Applied Research Project 37001/53

The determinants of Payment methods chosen in Australian M&A Market

Jiapeng Wang ID 1001101 Supervisor: Dr. Jun Chen

Abstract

The purpose of this study is to figure out the key determinant factors of the bidding companies payment method when they merge and acquire other companies. Five variables are considered as important factors that influence payment method of the bidding companies Bidder stock standard deviation, Markets index standard deviation, Bidders Fix Asset/ Total Asset ratio, Bidding firms ROE and Leverage ratio. This study will make a logistic regression to measure the relationships between these variables and payment method. This study will be divided into five sections. The first section is introduction; background of this topic is presented in this section. And the following section contains literature review that lists previous studies made by other researchers on the topic of payment method in M&A market in America and Europe. In the third part, methodology that will be used to examine the influential elements of payment method in Australia is introduced and source and process of data are explained. Logistic regression is appropriate to fit the relationship between payment method and the explanatory variables. The fourth section displays the results of logistic regression by using STATA. Analyses of the results are made. It is found that ROE and Market standard deviation are the main factors that influence the bidding companies payment method chosen in Australia M&A market. Meanwhile, the result of the logistic regression are evaluated in the fifth section, the results in this study are compared with those in previous studies and reasons are explored to explain the differences between this study and the previous studies. At the end, conclusions are made based on the whole analyses in the former part of this study.

Introduction
Over the last several decades, mergers and acquisitions remain the one of most wide spread form of company growth. It is believed that analysis of merger and acquisition activities will help analyst with discovering the logic of current business trend.

As the chart (Bloomberg, 2013) shown below, the worlds Mergers and acquisitions activities dropped significantly when the global financial crisis hit the world economy, but it started to recover since quarter two of 2009, and it peaked at quarter four of 2012.

Figure 1 Global M&A Quarterly Volume Since the Mergers and acquisitions market started to recovery after the global financial crisis, it is the right time to analysis the new logic behind the current M&A trend.Most of the previous studies mainly focus on the American and European mergers and acquisitions market, however, as the growth of Australia economy and Australian financial industry, it is useful to investigate the M&A market of the biggest country in south earth. The Bloomberg report shows below, in the first half year of 2013(2013-H1), Australia become the third largest acquires country and the second larges target country in volumes in APAC region. Comparing to the first half year of 2013 (Figure 2), Australia was not listed on the top acquires and it was the 4th largest target countries in volume in Figure 3.

Figure 2 Ranking of acquirers and targets in 2013

Figure 3 Ranking of acquirers and targets in 2012

Furthermore, in the early stage of M&A field, most studies concentrated on the Volume, quantity, influence and motivation of mergers and acquisitions. However, the payment methods chosen in M&A are of major concern to both academics and practitioners in this field.

Majluf and Myer suggested that cash offer might inform the market that bidding firms shares are undervalued and an offer to exchange shares may suggest public that bidding firms shares are overvalued. Travlos (1987) and Fishman (1989) found that cash offer send market positive information about the bidding firm but stock offer may signal the market negative information about the bidding firm. Whats more, Alfred R. and Mark L. S. said that the main distinction between cash and stock transaction is that bidding company will take all the risk when cash offer is made. But the risk is shared by Bidding and Target Company if an offer of stock exchange is made.

These explanations have been widely accepted in academic field and financial industry. Meanwhile, there are some recent studies have examined the various determinants of payment methods in Mergers and Acquisitions. Stulz (1988) discovered that if the bidding companys management board owns large numbers of bidding companys share, the cash offer would be preferred rather than an offer of exchange stock. Ghosh and Ruland (1988) found that preference of cash offer have positive relationship with the number of bidding firms share owned by their management board. These studies demonstrate that management board of more likely to propose cash offer in order to secure their owner ship in M&A transaction.

