Direct Evidence on the Market-Driven Acquisitions Theory James S. Ang* Bank of America Professor of Finance Florida State University Yingmei Cheng** Assistant Professor of Finance Florida State University First draft: March 2002 This draft: May 2003. .
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Direct Evidence on the Market-Driven Acquisitions Theory
James S. Ang*Bank of America Professor of Finance
Florida State University
Yingmei Cheng**Assistant Professor of Finance
Florida State University
First draft: March 2002This draft: May 2003.
.
*: Department of Finance, Florida State University, Tallahassee, Florida 32306. Email: [email protected]; Tel: 850-644-8208; and fax: 850-644-4225.**: Department of Finance, Florida State University, Tallahassee, Florida 32306. Email:[email protected]; Tel: 850-644-7869; and fax: 850-644-4225.
Direct Evidence on the Market-Driven Acquisitions Theory
1. Introduction
The AOL-Time Warner merger in January 2000, one of the largest in U.S history, is
notable for several reasons. From the viewpoint of creating corporate value out of synergy, it
is generally acknowledged as a failure; the combined firm loses value after the merger. And
yet, paradoxically, long-term shareholders of the original AOL are believed to be better off
with the merger. As of September 2002, shares of AOL-Time Warner are worth about twice
what AOL stock would have been without the merger1. However, former shareholders of
Time Warner experience the opposite fate, with their shares worth less than half of what the
original Time Warner stock would be2 (Sloan, 2002). Looking back, some may say that the
shareholders of Time Warner would have been better off without the merger, although they
would have fared even better if they had received cash for the merger, or cashed in their
AOL-TW shares as soon as possible. AOL shareholders are able to do better because they
used their overvalued shares to pay for the acquisition. This case is of academic interest,
since the apparent evidence that the acquirer gains at the expense of the target and the
merged firm loses value at the same time is contrary to the conventional belief in this area. Is
this an isolated case of an overvalued firm using its inflated stocks to pay for the acquisition?
Or is overvaluation a significant motive to induce firms to make acquisitions?
The purpose of this paper is to provide large sample empirical evidence on the role of
overvaluation in mergers. Shleifer and Vishny (2002) develop a model demonstrating
1 The result is obtained from comparison between AOL-Time Warner and a portfolio of internet companies with
market capitalization similar to the original AOL company. 2 The result is obtained from comparison between AOL-Time Warner and a portfolio of entertainment
conglomerates with sizes similar to the original Time Warner.
2
misvaluation as a motive for mergers. Rhodes-Kropf and Viswanathan (2002) propose
another theoretical model in which the target underestimates (overestimates) market-wide
overvaluation when the market is overvalued (undervalued). Several other papers have also
briefly mentioned misvaluation as a possible reason for acquisitions, e.g., DeBondt and
Thompson (1992), and Jenter (2002). Other related studies suggest a relationship between
mergers and stock market return, which may relate to but is not exactly equal to
misvaluation, e.g., Haque, et al. (1995), Clark, et al. (1991, 1996). Jovanovic and Rousseau
(2002) test a model in which merger and acquisition activities are related to Q, which, like
price momentum, may alternatively be interpreted as a proxy for overvaluation. In a similar
vein, Martin (1996) finds firms with higher Tobin’s Q are more likely to make acquisitions
with stock as the payment method. Thus far, there is no rigorous direct empirical evidence
linking the incidence of mergers with either acquirers or targets’ misvaluation, nor about the
relationships between misvaluation and the method of payment, or other terms of mergers.
We formalize and test several empirical questions that are inspired by the market-driven
mergers theories of Shleifer and Vishny (2002), and Rhodes-Kropf and Viswanathan (2002).
