1

CAN TAKEOVER TARGET BE PREDICTED USING HISTORICAL DATA?

BY
STUDENT NAME
COURSE NAME
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Abstract

Takeover prediction is the central to stock selection process but it always unpredictable.

Takeover decisions are driven by different motivations of the investors. These decisions can be

driven through a detailed study, on the market share, need for strategic fit and acquiring Research

& Development. This information is too complex to capture completely through statistical

models. However, it is a long standing question in the research community on takeover

predictability. Based on the hypothesis with respect to the corporate control, the prediction model

is developed. This study deals with testing the predictability of takeover targets using the

available financial data.

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Table of Contents
Chapter 1..........................................................................................................................................4
Introduction:.................................................................................................................................4
Aim:.............................................................................................................................................5
Objectives:...................................................................................................................................5
Research hypothesis:....................................................................................................................5
Chapter 2..........................................................................................................................................6
Literature review:.........................................................................................................................6
Takeovers definition:....................................................................................................................6
Motivations and drivers for mergers and acquisitions.................................................................7
Financial characteristics:..............................................................................................................8
Leverage:....................................................................................................................................10
Liquidity:....................................................................................................................................11
Growth-resource imbalance:......................................................................................................11
Tangible fixed assets:.................................................................................................................11
Firm undervaluation:..................................................................................................................12
Chapter 3........................................................................................................................................13
Methodology..............................................................................................................................13
Multiple regression models:.......................................................................................................13
Logit models:.............................................................................................................................14
Hypothesis definition:................................................................................................................14
ROE-Re......................................................................................................................................15
FCF:...........................................................................................................................................16
Total assets:................................................................................................................................16
Analysis:........................................................................................................................................16
Altman Z score:..........................................................................................................................16
Altman Z-Score Interpretation...................................................................................................17
Altman Z-Scores and the Financial Crisis.................................................................................18
Multiple regression model:........................................................................................................19
Logit analysis:................................................................................................................................20
Hypothesis explanation:.............................................................................................................22
Bibliography..................................................................................................................................25
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Chapter 1

Introduction:

Mergers and Acquisitions (M&A) have charmed the academics and the predictability of these

events has one of the subjects of study (Palepu, 1986). There are multiple methods used to

predict these events, but no model captures all aspects of the information and motivation behind

the possible merger. The most significant reasons for M&As decision are to fulfill the strategic

goals, exploiting synergies, improve asset base or to consolidate the market shares. The

motivation of Mergers and Acquisitions can be non-financial. Hence in most of the cases, a

financial analysis is deployed to screen the healthiest target. In cases where the acquisitions are

undertaken to acquire Research and Development or to decrease competition, there may not be

such screening undertaken as the target is already known. According to the theoretical

perspective, the reason behind takeover bid need to be proved successful and should offer

significant key to determine the merger and acquisition and the motivation behind the takeover

decision. The prediction model is used to determine the essential characteristics of takeover

targets. No statistical model can successfully capture the motivation aspect of the takeover.

However the statistical models can identify the likely candidates for takeover with marginal

success. These models use historical financials, key ratios and management discussion to identify

the likely candidates. The purpose of this study is to find financial characteristics using the most

recent financial statements of the companies that have undergone successful takeover in the

United States (2006-2016) for last 10 years. As a part of the study, we will also review the past
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research in this field, which will give us the characteristics that have previously been studied.

This can also be used as a part of the study in this research.

Aim:

The aim of the research is to evaluate the financial characteristics using the recent financial

statement of the companies which have undergone successful takeover within the United States

over the last ten years (2006-2016).

Objectives:

The objectives of this research are

To determine the financial characteristics of takeover targets in US companies

To evaluate the motivational aspects of the merger and acquisition companies

Research question:

The research statements states that takeover companies can be predicted using financial

characteristics in US companies.

Research hypothesis:

Hypothesis 1: Ineffective management Firm with ineffective management has high probability

being taken over.

