Title: Mergers, agency and managerial response
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Title: Mergers, agency and managerial response an empirical examination of potential wealth shifts in synergistic and non-synergistic corporate mergers
Physical Description: ix, 150 leaves : ; 28 cm.
Language: English
Creator: Trifts, Jack Wayman, 1956-
Publication Date: 1984
Copyright Date: 1984
 Subjects
Subject: Consolidation and merger of corporations   ( lcsh )
Corporations -- Finance   ( lcsh )
Finance, Insurance, and Real Estate thesis Ph. D
Dissertations, Academic -- Finance, Insurance, and Real Estate -- UF
Genre: bibliography   ( marcgt )
non-fiction   ( marcgt )
 Notes
Thesis: Thesis (Ph. D.)--University of Florida, 1984.
Bibliography: Bibliography: leaves 144-149.
Statement of Responsibility: by Jack Wayman Trifts.
General Note: Typescript.
General Note: Vita.
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Volume ID: VID00001
Source Institution: University of Florida
Holding Location: University of Florida
Rights Management: All rights reserved by the source institution and holding location.
Resource Identifier: alephbibnum - 000487136
oclc - 11912539
notis - ACQ5236

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MERGERS, AGENCY AND MANAGERIAL RESPONSE: AN
EMPIRICAL EXAMINATION OF POTENTIAL WEALTH SHIFTS
IN SYNERGISTIC AND NON-SYNERGISTIC CORPORATE MERGERS










BY

JACK WAYMAN TRIFTS


A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL
OF THE UNIVERSITY OF FLORIDA IN
PARTIAL FULFILLMENT OF THE REQUIREMENTS
FOR THE DEGREE OF DOCTOR OF PHILOSOPHY



UNIVERSITY OF FLORIDA


1984
















To my parents, Albert and Gertrude Trifts, in gratitude for their

unfailing support, confidence and encouragement throughout my life,

and to my wife Janet, whose love and many sacrifices made this study

possible.

















ACKNOWLEDGMENTS


I gratefully acknowledge the guidance and direction of Professor

Richard Pettway, chairman of my dissertation committee, and the

helpful comments of the other members, Professor Arnold Heggestad and

Professor Stephen Cosslett. I wish to thank my wife Janet for typing

and editorial assistance above and beyond the call of duty.




















TABLE OF CONTENTS


ACKNOWLEDGMENTS . . . . .


LIST OF TABLES . . . . . . . . ... . . . vi


ABSTRACT . . . . . . . . .


CHAPTER


1 INTRODUCTION AND BACKGROUND . . . . . . . .


Introduction. . . .
Background . . .
Notes . . . . .


2 REVIEW OF THE LITERATURE . . . .


The Merger Literature . . . . .
The Wealth Shift Literature . . .
The Agency Literature . . . . .
Summary . . . . . . . .


3 HYPOTHESES AND METHODOLOGY. . . .


Introduction . . . . .
Events, Definitions and the General
Tests of Hypotheses . . . .
Measurement of Critical Variables
Changes in Leverage -- AD. .
1
Variance -- AV. and AV2 . .
1 1
Maturity -- AM. . ... .
Change in Interest Rates -- AI.
Change in Equity Costs -- AE .
Demand for Cash -- C . . .
1
Synergy -- S. . . . ..
Point of First Informational Imp
Data Sources. . . . . . .


4 THE DATA . . . . . . .


Introduction. . . . . . .
Sample Selection Criteria . . .
Sample Characteristics . . .
Determination of the Date of
First Informational Impact. .
Note . . . . . . .


. . . . . 40


Model .













act I


PAGE


iii


viii


I


. . . . . . . .
. . . . . . . .
. . . . . . . .


. . . . . .
. . . . . .
. . . . . .













5 TEST RESULTS . . . . . . . . . . .

Introduction . . . . . . . . . .
Model One . . . . . . . . . . . .
Model Two . . . . . . . . . . . .
Summary of Results of Models Without
Control for Synergistic Effects . . . . . .

6 THE EFFECTS OF SYNERGY . . . . . . . . .

Introduction . . . . . . . . . .
Reestimation of the General Model . . . . . .
Reestimation of the Models on Subsamples . . . .
Subsamples Based on the Market Value Measure
of Synergy . . . . . . . . .
Subsamples Based on the Line of Business Measure
of Synergy . . . . . . . . . .
Summary of Subsample Reestimation . . . . .
Problems in the Estimation of Synergy. . . . .
Summary and Conclusions . . . . . . . .
Notes . . . . . . . . . . . . .

7 SUMMARY AND CONCLUSIONS . . . . . . . . .

Introduction . . . . . . . . . .
Summary of Results . . . . . . . . .
Future Research . . . . . . . . . .
Conclusion . . . . . . . . . . .


APPENDICES


A REFORMULATION OF THE TESTS BASED ON
PROXY FOR LEVERAGE . . . .


AN ALTERNATE


Introduction . . . . . . . . .
Reestimation of the Models
Without Control for Synergy . . . . . .
Model One . . . . . . . . .
Model Two . . . . . . . . .
Summary of Results . . . . . . . .
Reestimation of the Models
With Control for Synergy . . . . . .
Summary of Results . . . . . . . .
Conclusion . . . . . . . . . .


B MERGERS INCLUDED IN THE SAMPLE.


C CONTROL FIRMS . . . . . . . . . . .


REFERENCES . . . . . . .


BIOGRAPHICAL SKETCH . . . . . . . . . . .


90

92


112


S. 118

. 118
S. 119
S. 123
S. 125

S. 125
S. 133
S. 133

S. 135


. . . 144


PAGE


CHAPTER


150

















LIST OF TABLES


TABLE PAGE

1-1 Artificial Data for Two Unrelated Firms
Prior to Merger. . . . . . . . . . 4

1-2 Artificial Data for the Merged Firm with Comparison
to a Value Weighted Portfolio of the Two Unmerged
Firms. . . . . . . . . . . . . 7

1-3 Neutralizing Wealth Shifts. . . . . . . . 9

1-4 Artificial Data for the Merged Firm
When Synergies Are Present . . . . . . .. 11

2-1 Empirical Studies of the Gains to Shareholders of
Merging Firms. . . . . . . . .... . 21

3-1 Data Sources. . . . . . . . . ... .. . 64

4-1 Stratification of the Sample by
Primary Standard Industrial Codes (SIC). . . .. 69

4-2 Stratification of the Sample by Year of Merger. ... . 70

4-3 Stratification of the Sample by
Estimated Market Value. . . . . . . . ... 71

4-4 Stratification of the Sample by
Relative Size of Acquisitions . . . . . ... 72

4-5 Changes in Leverage Around the Merger Dates. . . .. 74

4-6 A Comparison of Changes in Leverage with
the Kim and McConnell Study . . . . . ... 75

4-7 The Frequency Distribution of the Number of Days
Between the Formal Announcement Dates and the
Dates of First Informational Impact . . . . .. 78

5-1 Results of Model One . . . . . . . ... 83

5-2 Results of Model Two . . . . . . . ... 89









TABLE PAGE

6-1 Model One Reestimated with the
Inclusion of Synergistic Effects. . . . . ... 97

6-2 Model Two Reestimated with the
Inclusion of Synergistic Effects. . . . . ... 98

6-3 Model One Estimated on Subsamples Based on
Relative Synergy Measured by Market Value Changes . 102

6-4 Model Two Estimated on Subsamples Based on
Relative Synergy Measured by Market Value Changes . 103

6-5 Model One Estimated on Subsamples Based
upon the Line of Business of the Merging Firms. . . 105

6-6 Model Two Estimated on Subsamples Based
upon the Line of Business of the Merging Firms. ... . 106

A-1 Results of Model One Reestimated with
Market Value Leverage . . . . . ... .. . . 120

A-2 A Comparison of the Leverage Measures. . . . ... 122

A-3 Results of Model Two Reestimated with
Market Value Leverage . . . . . . .... . 124

A-4 Model One Reestimated with the Inclusion of
Synergistic Effects and Market Value Leverage .... 126

A-5 Model Two Reestimated with the Inclusion of
Synergistic Effects and Market Value Leverage ... . 127

A-6 Model One with Market Value Leverage Estimated on
Subsamples Based on Relative Synergy
by Line of Business . . . . . . . ... 129

A-7 Model Two with Market Value Leverage Estimated on
Subsamples Based on Relative Synergy
by Line of Business . . . . . . . ... 130

A-8 Model One Estimated on Subsamples Based on Relative
Synergy Measured by Market Value Changes. . . .. 131

A-9 Model Two Estimated on Subsamples Based on Relative
Synergy Measured by Market Value Changes. . . .. 132


vii

















Abstract of Dissertation Presented to the Graduate Council
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy


MERGERS, AGENCY AND MANAGERIAL RESPONSE: AN
EMPIRICAL EXAMINATION OF POTENTIAL WEALTH SHIFTS
IN SYNERGISTIC AND NON-SYNERGISTIC CORPORATE MERGERS

By

Jack Wayman Trifts

December, 1984

Chairman: Professor Richard H. Pettway
Major Department: Finance, Insurance and Real Estate

Each year, hundreds of corporations are involved in acquiring

other firms, yet recent studies have suggested that while the

acquired firm's shareholders typically gain, the acquiring firm's

shareholders do not necessarily benefit from such mergers. In fact,

it appears that often it is the managers of the acquiring firms who

stand to gain the most from mergers and that in the absence of

synergies, shareholders actually suffer a loss due to the wealth

shift characteristics of mergers. This result, if it is true,

contradicts the most basic assumption of finance theory, that

managers operate the firm to maximize shareholders wealth. Do

managers act in their own best interest at the expense of the

shareholders they are paid to represent or do they take actions to

offset these potential wealth shifts? Does the existence of synergy

allow managers to capture some of the gains for themselves?









This study attempts to act as a link between the academic theory

of mergers and actual management practice. Specifically, changes in

the capital structure of merging firms are examined to determine

whether they are consistent with managements' attempts to neutralize

the wealth shifts suggested by option pricing theory or whether they

may be explained in terms of general market forces or the terms of

the mergers. Further, the effects of synergies are examined to

determine whether managers attempt to retain some of the benefits of

the gains for themselves.

The results of the study support the hypothesis that managers

attempt to neutralize potential wealth shifts by altering the capital

structure of the firm. The study also provides evidence that mergers

which generate synergy are systematically different from those which

create no additional value. However, there is not consistent evi-

dence that managers are pursuing personal goals at the expense of

their shareholders. The results suggest that the capital structure

changes of merging firms are insensitive to changes in interest rates

and stock market levels but are impacted by the terms of the merger.

















CHAPTER 1
INTRODUCTION AND BACKGROUND

Introduction

The topic of corporate mergers and acquisitions has been one of

great interest to both business practitioners and academicians during

the past several years. The importance of the topic is perhaps best

explained by noting the large number of mergers which occur each year

(Mergers and Acquisitions, 1968 1983). Managing mergers and acqui-

sitions is obviously an important part of corporate management.

However, recent studies (Dodd and Ruback, 1977; Langetieg, 1978, and

others) have suggested that mergers are not necessarily beneficial to

the shareholders of the acquiring firms. Even though shareholders of

the acquired firm have been found to gain most, the managers of the

acquiring firms may also stand to gain from mergers and in the

absence of synergies, shareholders of the acquiring firm may actually

suffer a loss due to the wealth shift characteristics of mergers.

This result, if it is true, contradicts the most basic theoretical

assumption of finance, that managers operate the firm to maximize

shareholders' wealth. Do managers act in their own best interest at

the expense of the shareholders they are paid to represent or do they

take actions to offset these potential wealth shifts?

Specifically, this study examines the changes in capital struc-

ture which have been observed (Kim and McConnell, 1977) to occur

during mergers to determine whether these changes are consistent with

the neutralization of wealth shifts or simply due to the terms of the









merger or other market characteristics at the time of the mergers.

Further, the role of synergies in this process is examined to deter-

mine whether managers take actions to capture a share of the avail-

able gains. A model is formulated to test two central hypotheses:

first, that managers take actions, during mergers, consistent with

the maximization of shareholders' wealth and the neutralization of

potential wealth shifts and, second, that the existence of synergies

results in less neutralizing actions by the managers. The central

hypotheses are tested against two alternate hypotheses which suggest

that changes in leverage may be explained by market forces or the

terms of the merger.

This dissertation is composed of seven chapters. This chapter

introduces the goals of the study and outlines the underlying models

which will be used in the construction of empirical tests. Chapter 2

provides a review of the existing literature on this topic. Chapter

3 outlines the specific tests and explains how the data were collect-

ed. Chapter 4 provides a detailed examination of the actual sample

collected. Chapter 5 reports the results of the first series of

tests without controlling for synergistic effects. Chapter 6 reports

the results of the tests when synergies are controlled and also

discusses empirical and theoretical problems with synergy measure-

ment. Chapter 7 provides a summary and conclusion. Appendices

following the final chapter discuss related test results and provide

information about the data.









Background

It has been argued by Levy and Sarnat (1970) that the diversi-

fication effect of mergers does not create value. That is, in the

absence of synergies, value additivity holds and the post-merger

value of the firm is simply the sum of the values of the combining

parts. However, Galai and Masulis (1976) and Lam and Boudreaux

(1984) have shown that the change in the variance of asset returns

resulting from the merger may alter the relative positions of

bondholders and stockholders. Since the combination of two risky

assets, or firms, tends, to reduce total variance, the wealth trans-

fer will, in general, be from stockholders to bondholders.

