Measuring Returns and

Choice of Payments
Lecture 2
Sanjay Banerji
Principle Theory
Value •Transaction cost efficiency – mergers
Increasing optimize transaction costs
•Synergy – scale, best practices, etc.
•Disciplinary – takeovers can be used to
replace poor management
•Incentive effects

Value •Management entrenchment – firm invests

Reducing to increase managers’ value to
shareholders
•Agency costs of free cash flow – managers
reinvest FCF inefficiently back into firm

Value •Hubris – winner of takeover contest is firm

that most overvalues target
Neutral
 Gains and Losses in M&As
Combined Gains to Gains to
Theory Gains Target Bidder
Efficiency/ Non-
Positive Positive
Synergy Negative
Agency
More
Costs/ Negative Positive
Negative
Entrenchment

Hubris Zero Positive Negative

 Issues in Empirical Studies
• Attempt to determine effects of M&As
– Measurement of combined returns to target and
bidder shareholders
– Factors affecting magnitude of returns
– Measurement of post-merger performance
• Tests of alternative theories
• Determine whether or not total value is
enhanced by mergers
• Guides to management for merger planning
 Combined Returns in M&As
• Measure combined returns to explain
cause of mergers
– Positive: synergy and efficiency
– Negative: agency costs, managerial
entrenchment
– Zero: redistribution of wealth from bidder
(hubris)
• Bulk of event study evidence suggests
mergers have positive returns on average
 Combined Returns in M&As

Research Target Bidder Comb.

Paper Year Window Return Return Return
Bradley et al 1988 -5,+5 31.8% 1.0% 7.4%
Kaplan, 1992 -5,+5 26.9% -1.5% 3.7%
Weisbach
Servaes 1991 -1, 23.6% -1.1% 3.7%
resolv
e
Andrade et 2001 -1,+1 16.0% -0.7% 1.8%
al
 Target Returns in M&A
• Targets almost always experience large gain in
shareholder wealth – effects usually stem from
merger effects and not revaluation of target firms
• Cash deals usually create more target wealth –
possibly due to taxes
• Multiple bidders result in higher returns for target
• Target share prices have a positive run-up in
period prior to takeover announcement
• Takeover premiums reflect bidder’s strategy of
making large preemptive bid
 Target Returns in M&As
(Method of Payment)

Research
Paper Year Window Cash Mixed Stock
Huang, 1987 -1,0 29.3 23.3% 14.4%
Walkling %
Asquith et 1990 -1,027.5 32.2% 13.9%
al %
Servaes 1991 -1, 26.7 21.1% 20.5%
resolve %
Andrade et 2001 -1,+1 20.1 NA 13.0%
al %
 Target Returns in M&As
(Single vs. Multiple Bidders)

Research
Paper Year Window Single Multiple
Bradley et al 1988 -20,+1 24.0% 26.0%

Servaes 1991 -1, 20.8% 30.5%

resolve

Schwert 1996 -42,-1 13.4% 12.7%

 Target Returns in M&As
(Target Premiums Received)
Research
Paper Year Base Price Date Premium
Bradley 1980 41 before offer 49%
Jarrell et al 1988 30 before offer 53%
Jennings, 1993 10 before offer 23%
Mazzeo
Cotter, 1994 30 before rumor 47%
Zenner
Betton, 2000 60 before offer 51%
Eckbo
 Bidder Returns in M&As
• Bidder returns are more negative in stock deals
than cash deals
• Returns to bidder are lower in deals with multiple
bidders
• Do bad bidders become good targets? (Mitchell
and Lehn, 1990)
– More negative market reaction to a deal, the more
likely firm is future takeover target
– “Takeovers can be both a problem and a solution”
 Bidder Returns in M&As
(Method of Payment)

Research
Paper Year Window Cash Mixed Stock
Travlos 1987 -10,+10 -0.1% NA -1.6%
Asquith et 1990 -1,0 0.2% -1.5% -2.4%
al
Servaes 1991 -1, 3.4% -3.5% -5.9%
resolve
Andrade et 2001 -1,+1 0.4% NA -1.5%
al
 Bidder Returns in M&As
(Single vs. Multiple Bidders)

Research
Paper Year Window Single Multiple
Bradley et al 1988 -20,+1 2.8% -0.4%

Servaes 1991 -1, -0.4% -2.97%

resolve

Schwert 1996 -42,-1 1.9% 0.2%

 Summing UP of Gains and Losses

What is the stock price reaction when takeovers are

announced?