Hypothesis 2: Leverage Companies with high leverage has high probability of takeover target

Hypothesis 3: Investment behavior- Companies with high investment has high probability on

takeover target.
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Hypothesis 4: Mismatch of growth -financial resource- Companies with mismatch growth and

financial resource has high probability on takeover target

Chapter 2

Literature review:

Takeovers definition:

Tsagkanos, Georgopoulos, Siriopoulos, and Koumanakos, (2012) stated Takeover is the type of

corporate action in which acquiring company makes a offer to the target company shareholders

to purchase the target shares. If the takeover taken place, the acquiring company will be more

responsible for all target companys holding and operations. It tends to make a control of Target

Company in order to gain control of business. Ambrose et al (1992) researched takeover defense

tactics and found little evidence of these increasing or decreasing the likelihood of the firm. One

of the reasons for such a result can be that takeover bids can become hostile or where the

consideration is increased to woo the shareholders, eventually resulting in successful

acquisitions. Takeover prediction is not a stock selection process but it is described as

unpredictable one. This study reveals that takeover targets are predictable in US market. The

fund managers need to be active about the risk source by incorporating the prediction model with

the investment process. The recommended targets need to perform index in the long term. The

fundamental managers use the prediction model to minimize the existing short position for the

high probability takeover targets. The takeover probabilities are used in the model and make

neutral to the risk measure of the takeover. The fund manager also uses M&A model in the stock

selection model.
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Motivations and drivers for mergers and acquisitions

There are different reasons that involve in the management of the firm in making decisions for

mergers and the acquisitions. There are three theories that are categorized into three choices

which are the rational choice, the outcome of the process and the phenomena of the

macroeconomic. There is an involvement of several motives in the process of the takeover

decision in a synchronized way. Mergers and acquisition (M&A) failures and announcements are

similar to the earning surprise and profit warnings which influence a large shift in the security

prices. It is the combination of the incentives of business and management for target and acquirer

firms by the regulatory constraints. The impact of takeover is directly affected by the investor

who may hold a short position in target firm. Target firms are subject to the ineffective

management which can be considered as the undesirable by the stock market.

The choices for the rational choice are being subordinated into four main theories for the benefit

of the bidders shareholders. The main reason for the Merger and Acquisition are the theories of

the productivity. Three types of synergies are being classified by Trautwein (1990). They are

financial synergies, operational synergies, and managerial synergies. The capital cost is

decreased by the financial synergies through the process of lowering all the risk involved in

diversification. The size of the company is being increased through the internal capital market

development process. The operational synergies will have a higher cost efficiency and the

transfer of the knowledge funds through the process of the combination of all the operations

related to the business. Furthermore, in order to increase the target's performance, the managerial

synergies are used for the process of acquiring the managerial skills of the companys superior.

Monopoly theory is the theory that is recently proposed for the market power gain which can be
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achieved through the horizontal mergers. This is referred as the collusive series by the Chatterjee

in 1986. The empire theory explains that the M&A which lead to the managers utility is

maximum than the value of the shareholders. The complex problems are not solved by the people

for making the rational decision. This process is being proposed in the process theory. The

Raider theory is concluded by Trautwein (1990) as the theory is unlikely proven that the target

shareholders are always gaining by following all the tender offers. The managers have a very

good basement of the value of companys target is acquiring the firms and the capital market.

The Herbert Simons theory of bounded rationality concludes that the solution to the complex

problem seems to be satisfactory than optimal. Finally, mass behaviors are the macroeconomic

phenomenon that is mainly incorporated for the decision making in the Merger and Acquisition

for the financial market and the investor sentiment.

Financial characteristics:

Stevens (1972) used MDA in his studies on financial characteristics of merged firms. As per the

research conducted, the findings pointed out to the significance of financial characteristics in

merger decisions. These financial characteristics were derived using factor analysis to deal with

the problem of multicollinearity in the financial data. Multicollinearity problem exists in the

financial ratios where often the ratios are calculated using the same denominator and also

because movement in one ratio is often linked to movement in another ratio. This study

confirmed the usefulness of multivariate framework in financial analysis. This study was

conducted on a limited amount of ratios and could be further improved by using more ratios that

we believe are relevant for M&A decisions. The scope of the study was limited to only to

financial ratios and not taking into account the motivational or strategic aspects of M&A.
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Stevens (1972) studies are not only limited to the financial characteristics. Palepu (1986) in his

research used six hypothesis discussed herein. The first hypothesis is the inefficient management

hypothesis with the underlying logic that acquisitions are a method to replace underperforming

management (Palepu, 1986). An inefficient management results in underperformance and the

results are evidence of lower profitability, lower dividend growth, and ROE. The second

hypothesis is growth resource mismatch, whereby firms growth and its financial resources are

not optimally used. Financial variables that can be used a proxy for this is sales growth, liquidity,

and leverage. Numerous researchers found the support of this hypothesis except for where Free