The basic relationships can best be illustrated by a simplistic

numerical example. Consider two firms, A and B, both of which have

risky debt in their capital structures and which will merge and

become firm A For simplicity, these firms are assumed to exist

in a single period world where the face value of debt is payable at

the end of the period. Table 1-1 shows the required information for

two unrelated firms prior to their merger. Black and Scholes (1973)

have shown that their option pricing model can be used to value the

equity of the firm. The equity can be considered as a call option on

the assets of the firm. At the time the debt matures, the stock-

holders may choose to exercise their option by paying off the debt

and retaining the assets of the firm or let the option expire and

forfeit the assets to the debtholders. Using the values for firm A

in the numerical example, the value of firm A's equity can be

calculated using the option pricing model as follows:

S = VN(d ) De-rfTN(d2



















Value o

Face va


Varianc


4


Table 1-1
Artificial Data for Two Unrelated Firms Prior


Firm A


f the firm V = $500
A

lue of outstanding debt D = $300
A

2
e of total return o = .30
A


Correlation coefficient between
the return streams


Risk free interest rate


to Merger


Firm B


V = $700
B

DB = $500


2
a = .35
B











where dI = ln(V/D) + rfT / oT + +/T


d2 = dl ori

where S = the market value of the equity

V = the market value of the assets

D = the face value of the debt

r = the risk free rate of interest

T = time to maturity of the debt

N( ) = the cumulative probabilities for a unit normal

variable

Inserting the values for firm A yields the following result.
-.08 (1.0)
SA = 500 N(dl) 300 e08 (10N(d2)

dI = (ln(500/300) + .08 (1.0)) / /.3i + /'.-30

d1 = 1.3525

N(d ) = .9115

d2 = 1.3525 .5477

d2 = .8048

N(d2) = .7881
-.08 (1.0)
SA = 500(.9115) 300 e-08 ( (.7881)
A
= 455.75 218.25

= 237.50

As the total value of the firm equals $500, the market value of

the debt must equal $500 237.50 = $262.50 compared to a face value

of $300. The expected return on the risky debt of firm A may be

calculated as follows:

rA = (D B) / BA
A A A A









rA = 300 262.50 / 262.50

=.143 or 14.3%

Corresponding values for firm B are inserted in the table.1

Now consider the effect of the merger of these two firms where

no synergistic gains accrue to the combined firm. Table 1-2 contains

the market information for the combined firm and compares it with

that of a value weighted portfolio of the two firms without the
2
merger. The value weighted portfolio represents the total value of

a portfolio consisting of all outstanding debt and equity of the two

firms. The merger results in a decline in variance. The variance of

the combined firm is calculated as follows:

2 2 2 2 2
YAB = WAA + BB + 2WAWBABAB


where WA = VA / (VA + VB)

WB = V / (VA + V)

Inserting the appropriate values yields the following result.

WA = 500 / (500 + 700) = .417

W = 700 / (500 + 700) = .583
B

0AB (.417) .30 + (.583) .35 + 2(.417) (.583) (.548) (.592) (.5)


AB = .241


This new variance, along with other data for the combined firm,

can be used to calculate the value of the equity of the combined firm

using the option pricing model.4 The resulting values are inserted

in Table 1-2. It can be seen that the debt holders have benefited

from the merger while the equity holders have been harmed. Note that










Table 1-2
Artificial Data for the Merged Firm with Comparison to a Value
Weighted Portfolio of the Two Unmerged Firms


Merged Value Weighted Change
Firms Portfolio


Total value $1200 $1200 $ 0

Face value of debt 800 800 0

Value of equity 499.90 522.20 (22.30)

Value of debt 700.10 677.80 22.30

Rate of return on debt 14.3% 18.0% (3.7%)









the expected return on debt has declined from a weighted average

return of 17.9% to 14.3% and the total value of debt has increased.

Some authors (Lee, 1977; and Lewellen, 1971) have explained this

phenomenon as a co-insurance of debt effect. They note that the

combination of two, less than perfectly correlated, cash flows

results in a more stable series which reduces the default risk of the

debt held by the firm. Thus, in the absence of synergies, the value

of the firm's debt should increase, transferring wealth away from the

shareholders.

However, these wealth shifts may be partially or completely

neutralized by increasing the leverage of the firm and making the

debt riskier than it would normally be in the combined firm. There

are at least two ways to accomplish this. First, additional debt may

be issued and its proceeds used to retire existing equity. This is

often accomplished at the time of the merger by using the proceeds

from debt to liquidate the interest of the acquired firm's share-

holders with a cash purchase. This method neutralizes the wealth

shift while leaving the overall value of the firm constant. The

second method of neutralizing the wealth shifts involves expansion of

the firm financed by debt. This technique typically results in the

merged firm issuing additional debt after the merger to move to a new

equilibrium capital structure. This method will often be used

following a pure exchange merger which results in a wealth shift.

Table 1-3 illustrates each of these techniques and compares the

results with the simple combination from Table 1-2. Note that a

larger issue of debt is required in the expansion case because of the

increase in the total value of the firm. It is also interesting to










Table 1-3
Neutralizing Wealth Shifts


No Change Debt Used Debt Used
in Debt to Retire to Expand
Equity the Firm


Total value $1200 $1200 $1502.54

Face value of debt 800 924.20 1157.00

Value of equity

Stock value 499.90 416.80 522.20

Cash value 105.40


Total value $499.90 $522.20 $522.20

Value of debt 700.10 783.20 980.34

Increase in debt 0 105.40 302.54

Rate of return on debt 14.3% 18.0% 18.0%










note that the price per share of stock declines in the case where

debt is used to retire equity because equity holders receive part of

the value of their holdings in cash.

Two additional assumptions are required to obtain the results

shown in Table 1-3. First, it is assumed that there are no bond

covenants which prevent additional debt from being issued without

subordination. Secondly, in the expansion case, it is assumed that

available projects are efficiently priced and that their net present

value equals zero.

If perfect bond covenants exist which allow only subordinated

debt to be issued, the wealth shift to the original bondholders will

not be offset. It is not the purpose of this study to examine the

degree to which the original bondholders are protected by such

covenants but casual examination of actual mergers suggests that a

large portion of debt issued during mergers is not subordinated. If

projects with positive net present value are available, the new

equilibrium will be attained with less expansion.

It is important to note that in a non-synergistic corporate

merger of the type illustrated, the shareholders lose value unless

management issues more debt to neutralize the potential wealth shift.

Remember, the merger creates no value itself because there was no

synergy. Thus, a gain to one party must be directly offset by a loss

to another. However, some mergers result in a net increase in value

or synergy. In these cases, it is possible that the positions of

both the bond and stockholders can be improved. Table 1-4 shows the

results of a merger of the two previously discussed firms when the

merger results in $100 of synergy or additional value being created










Table 1-4
Artificial Data for the Merged Firm When Synergies Are Present


Merged Value Weighted Change
Firm Portfolio


Total value $1300.00 $1200.00 $100.00

Face value of debt 800.00 800.00 0.00

Value of equity 590.28 522.20 68.08

Value of debt 709.10 677.80 31.92

Rate of return on debt 12.8% 18.0% (5.2%)










by the combination. With the presence of synergies, gains by the

debtholders do not imply losses by shareholders. However, the

shareholders do not retain all synergistic gains but share them with

the bondholders, depending on the terms of the exchange.

A manager whose goal is to maximize shareholders wealth will be

motivated to increase the leverage of the firm to neutralize these

gains by the bondholders. Since this synergistic merger has in-

creased the value of debt above that in the non-synergistic case, a

larger amount of new debt will be required to neutralize the gains by

bondholders. It is important to note, however, that even if no

neutralizing actions are taken, the value of the stockholders claims

will increase over their pre-merger position. This phenomenon will

occur whenever the value of the synergistic gains exceeds the wealth

shift to bondholders.

The preceding examples have illustrated the potential for wealth

shifts in corporate mergers and lead directly to the central issues

examined in this study. A manager whose goal is to maximize share-

holders' wealth will be motivated to increase the leverage of the

firm to neutralize potential wealth shifts during mergers. However,

the existence of synergies may allow the managers to share in the

gains from the merger while still maintaining the wealth of the

acquiring firms shareholders at a level at least that prior to the

merger. The primary means by which managers may gain is through not

fully neutralizing the wealth shifts with increases in leverage.

Since a large portion of the manager's personal wealth is in the form

of human capital, dependent on the firm, the risk to that capital may

be reduced by reducing the financial risk of the firm. The central










questions of this study are whether managers act as if they are aware

of the wealth shift potential of corporate mergers and take actions

consistent with the neutralization of these wealth shifts and what

impact do synergies have on this process.

Notes

1. The value of firm B's equity can also be calculated using the
option pricing formula of Black and Scholes (1973).

SB = $700 N(d ) $500e-rf TN(d2


dl = (ln(700 / 500) + .08(1.0)) / /V-. + V.CT(1.0)

d1 = 0.9998

N(d ) = 0.8413

d2 = 0.9998 0.5916

d2 = 0.4082

N(d2) = 0.6591
-.08(1.0)
SB = $700(.8413) $500e08( ) (.6591)

= $284.70

The market value of debt is $700 $284.70 = $415.30 versus a face
value of $500. and the expected return on the debt is
r = (DB B ) / B

= (500 415.30) / 415.30

= .204 or 20.4%

2. The value weighted portfolio represents the total value of a
portfolio which consists of all outstanding debt and equity of both
firms without a merger of those firms.

3. In this example, and throughout the study, variables subscripted
AB refer to the combined firm as predicted from the pre-merger
component firms while the subscript A is used to denote the combined
firm as actually exists after the merger.

4. The value of the combined firm's equity can be priced as follows:
S= $1200 N(d) $800 e-rfTN(d
S = $1200 NDd ) $800 e N(d )











d = (ln(1200 / 800) + .08(1.0)) / /.1 + V.2-41(1.0)

d = 1.2344

N(dl) = .8907

d2 = .7435

N(d2) = .7704
-.08(1.0)
SA = $1200(.8907) $800 e 0810 (.7704)

= $499.90

The value of the combined firm's debt is $1200 499.90 = $700.10 and
the expected return on the debt is
rA* = (DA* BA*) / BA*

= (800 700.10) / 700.10

=.143 or 14.3%


5. To neutralize the wealth shift with no expansion, the value of
the equity, after the increase in debt, plus the market value of the
debt floated must equal the pre-merger total value of equity. Note
that the market value of new debt is included in shareholders' wealth
because the proceeds from the new debt are used to retire equity in
the no expansion case. Numerically, the following two conditions
must be met.
-.08(1.0)
S = $1200 N(d ) ($800 + F)e 8 N(d2)

$522.20 = S + F / (1 + R)
where F = the face value or promised amount of new debt issued to
retire equity.
F / (1 + R) = the current market value of the new debt.
The solution cannot be solved directly and must be obtained by
iteration. In this example, additional debt of $124.40 satisfies the
two equations.
-.08(1.0)
S = $1200 N(d ) ($800 + $124.40)e 0(.N(d2)


dI = (ln(1200/924.40) + .08(1.0)) / V.i41 + /.241(1.0)

d = .94

N(dl) = .8264

d2 = .94 '.241(1.0) = .45

N(d 2) = .6736











S = $1200(.8264) $924.40e 08(0)(.6736)
S = $416.80
D = $1200 $416.80 = $783.20
The rate of return on debt is
rA= (BA* DA*) / DA*

= (924.40 783.20) / 783.20
= .18 or 18%
Thus, the total wealth of the bondholders is
S + F / (1+rA ) = 416.80 + 124.40 / (1.18) = $522.20

To neutralize the wealth shifts with expansion, it is assumed
that the proceeds from the new debt are used to expand. In this
example, it is assumed that the available investments for expansion
are efficiently priced so that the increase in the total value of the
assets of the firm is equal to the increase in debt. This is not a
required condition for the solution of the expansion case but is
added for simplicity. As before, new debt with face value F is added
to force the rate of return on all firm debt (or the average return
on debt) to its pre-merger level and the value of equity to the sum
of the pre-merger equity levels. This is calculated by solving the
following equation for F:

S = $522.20 = ($1200 + F/1.18)N(dl) ($800 + F)e- 08(.0)N(d2)

This was solved by iteration and it was found that F = $357.00.
The new value of the firm is
VA = $1200 + $357/1.18 = $1502.54

The increase in debt is $357/1.18 = $302.54.
















CHAPTER 2
REVIEW OF THE LITERATURE

The prevalence of mergers in modern industrial organizations has

stimulated much attention from academe. This attention has resulted

in the creation of a large volume of literature. Additionally, the

nature of this study draws upon other bodies of literature only

tangentially related to the current thrust of merger research.

To facilitate a logical review, the literature is divided into

three parts. In the first part, the mainstream merger literature is

presented. In general, this research has addressed the questions of

why mergers occur, whether there are gains resulting from mergers and

how any such gains are distributed between shareholders of firms.

The second part of this chapter reviews the existing research on

wealth shifts between shareholders and bondholders which occur during

mergers. This section deals both with the more rigorous mathematical

models which suggest such shifts and the more intuitive explanations

of the co-insurance of debt literature. The third part of this

chapter examines the agency literature as it relates to merging

firms. The final segment of the chapter provides a synthesis of the

literature and outlines the motivation for this study.



The Merger Literature

As discussed in the introduction to this chapter, the majority

of existing merger literature has been focused on the questions of

why mergers occur, whether there are gains to merging firms and if

16










so, how any such gains are apportioned between shareholders of the

acquired and acquiring firms.

A number of theories have been proposed to explain why mergers

occur. Copeland and Weston (1983) provide a helpful summary of the

following theories:

1. Differential efficiency as a basis for merger,
2. Tax considerations,
3. Inefficient management,
4. Agency problem -- managerialism,
5. Undervalued company -- asymetric information,
6. Synergy,
7. Market power, or antitrust considerations,
8. Strategic realignment to changing environments
(Copeland and Weston, 1983, pp. 562).

The first theory, differential efficiency, is the most general.

If two companies differ in the efficiency with which they produce, a

merger may result in which the more efficient company acquires the

less efficient and then improves its operations. If the benefits

from increased efficiency outweigh the transactions costs of imple-

menting such a merger, it will increase the value of the combined

firm.

Copeland and Weston also note the effect of tax considerations

on mergers.

