Expected Market Reaction and the Choice of Method of Payment for Acquistions - Statistical Data Included

Financial Management (Financial Management Association), Winter, 1999 by Gary W. Emery, Jeannette A. Switzer

We hypothesize that a bidder's managers forecast the market's reaction to the announcement of an acquisition and choose the method of payment that they expect to provide the higher abnormal return. We find that most bidders chose the method of payment with the higher expected abnormal return although this result was stronger among the acquisitions for cash. In addition, the bidders that announced acquisitions for cash received actual abnormal returns that were higher than our estimate of what they expected if they announced an acquisition for stock. Our analysis reveals that the managers' choices were related to the effects of taxes and asymmetric information.

* Several studies have found an association between the bidder's returns and the payment method used for an acquisition. Some of the tests in these studies were conducted by classifying the announcement-period returns according to the method of payment. For example, Asquith, Bruner, and Mullins (1986) and Travlos (1987) found that the returns to bidders who used cash were positive but insignificant and that the returns to bidders who used stock were significantly negative.

Other tests used the payment method as an independent variable in cross-sectional regressions to explain bidder announcement-period returns. Travlos (1987) found that returns were negatively related to the proportion of equity in the offer. Peterson and Peterson (1991) conducted tests similar to Travlos but added independent variables that measured tax benefits and the relative size of the bidder and its target. The only significant explanatory variable in their regression was the dummy variable for stock, which had the negative coefficient they expected. [1]

The results of these studies raise some intriguing questions: Why do some managers choose stock as the method of payment for acquisitions when there is overwhelming evidence that they should expect a negative market reaction, and why do other managers choose cash with no effect? Are the managers who proceed with an acquisition for stock ignorant of the empirical evidence, or indifferent to it? Are the managers who use cash better informed and more attentive to the owners' interests? These are possible explanations for their choices but they are unappealing.

In this paper, we examine an alternative explanation for managers' choices. We assume that managers have the owners' interest in mind when they choose stock or cash to pay for an acquisition and are fully aware of how the market has reacted to similar choices in the past. However, we recognize that managers must form expectations about how the market will react to their choice considering the benefits and costs of an acquisition for stock or cash in their situation. Consequently, we predict that managers use their private information to anticipate the market's reactions to the announcement of an acquisition for stock and the announcement of an acquisition for cash and that they choose the method of payment that they expect to provide a higher abnormal return.

We tested this explanation of managers' choices by constructing models to estimate the abnormal returns the managers expected if they announced an acquisition for stock and an acquisition for cash. Then we compared the actual abnormal return they received with our estimates of the abnormal returns they expected. The results support our interpretation of the managers' choices: The majority chose the method of payment with the higher expected abnormal return as estimated by our expectation models. This result is stronger among the acquisitions for cash because these bidders never chose the method of payment with the lower expected abnormal return. Among the acquisitions for stock, the majority chose the method of payment with the higher expected abnormal return but a sizeable minority chose the method of payment with the lower expected abnormal return. Some bidders had negative expected abnormal returns using either method of payment.

The market partially validated the managers' choices because bidders that announced acquisitions for cash received actual abnormal returns that were higher than our estimate of what they expected if they announced acquisitions for stock. In contrast, bidders that announced acquisitions for stock received actual abnormal returns that were lower than our estimate of what they expected if they announced acquisitions for cash.

Our analysis of the coefficients of the variables in the expectations models indicates that these managers choices were related to the effects of taxes and asymmetric information.

These results contribute in several ways to our understanding of the payment method for acquisitions. First, we simultaneously considered the benefits and costs of acquisitions for stock and cash that have been proposed in earlier studies of the method of payment. Thus, we were able to test these explanations for the bidders' choices comprehensively. Second, we used variables that represent these benefits and costs in separate expectations models to test the hypothesis that bidders estimate the net effect of using both methods of payment before choosing one. This approach presumes the managers attempt to maximize the owners' wealth when they choose the method of payment. [2] Third, we used an econometric method to estimate the parameters of these expectations models that recognizes a bidder's choice is voluntary and intended to improve the owners' wealth. By using this method, we obtained the maximum amount of information from our sample.