Cash Flows were large and these companies were likely acquirers. The third hypothesis is related

to economic disturbance theory which suggests that industries can be popular for acquisitions

given the right economic stimuli or lack of growth. A recent history of merger activity in the

relevant industry can increase the likelihood of more merger activity (Palepu, 1986). The fourth

hypothesis is based on firm size. Smaller firms are more likely to be an acquisition candidate,

whereby the acquisition costs are lower. Larger firms can deploy defensive mechanism to fend

off a merger or acquisition proposal and it takes longer and is more expensive to fight such

defenses. Palepu (1986) found an inverse relationship between size and likelihood. The fifth

hypothesis is based on the asset valuations, whereby a firm with low P/B ratio. This is because

the market value of such firms compared to the similar firms in the industry is lower whilst

having a sizeable asset base. From acquirers point of view, this means lower consideration for

the asset base acquired and more room for enhanced negotiations if required. From the

shareholder's point of view, this may mean higher returns in an event of acquisition and more

chances of deal approval at board level. The final hypothesis is based on earnings valuations,

whereby company with low-profit earnings ratio. From acquirers point, this means paying less
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consideration for the earnings acquired and also bootstrapping the combined P/E ratio (Palepu,

1986).

Leverage:

Barnes (1999) used the financial characteristics data adjusted for sector specific information.

This accounts for industry specific dispersions by deducting the industry mean, divided by the

industry standard deviation. This model is developed on Palepu (1986) approach. In his

research, it is argued that debt makes the management more disciplined in their approach and

should lead to the company being less attractive for a takeover. An excessive amount of debt in

the capital structure makes the firms equity riskier and also affects the profitability of the

company when the operating profit drops as it is a fixed claim on the firms cash flows.

Borrowing capacity of the bidder is being exhausted due to the acquisition of the target at the

higher level. The acquisition will, in turn, results in the fewer gains to the bidders since it takes

very long time for consummating and also to associate with the multiple auctions of the bidder.

When the debt becomes risky and it is dispersed all of these will become compounded. All these

findings reveal that the higher leveraged firms will be more likely less in appealing to all the

potential acquirers of the debt (Tsagkanos, Georgopoulos, Siriopoulos, and Koumanakos, 2008).

Leverage is abbreviated as LEV which denotes the debt-equity ratio. This is the measure of the

average over to the three years of prior to the takeovers. The takeovers likelihood is very much

related to the LEV in a negative aspect which is implied by the hypothesis in consideration to the

previous work.

Liquidity:
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There are more chances of facing the hostile takeover when the targets firm liquidity is very

low. This is being proposed by Powell in 2004. There are liquid assets that are unutilized by

acquirers. There are no better options for the investment and so the pursue firms have become

less liquid. In Indian scenario, such an effect is being pronounced very often. The Indian

companies are sitting on the cash of the mountain with low options for the investment and riding

at the great heights of the booming economy. The takeover likelihood is very much related to the

LIQ in a negative manner.

Growth-resource imbalance:

The acquirers must be attracted by the firm that holds a good opportunity along with the new

reserved features. The firms would be a good target as it has incompatible growth and resource

potential. The resources are often being operationalized in terms of both the liquidity and the

leverage. The takeover likelihood is very much related to the GRD. This is increased when the

value of GRD is equal to 1 which is the hypotheses.

Tangible fixed assets:

The firms with a large proportion of tangible fixed assets will be likely to be sought after in the

assets structure. The advanced reasoning is that tangible fixed assets serve as the security for the

financing of the debt. This will, in turn, reduce the direct cost of the acquisition to the bidder.

The ratio of the tangible fixed assets to the total number of assets to the firms is the measure of

tangible fixed assets are abbreviated as TNG. The takeover likelihood is very much related to the

TNG in a positive manner which is the hypotheses.

Firm undervaluation:
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Firm undervaluation is popularly known that when the firms whose value of the market are less

than the values of the book are being undervalued. Thus it is a good buy. The basic idea behind

this provides an easier and the cheapest way for acquirers to buy the firm than building a new

firm from the scratch which is very costlier. The economic value of the assumptions is being

suspected because the value of the book firm will not reflect on any of the replacement values of

the assets. This is conveyed previously by Palepu (1986) and it is recalled here again. The

takeover likelihood is very much related to the MTB in a negative manner which is the

hypotheses. All the variables and the signs expected are being summarized from the hypotheses.

This literature review gave us an insight on the financial characteristics that we would wish to

analyze in our paper and develop a hypothesis. We are limited in our ability to source only the

financial data and not to test any non-financial factors.