One such tax consideration is to substitute capital gains taxes
for ordinary income taxes by acquiring a growth firm with a small
or no dividend payout and then selling it to realize capital
gains. Also, when the growth of the firm has slowed so that
earnings retention cannot be justified to the internal revenue
service, an incentive for sale to another firm is created.
Rather than payout future earnings as dividends subject to
ordinary personal income tax, an owner can capitalize future
earnings in a sale to another firm. (Copeland and Weston, 1983,
pp. 562)

Other tax considerations may also motivate mergers. Firms which

acquire other firms with accumulated tax losses may use those losses

to offset taxable income. Additionally, "The Economic Recovery Tax









Act of 1981 provided for the sale of tax credits from the use of

accelerated depreciation" (Copeland and Weston, 1983, pp. 563).

Mergers may also be considered as a market mechanism for replac-

ing inefficient management. Copeland and Weston note that the

inefficient management theory of mergers is closely related to both

the more general differential efficiency theory and the agency

problem theory. However, they suggest that differential efficiencies

most likely explain horizontal mergers while the inefficient manage-

ment theory provides an explanation for mergers between firms in

unrelated businesses.

The fourth theory suggested by Copeland and Weston, agency

problems, is central to the study carried out in this dissertation.

Therefore, a more complete review of the agency literature is carried

out later in this chapter. Briefly, the agency problem theory of

mergers suggests that managers may attempt to increase the size and

diversification of their firms for personal reasons such as increased

management renumeration and reduced risk of bankruptcy.

Mergers may also be explained by an undervalued company theory.

Copeland and Weston suggest two reasons that the acquired firm may be

undervalued. First, it is possible that there is asymetric informa-

tion. That is, the acquiring company may have information which is

not available to the general market. If this additional information

suggests a true value of the firm which is higher than its market

value, it will be profitable for the merger to take place. Second,

the value of the firm to be acquired may be less than the replacement

costs of its assets. If this is so, it may be profitable for a firm

to merge to acquire the assets rather than purchase or construct the










assets alone. Studies of this theory examine the q-ratio of merged

firms. The q-ratio is defined as a ratio of the market value of a

firm to the replacement cost of its assets. If the q-ratio of a firm

is less than 1.0, its market value is less than the replacement cost

of its assets. Weston and Chung (1983) suggest that fluctuations in

the average q-ratio in the economy may explain why mergers tend to

occur in waves.

A reason often offered by practitioners for mergers is synergy.

The synergy theory of mergers is quite simple. If the combination of

two firms will enhance the combined value of the pair, the merger has

synergistic effects. While it has been shown by Levy and Sarnat

(1970) and Schall (1972) that the simple combination of the two firms

does not create value per se, Copeland and Weston note several poten-

tial sources of synergy. They note that synergistic gains may arise

due to economies of scale in the areas of financing, production,

marketing, research and development and other operating areas of the

firm (Copeland and Weston, 1983, p. 560). While such gains may be

possible, Kitching (1967) notes a tendency for overestimation of the

potential gains due to economies of scale in production and oper-

ations.

Another theory suggested as explanation for why mergers occur is

market power. This theory is somewhat related to the synergy theory

and suggests that firms may improve their profitability by increasing

their market share. While the validity of this assertion is not

proven, it is often accepted as a basis for antitrust action by the

Department of Justice. The Justice department believes that undue









concentration in an industry will allow oligopolistic firms to

extract excess profits.

The final theory suggested by Copeland and Weston is strategic

realignment. They suggest that mergers may result because of firms'

need to change to adapt to a changing environment. Recent mergers in

the oil and steel industries have been explained in terms of the need

to respond to changes in the environment due to foreign competition

and reduced energy reserves. Mergers provide a much quicker avenue

for change than the slow process of internal reorganization.

The questions of whether mergers result in gains and how any

such gains are distributed have resulted in a broad body of empirical

research. Weston and Chung (1983), in a recent paper, reviewed the

major studies to date. Table 2-1 contains a sample of these empiri-

cal studies together with information on the data studied. The

studies differ from each other in terms of the time period studied,

sample selection characteristics and methodologies. The majority of

the studies do employ a variant of residual analysis but the specific

applications vary widely.

While one might hope that such attention would have resulted in

conclusive answers, the results have unfortunately been ambiguous.

However, some issues seem to have been at least partially resolved.

There is agreement that the shareholders of acquired firms do receive

large significant excess returns from mergers. There is little

agreement about returns to shareholders of acquiring firms. It

appears that these shareholders do not lose during the merger but the

evidence is too inconclusive to determine whether they actually gain.

The very nature of this outcome suggests that if the shareholders of










Table 2-1
Empirical Studies of the Gains to Shareholders of Merging Firms


Authors


Sample


Halpern (1973)

Mandelker (1974)


Ellert (1976) Part I


Part II


Dodd and Ruback (1977)


Kummer & Hoffmeister (1978)

Langetieg (1978)

Bradley (1980)


Dodd (1980)


Elgers and Clark (1980)


Jarrell & Bradley (1980)



Schipper & Thompson (1980)



Asquith (1982)

Asquith & Kim (1982)


Bradley, Desai & Kim (1982)


150 successful NYSE mergers, 1950-65.
Monthly data.
Mergers consummated between 1941-62;
NYSE; 241 acquiring, 252 acquired firms.
Monthly data.
205 NYSE mergers challenged by the
Justice Department; complaint filed
1950-72; settled by 1974. Monthly data.
772 large mergers 1950-70; 943 not
indicted by Justice Department. Monthly
data.
172 cash tender offers, 1958-76; 124
successful bidders, 136 successful
targets. Monthly data.
88 cash tender offer announcement,
1956-74. monthly data.
149 NYSE mergers, 1929-69. Monthly
data.
258 cash tender offers 1962-77; 161
successful, 97 unsuccessful. Daily
data.
151 announced merger proposals 1971-77;
71 completions, 80 cancellations. Daily
data.
337 acquiring, 66 acquired firms; FTC
large merger series, 1957-75. Monthly
data.
161 successful tender offers (same as
Bradley above); 47 unregulated, 94 under
Federal regulations alone, 20 under
state and Federal. Daily data.
30 firms which announced and then
engaged in aggressive acquisitions
programs, 1950-69; mostly conglomerates.
Monthly data.
196 successful mergers, 89 unsuccessful
mergers, 1962-76. Daily data.
FTC conglomerate mergers, 1960-78.
Shareholder and bondholder monthly and
daily returns.
104 bidders, 38 targets in unsuccessful
tender offers, 1962-80. Monthly and
daily data.






22


Table 2-1 Continued


Bradley, Desai & Kim (1982) 162 successful tender offers, 1962-80;
dollar and percentage gains. Daily
data.
Malatesta (1982) FTC large mergers announced in the Wall
Street Journal 1969-74; 272 acquiring,
90 acquired firms. Monthly data.
Wansley, Lane & Young (1982) 203 successfully acquired target firms,
1970-78; categorized by type of merger
and method of payment. Daily rates.



Source: Weston, J. Fred, and Kwang S. Chung. "Some Aspects of
Merger Theory," Journal of the Midwest Finance
Association, 1983, pp. 1-33, reprinted with permission.










acquiring firms gain, they gain very little. The majority of the

gains appear to go to the shareholders of the acquired firm.

One study examines this result in a particularly interesting

manner. While the majority of the empirical studies examine returns

in percentage rate form, Halpern (1973) examined the gains to share-

holders in dollars. He found that the total dollar amount of gains

to the acquiring firm's shareholders was not significantly different

from that accruing to the acquired firm shareholders. He reconciled

his results to those of other studies by noting that the tendency for

the acquiring firm to be of much greater size then the acquired

results in equal dollar gains being shared by the many more share-

holders of the acquiring firm. Thus, in rate of return form, the

gains to the acquiring firms shareholders appear much smaller and

often insignificant.

While most of the empirical studies have examined gains to the

shareholders of the component firms, Haugen and Langetieg (1975)

examined the combined firm's returns and tested for synergy. Their

study differs from the above discussed studies in two ways. First,

the examination of gains to each shareholder group individually

allows for the chance that gains to one group will be offset by

losses to another. Further, Halpern's (1973) results discussed

earlier suggest that a large percentage gain to a very small group of

acquired firm shareholders could have minimal effect on the overall

gains. Haugen and Langetieg's analysis differs in that they examine

the combined returns to attempt to determine whether there are any

net gains to the combined entity. The second major difference in

their study is their methodology. Rather than examining the return









stream for change due to increased returns, they concentrate upon

determining whether there are any changes in risk associated with the

mergers. Of course, net gains to shareholders can occur because of

increased returns or decreased risk. They find no evidence that

mergers create synergy in the form of reduced risk.



The Wealth Shift Literature

The body of literature concerned with wealth shifts in corporate

mergers has its origins in two areas. One group of authors have

examined the effects of mergers from the stockholders perspective and

concluded that the reduction in variance that often results from

diversification effect in mergers reduces the value of the equity in

the firm. Since the value of the firm remains constant, wealth is

shifted to the bondholders. Much of this body of literature is based

upon option theory. Another approach to the same issue has resulted

in the examination of mergers from the perspective of the bond-

holders. These authors have noted that the combination of two firms

results in a co-insurance of debt effect which increases the value of

the firms debt. Since, the value of the firm remains constant, this

increase in bondholders wealth must come at the expense of the

shareholders.

As much of the following discussion is based upon option theory,

it appears useful to review its basic results. In a seminal paper,

Black and Scholes (1973) outlined the now familiar option pricing

model. While the valuation of options had been of interest prior to

their discovery, Black and Scholes were the first to formulate a










closed form valuation model in terms of observable exogenous vari-

ables. Their model is presented below.



c = SN(d ) Xe-rfT N(d2)

where di = ln(S/X) + rfT / o/T + oa/T


d2 = di

where c = the

S = the

X = the

T = the
2
0 = the

N( ) = the

The option


- G/T

value of the call option

market value of the stock

exercise price of the option

time until the option expires

variance of the return on the stock

cumulative probabilities for a unit normal variable.

pricing formula has the following properties:


2
dc/ds > 0, dc/dX < 0, dc/dr > 0, dc/dT > 0, dc/do > 0


That is, the value of a call option increases with increases in the

stock price, risk free rate, time to the exercise date or the vari-

ance of the returns on the underlying stock. The value of the call

option decreases with increases in the exercise price. While the

Black-Scholes option pricing model was derived under a number of

unrealistic assumptions, including continuous time, frictionless

capital markets and no short selling restrictions, the model has

proven to be quite robust. Since development of the Black-Scholes

model, a number of alternative formulations, based on varied as-

sumptions, have been developed (Rubinstein, 1976; Kim, 1978; Brennan,

1979; and Cox, Ross and Rubenstein, 1978). However, in practice,










their results are very similar to those obtained by the Black-Scholes

model.

In their initial paper, Black and Scholes recognized the poten-

tial of their model for the valuation of corporate claims. They note

that "In effect, the bondholders own the company's assets, but they

have given options to the stockholders to buy the assets back"

(Black and Scholes, 1973, pp. 649-650). They also note the effect a

change in the capital structure will have on the relative positions

of stockholders and bondholders.

An increase in the corporation's debt, keeping the total value of
the corporation constant, will increase the probability of
default and will thus reduce the market value of one of the
corporation's bonds. If the company changes its capital
structure by issuing more bonds and using the proceeds to retire
common stock, it will hurt the existing bondholders, and help the
existing stockholders. The bond price will fall and the stock
price will rise. In this sense, changes in the capital structure
of a firm may affect the price of its common stock.
(Black and Scholes, 1973, p. 650)

In a paper immediately following Black and Scholes, Merton

(1974) develops a similar model for pricing corporate claims. His

results are similar to those of Black and Scholes but his analysis

concentrates on the valuation of risky debt and is more complete than

the earlier work.

Galai and Masulis (1976) combined the option pricing model with

the capital asset pricing model to develop a more complete model of

valuation. Their paper was the first to explicitly consider the

redistribution effects of mergers. They simplify their analysis by

assuming a firm with only one, pure-discount bond issue and one

common stock issue. Under this simplifying assumption, they show the

value of the firms equity can be priced as a call option on the firms

assets, using the Black-Scholes option pricing model.











S = VN(d) De-rfT N(d2)


where d = ln(V/D) + rT / o/T + /T


d2 = dl ao/

where S = the market value of the equity

V = the market value of the assets

D = the face value of the debt

rf = the risk free rate of interest

T = the time to maturity of the debt

N( ) = the cumulative probabilities for a unit normal

variable.

The authors extend their analysis using case studies, including

a study of the effects of conglomerate merger upon the relative

positions of the firms' security holders. They consider two firms

which for simplicity have equal variance but less than perfectly

correlated returns. These firms are then merged in a pure conglomer-

ate merger which they define as having no synergistic effects on the

combined value to the firms. They note that the reduction in vari-

ance caused by the merger results in a decrease in the value of the

equity and an equivalent increase in the value of the debt.

Rubinstein (1976) explains this effect by noting that the merger has

hurt shareholders by weakening their limited liability. That is, the

shareholders of each component firm are made liable for the financial

distress of the other. This additional liability, of course, im-

proves the position of the debtholders.

Galai and Masulis note, however, that the effects of this wealth

shift can be offset by the increased use of debt by the merged firm.










In other words, by increasing the debt equity ratio of the merged
firm, the market values of the original security holders can be
restored to their pre-merger levels. This result is consistent
with the claim that mergers "allow" the firms to increase their
"debt capacity." (Galai and Masulis, 1976, p. 69)

Shastri (1983) has extended the analysis of Galai and Masulis by

allowing the two merging firms to have different variances, matu-

rities of their debt, and leverage. The most important difference in

results occur in the analysis of the wealth shifts caused by the

changes in variance. Shastri found that in the case where the

variance of the combined firm fell between the variances of the

component firms, the direction of the wealth shift became ambiguous.

The bondholders of the component firm with the higher variance

experience a gain in value but the bondholders of the component firm

with the lower variance suffer a loss in value. The net position of

shareholders depends upon which wealth transfer is larger. Similar

results were found in the analysis of maturity and leverage. How-

ever, the lack of diversification effects on these variables make the

results more straight forward.

