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

The remainder of this paper describes our predictions and results in more detail. Section I describes our empirical predictions, that managers make good choices given their expectations about the market's reaction. Section II describes our expectations models. We explain how we used prior theoretical models and empirical results to choose the variables in these models, and how we estimated the coefficients of these variables using a censored sample. Section III provides our results while Section IV is the summary.

I. Empirical Predictions

In this section, we describe our predictions about bidders' expected abnormal returns and their choice of payment method. We also describe the potential benefits and costs of acquisitions for stock and cash that form the basis for these expectations.

A. Predictions about Expected Abnormal Returns and the Method of Payment

We hypothesize that a bidder's managers choose the payment method for an acquisition that provides the higher expected abnormal return given their private information about the benefits and costs of an acquisition for stock and cash.

We are primarily interested in the expected abnormal returns. We predict that bidders that actually used cash as the method of payment expected an abnormal return from an acquisition for cash that was greater than or equal to zero and greater than the abnormal return they expected from an acquisition for stock. Conversely, we predict that bidders that actually used stock as the method of payment expected an abnormal return from an acquisition for stock that was greater than or equal to zero and greater than the abnormal return they expected from an acquisition for cash. Evidence that supports these predictions is consistent with the view that managers choose the method of payment by forecasting how the market will react to their choice.

We also are interested in the market's reaction to the managers' choices. We predict that bidders obtained actual abnormal returns not significantly different from what they expected when they made their choice. At the same time, we predict that their actual abnormal returns were greater than they expected had they made the opposite choice. In other words, we expect that the actual market reactions validated the managers choices. Evidence that supports these predictions is consistent with the view that managers made good choices, given their information.

All of our predictions are concerned with the method of payment. We take the acquisition decision itself as given and do not consider "no acquisition" as one of the bidder's alternatives.

Table 1 summarizes our predictions about the method of payment, the expected abnormal returns, and the difference between actual and expected abnormal returns. Table 4 presents our results in the same format for ease of comparison.

We constructed models of the expected abnormal returns from announcing an acquisition for stock or cash using variables that represent the benefits and costs of these methods of payment. Variables that appear as benefits in the acquisition-for-stock model appear as costs in the acquisition-for-cash model and vice versa. We relied on prior theoretical models and empirical results to identify these benefits and costs and to choose these variables. The variables we chose represent the effects of taxes, asymmetric information, and competition.