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Chapter 3

Methodology

Research methodologies used in the literature reviewed above are Linear Probability Models

(LPM), Multiple Discriminant Analysis (MDA) and Logit analysis. The data used for these

models are financial ratios using historical reports and accounts. Stevens (1972) made use of

MDA in his research, although a significant approach for determining the relationships between

several variables, it is most preferred for resolving financial problems where nonmetric is

denoted as the dependent variable (Stevens, 1972). MDA consolidates multi-dimensional

variables into a single discriminant function Z. It is a linear combination of independent

variables. The dependent variable in this analysis is a dummy variable and takes a form of 1 or 0,

depending on if the firm is acquired or not. MDA works with an assumption that independent

variables are normally distributed and where this is not the case MDA is not consistent. Another

problem with MDA is multicollinearity (Stevens, 1972), to get around this problem Stevens

(1972) used factor analysis on the ratios. Because of this multi collinearity issue, we reject MDA

analysis. Here, the prediction model denotes Altman Z score model, Logit and LPM models.

These models are used to predict the probability of takeover targets of acquiring company.

Altman Z score has used to examine which companies actually undergo for bankruptcy. This will

help acquirers to take preventive action before they met bankruptcy. In this study, multiple

regression, logit models, and Altman score will be addressed.

Multiple regression models:

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Multiple regression model is one of the prediction models in this study. Linear Probability

Models (LPM) or Multiple Regression Models can be used where the dependent variables are the

financial characters and the dependent variable is either 1 for acquired firms or 0 for non-

acquired firms. Multiple regression procedures will estimate a linear equation of the form:

Y = a + b1*X1 + b2*X2 + ... + bp*Xp

X and Y are the independent variable and dependent variables respectively.

Logit models:

Logit model does not assume the normal distribution of independent variables, instead, these are

dependent on the log of the independent variables. The use of logit infers the interpretation of the

estimation results makes more direct. It does not depend on the statistical properties of the data.

The formula used for logit analysis is as follows,

Altman Z score:

Altman Z score is the prediction model used to determine the probability of companies who has

chances of reaching bankruptcy. The Altman Z-Score is the statistical tool used to evaluate the

presence which a company will go bankrupt. Altman used Z-score model to predict which

companies would undergone bankrupt. Altman used statistical technique called multivariate

analysis and ratio analysis technique which does not evaluate the efficiency of ratios on

determining predictiveness of bankruptcy model but consider how these ratios influence each
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other in the model. The investment in the current assets is significant either high or less. It has an

optimum level of investment in the current assets. According to Altman Z score model, the score

should never be less than 1.8. The retained earnings of the investment will be less than the

burden of interest. EBIT to total assets ratio demonstrates the profitability of the company.

Every year the market value and total liabilities have increased but not in a constant equilibrium.

If the score is high, then the company has effective opportunity to enhance the sale capacity but

fail to use the assets in creating the sales revenue. It has an effective positive influence on the

performance. The main significant financial health for the business firm is related to the

stakeholders. While taking a decision about financial consideration, they should have

involvement with the particular company. The Altman Z score is the best tool which can provide

the decision of stakeholders. The Altman Z-score is calculated as follows:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

A = working capital / total assets

B = retained earnings / total assets

C = earnings before interest and tax / total assets

D = market value of equity / total liabilities

E = sales / total asset

Hypothesis definition:
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The hypothesis has derived from the previous study of Palepu (1986). By reviewing his study,

the variables used in the study will be applicable for this study. But the author didnt prove

hypothetically.

Hypothesis 1: Ineffective management Firm with ineffective management has high probability

being taken over.

Sales growth, EBITDA margin, return on equity (ROE) and asset turnover is the employed

variables for this hypothesis. The assessment of the management success of the firms they are

mainly assumed to be a relevant factor.

Hypothesis 2: Leverage There is a higher probability of the firms with high leverage has the

probability of taken over.

This hypothesis suggests that companies with high leverage has a high probability of takeover

targets and measured as debt to equity.

Hypothesis 3: Investment behavior There is relationship between higher probabilities of the

firms with higher investments and take over

This hypothesis suggests that companies with high leverage has a high probability of takeover

targets and measured as debt to equity. Certainly, the acquirers look at the targets with tangible or

intangible assets and competitive advantage.

Hypothesis 4: Mismatch of Growth-financial resource there is a high probability of the firms

which have a mismatching growth that is associated with financial resources.

The other components in the analysis are the independent variables or the financial

characteristics to be used. For the purpose of this paper, we will look at the cross section analysis
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of the financial ratios. Financial ratios as an alternative of absolute amounts are used to

standardize data across different firms for comparison purposes. These ratios are based on the

historical financial information which gives us an insight into how a firm is managed and funded.

For the purpose of this study, we will sample ratios discussed in different kinds of literature

reviewed, with slight changes:

Roe-Re Growth component

P/FCF Cash flow component
Leverage Capital Structure
Total assets R & D components

ROE-Re

We use ROE-Re instead of ROE as a measure of profitability and firms growth. The amount of

net income which is returned as a shareholders percentage equity is termed as Return on equity

(ROE). ROE evaluate the corporations profitability by estimating the total amount of companys

profit with includes investment money of shareholders (Barr, Giamouridis, & Liodakis, 2009).