While the basic Black-Scholes option pricing model provides a

useful model for expositional purposes, its direct applicability for

the analysis of real corporate claims is limited. Possibly the

greatest hurdle is the requirement that firms hold one issue of pure

discount debt which matures at one point in the future. Few, if any,

real firms exist with such a capital structure.

Geske (1977) addresses this issue and notes that the real struc-

ture of corporate claims is that of a compound option. Consider as

an example a firm whose debt is composed of an issue of 10 year

annual coupon bonds. The stockholders of this firm now hold a










compound option. At each coupon date, they may choose to exercise

their option, pay the coupon, and retain the firm composed of assets

and the remaining debt. Should they choose to default on any coupon

payment, the remaining coupons and the principal payment are automat-

ically in default. An accurate option pricing formulation must

reflect these interdependencies. Geske has formulated such a model.

Unfortunately, the solution of the Geske model requires the estima-

tion of the multivariate normal distributions for which no closed

form exists and further, one must have estimates of the covariances

between the subparts of the option. These requirements render the

model unsatisfactory for direct application to real data.

Geske analyzes the properties of his model and fortunately finds

that it has essentially the same properties as the more simplistic

Black-Scholes model. He finds that the value of the stock (or call

in a compound option) is positively related to the value of the firm,

the time to maturity, the riskless rate of interest, the variance of

the firm and the final expiration of the option. The value of the

stock (or call) is negatively related to the face value of the debt

or the option's exercise price. Thus, it appears that for most real

applications, inferences of the simple Black-Scholes model are

robust.

Another, more technical criticism has also been raised against

the application of the Black-Scholes option pricing formula to

merging firms (Eger, 1983). The Black-Scholes model is formulated on

the assumption that the underlying stock's price is distributed

lognormally. Therefore, the implicit assumption is made in valuing

corporate claims that the assets' value also follows a lognormal









distribution. This is not a troublesome assumption for the eval-

uation of a single firm. However, in the evaluation of merging

firms, the formula is used to value both the merged firm and its

pre-merger component parts. If the component firms have values which

are lognormally distributed, the value of the combined firm cannot

follow a lognormal distribution, as the sum of two lognormally

distributed variables is not distributed lognormally. Eger (1983)

therefore notes that the Galai and Masulis results are only an

approximation.

Brennan (1979) provides a solution to this problem with his

contingent claims model which is formulated in discrete time and

based upon the underlying asset values following a normal distri-

bution. This solves the distribution problem as the sum of two

normally distributed variables also is normally distributed. How-

ever, Brennan's model is more complex and not as easily used as the

Black-Scholes model. Fortunately, analysis of Brennan's model

indicates that its results are very close to those obtained by the

Black and Scholes model.

Using Brennan's model, one can show that the value of the
contingent claim (stock) decreases with a decrease in the return
variance on the underlying asset (firm). Although this model has
some additional limiting assumptions that differ from those of
the continuous time model, the relationship between contingent
claim value and assets return variance appears robust across
models. (Eger, 1983, p. 549)

While the previously discussed studies have been directed at

determining whether the option pricing model approach to valuing

corporate claims leads to proper inferences, at least two studies

have examined whether the magnitude of the wealth shift suggested by

option theory is correct. Stapleton (1982) employed a discrete-time










bond valuation model assuming normally distributed cash flows and

exponential utility. The results of his analysis suggest that the

debt capacity effects of merger may be underestimated by simpler

models. He shows that even the merger of two firms with perfectly

correlated cash flows can lead to an increase in debt capacity.

The effect of mergers on bond yields is not simply due to the
correlation structure of the earnings. It is clear that even if
cash flows are perfectly correlated, then added protection is
afforded to debtors if one of the two companies is below its debt
capacity at the time of the merger. (Stapleton, 1982, p. 18)

Lam and Boudreaux (1984) also study the wealth shift potential

of mergers and analyze the conditions for a redistribution not to

occur. Like Stapleton they conclude that the perfect correlation of

returns between merging firms does not preclude a wealth shift but

unlike Stapleton, they do not require one firm to have excess debt

capacity prior to the merger. Their analysis shows that perfect

correlation of returns is a necessary but not sufficient condition

for the absence of a wealth shift. "In addition, if the market value

of the debt claims is to be unchanged, maintaining pre-merger debt

promises, merging firms must be perfect scalar multiples" (Lam and

Boudreaux, 1984, p.278).

The literature discussed to this point has been based upon

variants of the option pricing model. However, one should not

conclude that the suggested inferences are somehow peculiar to the

use of option theory. Higgins and Schall (1975) have derived very

similar results using a state preference model to analyze cash flows.

They analyze the effect of the merger on the total value of the firms

using Schall's (1972) Value Additivity Principle (VAP) and assuming









perfect capital markets. They then examine the effect of the merger

on the relative positions of the debt and equity holders.

In terms of conglomerate merger, the VAP implies that merging N
firms into firm T merely to diversify income streams will produce
no increase in total value; the sum of the values of the N firms
if not merged will equal the total value of the firm created by
the merger, provided only that the total payments of the new firm
equals the sum of the payments of the firms if not merged (i.e.
provided that the merger is purely conglomerate). Thus, if firms
1 and 2 combine into T, the VAP implies that the value of firm T
will equal the sum of the values of firms 1 and 2 if they were
not merged. This is so regardless of any diversification effects
of merger which may reduce the probability of bankruptcy.
It is important to understand that the above arguments do not
imply that either total stock or total bond values will be the
same before and after merger. In fact, if the pre-merger debt
remains outstanding after merger, . bond values will
generally rise and stock values fall due to the merger. (Higgins
and Schall, 1975, pp. 98-99)

Two empirical studies have examined the wealth shift potential

of mergers and explicitly noted the potential for neutralizing these

shifts by increasing the leverage in the post-merger firm. The

earlier paper, by Kim and McConnell (1974) outlines the basic wealth

shift arguments and concludes that a firm which is managed to maxi-

mize the wealth of the shareholders will neutralize the wealth shifts

from equity to debt though an "increase in their use of financial

leverage to the point where the post-merger default risk of the

previously outstanding debt is increased sufficiently to negate the

co-insurance effect and to cancel any wealth transfers from equity

holders to debtholders" (Kim and McConnell, 1977, p. 352). They note

that if these neutralizing actions are taken, an examination of

bondholder returns around the merger date should find no evidence of

abnormal returns. Further, they suggest that one should observe that

merged firms increase their use of debt around the time of the

merger. Their study finds evidence to support both hypotheses. The










returns to bondholders showed no significant signs of excess returns

around the merger dates and of 31 firms in their sample, 18 to 26

showed increased leverage after the merger depending upon the lever-

age measure used.

It should be noted, however, that Kim and McConnell's analysis

is incomplete in at least two ways. First, their analysis was

performed on an average of bond returns for all firms in the sample.

Shastri (1983) has shown that bondholders do not always gain. Thus,

including all bonds in an index may result in bonds with positive

excess returns being negated by bonds with negative excess returns.

Second, Kim and McConnell's analysis of changes in capital structure

was extremely simplistic. While they noted that a large percentage

of the sample firms increased their use of debt, no attempt was made

to determine whether these shifts were related to the tendency for

wealth shifts. The purpose of this dissertation is to study this

issue.

The second study which explicitly allowed for the neutralization

of wealth shifts is by Eger (1983) who performed an analysis similar

to Kim and McConnell but used a more selective sample which con-

trolled for changes in leverage. Her results are supportive of the

theories which predict wealth shifts as she finds statistically

significant gains to debtholders as a result of pure exchange mer-

gers. Eger's methodology is also interesting because of her

selection of variables used in the analysis. Her analysis indicated

that leverage was satisfactorily proxied as (book value debt / (book

value debt + market value equity)). Eger's also noted the empirical

problems of proxying the variance of firms returns.










Because total firm returns are not observable, their returns'
variance and covariances cannot be calculated directly. These
surrogates for firm returns' variance were used in this study:
stock returns' variance; weighted stock returns variance; and
accounting returns' variance. If all of the securities of a firm
other than the common stock are riskless, then stock returns'
variance weighted by the square of (stock value / (stock value +
debt value)) would be the firms returns' variance. However, it
is clear that the firms used in this study have risky debt
outstanding, and in this case the weighted stock returns' vari-
ance would be an understatement of the firm returns' variance.
However, in general, unweighted stock returns' variance is an
overstatement of firm returns' variance. Since an examination of
only the direction of change if firm returns' variance is needed
in this study, both of these surrogates were examined as
approximations. (Eger, 1983, p. 556)

Two authors have examined the wealth shift effects of mergers in

a different way. Lee (1977) and Lewellen (1971) concentrate on the

effect mergers have upon the riskiness of the firms' debt. They note

that the merger creates a co-insurance effect which increases the

value of the firm's debt. It is important to note that while the

results are identical to those of the previously discussed studies,

the concentration is upon the effect of the reduced variance on

bondholders rather than stockholders. Lewellen argues that the value

of a firm's debt and its ability to borrow is determined by the

distribution of the cash flows available to service the debt and the

probability of those cash flows being below the minimum required to

maintain solvency. This is consistent with the much earlier work of

Donaldson (1962) who argued that firms must be concerned with the

"maximum adverse limits" of their cash flows. Lewellen argues his

point as follows:

Put differently, the lender concern is almost exclusively with
the probabilities attached to "disaster" levels of borrower cash
flow outcomes -- a disaster being defined as an inability to meet
the interest and repayment commitments specified by the loan
agreement. The body of published analytical work on lender
decision rules and the concern with interest and sinking fund
"coverage" ratios by lenders, underwriters, borrowers, and rating










services, all attest to the prevalence of this attitude.
Accordingly, in addressing the notion of corporate debt "limits"
or debt "capacities" with reference to companies who merge, our
concern should be with the effects of merger on the lower tail of
the resulting probability distributions of corporate earnings
outcomes. (Lewellen, 1971, p. 526)

Lewellen, claims that it is the area within the tail of the cash flow

distribution below the disaster level that determines the value of

debt. He notes that the combination of two firms' cash flows, which

are not perfectly correlated, will result in a decrease in the area

in the tail of the distribution and therefore increase the debt

capacity of the combined firm.

Should the two companies merge, however, the likelihood of
disaster at the same aggregate scale of lending must inevitably
decline, as long as the relationship between the annual cash
flows of the combining enterprises is such that, prior to merger,
default on their respective loans did not always occur
simultaneously. (Lewellen, 1971, p. 530)

The co-insurance arguments lead to identical conclusions regarding

the effect of mergers on the relative positions of debt and equity

holders.

The Agency Literature

Earlier in this chapter, eight popular motives for corporate

mergers were outlined. Essentially, all of these motives are based

on the belief that the combination would result in net gains or

synergies which would not otherwise be available. However, other

studies discussed showed no clear indication that such gains normally

materialize. Why, then, are mergers so prevalent? One suggested

answer to this question is based in agency theory.

Jensen and Meckling (1976) provide the most comprehensive frame-

work for analysis of the agency relationship. They note that an

agency relationship exists when one or a group (principals) contracts










with another person or group (agents) to perform some service which

involves delegating some decision making authority to the agents. If

both principal and agent are utility maximizers, there is a tendency

for the agent to take some actions which are not in the best interest

of the principal. While there may be incentives, bonding and moni-

toring systems instituted to reduce the agent's divergences from the

principal's interests, the systems will not, in general, result in

the agent always acting in the principals best interest. The frame-

work is directly applicable to the modern corporation which is

managed by non-owner managers.

Fama (1980) argues that, while Jensen and Meckling's analysis is

essentially correct, there are signals provided by the managerial

labor market and the capital markets and other market mechanisms

which discipline managers. Thus the agency relationship does not

create a divergence between owners' interests and management's

actions. Any actions taken by management are subject to an ex post

settling process which eliminates any potential for gain at the

shareholders expense. That is, managers who attempt to extract extra

perquisites are penalized in the future wage market negating the

gain. However, Fama notes that the system is not perfect.

No claim is made that the wage revision process always results in
a full ex post settling up on the part of the manager. There
are certainly situations where the weight of anticipated future
wage changes is insufficient to counter balance the gains to be
had from ex post shirking, or perhaps outright theft, in excess
of what was agreed ex ante in a manager's contact. (Fama, 1980,
p. 306)

Thus, it appears that while there may be market mechanisms which

reduce the impact of the agency problem, the controls are









insufficient to prevent all problems. Thus, it appears possible that

managers may engineer some mergers for personal gain.

Amihud and Lev (1981) examine the effect of the agency relation-

ship on merging firms and conclude that managers may tend to pursue

mergers as a method of reducing their personal risk. "Specifically,

managers, as opposed to investors, are hypothesized to engage in

conglomerate mergers to decrease their largely undiversifiable

"employment risk" (i.e., risk of losing job, professional reputation,

etc.)" (Amihud and Lev, 1981, p. 605). The authors note the liter-

ature which shows that diversification does not create value for the

investors who may personally diversify. However, they argue that a

large portion of the managers personal wealth is in the form of human

capital and based upon the future of the firm he manages. This

exposed the manager to a large degree of risk which cannot be diver-

sified in the security markets. The manager may only diversify this

"employment risk" by diversifying the firm itself, a task most easily

accomplished by corporate merger. Further, the management will have

an incentive to pursue such mergers even if they result in no gain,

or even a loss, to the firm's shareholders.

It is important to note that Amihud and Lev's analysis is only

applicable to management of the acquiring firms. Management of those

firms which are acquired often are in risk of being replaced. This

may explain why so many takeovers are vehemently opposed.

Boudreaux (1973) finds empirical evidence consistent with Amihud

and Lev's results. He finds evidence that firms with less control

exerted by owners exhibit lower levels of risk and return. This

suggests that managers may be attempting to reduce their employment










risk by reducing the risk, and hence the expected return, of the

firms they manage. This article is interesting in two respects.

First, it provides empirical evidence of Amihud and Lev's contention

that managers are concerned with "employment risk." Second, the fact

that such differences in the risk-return characteristics of owner

versus manager controlled firms exist tends to support Fama's con-

tention that the ex post settling up process is imperfect.