Utilizing a sample of over 3,000 mergers between 1981 and 2001, we find that (1) acquirers,
on average, are overvalued based on both absolute and relative measures; (2) acquirers are
much more overvalued than their targets; (3) successful acquirers are more overvalued than
the unsuccessful ones; and (4) the probability of a firm becoming an acquirer significantly
increases with its degree of overvaluation, after we control for other factors that may
potentially affect the firm’s acquiring decision. Since overvalued acquirers can only gain
from their misvaluation by paying for the acquisitions with their stocks, we postulate and
verify that stock-paying acquirers are substantially more overvalued than their cash-paying
3
counterparts. This is further supported by the logistic regression result that the probability of
stock being utilized as the payment method significantly increases with the acquirer’s
overvaluation. Long-term abnormal returns of the combined firms in stock mergers are
negative, confirming the findings of Rau and Vermaelen (1998), and Loughran and Vijh
(1997). However, we offer two new insights concerning the observed abnormal returns. We
show that for stock mergers, the combined firms are still overvalued immediately after the
merger completion. This finding is significant because it predicts that these merged firms
will eventually face price corrections from their elevated levels. That is, empirically,
negative long-term abnormal returns for the shares are to be expected. Second, the decision
to acquire via own stocks may still be consistent with the acquiring managers pursuing long-
term share value maximization. After we examine the abnormal returns of the original
shareholders of the acquirers and the targets separately, new results emerge: Long-term
shareholders of the original acquirers do not suffer significant wealth loss at the 5% level.
On the other hand, former shareholders of the target firms who retain the shares of the
merged firms fare poorly in comparison to those who sell right after the mergers. These
results give empirical support to a critical assumption made by Shleifer and Vishny (2002)
that shareholders and management of the targets must have a short holding period, while
those of the acquirers have a long holding period.
There have been studies on how valuation of corporate securities influences the
decision and timing of firms’ financial transactions. D’Mello and Shroff (2000) provide
evidence that undervalued firms repurchase their own shares. Baker and Wurgler (2000) also
suggest that new equity issues are in response to perceived share prices misvaluation.
Loughran and Ritter (2000) recognize that the incidence of firms’ cash flow transactions,
4
such as issuing or buying back equity with the capital markets, could be affected by
misvaluation. Jindra (2000) studies the relationship between seasoned equity offerings and
stock overvaluation. As to its impact on real decisions, Stein (1996) analyzes capital
budgeting decision when a firm’s share is mispriced. Baker, Stein and Wurgler (2002)
provide evidence that share prices could affect the investment decisions of equity dependent
firms. Our paper studies how stocks’ overvaluation affects one of the corporate real
transactions, i.e., acquisition of firms.
The paper is organized as follows. Section 2 discusses the testable hypotheses derived
from the market driven acquisition theories. Section 3 describes the methodology of
valuation estimation and abnormal return analysis. The sample selection and description are
presented in section 4, and section 5 analyzes the results. Section 6 concludes.
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paper. Ohio State University.
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acquiring firms. Journal of Financial Economics 49, 223-254.
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Unpublished working Paper. Columbia University and Duke University.
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Appendix: A tabulation of how sample size varies with various inclusion criteria.
Criteria to meet Number of observations Change of the sample size with each additional
criterion1.Mergers with U.S. targets announced
between 01/01/1981 and 12/31/200132,390
1. & 2. The mergers are either withdrawn or completed by 12/31/2001
27,330 -5,060
1,2 &3. The acquirers are recorded on COMPUSTAT with necessary data
before the announcement month
9,202 -18,128
1,2,3 &4. The acquirers are recorded on CRSP with necessary data with
necessary data
8,869 -333
1,2,3,4 &5. Acquirers are recorded on I/B/E/S with necessary data before the
announcement month.
3,862 -5,007
Table 1Number of mergers in the sample by announcement years, 1981-2001.
This table lists the number of announced mergers by the calendar year, from January 1,1981 to December 31, 2001. The acquirers must be listed on CRSP, COMPUSTAT, and I/B/E/S before the merger announcement month. “Successful mergers” refer to the announced mergers that are completed before December 31, 2001. “Withdrawn mergers” refer to the cases in which the target or the acquirer had terminated the proposed acquisition. Between 1981 and 1984, there are missing data in the method of payment. In calculating the percentage of stock mergers among successful mergers, the data from 1981 to 1984 are marked * to show caution on the missing data.
Table 2:Overvaluation of the acquirers and non-acquirers in the same industriesThis table reports the overvaluation of the acquirers in mergers announced between January 1, 1981 and December 31, 2001, and the overvaluation of the non-acquirers in the same industry. The firms must be listed on CRSP, COMPUSTAT, and on I/B/E/S. The overvaluation of the acquirers are calculated as (P-EV)/P, with P being the close price on the day before merger announcement, and EV being the expected value estimated by RIM using most recent earnings forecasts issued before merger announcement. The overvaluation of the non-acquirers are calculated as (P-EV)/P, with P being the close price at the end of June, and EV being the expected value estimated by RIM using most recent earnings forecasts. Kruskal-Wallis test is used to examine whether the acquirers and non-acquirers have the same magnitude of overvaluation.