The logic behind this is that a mature company usually has ROE=Re whereas a growing

company that is adding value consistently to its reserves and retaining most of its earnings will

have ROE>Re which in turn means higher growth (g= ROE X retention ratio).

FCF:

To capture the FCF effect, we use P/FCF ratio which is expected to have an inverse relationship

with another dependent variable. Higher FCF companies researched in the past exhibited less

likelihood of being taken over.

Total assets:
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R&D effect was captured using the R&D/Total Assets measure. This may require further study

and treatment as not all industries have a higher R&D as a part of their assets. Industries with a

high knowledge component tend to have a high R&D and also M&A activity based on this.

Altman Z score model consists of five significant ratios. They are as follows, (i) networking

capital to total assets ratio is the difference between current assets and current liabilities. Total

asset is defined as the total of fixed assets and current assets. (ii) Retained earnings to total assets

refer to the amount used for investing and the earnings or losses affects the leverage ratio of the

company. These assets will be paid by company profits. The companies with high retained

earnings to total assets have financed the assets through profit retention. It does not utilize by

using debts. It demonstrates the use of internal funds for growth and peoples money. It evaluates

the overall leverage and profitability. (iii) Earnings before interest and tax to total assets are the

determination of the operating performance and earning capability of the company. This also

evaluates the productivity of firm asset and leverage factors. The companys growth depends on

the earning power of assets and the ratio is used to determine credit risk. (iv) Capital funds to

total liabilities are the computation of long term solvency. It is reciprocal to debt equity ratio and

the equity will be computed by the market value of shares. The debts consist of both long term

and current liabilities. This is used to evaluate how much assets of the company refuse the value

before liabilities above assets and the issue becomes insolvent. (v) Net sales to total assets are the

measure of standard turnover. It needs to be varied from one company to another. It highlights

the sales creating the capacity of assets and management capacity to determine the competitive

conditions.

These financial characteristics are evaluated by using Altman score model. This model is used to

determine the credit strength test which manages trading manufacturing companys likelihood.
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As it is focused on five financial ratios which can be computed presented in the annual 10K

report of the company. They are liquidity, leverage, profitability, activity, and solvency to

forecast whether the company has a high probability of being insolvent. Altman Z score model

use efficient five weighed financial ratios to evaluate the financial characteristic and bankruptcy

of the company. Alkhatib (2011) proposed a study to evaluate the efficiency of financial ratios in

the prediction of bankruptcy in Jordanian companies by using this Altman Z score model and

Kida models. But they implicated to use at least one of these two models to evaluate high

credibility for forecasting bankruptcy. Generally, a model of corporate bankruptcy prediction was

proposed by Altman in most commonly used the tool. This Altman Z score model is applied and

utilized in various countries for predicting bankruptcy. Rahman (2011) made a study for

forecasting bankruptcy of pharmaceutical industry. This study consist of six companies. The

results implicated that two companies have no possibility of bankruptcy in future and other firms

seem to be unsatisfactory as they dont have a likelihood of bankruptcy. The market value of

equity of many firms does not reflect the respective companies. Altman stated that financial

statement has the adequate information to manage the discriminate function of the large business.
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Chapter 4

Analysis:

For this analysis, data from five US companies and their financial characteristics during the time

of merger and acquisitions have taken. They are Verizon, DuPont, EMC Corporation, St Jude

medical and Time Warner. These are recent acquisition companies which contributed towards

revenue of the United States of America. The purpose of this analysis is to evaluate the

probability of takeover using the available financial data. The data collection will be done on a

list of listed companies that underwent takeover bids in the past 16 years. The first 10 years will

be used for in sample measurements whereas the remaining 6 years we will use to check output.

The firms used in the sample will be listed firms and in the US market with a cut-off market

value. This market value will be decided once the list is populated and we have a sample of at

least 7-10 deals to review. Financial ratios will be calculated based on the GAAP financial

statements and compared with the Bloomberg database of ratios for accuracy. Once the financial

ratios are calculated for each of the target funds, then a comparison with the mean values of the

industry will be undertaken. This is to analyses if the companies were under or over values in

relative terms and their comparative ratios. Output from the above modelling will then be used to

predict the out of sample M&A activity to see if it provides the correct prediction. The output

will be in a form of a score which would require some sort of boundaries like in a Z Altmans

scores. Here, I chose five companies for analysis.