There are also other possible reasons that managers might pursue

mergers. Firth (1980) finds evidence that senior management pay is

more closely related to firm size and growth than profitability.

They noted that mergers did not tend to improve the financial posi-

tion of shareholders but did result in financial gains to management.

They note that "this evidence is consistent with takeovers being

motivated by maximization of management utility reasons" (Firth,

1980, p. 258).

Meeks and Whittington (1975) find similar results in their

examination of directors pay. They find that firm size is a signifi-

cant factor in explaining directors pay. However, they qualify their

findings by noting that on a year to year basis, growth is no more

important than profitability.

It is important to note that the issue of the determinants of

managerial pay is not completely resolved. In a study carried out

prior to that of Meeks and Whittington, Lewellen and Huntsman (1970)

find evidence that managers are rewarded for profitability, not size

or growth, in the face of such conflicting evidence, one can only

conclude that all three factors, profitability, size and growth may

be determinants of managerial pay. However, to the extent that size









and growth are beneficial to managers, mergers provide an ideal

avenue to both.

Summary

The size of this chapter is indicative of the voluminous litera-

ture of corporate mergers. It appears useful to review a few of the

major results. It was noted that there are several theories which

have been put forth to explain mergers. Essentially all of these

theories are based upon the belief that mergers capture synergies.

However, examination of security returns seems to suggest that few if

any gains accrue to the shareholders of the acquiring firm. Further,

the wealth shift literature suggests that, in the absence of

synergies, mergers generally result in a loss to shareholders and a

gain to bondholders. It was also shown that such wealth shifts may

be neutralized by increases in leverage.

It is within this framework that this study is set. This study

tests whether managers take action to neutralize the wealth shifts.

Further, since it has been argued that managers may often pursue

personal goals, the role of synergies is examined. Synergies are

important because their existence could allow managers to not in-

crease the firm's debt enough to completely offset a wealth shift yet

shareholders could still experience no loss, and possibly gain. Thus

prior examinations of shareholder returns in merging firms which did

not control for changes in leverage may have been misspecified.

















CHAPTER 3
HYPOTHESES AND METHODOLOGY

Introduction

The empirical validity of the relationships between security

returns, debt capacity, synergies and managerial response are the

central issues of this dissertation. Specifically, the following two

central hypotheses will be tested against two alternate hypotheses:

Central Hypothesis 1: Managers act as if they are aware of the

wealth shift potential of mergers and take

neutralizing actions commensurate with the

magnitude of the shifts. That is,

managerial response is directly related to

the magnitude of the potential wealth

shifts.

Central Hypothesis 2: The degree of managerial response is

inversely related to the magnitude of

potential synergies available from the

merger, because the presence of synergies

allows wealth to be hidden by offsetting

gains.

Alternate Hypothesis 1: The changes in capital structure which

occur during a merger result from managers

reactions to existing conditions in the

financial markets at the time of the merger.

Alternate Hypothesis 2: The changes in capital structure which occur

40










during a merger are simply a result of the

terms of the merger.

This chapter is organized into five sections. The first section

following this introduction outlines the events under study, defines

the needed variables and presents the general model. Next, the

specific empirical tests are developed. The following section

discusses the measurement of the critical variables used in the

study. Finally, the sources of data are outlined.



Events, Definitions and the General Model

This study concentrates on the effects of the merger on the

acquiring firm's shareholders. Throughout the study, the acquiring

firm is designated as firm A prior to the merger and as firm A after

the merger.

The time period under study for each merger can be divided into

three parts: the base period, the adjustment period and the

post-merger period. As in all studies which examine the effect of an

event, a base period is needed with which to compare later results.

The base period in this study was taken to be the 52 weeks ending

four weeks prior to the first informational impact of the merger on

security prices (time I). The method used to determine date I is

outlined later in this chapter. Halpern (1973) has found evidence

that the formal announcement date (time A) is generally after the

date at which the market first learns of the pending merger. Since

the goal is to find a base period during which the impact of the

merger is not included in the variables under examination, the formal

announcement date (A) is not of great importance in this study.










However, announcement dates were gathered and were taken to be the

first announcement in the Wall Street Journal of the pending merger.

The adjustment period over which the changes in the test variables

are measured was taken to be the period beginning four weeks prior to

the point of first informational impact (I) and ending 26 weeks after

the consummation date, the date at which the merger was legally

completed as reported in Mergers and Acquisitions (1968 1983) (time

C). The post-merger period is taken to be the period following 26

weeks after the consummation date.

The general form of the test equation is as follows:

AD. = f(AVl AV2., AM., AI., AE., C., S.)


where AD. = the change in leverage associated with merger i,
1

AV1. = the change in variance associated with the acquiring
1

firm in merger i,

AV2. = the change in variance associated with the acquired

firm in merger i,

AM. = the change in the weighted average maturity of debt in
1

merger i,

AI. = the change in average long term interest rates from
1

the base period to the adjustment period,

AE. = the change in the average level of the stock market

from the base period to the adjustment period,

C. = the ratio of cash used during the merger transaction
1

to the post-merger value of the merged firm,

S. = the index of relative synergy resulting from merger i.
1

Changes in the levels of debt (AD) are measured by comparing

financial statements and market data from the last financial report










prior to time I with the first available report following time C plus

26 weeks. The decision to measure the debt changes by examining data

26 weeks after the consummation of the merger rather than immediately

after the consummation date was made to better ensure that the

results represented a change in capital structure rather than a

temporary increase or decrease in debt around the merger date.

The explanation of the actual changes in the debt levels of

merging firms requires variables which measure the theoretical debt

capacity or wealth shift potential of mergers. The change in vari-

ance (AV1.) and the change in the maturity structure (AM.) caused by
1 1

the merger are included to reflect the wealth shifts potential.

Shastri (1983) has noted that it is possible that the bond-

holders and stockholders of each component firm in a merger exper-

ience wealth shifts of opposite direction. That is, the bondholders

of the acquiring firm may gain while the bondholders of the acquired

firm may lose. He notes this may occur when the variance of the

combined firm falls between the variances of the component firms.

The emphasis in this study is on the effect of the merger to the

shareholders of the acquiring firm. However, to test for the pos-

sibility of an offsetting wealth shift in the acquired firm resulting

in a change or moderation of the change in capital structure, the

variable AV2. is included. This variable measures the change in
1
variance experienced by claimants of the acquired firm.

The role of synergies in determining debt policies is examined

with the use of the variable S. which is measured as the relative
I

change in value of the merging firms compared to control firms in

similar businesses. The measurement of this variable is detailed









later in this chapter. Two techniques will be employed to test the

effect of synergies. First, the variable will be included in the

test equations and the impact of its presence both in terms of its

significance and sign and its affect on the coefficients of other

variables will be examined. Second, the sample will be split into

two subsamples by relative size of the synergy variable. The test

equation will be estimated on each subsample independently and

differences between the two examined.

In any research which attempts to explain the movement of one

variable in terms of the movements of others, one must be careful to

ensure that significance is not obtained because of the omission of

another variable. The two alternate hypotheses are included as

possible explanations of the observed changes in leverage. It may be

that mergers tend to happen at times coincident with declining

interest rates that make increasing the debt levels of firms desir-

able. To test this hypothesis the variable AI is collected which

compares borrowing rates during the merger period (1-4 to C+26) with

the base period. A similar possibility is that increased debt may

simply be the result of unattractive equity markets coincident to the

merger period. To test this hypothesis AE is collected which com-

pares stock market levels during the merger period with the base

period. A second hypothesis is that the increased debt level is

simply a response to the need for excess cash to fund the merger

transaction which remains in the capital structure. To test this

hypothesis, the variable C. is included which measures the cash used

in the merger as a proportion of the post-merger firm.










Tests of Hypotheses

The preceding section presents the general form of the model and

defines the critical variables of the study. A detailed outline of

the methodology which has been designed to allow the measurement of

these variables is contained in the next section.

If the first hypothesis is true, one should observe a direct

relationship between the amount of debt capacity created, as reflect-

ed by decreasing variance and declining maturity of debt, and the

change in the proportion of debt held by the merging firms around the

merger (AD.). If the first alternate hypothesis is true, one should

observe an inverse relationship between AI and AD and between AE and

AD. If the second alternative hypothesis is true, one should observe

a direct relationship between the amount of cash used in the merger

and the dependent variable. Note that the role of the synergy

variable and the second central hypothesis is not discussed at this

time. Additionally the linear form of the test equation which

follows does not include the synergy variable. This exclusion is

deliberate. The tests in this study will be carried out in two

separate phases. The first series of tests assumes the maximization

of shareholders wealth by managers and tests the first central

hypothesis against the two alternate hypotheses. The second series

of tests relaxes the wealth maximization assumption and allows for

the possibility that managers may attempt to capture some of the

benefit of available synergistic gains for themselves. This second

series of tests examines whether the assumption of wealth maxi-

mization appears valid for the firms studied.

The linear form of the test equation for the first series of










tests is as follows:


ADi = Y0 + Y Vli + Y V2i + Y3AMi + 4 I + y AE + Ci + Ei


Where YO, YT Y2, Y3, Y4, Y5, Y6 are the regression parameters

E. = the random error of the regression.
1

The linear form of the test equation for the second series of

tests is identical to the above form except for the inclusion of the

synergy variable S.. As discussed earlier, two forms of the test
1

equations will be estimated in the second series of tests. The first

form will include the variable S. in the equation linearly with the

coefficient Y7- The second form will use S. to divide the sample
1

into two subsamples. The test equation from the first series of

tests will be reestimated for each subsample and differences exam-

ined.

As is discussed in more detail in the next section, some of the

above variables may be measured in more than one way. Changes in

leverage may be measured in book value or market value and both upper

and lower bounds of the variance variable may be computed. The main

series of tests used book value definitions of leverage because of

the availability and stability of the measures. A market value proxy

which had been used by other authors was also tested and will be

reported in an appendix to the text. Comparison of these formu-

lations will provide information on which variables are most useful

proxies of managerial response and the sensitivity of the general

model to different formulations.

For a statistical test to be meaningful, the researcher should

be able to define the expected signs of the coefficients of the test









equation prior to the test. If the central hypothesis is correct and

managers are acting as if they are aware of the potential for wealth

shifts and acting to neutralize these shifts, the values for

Y1 and Y3 should be negative and significant. Shastri's (1983)

analysis suggests that the sign of y2 should also be negative.

Analysis of the expected sign of the coefficient of the synergy

variable, S., is particularly interesting. If the second central

hypothesis is correct and the existence of synergies allows managers

to refrain from increasing leverage as much as they would have

without synergies, the sign of Y7 should be negative and significant.

This would be evidence of an agency problem and indicate that

managers are using synergistic gains to offset wealth shifts. In

this case, shareholders may still appear to gain from the merger but

the gain will be less than that had the wealth shift also been

neutralized. It should be noted that the managers have an incentive

to do this because increasing the leverage increases the financial

risk of the firm and thus increases the managers employment risk.

A positive sign for the coefficient of S. is evidence that

managers are aggressively pursuing a goal of shareholder wealth

maximization. As was illustrated by the simple example in chapter

one, in the absence of any managerial action to increase leverage,

both bondholders and stockholders share in synergistic gains from

merger. In fact, the value of debt increases more when synergies are

available than when there are no such gains. Thus, if managers are

actively pursuing a wealth maximization policy, the increase in

leverage in a synergistic merger will be larger that in a non-

synergistic one.










It is also possible that the coefficient of S. will have a sign

not significantly different from zero. This is evidence that the

values of synergies do not affect managerial action. This dissert-

ation is the first study which has hypothesized any relationship

between management's debt policies and synergistic gains in mergers.

It is possible that management does not consider synergistic gains in

determining changes in leverage around mergers. It is also possible

that management judges such gains without reference to the effect the

merger has had on the market price of the companies' shares.

The variables AI., AE. and C. are suggested by the alternate
1 1 3

hypotheses and are included in the analysis to control for other

market influences which might affect the leverage of a firm. If the

changes in leverage are simply the result of general market con-

ditions which make debt more attractive because of a decline in

interest rates, one should observe a negative and significant value

for Y4. If the changes in leverage are the result of a deterioration

in the equity markets which are forcing companies to substitute debt

for equity, a negative value should be observed for YS. If the

changes in leverage are simply a response to the need for cash to

finance the merger, one should observe a positive and significant

value for yg.



Measurement of Critical Variables

The tests presented in the previous section of this chapter

require variables which proxy the changes in variance and maturity

and measure synergistic gains and other market influences which may

affect leverage. Further, the proper measurement of these variables










requires the determination of a base period during which the vari-

ables can be measured prior to any impact of the merger. Thus, a

method of estimating the point of first informational impact of a

merger is needed. The section outlines the estimation of the vari-

ables used in this study.



Changes in Leverage -- AD.
1


The change in leverage ratio, AD., is measured as the change in

the total debt to total assets ratio from the last available

financial report prior to I-4 to the first available report after

C+26. An example should clarify the measurement of AD.. Consider
1

two equal sized firms.ovFirm A has a pre-merger (time I-4) debt ratio

of .2, while firm B's is .3. The merger of these two firms should

result in a post-merger debt ratio of .25 for the combined firm.

Suppose a debt ratio of .35 is observed in the post-merger period.

The variable AD would be calculated as follows:

AD = .35 / .25 = 1.40

Total debt was chosen over long term debt for two reasons.

First, because of the accounting convention to report any debt which

has a maturity of less than 1 year as short-term, it is possible for

firms to carry sizable amounts of demand loans which are consistently

rolled over for long periods as short-term debt. Secondly, many

mergers are initially financed by short-term debt which is subse-

quently refinanced with long-term sources. Short-term funds are

often initially used because they are easier to raise quickly than a

long-term loan or bond issue. It is also noted that for many










companies, which carry minimal short-term debt, the difference

between using total and long-term debt is insignificant.