Acquirers Non-acquirers in the same industries as the acquirers
Table 3Logistic Analysis of Factors affecting the decision to acquireThe table presents the results of a logistic analysis of the decision to acquire. The sample includes the acquirers and the non-acquirers, who are in the same industries as the acquirers, between 1981 and 2001. The firms must be listed on CRSP, COMPUSTAT, and I/B/E/S. If the firm announces a merger in a year, then the dependent variable is set to be 1; otherwise the dependent variable is 0. Industry dummy is a set of dummy variables based on Fama and French’s 48-industry classification; Calendar year is a set of dummy variables for each year from 1981 to 2001; Size is defined as the natural log of a firm’s total assets (COMPUSTAT data item 6 is used, in millions of dollars); Sales/assets is the ratio of net sales to total assets (data items 12 and 6 are used); Industry-adjusted sales/assets is the individual firm’s sales/asset ratio minus its industry median sales/asset ratio; Liquidity is defined as the ratio of the net liquid assets of a firm to its total assets (data items 1,2, and 6 are used); Industry-adjusted Liquidity is the individual firm’s liquidity minus its industry median liquidity; Leverage is defined as the ratio of the long-term debt of a firm to its equity (data items 9, 10 and 11 are used); Industry-adjusted leverage is the individual firm’s leverage minus its industry median leverage. The momentum is the buy-and-hold return in the last 12 months; firm’s overvaluation is calculated as (P-EV)/P, where P is the price of the firm at the beginning of each year and EV is the expected value measured by RIM using most recent earnings forecasts issued before the beginning of each year. All accounting variables are measured as of the fiscal year end prior to the beginning of each calendar year.
Pseudo R-squared 7.10%***, **, *: significant at 1%, 5% and 10% level respectively.
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Table 4Overvaluation of acquirers and targets in successful and withdrawn mergers
This table examines overvaluation of acquirers and targets in both successful and withdrawn mergers announced between January 1, 1981 and December 31, 2001. “Successful mergers” refer to the announced mergers that are completed before December 31, 2001. “Withdrawn mergers” refer to the cases in which the target or the acquirer had terminated the proposed acquisition. Kruskal-Wallis test checks whether the successful and withdrawn mergers are significantly different in terms of acquirer’s overvaluation, target’s overvaluation. Signed rank test examines whether the overvaluation gap between the acquirers and their targets is significantly different from zero. In Sample 1, the acquirers must be listed on CRSP, COMPUSTAT, and I/B/E/S before the merger announcement month. In Sample 2, both the acquirers and their targets must be listed on CRSP, COMPUSTAT, and on I/B/E/S before the merger announcement month. The overvaluation of the acquirers/targets are calculated as (P-EV)/P, with P being the close price on the day before merger announcement, and EV being the expected value estimated by RIM using most recent earnings forecasts issued before merger announcement.