Furthermore, Davidson and Cheng (1997) suggested that bidding companies with large free cash flow are intended to use cash offer in mergers and acquisitions. The use of cash in M&A can help the bidding firm with avoiding tax which implies to the cash dividend pay out.

There is no research that examines the relationship between the volatility and payment method chosen in M&A. Volatility include the standard deviation of the bidding company and target companys stock price, the market volatility. However, the volatility can be regarded as risk. The Risk Sharing Hypothesis mentioned by Martin (1996) suggest that the bidding company may chose to use stock offer rather than cash offer when there is

uncertainty associated with both firms and market. Because the risk is shared by both bidding and target firm and target firm will have the incentive to make a success of the M&A transaction.

In Baker, Coval and Steins report (2007), firm size was discovered to have relationship with payment method in M&A. They stated that if the target company has higher market value, the bidding company is more willing to choose cash offer rather ran stock offer. However, the probability that bidding company using stock offer in M&A transaction is positively correlated with the market value of bidding company. However, Mara Faccio and Ronald W. Masulis(2004) found that bidding firms with larger size of asset have higher possibility of using cash offer in M&A. Bidding firms with larger asset size are normally well diversified, therefore, their ability to handle risk is better than firms that have relatively smaller size of assets. Thus, they are more likely to propose cash offer in M&A transaction. Meanwhile, Mara and Ronald believed that firms with relatively larger size would prefer cash offer because they have better access to debt and their flotation cost is relatively lower.

Moreover, Bidding companies leverage ratio is found to have negative relationship with the possibility of using cash offer in M&A transaction. Highly leveraged bidding companies may be constrained in their capacity to raise new capital from issuing new debt. Thus, bidding firms who have relatively higher leverage ratio may have higher possibility to use stock offer in M&A transaction. This explanation is been widely accepted; Paul Andr and Walid Ben-Amar (2009) also found that bidding firms with larger capacity to raise new fund would prefer cash offer rather than stock offer in M&A transaction. Contrarily, bidders may choose to propose stock offer when it is hard for them to raise new fund.

Whats more, report (What determin payment methods in Mergers and acquisition?) suggests that the profitability of bidding firms is positively correlated to the probability of using cash offer in M&A transaction. The authors claimed that the higher bidders return on equity before the announcement of M&A decision; the more likely cash offer will be

use in M&A transaction. They also stated that firms with relatively higher ROE prefer cash offer rather than stock offer because large amount of cash is retained.

Even though most of the previous studies did provide the guidance for discovering the determinations of payment method in M&A, most of them are based on American and Europe M&A market where the internal and external environment of firm is different from other countries like Australia. Australia, the biggest country in south earth, firms in Australia may have different industry, market and regulation environment with the rest of the word. In addition, Australian firms corporate structure, taxation system and firm specific risk may differ from the American European companies. Consequently, lack of research based on Australian M&A market motivates me to examine the determinations of M&A payment method based on Australia.

This research project will investigate the determination of M&A payment method in Australian M&A market. Logistic regression analysis method will be employed to examine the statistic significance of the determinants of M&A payment method.

Previous study proposed many factors might influence the payment method chosen in corporate M&As. Variables that were widely accepted are imported into this research project, the selected variables are set as follow: size of the bidding and target firm, volatility of the market and both bidding and target company, profitability of the bidding company and the leverage ratio of the bidding company. Meanwhile, Standard deviation of both firms stock price and markets index will be employed to measure the volatility. Firms market value will be used to measure the size of both firms. Furthermore, firms leverage ratio will be measured by the long-term debt hold by bidding company. In addition, return on equity (ROE) will be employed to measure the bidding firms profitability. The rest of the research is organized as follow: literature review about the M&A payment method chosen will analysis in section one, section two will demonstrate the selected samples and data that will be used in the regression analysis. Moreover, the outcome of

the logistic regression analysis will be presented in section three and interpretation of data will be presented in section three as well. Consequently, summary of this research project will be concluded in the final section.