Multiple regression Model:

Multiple regression Models can be used for denoting the financial characters as the dependent

variable. This prediction model will also help to determine the objectives of the study. LPM is
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also known as multiple regression model. The dependent variables can either be 1 for acquired

firms or 0 for non-acquired firms (Wardrop and Edwards, 1987). Multiple regression is the

extended form of linear regression. It is used to predict the value of a variable based on two or

more variables and their values. The variable used to predict is called dependent variable. The

variables used to forecast the value of the dependent variable is called the independent variable.

This multiple regression helps to evaluate the variance in this model and also helps to measure

the contribution of each predictor to the total variance.

Multiple regression procedures will estimate a linear equation of the form:

Y = a + b1*X1 + b2*X2 + ... + bp*Xp

X and Y are the independent variable and dependent variables respectively.

Here X and Y
are the
variables. X
denotes
dependent
variable and Y
be the
independent
variable.
DuPont, Time
Warner, St
Jude Medical,
Verizon and
EMC are the
five companies
used for
analysis. In this
analysis, the
companys
financial ratios
are taken into
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consideration
to evaluate the
significance. In
order to
evaluate the
importance of
financial ratios,
the ratios used
for capital
structure and
cash flow are
used. FCF,
leverage and
total assets are
considered as
the dependent
variable of
ROE. However,
these ratios are
mainly based
on return on
equity
ratio.XSUMMAR
Y OUTPUT
Regression
Statistics
Multiple R 0.86053
R Square 0.740513
Adjusted R -0.03795
Square
Standard 26.70956
Error
Observatio 5
ns
ANOVA
df SS MS F Significan
ce F
Regression 3 2035.8 678.62 0.9512505 0.619329
68 25 53
Residual 1 713.40 713.40
04 04
Total 4 2749.2
68
Coefficien Standar t Stat P-value Lower Upper Lower Upper
ts d Error 95% 95% 95.0% 95.0%
Intercept 6.01164 59.768 0.1005 0.9361820 -753.418 765.44 - 765.4415
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43 82 18 15 753.41
8
FCF 3.084334 2.3377 1.3193 0.4128873 -26.6194 32.788 - 32.78805
33 69 91 05 26.619
4
leverage -5.32862 9.8065 - 0.6831285 -129.933 119.27 - 119.2756
64 0.5433 03 56 129.93
7 3
Total assets -4.04503 26.641 - 0.9040722 -342.553 334.46 - 334.4628
14 0.1518 99 28 342.55
3 3

ANOVA
d SS MS F Significance F
f
Regression 3 2035.87 678.623 0.95125055 0.619329
Residual 1 713.4 713.4
Total 4 2749.27

Coefficient Standard t Stat P-value Lower Upper Lower Upper

s Error 95% 95% 95.0% 95.0%
Intercept 6.01164 59.76843 0.10058 0.936182018 -753.418 765.442 - 765.442
2 753.42
FCF 3.084334 2.337733 1.31936 0.412887391 -26.6194 32.7881 - 32.7881
9 26.619
leverage -5.32862 9.806564 -0.54337 0.683128503 -129.933 119.276 - 119.276
129.93
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Total -4.04503 26.64114 -0.15183 0.904072299 -342.553 334.463 - 334.463

assets 342.55

From the above analysis, the leverage and total assets are not significant components which can

be involved in the probability of takeover targets. Because p value for both leverage and total

assets are more than 0.5. The p value should always be less than 0.5. In this case, the cash flow

(FCF) components are significant for the companies to make the business successfully with the

acquirer company.

Logit analysis:

Logit is also termed as a logistic regression model. This model belongs to the same family of

probability models. Logistic regression is the statistical technique for determining the data set

where two or more independent variables tend to evaluate the outcome. The outcome can be

determined in two possible ways. The dependent variable is the binary one that can be encoded

as 1. Logit model does not assume the normal distribution of independent variables, instead these

are dependent on the log of the independent variables. The use of logit makes the interpretation

of estimation results more direct and is less dependent on the statistical properties of the data.

The objective of logit analysis is to determine the best fitting model to exhibit the relationship

between the independent and dependent variable. It also generates the coefficient with

significance level and standard error to predict the logit transformation of the probability. The

formula used for logit analysis is as follows,

( Gritta, R., Adrangi, B., Adams, B. and Tatyanina, 2011).

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Once evaluating the value, the transformed logit value need to be computed by using this

formula.

The above formula used for evaluating the probability of logistics transformation among five

companies with their financial characteristics. The below table represents the logit analysis of

given companies.

