent with market timing.

How Is This Research Useful for Practitioners?

Debt capacity is one of the fundamental concepts in the capital structure theorem; it refers to the maximum amount of indebtedness a company can incur and repay. The authors find that increased expected debt capacity enhances the value of the combined company for any type of acquirer.

The authors consider two different financial motivations for acquirers, which differ based on the pre-transaction level of excess leverage. In theory, overlevered acquiring firms desire to decrease leverage and increase debt capacity. Underlevered firms seek extended debt capacity in order to secure funds for potential new investments. The authors find that unlike overlevered acquirers, underlevered acquirers are unwilling to pay higher premiums for this synergy.

In addition, the authors do find that underlevered acquirers will pay higher premiums when the acquirer’s share price is overvalued and shares are used to purchase the target. This behavior is consistent with market timing.

Given these findings, a practitioner involved in M&A transactions benefits from knowing the acquirer’s capital structure and how the capital structure may affect the acquisition premium.

How Did the Authors Conduct This Research?

The authors use a sample of 1,810 US M&A deals between January 1990 and December 2013. Inclusion in the sample depends on the transfer of control and excludes financial and utility firms.

The optimal leverage is estimated through an application of a fitted regression model with industry fixed effects. A firm is over- or underlevered if its leverage is higher or lower, respectively, than the optimum debt level. The change in debt capacity is proxied via two measures: change in leverage (before and after the merger) and change in optimal leverage.

The authors run a panel regression model to test whether acquirers pay premiums for increases in the debt capacity. They observe that the model’s results are statistically significant for overlevered but not for underlevered acquirers. Further, acquisition premiums tend to exhibit positive correlation with stock overvaluation, but this dynamic appears to be true for underlevered acquirers only when they pay the acquisition price using shares.

Abstractor’s Viewpoint

Again, the capital structure theorem and related research are among the pillars of the contemporary science of corporate finance. Even though several powerful theories are in place that model the behavior of a company when formulating capital structure, no undeniable practical application exists, to my knowledge.

The authors add an innovative area to the literature—namely, they indicate a relationship between capital structure considerations and pricing and valuation in the M&A process. By separating the motives from the indebtedness of the acquirers, the authors deliver more specific and less biased results than previous researchers.

In conclusion, I highly value the article and the work of the authors. They open yet another direction for the discussion on the corporate capital structure.

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