Empirical evidence and literature review on payment methods chosen in M&As

Most previous study about payment method chosen in M&A did not deeply analysis the relationship between volatility and payment method chosen in M&A transaction. John C. Hulls (Hull, 2005) presented that volatility is a measure for variation of stock and asset price or market index over time. Therefore, volatility can be regard as a risk.

Moreover, there are vastly studies have examined the relationship between risk and the choice of M&A payment method. Martins risk sharing hypothesis states that the level of risk is positively correlated with the possibility of using stock offer. Meanwhile, risksharing hypothesis has been examined in Martins study that involves number of M&A transaction with different level of risk. Result of this study claims that in high-risk M&A transaction, 68% of M&A transactions have used stock offer and 16% of them chose cash offer as payment method. Furthermore, in a sample of low-risk M&A transactions, only 26% of the M&A transaction were financed by stock but 42% of the M&A transactions was financed by cash.

As mentioned above, Davidson and Chengs research (Target Firm Returns: Does the Form of Payment Affect Abnormal Returns?, 2003) claimed the level of bidding companies free cash flow is highly correlated with chance of employing cash offer in M&A transaction. This explanation was accepted by Mara and Ronald, in Mara Faccio and Ronald W. Masulis study (The choice of payment method in European mergers & acquisitions, 2004), they found that firm with relatively higher tangible asset would prefer cash offer while it easier for them to raise fund by issuing debt. Meanwhile, They also declared that bidders payment choice can be constrained by bidding companys assets size. If the bidding company have higher level of asset size, the more likely they are going to choose cash offer in M&A transaction.

Furthermore, Return on Equity can be regard as a measurement of firms profitability, and pre-M&A ROE can demonstrates how health is the firms cash flow. Report published by Pingshun, peijie Wang and Treforhas examined the relationship between ROE and payment method chosen. The result of their study presented that the pre-M&A performance of bidding companys ROE is positively correlated with the likelihood of choosing cash offer in M&A transaction. Consequently, their result suggests that the higher the return on equity of the bidder, the higher possibility that M&A would be financed by cash. Meanwhile, their result is significant at the 1% level, which means it is statistically significant.

As mentioned before, Faccio and Masulis stated that the leverage ratio is negatively correlated with the probability of offer stock exchange in M&A transaction. They suggested that the highly leveraged firm might not able to raise new capital by issuing debt because their debt capacity was met. Walid Ben-Amar and Paul Andr supported Faccio and Masulis suggestion, in the study by Walid and Paul; they found in the cash financed M&A transaction, bidding company has a collateral of 45.6%. Meanwhile, in the stock financed M&A transaction, bidding firm only has a collateral of 30.8%. Their finding proved that the firms pre-M&A capacity to borrow is positively correlated with the likelihood of using cash offer in M&A transaction. In another words, bidding firms preM&A leverage ratio is negatively correlated with the probability of using cash offer in M&A transaction.

Data and Methodology

In order to figure out the determinant factor of payment method, regression will be conducted. Because the dependent variable is dummy, logistic regression is appropriate to fit the data. There are many variables influencing the method of payment. According to the studies made by other researchers in the last section, the volatility of both the bidding companies and the market, the level of the bidding companies free cash flow, tangible asset, assets size, pre- M&A ROE, leverage ratio and pre-M&A capacity to borrow will affect payment method. In this study, the volatility of the bidding companies and market, the assets situations, pre- M&A ROE and leverage ratio will be considered