Name WC/TA RE/TA EBITDA/TA MV/TL S/TA logit probability

Verizon 0.000503 0.006501 0.15346336 0.302935 0.674662 0.156903 2.339764871
Dupont 0.179809 0.352475 0.099718214 0.200413 0.811535 0.191621 2.422422216
Time Warner 0.057333 1.113528 0.127141255 0.036969 0.704269 0.2649 2.606601539
EMC 0.006951 0.465545 0.117223033 0.388189 1.033943 0.273625 2.629442899
St Jude Medical 0.033331 0.372857 0.144326609 0.044146 0.677087 0.301667 2.704220537

WC/TA represents working capital/Total assets which measure the liquid assets of the

company
RE/TA represent retained earnings/ Total assets which evaluate the profitability reflects

the earning power

 26

EBITDA/TA represent earnings before interest and taxes/ total assets which measure the

leverage factors. It recognizes operating earnings as being important to long-term

viability.
MV/TL represent market value of equity/ total liabilities that evaluates price fluctuation
S/TA indicates sales/total assets which measure the total asset turnover

The result predicts that companies Time Warner, EMC and St Jude Medical have a high

probability of takeover targets than other companies. Because the logit value of these three

companies is higher than the other two. Here the numbers 1, 2,3,4,5 represents companies

Verizon, DuPont, Time Warner, EMC, St. Jude Medical respectively. For the above table,

this graph will be included.

6 0.35

5 0.3

0.25
4
0.2
3
0.15
2
0.1

1 0.05

0 0
1 2 3 4 5
Na me l ogi t

The above graph represents the logit analysis of the companies with their financial characteristics

at the time of merger and acquisitions. The line slightly increase from one company to another

company and attains the probability rate of 0.3. The result predicts that last three companies have

a high probability of growth, cash flow and leverage in the organization.

 27

Altman Z score:

The Altman Z-score is the outcome of the credit strength which involves the publicly traded

manufacturing company with respect to bankruptcy. The Altman Z score used five financial

ratios that can be obtained from companys annual report. The ratios are leverage, solvency,

liquidity, activity, and profitability to forecast whether the firm has a high degree of probability

of being insolvent.

The Altman Z-score is calculated as follows:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

A = working capital / total assets

B = retained earnings / total assets

C = earnings before interest and tax / total assets

D = market value of equity / total liabilities

E = sales / total assets

Altman Z-score is used to determine the manufacturing and non-manufacturing companies and

the public and the private companies located with the US and the companies located outside the

US. Furthermore, it is used to determine the corporate credit risk (Alexakis, 2008). If Altman Z

score goes below 1.8, then the company will face bankruptcy in future years. The companys

scores which are above 3 are not headed for the bankruptcy. Generally, the investors use this

method to evaluate the decision of buying and selling the particular stock as they are concerned

about the financial strength of the company. The investor could consider on buying the stock if

the company scores are closer to 3 and could short the stock if the value is close to 1.8.
 28

The Altman Z score signified that the companys related risks were increasing and headed for

bankruptcy. Altman computed the credit rating of the companies in 2007 which was 1.81. This

predicts that fifty percent of the companies have rated low, highly distressed and headed for

bankrupt. The calculation of Altman led to believe that crisis would occur and would lead to a

downturn in the credit market. Altman stated that the crisis would emerge from corporate

defaults and started with mortgage backed securities. By considering this meltdown, the

corporate has become strong in 2009.

Reference Values
Z < 2.60 = Safety zone
< Z < 2.6, = Grey zone
Z<1.1 = Bankrupt zone
The data collection will be done on a list of listed companies that underwent takeover bids in the

past 16 years. Here, I used five reputed companies for analysis. By using this Altman Z score

model, we can predict the company which has chance of bankruptcy. This will help acquirer to

make decision while acquiring Target Company.

In the given analysis, the Altman Z score for five US companies are listed below.

Name of the Companies Altman Z score

Verizon 1.138065226
DuPont 1.198918213
Time Warner 2.03924008
EMC 2.011851391
St Jude medical 1.271746806

The above table represents the Altman Z score of the selected companies. In this interpretation,

Time Warner, EMC, St Jude Medical Z scores are between the values 1.1 to 2.6, which falls

under the grey zone category. This denotes that they have a chance for bankruptcy in the near
 29

future. The other two companies are close to or below 1.1 and fall under the Bankrupt zone. This

denotes that these two companies are already at bankruptcy zone and has become insolvent. In

this analysis, the companies which scored above 1.1 to 2.6 have a possibility for takeover in the

near future. And the companies, who's scoring are less than 1.1 is at the stage of bankruptcy and

has a very high possibility for takeover. Among the selected companies, no companies have

scored above 2.6. Therefore, its clear that this model assists the investors to predict the

possibility of the takeover with the available financial data.