Sample 1: Acquirers are recorded on CRSP,
COMPUSTAT and I/B/E/S
Sample 2: Both acquirers and their targets are recorded on CRSP, COMPUSTAT and I/B/E/S
Number of observations
Acquirers’ overvaluation:Median
Number of observations
Acquirers’ overvaluation:Median
Targets’ overvaluation:Median
Signed rank test:p-value
Successful mergers
3,454 26.75% 325 28.25% 21.00% 0.01
Withdrawn mergers
408 18.08% 82 14.14% 12.88% 0.36
Kruskal-Wallis Test: Chi-squared(p-value)
-- 30.53(<0.01%)
8.89(<1%)
4.12(0.04)
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Table 5Logistic Analysis of Factors affecting the success of mergers The table presents the results of a logistic analysis of the factors affecting whether an announced merger would lead to completion. The sample includes mergers announced between 1981 and 2001. If the merger is completed by December 31, 2001, the dependent variable is set to be 1; if the merger is withdrawn, i.e., the target or the acquirer had terminated the plans for the acquisition, the dependent variable is 0. Industry dummy is a set of dummy variables based on Fama and French’s 48-industry classification; Calendar year is a set of dummy variables for each year from 1981 to 2001; Acquirer’s size is defined as the acquirer’s total assets (COMPUSTAT data item 6 is used, in millions of dollars); Sales/assets is the ratio of net sales to total assets (data items 12 and 6 are used); Industry-adjusted sales/assets is the individual firm’s sales/asset ratio minus its industry median sales/asset ratio. Liquidity is defined as the ratio of the net liquid assets of a firm to its total assets (data items 1,2, and 6 are used); Industry-adjusted liquidity is the individual firm’s liquidity minus its industry median liquidity. Leverage is defined as the ratio of the long-term debt of a firm to its equity (data items 9, 10 and 11 are used); Industry-adjusted leverage is the individual firm’s leverage minus its industry median leverage. The 1-year pre-announcement return is the buy-and-hold return from month –12 to month –1 (the announcement month is month 0); acquirer’s overvaluation is calculated as (P-EV)/P, with P being the close price on the day before merger announcement, and EV being the expected value estimated by RIM using most recent earnings forecasts issued before merger announcement; Premium is the difference between the price per share paid by the acquirer and the target share price 4 weeks before the announcement date, divided by the target share price 4 weeks before the announcement date, as reported by the PREM4WK variable in the SDC database. For the successful mergers with missing “PREM4WK”, we use the target’s close price on the last trading to proxy for the price per share paid by the acquirer. For the withdrawn mergers with missing “PREM4WK”, we use the highest target price within 60 trading days of the merger announcement to proxy for the price per share offered by the acquirer. All accounting variables are measured as of the fiscal year-end prior to the merger announcement. Column 2 uses the sample including both public and private targets, column 3 is the sample including only 100% cash mergers with public targets, and the sample in column 4 consists of only 100% stock mergers with public targets.
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Successful merger=1, withdrawn merger=0All targets Public targets with 100%
Natural log of target’s market value/acquirer’s market value
-- -0.93***(-4.83)
-0.68***(-3.77)
The acquirer and target are in different industries
0.30**(2.30)
0.33(0.73)
0.17(0.64)
Target’s 1-year pre-announcement return (%)
-- -0.0046(-0.39)
0.0091(1.18)
Target’s market-to-book ratio -- -0.01(-0.84)
-0.03(-1.29)
Acquirer’s size (Natural log of millions of
dollars)
0.06*(1.66)
0.02(0.10)
0.27*(1.76)
Acquirer’s industry-adjusted sales/assets
0.05(0.42)
0.86*(1.80)
-0.02(-0.08)
Acquirer’s industry-adjusted liquidity
0.34(1.00)
1.41(0.80)
1.16(0.85)
Acquirer’s industry-adjusted leverage
0.02(0.88)
0.05(0.62)
-0.13(-1.30)
Acquirer’s 1-year pre-announcement return
(%)
0.0031**(2.40)
0.0015(0.50)
0.0026*(1.65)
Acquirer’s overvaluation(%)
0.0036***(3.46)
0.0022(1.44)
0.0039**(2.17)
The method of payment is 100% stock (100% cash is the
default level)
0.27(1.50)
-- --
The method of payment is mixed (100% cash is the
default level)
0.14(0.83)
-- --
Premium (%) -- 0.0033(1.07)
0.0014(0.56)
Intercept 18.96***(15.97)
-10.45***(-7.24)
17.12***(6.63)
LR Chi-squared statistic(p-value)
176.53(0.0000)
85.27(0.0000)
108.55(0.0000)
Pseudo R-squared 8.50% 21.91% 32.31%***, **, *: significant at 1%, 5% and 10% level respectively.
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Table 6Methods of payment and overvaluationThis table reports how the magnitude of acquirers and targets’ overvaluation differs across the methods of payment in the successful mergers announced and completed between 1981 and 2001. Sample 1 includes both public and private targets, and sample 2 only includes the subset with both acquirers and targets recorded on CRSP, COMPUSTAT and I/B/E/S. “Cash acquisitions” refers to the acquisitions with 100% of cash as the form of payment, and “stock acquisitions” refers to those with 100% of common stock as the form of payment. Kruskal-Wallis test examines whether cash acquisitions and stock acquisitions have the same magnitude in acquirers and targets’ overvaluation. The overvaluation is calculated as (P-EV)/P, with P being the close price on the day before merger announcement and EV being the expected value estimated by RIM using most recent earnings forecasts issued before merger announcement.