into the initial regression model. And volatility of both the bidding companies and market will be measured by standard deviations. Therefore, the dependent variable is payment method (which is denoted as Y in the following section) and the following five variables will be considered as the independent variables bidder standard deviation (which is denoted as X1),! Market standard deviation (which is denoted as X2),!Fix Asset/ Total Asset ratio (which is denoted as X3), ROE (which is denoted as X4) and leverage ratio (which is denoted as X5). The collected data should be processed in order to simplify the model. The payment method would be set as dummy variable, 0 for cash offer, and 1 for stock offer. Thus, completed M&A transactions financed by cash will be denoted as 0 and M&A transactions financed by stock will be denoted as 1. Furthermore, in order to standardize the explanatory variables, the remaining independent variables are modified into percentage and log value. Firm size of bidding firms will be measured in their pre-M&A three-year average Fix asset/ Total Asset ratio. Standard deviation of bidding firms three-year historical return will be used as a mean to measure the volatility; Meanwhile, the gross historical return of bidding firm was obtained by processing their daily historical stock price. Once the historical daily return was obtained, the standard deviation can be calculated. Moreover, market volatility will be concerned as well. This research project uses the market indexs standard deviation to measure the market volatility. Firstly, which stock exchange bidder companies list their stock is defined. The selected bidding firms are listed in Australian stock exchange, New Zealand stock exchange, Singapore stock exchange and New York stock exchange. Therefore, the historical data from stock index of different stock exchanges were used to calculate the indexes historical return. The stock index includes ASX200, NZ50, NYSE index AND SG index. Consequently, the standard deviation of indexs gross return will be acquired, and it will be used in the regression analysis. Furthermore, Three-year average return on Equity (ROE) of bidding firms will be acquired to measure the profitability of bidding firm, Return on Equity of bidding firms were calculated by this function: ROE = (Net Profit / Shareholders equity). Whats more, the debt-to-equity ratio of bidders firms will be used as a measurement for bidders leverage ratio. Meanwhile, this study is going to take the three-year average debt-toequity ratio of bidders firm as an explanatory variable in this logistic regression.

Result and interpretation

After all the data is collected, logistic regression model can be fitted based on the data. The model is analyzed by STATA. In the first step, all the five explanatory variables are included into the model. The results that were made by STATA are showing in Figure 4. It can be seen that after iteration, the value of log likelihood is 0. So the value of likelihood is 1. In mathematical statistics, likelihood is a function of statistical parameters in the model. It shows the likelihood of the parameters that are fitted by the model and the real value of the parameters. Likelihood function has a major role in statistical inference. Generally, a larger likelihood indicates that parameters that are fitted by the model are closer to their real values, thus the fitting effect of the model is better. Therefore in this case, likelihood with a value of 1 shows that parameters that are fitted by the model are almost or exact their real values and the fitted model can truly fitting out the real relationship between the dependent variable and its explanatory variables. However, the world is full of all kinds of uncertainty. It is impossible to capture the real relationship between various variables. Statistical models are fitted to find the relationships of these variables as far as possible. One of the basic assumption in statistics is the dependent variable is affected by uncertain elements that are either cannot be measured or are unknown, which is usually denoted as ! in the model. Therefore it is necessary to find out the reason why log likelihood is 0 in this model.

Figure 4 Logistic regression results including five explanatory variables

It is also seen in Figure 4 that the standard error, z-value, p-value and confidence interval with a confidence level of 0.05 are not listed in the fitted model. Therefore there exists error in the model. It is mainly because there exists multicollinearity between the five independent variables. Table 1 shows the correlation relationship between X1, X2, X3, X4 and X5. It can be seen that the correlation coefficient between X1 and X5 is 0.834824 and the correlation coefficient between X1 and X3 is -0.77345, which indicate that X1 is significantly correlated with X3 and X5. So there exists multicollinearity between X1, X2, X3, X4 and X5.

correlation coefficient

X1 1 "#$%$&$'! ("#))%*+! "#"**,&%! "#&%*&'*!

X2 "#$%$&$'! 1 ("#%,,,)! ("#,&*&$! "#%-$-)*!

X3 ("#))%*+! ("#%,,,)! 1 "#"&"')&! ("#),)*)!

X4 "#"**,&%! ("#,&*&$! "#"&"')&! 1 "#,",,,*!

