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Internal vs External Financing of Acquisitions: Do Managers Squander Retained Profits?

Andrew Dickerson (), Heather Gibson () and Euclid Tsakalotos ()

Studies in Economics from School of Economics, University of Kent

Abstract: This paper investigates the proposition that the source of financing of new investment has a bearing on its profitability. One important argument in the literature is that managers who have control over investment finance are more likely to pursue their own goal of firm growth, while managers who have to raise funds externally are monitored more closely by the financial markets and hence are more likely to act in shareholders' best interests. Thus, the profitability of externally financed investment should be greater than that from internally financed investment. We focus on investment in acquisitions and, as in previous studies, we show that there is a negative net impact of such investment on long-run profitability. Moreover, when we distinguish the means by which acquisitions are financed, we find that this negative net impact derives from externally financed acquisitions, while internally financed acquisitions would appear to have no significant impact on profitability. Our results therefore do not support the hypothesis that managers squander internal funds on poor investment projects. More significantly perhaps, we find evidence to suggest that capital markets and financial institutions do not generate the anticipated beneficial effects.

Keywords: Investment Financing; Free Cash Flow; Acquisitions; Company Performance (search for similar items in EconPapers)
JEL-codes: G34 L1 L2 (search for similar items in EconPapers)
Date: 1996-12
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Forthcoming in Oxford Bulletin of Economics and Statistics, 2000

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