The Role of Medium of Exchange in Merger Offers: Examination of Terminated Merger Proposals
Sullivan, Michael J., Jensen, Marlin R. H., Hudson, Carl D., Financial Management
Research reveals significantly higher valuation effects accompanying cash merger offers for both target and bidding firms than the valuation effects accompanying stock offers (Asquith, Bruner, and Mullins (1983), Wansley, Lane, and Yang (1983), Huang and Walkling (1987), Travlos (1987), Franks and Harris (1989), Murphy and Nathan (1989), and Eckbo, Giammarino, and Heinkel (1990)). There is also research on the persistence of value changes. At termination of a takeover bid, Dodd (1980) finds that target shares in target-canceled mergers are permanently revalued but that prices revert fully in the case of bidder-canceled mergers. Dodd and Ruback (1977) and Bradley (1980) also demonstrate a revaluation of target shares for canceled tender offers. Bradley, Desai, and Kim (1983), Fabozzi, Ferri, Fabozzi, and Tucker (1988), and Davidson, Dutia, and Cheng (1989) attribute this revaluation to anticipation of a subsequent offer, not to takeover type or terminating party. These studies do not address any permanent revaluation of target shares related to using a different offer medium.
Do differences in the market's reaction to terminated merger proposals depend on the medium of exchange? We explore whether the difference in merger gains that is dependent on the offer medium can be explained by synergy, tax code incentives, or the presence of a financing or investment signal. The empirical support for the tax and the financing signal explanations has been based on reactions in the market at the time of the initial announcement of the merger offer. A study of terminated merger proposals provides an avenue for investigation of further explanations.
We find that merger premiums are higher for target shares at the initial announcement when cash rather than stock is offered. This difference continues after the offer is terminated, even when there is no subsequent bid, indicating a permanent revaluation of target share value. Bidding firm shares are not permanently revalued in reaction to either merger or termination announcements, whatever the medium offered.
These results persist even after we control for variables shown in previous studies to influence target and bidding firms' wealth effects around merger announcements. We conclude that these findings are consistent with synergy, tax, and investment signal explanations but inconsistent with the financing signal explanation.
I. Testable Predictions
Share price reactions may depend on offer type for several possible reasons. Cash offers produce higher returns than stock offers for both target and bidding firm shareholders. This cash premium is attributable to a signal that the medium of exchange provides to the market. The party possessing the signaled information may be the target and/or bidding firm management, and the information may be based on (1) synergy, (2) target firm stand-alone value, or (3) bidding firm stand-alone value.(1)
We present our hypotheses and discuss the predicted share price reactions both around the initial merger announcement and for a period extending from the initial announcement through termination. Analysis of terminated merger proposals will let us better discern among hypotheses.
A. Synergy Hypothesis
Synergy explanations assume that private information regarding the synergistic value of either the target or bidding firm is revealed to the market through the offer medium. A merger is motivated by synergy if the combination of two firms' resources results in economic gains. Berkovitch and Narayanan (1990) develop a model positing that the bidding firm has private information concerning potential synergistic value. According to this model, the offer medium signals private information to the market, where high-synergy bidding firms use cash and low-synergy bidding firms use stock. This will cause bidding firm shares to react more favorably to cash offers than to stock offers at the initial acquisition announcement. …