X5 "#&%*&'*! "#%-$-)*! ("#),)*)! "#,",,,*! 1

X1 X2 X3 X4 X5

Table 1 Correlation coefficient of X1-X5 In order to reduce the impact of multicollinearity to the model, it is necessary to reduce explanatory variables. It should be noted that the final model should pass the test of significance for both the whole model and every coefficient. Frequently, when it is related to multiple regres sion, it is difficult to ensure that all the selected independent variable has significant impact on the dependent variable. It is also hard to guarantee the independence between these variables. Therefore, it is necessary to select which variable should be considered into the equation according to the contribution to the equation of each variable when fitting a multiple linear regression equation. Variables that make small contributions to the equation or have close relationship with other independent variables should be excluded by the model in order to obtain a refined and stable model. The most commonly used methods for selecting variables are forward, backward and stepwise method. This case adopts the method of forward. Any equation that failed the

test of significance for coefficient will be dropped. And the equation that passed the test of significance for coefficient will be retained. If there are more than one equations passed the significance test for coefficient, then other information such as the goodness of fit will be compared to select a better model that extracts more information from the variables. (Bloomberg, 2013) After selected by STATA based on the method of forward, the final model is formed. There is only one model passed the significance test for coefficient. The detailed results are displayed in Figure 5.

Figure 5 Final selected logistic regression results From the above figure it can be seen X2 and X4 are retained in the model while other variables are dropped due to failing significance test for coefficient. After iteration, log likelihood is stable at a value of -6.691627. So the likelihood is about 0.5 after calculated. It shows that the probability that the fitted model is wrong is roughly 0.5. The p-value of X2 is 0.05 and the p-value of X4 is 0.044. When the confidence level is 0.05, the coefficient of X2 and X4 passed the significance test of coefficient. Although constant failed significance test, it is considered that the model would not be affected because constant has no practical significant. It is not the cared variable in the model. So the model is effective at a confidence level of 0.05. The coefficient of X2 is 621.8741 and the coefficient of X4 is -23.20613. The final fitted model is:

! ! !!!!""#$% ! !"!!"#$% ! !" ! !"#!!"#$ ! !" From the model it can be seen X4 has a negative relationship with Y while X2 has a positive relationship with Y. Here X2 stands for log value of market standard deviation and X4 stands for log value of ROE. So a larger market standard deviation would contribute to a larger value for Y, that is to say, a larger probability for the bidding company to choose stock offer as the payment method. And a larger ROE of the bidding company would contribute to a smaller value for Y, thus a larger probability for the bidder to choose cash offer. In conclusion, the final model shows that when the bidding company have a big ROE and when the market volatility is not severe, the bidding company will be likely to choose to pay for the target company with cash. On the contrary, when the ROE of the bidding company is small or the volatility of the market is severe, the bidding company is more likely to pay for the target company by sharing risks with stock offer.

Evaluation of logistic regression result

The existing researches that are related to the determinations of payment method in M&A market are mostly based on American and European market. Few of them put their eyes on Australian market. Nevertheless, due to the differences of firms corporate structure, internal and external environments of firms, taxation system and firm specific risk between American and European market and Australian market, it is necessary to analyze the influential factors of payment method in Australian M&A market. This study is based on the Australian M&A market. This is the first difference of this study and previous studies. As for the detailed determinants of payment method in M&A market, this study has several differences with previous studies. It is mentioned in the previous section that Acquisitions. Stulz (1988) argued whether management board owns large numbers of bidding companys share plays an important role in the selection of cash offer or stock offer when a company is going to merge and acquire other companies. Ghosh and