Sample 1: Acquirers are recorded on CRSP,
COMPUSTAT and I/B/E/S
Sample 2: Both acquirers and their targets are recorded on CRSP, COMPUSTAT and I/B/E/S
Table 7Logistic analysis of factors affecting the choice of payment
The table describes the logistic analysis of factors affecting the choice of payment, among the public acquirers that use cash or stock for the acquisitions. The sample includes only successful mergers with public targets, announced and completed between 1981 and 2001. If the acquirer uses stock, then the dependent variable is set to be 1, if the acquirer uses cash, then the dependent variable is 0. Industry is a set of dummy variables based on Fama-French’s 48-industry classification; Calendar year is a set of dummy variables for each year from 1981 to 2001; Debt/capital is (long-term debt + short-term debt) divided by (long-term debt + short-term debt + preferred stock + market value of the acquirer’s common stock) (data items 9, 44 and 10 are used); Industry-adjusted Debt/capital is the individual firm’s debt/capital ratio minus its industry median debt/capital ratio. Deal Value is the natural log of the amount paid by the acquirer; Cash available/deal value is the ratio of cash to the amount paid for target firms; 1-year pre-announcement return is the buy-and-hold return from month –12 to month –1 (the announcement month is month 0). The acquirer’s overvaluation is calculated as (P-EV)/P, with P being the close price on the day before merger announcement and EV being the expected value estimated by RIM using most recent earnings forecasts issued before merger announcement. All accounting variables are measured as of the fiscal year-end prior to the merger announcement.
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***, **, *: significant at 1%, 5% and 10% level respectively.
Natural log of target’s market value/acquirer’s market value
0.72(1.36)
Target’s 1-year pre-announcement return(%)
0.0037**(2.24)
Target’s market-to-book ratio 0.005(0.66)
Intercept 19.13***(4.07)
LR Chi-squared statistic(p-value)
133.29(0.0000)
Pseudo R-squared 20.91%
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Table 8Combined firms’ relative overvaluation and abnormal returnsThis table reports the combined firms’ relative overvaluation and abnormal returns up to three years after the merger completion date. The sample includes the mergers completed between 1981 and 1998. The acquirers and their match firms must be listed on both CRSP, COMPUSTAT and I/B/E/S. Any merger that is completed within three years of a previous merger by the same acquirer is excluded from the sample, in order to maintain the independence of observations. The overvaluation is calculated as (P-EV)/P, with P being the close price on the day of merger completion and EV being the expected value or fair value of the stock measured by Residual Income Model using analysts’ first earnings forecasts issued after the merger completion date. Relative overvaluation is the difference of overvaluation between the merged firm and its match. Abnormal return is the difference in buy-and-hold return between the merged firm and its match. The matched firm is obtained by the industry-size-book/market-momentum four-way matching. Panel B presents the Spearman correlation coefficients between the combined firms’ relative overvaluation and abnormal returns. p-value are in the parenthesis.
Panel A: Combined firms’ relative overvaluation and abnormal returnsAll
(n=1414)Cash mergers
(n=290)Stock mergers
(n=489)Relative overvaluation
After merger completion5.98%**(4.77%)
-2.29%(-1.68%)
9.98%***(7.30%)
1-year abnormal returns -3.76%**(-3.08%)
1.08%(0.76%)
-4.69%**(-3.36%)
2-year abnormal returns -5.69%***(-6.02%)
-0.45%(-1.33%)
-7.72%**(-8.19%)
3-year abnormal returns -9.70***(-7.95%)
-1.68%(-2.59%)
-11.02%***(-9.33%)