The main test equations presented in this study use leverage

defined in accounting terms. Accounting data were used because of

the accuracy with which accounting leverage may be measured and the

stability of the measure relative to market value estimates. Since

market value leverage is unobservable, some proxy must be used. The

proxy used in this study is that of Eger (1983), who approximated the

market value of total assets as the market value of equity plus the

book value of debt. This, Eger notes, results in a closer approxima-

tion of the market value of the total assets. It differs from the

true market value of total assets by the difference between the book

value of debt and the market value of debt. A preferable estimate

would include the market value of debt. However, its estimation is

difficult and subject to even larger estimation errors.



Variance -- AV. and AV2.
1 1


Two variance variables appear in the test equation. The first

variable, AVl., is of primary importance as it represents the change
1

in variance experienced by the shareholders of the acquiring firm,

and it is the actions of the managers of this firm which are under

study. The second variance variable, AV2., is included to test for

differing intra-firm wealth shifts in the acquired firm which Shastri

(1983) suggests may impact the magnitude of the total wealth shift.

The variables are calculated, for each merger i, as follows:
2 2
AVi = AB/ A










2 2
AV2i = AB / B



2 2 2 2 2
where AB A= A+ BaB + 28AB ABAB


and aA = A / VA + B


6 = VB / VA@ VB


where VA,VB = market value of equity plus the book value of debt

for firms A and B respectively,
2 2
Ao = the pre-merger variance of the returns of the
A B
component firms, A and B,
2
0B = the estimated post-merger variance of the combined

firm A ,

PAB = the correlation between the returns of the component

firms.

The variance variables should theoretically represent the

variance of the return on value of the total firm. Since this

variable is unobservable it must be proxied. Following similar work

done by Eger (1983), two proxies will be used in different estima-

tions of the test equation. The true variance of the return on

value for any firm j is as follows:

22 22
Var(R .) = y.o + (1 y.) a + 2y. (1 y.)p a .0 .a
v,] 3 dj ,j s,j j j sd,j d,j s,j


2
where dj = the variance of the return of firm j's debt during the

period,

S = the variance of the return of firm j's stock during
s,j
the period,










yj = the proportion of debt in firms j's capital structure,

psd,j = the correlation coefficient of the two return streams.

2
However, as Eger noted, the estimation of adj like the

estimation of the market value of debt, is subject to large

estimation errors which could damage the usefulness of the resulting
2
estimation. Because of this, the estimation of od,j is not attempted

in this study. Instead, two estimates of the variance variables were

collected which represent the upper and lower bounds on the estimates

of the true variance. The first estimate, the variance of the return

2
on equity, .,j represents an upper bond as the variance of debt

returns must be less than the variance of equity returns for
2 2
any firm. Substituting oa d = o into the Var(R .) equation


2
yields the result Var(R .) = os
v,] s,j

2 2 2
While the upper bound for a is a ., the lower bound for a ,
d,j sej d,j

is 0, as variance cannot be negative. Substituting, this estimate

into the Var(R .) equation yields the following result:
v,3

2 2
Var(R ) = (1 y)
v,J SJ


These two estimators are proxied in this study using the
2
variance of equity returns over the base period as the estimate of as
s

and using the market value of equity divided by the market value of

equity plus the book value of debt as the estimate of (1 y.). The

variance estimators are summaried as follows:
2 2
UA = S,A

a2 a2 (M / (EV D B 2
LA S,A (MVE,A E,A VD,A










2 2
U B S,B


LB S,A E,B / E,B + BVD,A

L 2


where


WM

B


UaA UCB = the upper bound estimates of the variances of

firms A and B respectively,
2 2
LA LB = the lower bound estimates of the variances of

firms A and B respectively,


EA, MVE,B = the market value of the equity of firms A and B

respectively,

,A, BVD,B = the book value of the debt of firms A and B
respectively.
respectively.


Maturity -- AM.
1


The longer the time period to the exercise date, the larger the

value of an option. Thus, the longer the maturity of a firms debt,

the greater the value of its stock. This suggests that any actions

which reduce the maturity structure of the firm's debt will create a

wealth shift away from the shareholders. This results in increased

wealth shifts as greater increases in the level of debt are required

to neutralize this shift. To measure this effect empirically, the

following variable was measured:

AM. = WAMD / WADA
a. A


where WAMDA* =
A


WAMD =


the weighted average maturity of debt of the

combined firm after the merger, measured at the

beginning of the post-merger period,

the weighted average maturity of debt of the


A










acquiring firm before the merger, measured using the

first available data prior to the point of first

informational impact.

It should be noted that Shastri (1983) predicts a similar

intra-firm wealth shift potential from change in maturity as from

change in variance. This would suggest the inclusion of another

maturity variable to measure the effect of the merger on the maturity

of the acquired firm. However, this is not needed for two reasons.

First, Shastri notes the effect of the maturity change will not alter

the direction of the total wealth shift. Additionally, the second

maturity variable would be collinear with AM. as there is no diversi-

fication effect with maturity. The combination is strictly linear.

Therefore, a second maturity variable is not needed.




Change in Interest Rates -- AI

In order to allow for the possibility that the changes in

leverage are simply due to changes in the attractiveness of borrowing

rates, the variable AI. is included. This variable is measured as a
1

ratio of the average weekly rate of interest on long-term government

bonds during the adjustment period to the average weekly rate during

the base period. If rates have fallen, AI. will be less than one.
1

If rates have risen, AI. will be greater than one.



Change in Equity Costs -- AE

Using a similar argument to that for including an interest rate

variable, it is possible that leverage changes are the result of

changes in the attractiveness of raising capital in the stock market.










When the stock market is high in value relative to a prior period, it

may be that firms will prefer to raise capital with stock issues thus

reducing leverage. Alternately, when the market is at a low level

relative to prior periods, firms may prefer to raise capital by

borrowing, thus increasing leverage. To capture this effect, the

variable AE. is included. This variable is measured as a ratio of
1

the average value of the value weighted market index during the

adjustment period to its average level during the base period. The

market is approximated using the value weighted index of the Center

for Research in Security Prices at the University of Chicago. An

example may clarify the measurement of AE.. Suppose that for some
1

merger, the average value of the market index during the base period

was 1.2 and during the adjustment period was 1.8. In this case AE.
1

would be calculated as AE. = 1.8 / 1.2 = 1.5 indicating a rise in the
1

market.




Demand for Cash -- C.
1


To allow for the possibility that the change in leverage is

simply a response to the need for cash to finance the merger, the

variable C. is included. The variable C. is measured as the ratio of
1 i

cash used in the merger transaction to the post-merger value of the

combined firm as previously estimated.

C. = Cash used in merger i
1 *
Total assets A


C. is also computed in book value form with the total assets of the
1

post-merger firm in the denominator of the above ratio replaced by

the market value proxy discussed earlier.










Synergy -- S.


It is hypothesized that the degree of managerial response is

inversely related to the magnitude of any synergies that are avail-

able to the shareholders of the acquiring firm. That is, the exis-

tence of synergistic gains allows the three parties in the mergers

(shareholders, bondholders and managers) to simultaneously gain.

Therefore, even if the merger results in wealth shifts from the

shareholders to the bondholders, the shareholders may still experi-

ence net gains from their share in the synergies. In such a merger,

where the shareholders have registered overall gains, one might

expect that the incentives for managers to neutralize the wealth

shifts would not be nearly so great.

The empirical test of this hypothesis requires a method of

measuring the synergies available to management and shareholders of

the acquiring firms. However, it should be noted that the measure

should capture the expected synergies a prior rather than the actual

realized synergies. Managerial action during the merger must be

influenced by expected gains. As is discussed in more detail in the

following pages, all existing measures of synergy measure realized

rather than expected synergy. This problem may result in significant

measurement error.

Three commonly used methods of estimating synergies currently

exist. The first is ad hoc and attributes synergy to mergers between

firms in the same line of business. Conglomerate mergers are con-

sidered to be non-synergistic. Measured in this way, the variable S.

is a dummy with a value of one if the merger is synergistic and zero

otherwise. This form of the variable was used in the tests. There









are a number of problems with this measure of synergy. First, the

variable is a dummy which allows no distinction between mergers which

have large synergistic gains and those with only small gains.

Second, synergies do not necessarily result from all combinations of

firms in the same industry nor is it impossible that conglomerate

mergers result in gains. For example, synergies may result from the

transfer of tax losses in conglomerate mergers.

The two other measures of synergy are based upon actual changes

of the stock prices of the merging firms. Both techniques divide the

price changes which occur around mergers into two portions. The

first portion is that which would have been expected had the merger

not occurred, and is based on the movements of a control group. The

second portion is attributed to synergy. The two methods differ only

in their.choice of control group. The first method uses a market

model to control for expected movements in price. The second method

uses individual control firms in the same industry. The market model

technique was considered for this study but was dismissed.

Individual securities are known to have very low correlations to the

general market when considered individually while the specific

control firms are much more highly correlated and thus control for a

higher proportion of variation. This occurs because the market model

index will not, in general, capture as many industrial and company

effects as the control sample technique. Thus, the control sample

approach is better.

Using the control firm technique, synergy is defined as in-

creases in equity values which result from a merger beyond what could

have been achieved by simply holding a two stock portfolio of the two









independent firms. A numerical example may be helpful. Consider two

firms, A and B, in a one period world. Initially each firm's equity

is valued at $100. At the end of the period, if no merger occurs, A

is expected to be worth $120, and B, $130. Assume the firms merge at

the beginning of the period and that the expected value of the

combined firm's equity (A ) is $275. Under the definition of synergy

employed in this study, and ignoring the time value of money for

simplicity, the synergy created by this merger is

$275 ($120 + $130) = $25.

This definition of synergy is conceptually similar to that of

Haugen and Langetieg (1975). However, they concentrate on changes in

the distribution of returns where this study examines changes in

value. Specifically, the methodology is designed to partition

changes in value of the merged firm in the post-merger period into

two categories. The first is the increase that would be expected to

accrue to an investor holding the two firms' stock had no merger

taken place. The second is the change in value that occurs above

this level, if any, which can be attributed to synergies resulting

from the merger.

To estimate the change in value which would have been expected

without the merger, paired control firms from the same industries as

the merging firms are utilized. The control firms are chosen using

Haugen and Langetieg's (1975) technique of choosing the firm with the

same Standardized Industrial Code that has the highest correlation of

returns with the firm under study. In this study, each merging firm

in the sample was paired with that firm which had the same four digit

Standardized Industrial Code and exhibited the highest correlation of









returns. Where no feasible control firms were available with

identical Standardized Industrial Codes, firms whose codes were

within two digits were used. This technique ensured that firms from

very similar industries were chosen. Using data from time 1-4, two

equal value portfolios were constructed.

C C
(NA,I-4) (PA,I-4) + (NB,-4B,I-BI-4) = Wi( PA,I-4 B ( ) ,I-4


where PA,I-4' PB,I




NA,I-4 NB,I



PC C,
A,I-4' B,I


The total syne


= the price per share of equity at time 1-4 for

firms A and B respectively,

= the number of outstanding shares at time I-4

for firms A and B respectively,

= the price per share of equity for the control

firms at time I-4 for firms A and B

respectively,

6 = market value of equity of A divided by the

sum of the market values of A and B,

W. = a scaling factor to force the equality, and
1
the remaining parameters are defined as

before.

ergy attributed to the merger is measured as


follows:


STOTAL A= *C + i W (PC + P (1 6))
TOTAL A*,C+26 A,C+26 B,C+26


The variable c. is the total amount of cash used during the merger.

It is added STOTAL in the above equation because it represents wealth

which has accrued to owners of the original portfolio of the two

merging firms prior to the merger. Since the STOTAL variable will

differ in size across mergers simply due to scale, it is standardized










in the tests as follows, for each merger i.


C C
S =Si= /W (P e+P (1-6))
S TOTAL i A,C+26 B,C+26 -


It may be argued that, in an efficient market, the value of the

firms at time I-4 will include the expected effect of the merger and

that, therefore, S. can be expected to, on average, equal zero.
1

Halpern (1973) offers an explanation to refute this assertion. He

suggests that merging firms may have unique characteristics which

allow synergistic gains to be captured only in mergers with specific

partners. The probability of these two firms finding each other will

not, in general, be unity and thus security prices will not reflect

total potential synergistic gains.

For completeness, the resulting S. was tested in two forms. As

calculated, S. is a continuous variable and was used in this form.
1

Additionally, the continuous variable was used to create a dummy

variable. The sample was ranked by S. and the half with the higher
1

values were considered as highly synergistic and the others as having

low synergies. This formulation allows a more direct comparison of

the control group measure to the ad hoc measure discussed earlier.



Point of First Informational Impact -- I

To properly capture the full effect of a merger on a variable

under measurement, a base period prior to the event must be deter-

mined during which no effect of the pending merger is felt. Many

event studies assume that the formal announcement of the event is an

adequate proxy for the date at which the market first becomes aware

of the new information. Halpern (1973) provides evidence that this









is a poor assumption in the analysis of mergers. In fact, it is

generally the case that the market has reacted to information of the

pending merger several weeks before the formal announcement.

The determination of this first point of informational impact,

time I, uses the fact that returns to the acquired firm's share-

holders are known to move dramatically upward with first information

of the pending merger. This phenomenon has been consistently docu-

mented in all prior research (Asquith and Kim, 1982; Mandelker, 1974;

and Dodd and Ruback, 1977). Examination of geometrically accumulated

excess returns for the acquired firm substantiated Halpern's earlier

findings. Typically, the acquired firm's shareholders had already

experienced large positive excess returns by the formal announcement

date. To remove the effect of this pre-announcement increase in

share prices, the point of first informational impact I, was taken to

be the first point prior to the formal announcement date at which the

excess returns began a consistent positive trend.

The excess returns used in this analysis were taken from the

excess returns file of the Center for Research in Security Prices.

Daily excess returns in the file are calculated as the difference

between the actual daily return of the security and the actual daily

return of a portfolio of all other listed securities in the same risk

class. The risk classes are determined by grouping all listed

securities by Scholes and Williams' (1977) beta which is adjusted for

the effects of nonsynchronous data. These excess returns have an

expected value of zero and thus their geometric accumulation also has

an expected value of zero.










