Academic journal article Journal of Business Strategies

Corporate Governance and the Abnormal Returns to Acquisition Announcements

Academic journal article Journal of Business Strategies

Corporate Governance and the Abnormal Returns to Acquisition Announcements

Article excerpt

Abstract

This paper investigates the relationship between a firm "s corporate governance structure and the abnormal returns associated with acquisition announcements. Based on a sample of 294 acquisitions occurring from 1994 through 1998, it is found that acquiring firms have significant two-day abnormal returns of-2.71%. A multiple regression model that includes corporate governance variables has an Adjusted R-squared of 14.2% with board size, the sensitivity of the CEO's wealth to changes in share price, method of payment, and acquiring firm size all being significant explanatory variables.

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The modern corporation is a complex organization of interlocking relationships. For publicly held companies, one of the most important relationships is between the owners and managers of the firm. This relationship is a classic example of the principal-agent relationship and is characterized by a potential misalignment of goals where the agent may behave in his own interest instead of acting in the principal's interest. A firm's corporate governance structure can be used to reduce the total agency costs of a firm through the monitoring of management actions and by aligning the managers' self-interests with those of shareholders.

The board of directors has the responsibility to represent shareholders by monitoring top management. They do this by hiring and firing management, designing the executive compensation contract, and voting on major firm decisions. However, recent events from Enron to WorldCom indicate that the board may not always adequately monitor management. These events have stirred calls for board reform and the effect of board structure on corporate decision making is an important and widely debated topic.

A firm's compensation policy should be designed to attract and retain quality managers and also to align the managers' incentives with shareholders. Executive compensation is primarily composed of a base salary, a bonus often tied to accounting returns, and equity-based incentives. Stock option grants are an increasingly important component of compensation and can align interests by making compensation and overall wealth more sensitive to shareholder performance.

This study investigates the relationship between corporate governance and agency costs by examining the abnormal returns to acquisition announcements. While there are a variety of explanations for acquisitions that increase shareholder wealth, many acquisitions actually reduce shareholder wealth in both the short-run and the long-run. One explanation is that shareholder wealth reducing acquisitions are the result of the failure of corporate governance mechanisms to properly align managers' interests with those of shareholders.

The following section of this paper reviews the literature on corporate governance and mergers. The third section presents the data and methodology, followed by the empirical results in the fourth section. The final section summarizes the findings with suggestions for further research.

Literature Review

The existing literature investigating the relationship between managers' interests and mergers examines the issue from varying perspectives. Morck, Shleifer, and Vishny (1990) test managerial self-interest indirectly by arguing that self-interested managers will either diversify or buy growth firms. Since these types of acquisitions were found to be more likely to reduce shareholder wealth, they concluded that they were driven by self-interest. Kroll, Simmons, and Wright (1990) found that CEO compensation increased following acquisitions due in part to the increased size of the firm. CEO shareholdings and incentive plans were found to be positively related to announcement cumulative abnormal returns (CARs) by Travlos and Waegelein (1992). Ueng (1998) also found that managers with large stockholdings relative to salary are more likely to make acquisitions that increase shareholder wealth. …

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