***, **: significant at 1% and 5% level respectively.
Panel B: the Spearman correlation coefficient between combined firms’ relative overvaluation and abnormal returns
All (n=1414)
Cash mergers(n=290)
Stock mergers(n=489)
Correlation coefficient between merged firms’ relative overvaluation and 1-year
post-merger abnormal returns
-0.21(<0.0001)
-0.25(0.0009)
-0.24(<0.0001)
Correlation coefficient between merged firms’ relative overvaluation and 2-year
post-merger abnormal returns
-0.30(<0.0001)
-0.26(0.0015)
-0.32(<0.0001)
Correlation coefficient between merged firms’ relative overvaluation and 3-year
post-merger abnormal returns
-0.27(<0.0001)
-0.32(<0.0001)
-0.26(0.0012)
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Table 9Long-term abnormal returns of the combined firms, the original acquirers and the original targets
This table reports the abnormal returns for the combined firms from the day after to the three-year anniversary of the merger completion date, the abnormal returns of the acquirers from one day before the merger announcement date to the three-year anniversary of the merger completion date, the abnormal returns of the targets from one day before the merger announcement date to the three-year anniversary of the merger completion date. The sample includes the mergers completed between 1981 and 1998, with both the acquirers and targets being publicly traded companies with data on CRSP and COMPUSTAT. The acquirers have to be recorded on I/B/E/S. The match firms must be available on both CRSP and COMPUSTAT. For the combined firms, their matched firms are obtained by industry-size-book/market-momentum four-way matching on the day of the merger completion date. The abnormal return of the original acquirers is the difference between the return of the acquirers and the return of their matches. The matched firms are obtained by industry-size-book/market-momentum four-way matching on the day before the merger announcement. The abnormal return of the original targets is the difference between the return of the targets and the return of their matches. The matched firms are obtained by industry-size-book/market-momentum four-way matching one day before the merger announcement. The sample in Panel A includes the total sample of 541 mergers. The sample in Panel B is a subset of the sample in Panel A, including only mergers with 100% cash. The sample in Panel C is a subset of the sample in Panel A, including only mergers with 100% stock.
Panel A: the total sampleCombined firms Original acquirers Original targets
Number of observations 541 541 541
Abnormal returns between one day before the announcement date to the day of merger
completion
-- -0.56%(-1.14%)
30.35%***(23.26%)
Abnormal returns one year after the merger completion date
-1.21%(-1.63%)
-0.96%(-1.37%)
-3.14%(-1.99%)
Abnormal returns two years after the merger completion date
-4.17%**(-4.62%)
-2.44%(-3.08%)
-4.68%**(-4.97%)
Abnormal returns three years after the merger completion date
-6.32%**(-7.07%)
-3.09%(-4.11%)
-7.03%**(-7.22%)
Abnormal returns from one day before the announcement date until three years after the
merger completion date
-- -4.78%(-5.75%)
21.20%***(20.01%)
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Panel B: the cash mergers
Combined firms Original acquirers Original targetsNumber of observations 168 168 168
Abnormal returns between one day before the announcement date to the day of merger
completion
-- 0.41%(0.23%)
33.56%***(26.20%)
Abnormal returns one year after the merger completion date
0.65%(0.37%)
0.75%(0.96%)
1.17%(2.02%)
Abnormal returns two years after the merger completion date
-1.03%(-2.64%)
-1.62%(-1.35%)
-1.06%(-0.68%)
Abnormal returns three years after the merger completion date
-2.45%(-2.99%)
-2.03%(-2.64%)
1.22%(1.80%)
Abnormal returns from one day before the announcement date until three years after the
merger completion date
-- -1.80%(-2.57%)
35.49%***(29.02%)
Panel C: the stock mergers
Combined firms Original acquirers Original targetsNumber of observations 201 201 201
Abnormal returns between one day before the announcement date to the day of merger
completion
-- -1.09%(-1.42%)
26.62%***(21.14%)
Abnormal returns one year after the merger completion date
-2.15%(-2.79%)
-2.33%(-2.92%)
-4.76%**(-5.33%)
Abnormal returns two years after the merger completion date
-5.55%**(-6.56%)
-3.67%(-4.05%)
-8.26%**(-8.47%)
Abnormal returns three years after the merger completion date
-8.23%**(-9.85%)
-5.12%(-6.01%)
-10.66%**(-11.79%)
Abnormal returns from one day before the announcement date until three years after the
merger completion date
-- -6.06%(-7.37%)
13.45%***(10.10%)
***, **: significant at 1%, and 5% level respectively.