In examining this somewhat ad hoc determination of time I, the

purpose of the exercise must be remembered. The goal of this exer-

cise is not to find a date from which to examine returns over the

merger period but rather to find a period which is representative of

the normal variance of the firm's returns. When information of the

pending merger begins to impact the market for the firm's stock, its

value quickly moves to reflect the expected merger value of the

stock. In examining the wealth shift potential of mergers, it

appears much more important to analyze the return stream which is

representative of the ongoing firm. Thus, the effect of the merger

negotiations are deleted from the base period by using the first date

of informational impact. To further ensure stability in the base

period, four weeks or 20 trading days, are deducted from time I to

provide a larger margin for error in estimating time I.



Data Sources

Possibly the greatest hurdle to empirical research in the area

of mergers and acquisitions is the assembly of data. The problem is

not that few mergers take place. In fact, there have been hundreds of

mergers each quarter over the past several years. The problem is

that the gathering of information about these merged firms must draw

from several sources. No single comprehensive source exists. A

subsidiary goal of this study has been the development of a compre-

hensive machine readable data base which can also be used in future

research.






63


Table 3-1 contains a list of the variables used in this study

and their sources. A detailed analysis of the merger data collected

is contained in the next chapter.










Table 3-1
Data Sources


The merging firms



Consummation date

Formal announcement date




Industries represented
(Standardized Industrial
Codes)


Stock returns, market
returns and prices


Excess returns


Debt ratios and other
financial data


Interest rates


Mergers and Acquisitions (1968 1983)
lists all mergers in which the value of
the transaction exceeds $1 million.

Mergers and Acquisitions.

The Wall Street Journal Index
(1967 1982) and the Business
Periodicals Index (1967 1982).

Daily returns file of the Center for
Research in Security Prices tapes
records industrial codes and effective
dates.

Daily returns and daily master files of
the Center for Research in Security
Prices tapes.

Excess returns file of the Center for
Research in Security Prices tapes.

Industrial and Research Compustat
tapes, corporation annual reports and
10-K reports.

Federal Reserve Bulletin (1966 1983).


Mergers and Acquisitions.


Variables


Sources


Terms of merger
















CHAPTER 4
THE DATA

Introduction

The research undertaken in this study progressed through a

number of phases. First, the criteria for including mergers in the

sample was developed and the sample was collected. Second, the

relevant event dates were identified. Determination of these dates

defined the periods for which other data were collected. Third,

financial and other data for the merging firms were collected.

Finally, the test equations were estimated. The results of the first

three steps of this process are reported in this chapter.

This chapter is organized into two sections. The first section

outlines the sample selection criteria. The second section provides

a detailed analysis of the characteristics of the sample and includes

an analysis of the determination of the dates of informational impact

and the magnitudes of the values for the synergy variable.



Sample Selection Criteria

As discussed earlier, there are hundreds of mergers each quar-

ter. Thus, the lack of possible candidates for inclusion in the

sample was not a problem. However, the majority of these mergers

involve small firms for which public data is limited or unavailable.

In order to obtain the needed data the sample was restricted to those

mergers where both acquired and acquiring firms were traded on the

New York or American Stock exchanges at the time of the merger. This









restriction corresponds to the requirement that both firms in the

merger have publicly traded common stock recorded on the security

price tapes of the Center for Research in Security Prices (CRSP) at

the University of Chicago. Further, only those firms whose stock

traded daily up to the announcement of the merger were included.

Specifically, no more than two non-consecutive days without trading

were allowed for any firm in the period from the beginning of the

base period until the formal announcement of the merger. This

restriction was necessary to eliminate those firms whose securities

were too thinly traded to allow a reasonable estimate of the variance

of the returns.

One of the most restrictive criteria applied to the sample was

the requirement that each merger represent a unique event for each

component firm. That is, only those firms which had no other mergers

from the beginning of the base period until one year after the merger

were included. While this requirement limited the size of the

sample, it was necessary for two reasons. First, the effect of any

one merger cannot be isolated in firms with multiple mergers.

Secondly, Schipper and Thompson (1983) suggest that there may be

fundamental differences between firms which acquire other firms as

single events and those which acquire numerous firms as part of an

acquisitions policy.

Two other restrictions were imposed upon the sample. First,

because of the differences in the capital structures of financial and

non-financial firms, only non-financial firms were included in the

sample. Secondly, in order to make the time periods under study more

consistent, the period under study for each merger was not allowed to









exceed three years. This restriction was imposed to eliminate

mergers which took place over many years or which involved lengthy

anti-trust litigations. These mergers were eliminated because the

lengthy time period involved might allow too many other events to

affect the test variables.

The period under study is from January 1, 1969 to December 31,

1982. The beginning date of this period corresponds with the earli-

est date for which financial records of merging firms were available.

The ending date was chosen to be as current as possible while still

allowing time for post-merger data to become available. The time

period under study has a number of desirable characteristics. It is

long enough to limit the possibility that the results have occurred

because of a short term phenomenon. The period includes some of the

most active years for mergers and some of the largest mergers in

history.



Sample Characteristics

If the results of any empirical study are to be generalizable,

the sample must represent a reasonable cross section of the popu-

lation under study. The sample employed in this study appears to

have this characteristic. The mergers under study are listed in

Appendix B. This appendix contains the names of the acquiring and

acquired firms and the consummation dates of the mergers. The total

size of the sample is 126 firms or 63 mergers. This represents a

complete population of the mergers between publicly traded firms

which met the sample criteria and for which data were available.









Table 4-1 contains a classification of the sample by the major

industry divisions of the standard industrial code for both the

acquiring and acquired firms. It can be seen that the sample repre-

sents a broad cross section of non-financial corporations.

Table 4-2 delineates the sample by the year in which the merger

occurred. There is an obvious concentration of the sample in the

more recent years. This has resulted from the unavailability of data

for firms in the earlier periods. The greatest hurdle in carrying

out this research has been the collection of data. Because of the

need for data not contained in easily obtainable sources such as

Compustat, individual financial statements for each firm were exam-

ined. The availability of these financial statements from the

earlier years under study was severely limited.

Table 4-3 shows the sample classified by estimated market values

of the component firms prior to the mergers. Table 4-4 stratifies

the sample by the ratio of the value of the acquired firm to the

value of the acquiring firm. As can be seen, the sample contains

some of the largest publically traded firms along with some of the

smallest. Further, the mergers vary from being relatively small

acquisitions for the acquiring firms to acquisitions of firms larger

that the acquiring firms themselves. It should be noted that a

careful check of the mergers was made to determine which firm was the

acquiring firm. The acquiring firm was taken to be that firm whose

shareholders retained control of the merged firm. Mergers for which

the acquiring firm could not be identified were deleted from the

sample.










Table 4-1
Stratification of the Sample by Primary
Standard Industrial Codes (SIC)


Standard Number of Number of
Industrial Industry Acquiring Acquired
.Code Firms Firms


1000 1499 Mining 3 4

1500 1799 Construction 2 0

2000 2099 Food 3 2

2200 2399 Textiles and apparel 3 5

2400 2799 Wood and paper 2 3

2800 3099 Chemicals, petroleums 10 5
and rubber

3100 3299 Leather, stone, glass 3 0
and concrete

3300 3499 Primary and fabricated 4 6
metals

3500 3699 Machinery 8 6

3700 3799 Transportation equipment 2 4

4000 4899 Transportation and 6 5
communication

5000 5099 Wholesale trade 1 3

5300 5999 Retail trade 7 9

7200 8099 Services 3 4

Miscellaneous 6 7


Total 63 Total 63










Table 4-2
Stratification of the Sample by Year of Merger


Year Number of Mergers


1969 1

1971 2

1972 3

1973 6

1974 1

1975 1

1976 6

1977 11

1978 9

1979 7

1980 11

1981 5


Total 63










Table 4-3
Stratification of the Sample by Estimated Market Value


Range of Number of Number of
Market Value Acquiring Acquired
(in millions) Firms Firms


$ 0 -

100 -

200 -

400 -

600 -

800 -

1000 -

1200 -

1400 -

1600 -

1800 -

2000 +


$ 99

199

399

599

799

999

1199

1399

1599

1799

1999


9


Total 63


Mean Market Value

Minimum Market Value

Maximum Market Value


33

10

11

4

2

0

0

0

1

0

0

2


Total 63


$1307.76

34.45

11876.18


$250.93

9.14

3036.93










Table
Stratification of the Sample by


Range
(in percent)


Relative Size of Acquisitions


Number of
Mergers


0 9.999 15

10 19.999 20

20 29.999 14

30 39.999 2

40 49.999 3


50 59.999

60 69.999

70 79.999

80 89.999

90 99.999


100 +


Total 63


Mean Relative Size

Minimum Relative Size

Maximum Relative Size


1. Note that relative size is measured as the ratio of the estimated
market value of the acquired firm to the estimated market value of
the acquiring firm. For example, if firm A, with an estimated market
value of $40 million buys firm B, with an estimated value of $10
million, the relative size of the acquisition is $10.M/$40.M = .25 or
25 percent.

2. Relative size of greater than 100 percent indicated that the
acquired firm was larger than the acquiring firm. Three mergers in
the sample had this characteristic. In each case, further
examination was made to ensure that the acquiring firm did retain
control of the combined firm following the merger.


29.79 percent

1.66 percent

212.53 percent









Of the 63 mergers in the sample, 31 or 49.2 percent had terms

which stipulated at least partial payment in cash. The remainder

were effected as pure exchange mergers involving only the exchange of

shares. The mergers funded by cash were of two main types: 65

percent used only cash and 35 percent used a combination of cash and

share exchanges. Some of these mergers were two step transactions

with the acquiring firm obtaining control of the target firm by a

cash tender offer for shares and later obtaining the balance of the

outstanding equity through a share exchange. Another group of

mergers which were funded partially by cash were carried out in one

step, with the acquirer purchasing the acquired firm for a package of

cash and securities.

As the primary goal of this study involves explaining changes in

capital structure of merging firms, it is useful to examine the

changes which occurred in the sample firms. Table 4-5 shows the

range and distribution of the changes in leverage for the sample,

using both book value and market value measures. Recall that these

variables are calculated as the actual change in leverage which

occurred over the adjustment period in each merger.

In an earlier study, Kim and McConnell (1977) analyzed a sample

of 31 mergers using measures of leverage similar to the ones employed

in this study. Table 4-6 presents comparative data from the two

studies. It can be seen that both studies find similar tendencies

for merging firms to increase their leverage. The Kim and McConnell

study finds increases in leverage that exceed the magnitudes of

similar measures used in this study. These differences can be traced

to two major dissimilarities between the samples used in the two










Table 4-5
Changes in Leverage Around the


Merger Dates


Number of Firms Number of Firms
Range Market Value Measure Book Value Measure


Greater

-50%

-40%

-30%

-20%

-10%

0

10%

20%

30%

40%

Greater


than -50%

- -40%

- -30%

- -20%

- -10%

0

- 10%

- 20%

- 30%

- 40%

- 50%

than 50%


1

0

6

4

10

11

7

8

6

2

0

8


Total 63


Mean Change in Total Market Value Measure

Mean Change in Book Value Measure


0

0

0

1

9

16

14

10

7

3

0

3



Total 63


14%

7%










Table 4-6
A Comparison of Changes in Leverage with the Kim and McConnell Study


Present Kim and McC nnell
Item Study Study


Sample size 63 31

Period of study 1969 1982 1960 1973

Market value leverage

Mean change +14% +36%

Number increasing 35 18

Number decreasing 28 13

Book value leverage

Mean change + 7% +16%

Number increasing 37 26

Number decreasing 26 5



1Source: (Kim and McConnell, 1977)
Source: (Kim and McConnell, 1977)










studies. First, the time period of the Kim and McConnell study was

1960 to 1973 while the current study examines the period 1969 to

1982. It may be that part of the variation results from these

different time periods, possibly due to differences in the relative

levels of interest rates which affect the costs of debt in each

period. The second major dissimilarity between the two samples is

the restriction in Kim and McConnell's sample to include only mergers

where the acquired firm was at least 10 percent of the size of the

acquiring firm. As was discussed earlier and can be seen in Table

4-4, the sample in the current study contains several mergers with

acquisitions ratios less that 10 percent. Further, there are

correlation coefficients of .04 and .26 between ratio of value of

acquired to acquiring firms and the market and book value measures of

changes in leverage, respectively. Especially in the case of book

value measures of leverage, these correlations suggest that the

differences in results of the two studies occur largely because of

this difference in sample selection criteria.



Determination of the Date of First Informational Impact

The primary goal of this study is to attempt to explain changes

in leverage of merging firms in terms of the parameters suggested by

the option pricing model as it applies to the valuation of firms.

The most critical variables in this study are the variances of the

two firms in each merger. If these variances are to represent the

volatility of the firms in the merger independent of any combination

of the two firms, the period over which the variance is measured must

not include any period in which information of the pending merger has









reached the market. As was discussed in detail in chapter three, the

assumption that information of a pending merger does not impact the

market prior to the formal public announcement is a poor one

(Halpern, 1973, pp. 565-568).

Following the methodology outlined in chapter three, the returns

to the acquired firms' shareholders were analyzed. Table 4-7 con-

tains the distribution of days prior to the formal announcement dates

at which information of the pending mergers appeared to begin to

affect the trading securities. Halpern (1973), using a somewhat

similar methodology based on monthly, rather than daily, returns

found that using a date seven month prior to the formal announcement

of the merger included the majority of firms in his sample. The

results of Halpern's study are generally similar to the results of

this study although it appears that seven months would have been an

overly large adjustment to the announcement date in this sample.

Note

1. While this sample size may appear relatively small compared to
the total number of mergers over the period it is not of unusual size
compared to the samples used by other researchers of mergers. For
example, Kummer and Hoffmeister (1978) examined 88 mergers, Dodd's
(1980) sample included 71 completed mergers and Schipper and Thompson
(1980) analyzed a sample of 30 firms. The size of the sample in each
of these studies is affected by the availability of a wide cross
section of data. Studies, such as Mandelker (1974) and Elgers and
Clark (1980), which examined much larger samples were restricted to
examining fewer variables and typically looked only at returns to
equity holders.