Ruland (1988) also demonstrated this opinion. However, this factor is not considered as a determinant factor of payment method in this study. This is mainly because the amount of shares that management board owns of the bidding company is unknown and not easy to collect in Australia. So the data cannot be collected, thus the factor cannot be included into the model. Davidson and Cheng (1997) proposed that the cash flow of the bidding company would affect the bidding companys payment method. Companies with better situation of cash flow would have more tendencies to pay with cash. However this variable is not included into this study either. The reason is that cash flow is not the main factors that affect the payment method. Supposing that there is a company whose case flow situation is not so good but the company has strong ability to borrow money. For this situation the company can also choose to pay for the target company with cash. Therefore case flow is not considered as a determinant variable in this study. Martin (1996) proposed the Risk Sharing Hypothesis that maintained when there exist risks in both firms and market, the bidding company is more likely to choose stock offer. However Martin did not examined the detailed relationship between the volatility and payment method chosen in M&A. This study takes standard deviation as a measurement for risks. This study performed logistic regression and examined the relationship between payment method and risks from companies and market quantitatively based on the collected data. The results show market standard deviation would affect the payment method while bidder standard deviation is not so important when considering payment method. It is mainly because many companies in Australia such as companies in coal and steel industry are experiencing a highly developing stage. Although some of them are suffering in severe volatility, the whole industry has a trend of steady rise. So they are not afraid of risks and are full of courage to compete in risks. Baker, Coval and Stein (2007) suggested that firm size and asset size are influential factor of payment method for bidding companies. Mara and Ronald supported this idea. However firm size and asset size are not included into the model in this study. Instead! Fix Asset/ Total Asset ratio is considered as a determinant factor in this study. The reasons for the differences are that firm size is not the main factor that determines payment method. Besides it is better to use Fix Asset/ Total Asset ratio than asset size to determine the bidding companies payment method because asset size is an absolute

value and its values of different firms with different size may vary a lot. It is wise to use Fix Asset/ Total Asset ratio because this indicator can be used to compare between different companies. Paul Andr and Walid Ben-Amar (2009) found that the bidding companies leverage ratio has great impact on its payment method. Companies with higher leverage ratio would have bigger probability to choose stock offer when pay for the target companies. This study considered this factor in the beginning of model fitting. However, the results of the fitted logistic regression model show that leverage ratio has little effect on the bidding companys payment method. It is mainly because companies in America/Europe are different from companies in Australia. Australian companies are more conservative than companies in America and Europe. Their leverage ratios are frequently lower than those in America and Europe. Pingshun, peijie Wang and Treforhas examined the relationship between ROE and payment method chosen. Their studies presented that the pre-M&A performance of bidding companys ROE is positively correlated with the likelihood of choosing cash offer in M&A transaction. This study justifies this opinion by fitting logistic regression model using data that is collected in Australia. Therefore the bidding companys ROE is surely affecting the payment method of bidder. Section 5 Conclusions This study researches the determinant factors of payment method for the bidding companies in Australia when they are going to merge and acquire other companies. Although there are many researchers studied the same topic in America and Europe, there is no similar study in Australia. It is of great necessity to study which factors would affect payment method for the bidding companies in Australia in M&A field especially when mergers and acquisitions activities frequently happened in Australia in recent years. This study adopt logistic regression to inspect whether bidder standard deviation, market standard deviation, Fix Asset/ Total Asset ratio, ROE and leverage ratio of the bidding companies would affect their choices of payment method. Through analyzing by STATA, it is concluded that bidder standard deviation, Fix Asset/ Total Asset ratio and leverage ratio have little impact on the bidding companies choices of payment method while ROE

and market standard deviation would affect the payment method of the bidders. Besides, this study has found that when the bidding companies level of ROE is high or the market volatility (market standard deviation) is not severe, the bidding companies will be more likely to choose the method of cash payment because paying by cash is to send signals to the market that the company is operating well. On the contrary, when the bidding companies have low level of ROE or the volatility of the market is severe, it is wise for the bidding company to choose stock offer to pay for the target companies because through stock offer, risks will be shared by both the bidding companies and the target companies. There exist many differences between this study and previous studies. It is mainly because American and European companies have many differences with Australian companies in various aspects, such as corporate structure, internal and external environments of companies, taxation system, firm specific risk and market risk. !