• Target shareholders gains are substantial (from 10%

to 53%)

• Bidder shareholders
• Gains have decreased over time
• Non-significant returns on average

Hence: Combined market values of target and

bidder go up
 Summing Up Contd.
Method of Payment affects announcement results
• Stock payments reduce the stock returns of bidders and target:
– If stock is used to acquire bidders stock falls in 1.47%
– If cash is used to acquire bidders stock increases slightly (around 0.24%)
• Consistent with the idea that use of stock by bidder firm signals overvaluation

Evidence consistent with managerial “empire-building”

• Announcement returns lowest for acquiring firms
• … in which management has smaller stakes
• … that have under-performed their industries
• … buying outside (vs. inside) their main business (-3.9% vs. +2.9%)
• … that “buy growth” (returns 7% lower)
 A problem
• In the fall of 1997 the Bank of New York (BNY) offered to exchange 1.575
shares of BNY common stock, plus $15 in cash per common share of Irving
Bank Corporation. 1987 data for each company are as follows:
»
» Irving BNY
» Net Income $118 $153.5

• Common shares (fully diluted) 18.391 m 33.092 m

• Pre-announcement stock price $ 39.337 $31.526
•
• Questions:
• 1. What are the gains and (losses) to each group of shareholder under the
assumption that the combined entity is worth $300 million more than its
original parts. That is, how do you expect the stock price of BNY and Irving to
react upon announcement of the deal?

• 2. What should be the increase in the value of the combined entity that has to
take place in order to justify the acquisition from the point of view of BNY
shareholders.
 Solution
– (a)
– Irving BNY_____
– Pre-announcement price 39.337 31.526
– Shares 18.391 33.092
– -----------------------------------------
– Market value 723.45 1,043.26

– Synergy = $300m, Cash payment = 18.391 x 15 = $275.87m

– Value of the combined firm:, VC = 723.45 + 1,043.26 + 300 – 275.87 = 1,790.84

– The share of the combined firm that goes to the Irving =

– [ 28.966 /(28.966 + 33.092)]X 1,790.84= $835.30

– The total sum (in the form of stock + cash) that goes to Irving’s shareholders =
835.30 + 275.87 = 1,111.20
– Irving shareholders gain = 1,111.20 - 723.45 = 387.80
– or 387.80/18.39 = 21.09 per share
– BNY shareholders gain = Synergy – gains of the IBC shareholders, = -87.80
– Synergy = -87.80 + 387.80 = 300.00
 Solution
• For break-even synergy, (VI  VBNY  S  P)  VBNY  0
• where, = share that goes to the shareholders of
BNY.= 33.092
 .53
62.052
• From the equation, we get ,the break-even value of
synergy:
(1   )
S  VBNY  VI  P  .88(1043.26)  275.87  723.45  $470.48


• Main point: Unless synergy is sufficient, and gains

and losses from M and A are unevenly distributed,
One party gains at the expense of the other party.
– Example of a Merger process
– Reasons given for the merger
• Economies of scale in PC industry
• Projected synergies of $2.5 billion
• Strategic response to conditions in computer and
information technology sectors
– Market reaction to 9/3/01 announcement
• Hewlett-Packard declined 19%
• Compaq fell by 10%
– Major events in the merger process
• CEOs initiated discussion in June 2001 – firms
then undertook extensive due diligence
• Consulting firms McKinsey and Accenture were
involved in the analysis of the merger
• Goldman Sachs (HP) and Salomon Smith Barney
(Compaq) were engaged in July 2001, to provide
financial advice
• Members of Hewlett and Packard families
threatened to vote against the merger
• Shareholders approve in May 2002
 Example I contd.
– Major events in the merger process
• 2/22/02 – Northrop releases letter sent to TRW
proposing a merger
• 3/3/02 – TRW rejected $47 stock offer
• TRW sought other bidders and considered
implementing a split-up
• Northrop increased offer
• 7/2/02 – announced merger agreement for $60
stock
• Example II
– Deal began as a hostile bid by Northrop and evolved
into merger
– Reasons given for the merger
• Economies of scale in defense industry
• Complementary product mix
– Market reaction to initial announcement (2/22/02)
• TRW increased 26.4% (speculation that there may be more
potential bidders, or that TRW would get a higher price from
NG )
• NG dropped by 6.7%
 Example II Continued.
– Major events in the merger process
• 2/22/02 – Northrop releases letter sent to TRW
proposing a merger
• 3/3/02 – TRW rejected $47 stock offer
• TRW sought other bidders and considered
implementing a split-up
• Northrop increased offer
• 7/2/02 – announced merger agreement for $60
stock