Table 4-7
The Frequency Distribution of the Number of
Announcement Dates and the Dates of First


Days Between the Formal
Informational Impact


Number of Days Number of Mergers


1 -

21 -

41 -

61 -

81 -

101 -

121 -

141 -

161 -

greater


20

40

60

80

100

120

140

160

180

than 180


Total


Mean number of days

Minimum number of days

Maximum number of days

Range in days

















CHAPTER 5
TEST RESULTS

Introduction

The final step in this research was the estimation and interpre-

tation of the test equations. As outlined in chapter three, the test

equations were formulated to test two central hypotheses against two

alternate hypotheses. Prior to reviewing the results, it may be

useful to reiterate these hypotheses.

Central Hypothesis 1: Managers act as if they are aware of the

wealth shift potential of mergers and take

neutralizing actions commensurate with the

magnitude of the shifts.

Central Hypothesis 2: The degree of managerial response is

inversely related to the magnitude of

potential synergies available from the

merger.

Alternate Hypothesis 1: The changes in capital structure which occur

during a merger result from managers

reactions to existing conditions in the

financial markets at the time of the merger.

Alternate Hypothesis 2: The changes in capital structure which occur

during a merger are simply a result of the

terms of the merger.

Two series of tests were performed during this study. First,

the test equation was estimated on the entire sample without










controlling for the effects of synergy. The results of these tests

are presented in this chapter. Next, the effects of synergy were

included in the analysis. The results of these tests are presented

in the next chapter.

The organization of this chapter follows that of the present-

ation of the linear models in chapter three. These models test the

first central hypothesis against the two alternate hypotheses under

the assumption that managers act to maximize shareholders' wealth.

No attempts are made to control for the effects of synergy. The

final section of this chapter summarizes the results of the various

models.

The results presented in this chapter are based upon the use of

accounting data as a proxy for firm leverage in the dependent vari-

able. Financial theory suggests that the model should be formulated

with the dependent variable in market value terms. As the true

market value of the firm is unobservable, some proxy must be used.

However, these proxies tend to be subject to substantial estimation

errors. For completeness, the tests reported in this chapter were

repeated with Eger's (1983) proxy for market value. The results of

these tests and a discussion of the problems with using this proxy

are contained in Appendix A.



Model One

The first test equation estimated uses the most observable

measure of variance, the variance of the firms equity returns. This

measure of variance was shown to be the upper bound of the variance

of the return on value for the total firm.










The test equation is as follows:


AD. = Y + yAV1I + Y AV2 v + Y3 M. + Y AI. + YYAE + Y C. + .
1 0 1 1 2 + 3 4 A 5 I 6A 1


Where y0, Y1, Y2, Y3, y4, Y5, Y6 are the regression parameters.


AD. = the change in leverage associated with merger i with

leverage measured as the book value of total debt

divided by the book value of total assets.

U
AV1. = the change in variance associated with the acquiring

firm using the upper bound measure of variance.

U
AV2. = the change in variance associated with the acquired

firm using the upper bound measure of variance.

AM. = the change in the weighted average maturity of debt in
1

merger i.

AI. = the change in average long term interest rates from

the base period to the adjustment period.

AE. = the change in the average level of the stock market
1

from the base period to the adjustment period.

C. = the ratio of cash used in the merger to the

post-merger total assets of the firm.

If the first central hypothesis is valid, one should observe

negative and significant values for the coefficients of AV1. and AM..
1

Shastri's analysis suggests that the coefficient of AV2. should be

negative. Significant negative values for the coefficients of AI. or

AE. would be supportive of the first alternate hypothesis and if the
1

second alternative hypothesis is valid, one should observe a positive

and significant value of the coefficient of C .
1










The results of the regression appear in Table 5-1 along with the

relevant test statistics. The model appears to have reasonable

explanatory power as reflected in the R-square value. It must be

remembered that the model being estimated is cross-sectional.

Pindyck and Rubinfeld (1981, p. 64) note that cross-sectional models

tend to have low R-square values even when the models are satis-

factory because of the large variation inherent in the data.

It should also be noted that, while the intercept is significant

it provides very little information. There are two reasons for this

conclusion. First, the intercept is a measure of the mean of the

dependent variable when all independent variables are simultaneously

equal to zero. However, both the interest rate and equity level

variables cannot equal zero under economically rational conditions.

Thus the intercept provides no information. Second, while the

intercept is significantly different from zero, it is not signifi-

cantly different from one, the level of the dependent variable if

leverage remains constant. Therefore, the intercept does not suggest

the direction of leverage changes without a change in the independent

variables.

The results of this model support the central hypothesis that

managers act as if they are aware of the wealth shift potential of

mergers and take neutralizing actions commensurate with the shifts.

Option pricing theory suggests that as the diversification effect

increases, managers should increase the leverage of the firm to

neutralize the increasing size of the wealth shift. This suggests

that the coefficient of AV1 should be negative and significant as was

found in the model. Thus it appears that, for the firms studied, the










Table 5-1
Results of Model One


Coefficient T
Value Statistic Significance


Intercept 1.386 5.03 .000

Coefficient of: AV1U .388 -2.18 .034

6V2U .154 -1.89 .064

AM .065 2.22 .031

AI .088 1.19 .241

AE .115 .66 .513

C 1.012 3.00 .004


F value = 7.6060

Significance = .0001

R-square = .4400



The T-statistic is calculated under the null hypothesis that the
coefficient equals zero.
**
The significance level is defined as the probability of obtaining
a larger absolute value of the coefficient when the coefficient is
actually equal to zero.









greater the wealth shift potential of a merger, the greater the

increase in leverage undertaken by managers. This is consistent with

managements' maximization of shareholders wealth.

A number of other interesting items result from the estimation

of this model. First, note that the coefficient of AV2 is negative

and significant. This suggests that managers are influenced not only

by the diversification effects of the merger to their own share-

holders but also the effects to the shareholders of the acquired

firm. This result is supportive of Shastri's (1983) work which

asserts that the magnitude of the total wealth shift depends upon the

relative changes in variance experience by both groups of share-

holders in the merger. It appears that management tends to take

actions to offset all gains to debtholders, whether they result from

wealth shifts from the acquiring firms shareholders or the acquired

firms shareholders. This result is also consistent with a management

which attempts to maximize shareholders wealth.

A second item of interest is the sign of the coefficient of AM,

the maturity variable. The coefficient has a positive sign and is

significant at the three percent level. Option pricing theory

suggests that a merger which results in a decrease in the overall

maturity of debt harms the shareholders unless management increases

the leverage of the firm. Thus, the coefficient was expected to have

a negative sign because, as the maturity of debt increases, less debt

is required to neutralize any particular wealth shift. The observed

result may have occurred because of the tendency of managers to

increase their permanent leverage by issuing long term debt. How-

ever, the result obtained is completely consistent with wealth









maximizing goals of the managers. Option pricing theory suggests

that a manager, whose goal is to maximize shareholders wealth, will

issue debt of as long a maturity as possible, ceteris paribus. Thus

the positive sign of the AM coefficient is consistent both with the

option pricing framework and wealth maximization by managers.

A third item of interest is the apparent lack of influence of

market factors upon changes in leverage around the time of mergers.

Note that the coefficients of both the change in interest rates and

the change in stock market levels were found to be insignificant.

This suggests that changes in leverage which occur during mergers are

not influenced by recent changes in the relative costs of debt and

equity. These results suggest that the first alternative hypothesis

can be rejected. There are at least two possible explanations for

these results. First, managers may believe in the efficiency of

financial markets and thus not believe that they can time their

choices of financing to obtain lower overall costs of funds. If this

scenario is correct, one would expect the coefficients to not be

significant. Second, it may be that the role of interest rates and

market levels are too complex to result in significance in this

rather simple formulation. This study is only concerned with one

issue within the broad area of merger research. It has been observed

that mergers tend to occur in waves (Weston and Chung, 1983).

Researchers have not reached a conclusive answer to this phenomenon

but it is possible that market forces including interest and equity

rates may play a role in some complex way. Thus mergers may tend to

occur when certain conditions prevail in the debt or equity markets.









If so, examination of these mergers might not lead to a significant

relationship being found for the variable included in the model.

A final item of interest in this first model is the importance

of the terms of the merger in explaining the changes in leverage.

The coefficient of C is positive and significant. This supports the

second alternate hypothesis. However, remember that the central

hypothesis is also supported. That is, while that magnitude of the

potential wealth shift has a strong influence on managerial response,

the amount of cash used in the merger also influences the degree of

change in leverage. This result may be explained by reference to the

expansion and no expansion cases discussed in chapter one. Recall

that there are two ways for the firm to increase its leverage. The

proceeds from debt may be used to retire equity without any expansion

in the firm, or the firm may finance future expansion with debt until

a new desired degree of leverage is obtained. A merger which is

funded with cash provided by the proceeds of debt is essentially

analogous to the nonexpansion case. Thus a merger which is funded by

cash may allow the manager to move to a new degree of leverage much

more quickly than a pure exchange merger. It may be that the result

obtained in the test equation occurs because managers of the firms

involved in pure exchange mergers have not had sufficient time to

move their firms' leverage to the new desired level.

In summary, the results of the first model support the central

hypothesis, reject the first alternate hypothesis and support the

second alternate hypothesis. Managers appear to be taking actions

consistent with the maximization of shareholders wealth in that they

are cognizant of potential wealth shifts and act to prevent such










shifts from hurting shareholders. Also, the variables suggested by

option theory appear to have strong explanatory power for changes in

leverage.




Model Two

Model one was based upon the variance of the firms' equity

returns which was shown to be the upper bound for the total variance

of the firm. The second form of the model substitutes the lower

bounds for the variance estimates. This form of the model provides

an important test of the sensitivity of the model to alternate

estimates of the variance variable. If the results of this model are

consistent with those of the first, there is less need for concern

about the true variance estimate.

The test equation is as follows:

.D = 0 + YV1 + Y2AV2 + 3AMi + y4AI + 5AE C + Y E


which is identical to the formulation of model one except AV1. and
1

and AV2t are replaced with the following variables respectively.
1

AV1 = the change in variance associated with the acquiring firm

using the lower bound measure of variance.

L
AV2. = the change in variance associated with the acquired firm

using the lower bound measure of variance.

As this model differs from the preceding one only in the

estimate of variance employed, the expected signs remain unchanged.

L L
The coefficients of AVl., AV2, and AM should be negative. Again, the
1 1

first alternate hypothesis would be supported by negative and

significant values for AI. and AE. and the second alternate
hypothesis suggests the coefficient for C should be positive and
hypothesis suggests the coefficient for C. should be positive and
1










significant if the hypothesis is valid. The overall significance of

the model relative to the prior estimation is difficult to specify in

advance. It is possible that the lower bound estimate of variance,

which takes into consideration the firms' capital structure will be a

more accurate figure and improve the estimate. However, it is also

possible that the inclusion of the estimated capital structure of the

firm in the variance estimate will increase the error in estimation

and thus reduce the significance of the model. Table 5-2 contains

the results of the second model.

As can be readily observed, the structure of this formulation

varies only slightly from that of model one. All variables retain

the same signs and those variables without significant coefficients

in the first formulation are still insignificant. The only signifi-

cant change which results from this formulation is that the coeffi-

cient of AV2 is now insignificant. One cannot determine whether this

occurs because the change in variance experienced by the acquired

firms' shareholders is not a determinant of the change in leverage or

whether it appears insignificant simply because its true value is

small but non-zero. As earlier discussed, it is possible that

increased variation in the estimate results in this insignificance.

While the economic interpretation of the second model is identi-

cal to that of the first, the second formulation provides an impor-

tant test of the model's sensitivity to the estimates of variance.

As was discussed in chapter three, the most difficult variable to

estimate is the ex ante variance of the return on value of the firm.

Since the return on value of a firm is unobservable itself, the

estimation of its ex ante variance is extremely difficult to deter-

mine. However, using historical returns as a predictor of future










Table 5-2
Results of Model Two


Intercept

Coefficient of:















F value =

Significance =

R-square =


AV1L

AV2L

AM

AI

AE

C


7.5370

.0001

.4500


The T-statistic is calculated under the null hypothesis that the
coefficient equals zero.
**
The significance level is defined as the probability of obtaining
a larger absolute value of the coefficient when the coefficient is
actually equal to zero.


Coefficient
Value


T
Statistic


4.64

-2.46

-1.17

2.54

1.08

- .80

3.57


1.234

- .204

-.088

.073

.079

-.147

1.102


Significance


.000

.017

.249

.014

.286

.425

.001









returns, the upper and lower bounds of the variance can be estimated.

Unfortunately, should these two estimates provide results which are

inconsistent with each other, no conclusions can be reached. Fortu-

nately, the results of models one and two are completely consistent

with each other, which suggests that the general formulation of the

model is robust to the estimate of variance employed.

In summary, the results of the second model are consistent with

the central hypothesis and alternate hypothesis two. The results

suggest that the first alternate hypothesis can be rejected. The

results of the first and second models combined suggest that the

general formulation is robust to the estimate of variance of return

on firm value.



Summary of Results of Models Without Control for Synergistic Effects

The results of both formulations of the model have provided

strong evidence that managers do act as if they are aware of the

wealth shift potential in mergers and do take neutralizing actions to

offset those shifts. Both formulations of the model support re-

jection of the first-alternate hypothesis. The changes in capital

structure occurring during mergers do not appear to be related to

changes in conditions in the financial markets. Additionally, both

forms of the model provide evidence that the terms of the merger

impact the use of debt. This result may have occurred because of the

time periods involved and the managers differing ability to change

leverage quickly in expansion and nonexpansion cases.

Another important result is the apparent robustness of the model

to the estimate of variance. The use of upper and lower bound






91


estimates of variance in the equations resulted in nearly identical

structures of the resulting model. All inferences were consistent

between the models. This result is an important one in itself as it

suggests that the unobservable variance of the firm may be adequately

proxied using upper and lower bound estimators and available data.




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