Cash holdings, M&A decision and risk premium

Abstract In the market with financing friction, cash holdings enable the acquirers with financial constraints to decrease their external financing costs when they initiate M&A activities. This paper develops a real option model to demonstrate the effect of cash holdings on the acquirer’s M&A decision and then uses the pricing kernel technique to explore the role of cash holdings in the relation between M&A investments and the dynamic of risk premium on the acquirer’s assets. The results predict that, in the presence of financial constraints, higher cash holdings not only encourage the acquirer to initiate M&As at an earlier timing, but also leads to a more pronounced impact of M&A investments on the risk premium on the acquirer’s assets. The evidence from Chinese listed firms during 1998-2016 supports our theoretical predictions well.