Hypothesis explanation:

Derived hypothesis have proven results by using these models.

Hypothesis 1: Ineffective management Firm with ineffective management has high probability

being taken over.

For the above hypothesis, Sales growth, EBITDA margin, return on equity (ROE) and the asset is

the variables. In the multiple regression analysis, the ROE has a greater dependency on the cash

flow components. Hence this EBITDA and assets are not applicable for the effective

management. In the assessment of the management success of the firms, they are mainly

assumed to be a relevant factor.

Hypothesis 2: Leverage There is a higher probability of the firms with high leverage has the

possibility of taking over.

This hypothesis suggests that companies with high leverage has a high probability of takeover

targets and measured as debt to equity. This hypothesis has been proved in the method of logit

analysis. As the companies have high probabilities with effective investments, there is the
 30

possibility of successfully take over in the near future. In Altman Z score method, the value for

each company with respect to the financial characteristics has been evaluated.

Hypothesis 3: Investment behavior There is relationship between high probabilities of the firms

with high investments and take over

This hypothesis suggests that companies with high leverage has a high probability of takeover

targets and measured as debt to equity. The acquirers look at the takeover targets basis the

tangible or intangible assets and its competitive advantage. This hypothesis has proved with

particular results in the multiple regression analysis.

Hypothesis 4: Mismatch of Growth-financial resource there is a high probability of the firms

which have a mismatching growth that is associated with financial resources.

This hypothesis match with the given variable of ROE as it defines the mismatch of growth

financial resources. The ROE is the amount of net income which is returned as a percentage of

shareholders equity is termed as Return on equity (ROE). ROE evaluate the corporations

profitability by estimating the total amount of companys profit with includes investment money

of shareholders. This can predict the growth of financial resource. This hypothesis has proved in

the multiple regression analysis.

Hypothesis Accepted or rejected

Hypothesis 1 Accepted
Hypothesis 2 Accepted
Hypothesis 3 Accepted
Hypothesis 4 Accepted
 31

The research study has been completed by making this hypothesis acceptable. Therefore its

observed that the mergers and acquisitions of US companies are successfully sustaining in the

competitive environment.
 32

Chapter 5

Conclusion:

In this study, the prediction of the takeover target of US companies using financial characteristics

has been evaluated. We have used five US companies for this study. The study used three

different types of model to evaluate the prediction of these companies. In Multiple regression

models, the correlations between the hypothesis variables were tested. It is significantly proven

that total assets and leverage ratio does not have high impact on the probability of takeover

targets. But, the companies need to maintain equal proportion in these ratios. Cash flow

components are important to run the business and attract the acquirer. This will be significant for

the companies to make the business successful with the acquirer company. This model highlights

the significant ratios or aspects need to be considered in determining the probability of takeover

targets. In Logit model, the five weighted financial ratios are figured. The result predicts that last

three companies have a high probability of growth, cash flow and leverage in the organization. In

Altman Z score model, the interpretation predicts that EMC Corporation, St. Jude Medical and

Time Warner scores are less than the predicted value. This demonstrates that they have a chance

for bankruptcy in the near future. Verizon and Dupont are already at bankruptcy position. Hence,

the companies who have scored less have a possibility for takeover in the future. Among five

companies, no companies have scored the Altman score value as 1.8. This model clearly predicts

the possibility of takeover by using this financial data which will assists the investors. This study

demonstrates that this model has potential to predict the possibility of takeover target using the

financial ratios. The finding of the study indicates that it is possible to maximize the chance of

determining the takeover targets through developed prediction model.

 33

Future work:

Future research need to provide an explanation for the exact part of returns produced based on

M&A announcement returns of predicted takeover targets. In the aspect of takeover bid, the level

of expected premium and changes in the takeover probability and implied takeover premium

would provide more explanations on the market efficiency. By using return of takeover

probability portfolios, the market inefficiencies would be determined. The prediction model

needs to be modified to forecast some targets like hostile target and LBO.

The same firms look undervalued or attractive to the acquirer firm which has the potential for

business strategy. But the potential synergies are declined by one-dimensional model which need

to insight into the features of takeover firms by avoiding the potential synergies to active

acquirers. This challenge is applicable for future work. Moreover, the implementation of

investment strategies and application areas of prediction model need to be considered in future

study. The short positions for hedge funds and determination of takeover targets for financial

investors have to be considered. The prediction takeovers have to explain the theories of market

for the corporate control. These models oversight the takeover with various motives.
 34

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