In recent years, the level of corporate acquisition activity has been increasing dramatically. Much work, as a result, has been done in terms of the exploration of Merger and Acquisition (M&A) activities from an individual country’s perspective or that of international comparisons. Issues such as the Foreign Direct Investment through M;A, the post-acquisition performance of both bidders and targets, and other aspects, have attracted the most attention for the study in this field over the past years.
Among the previous literature, there are several studies by far having attempted to investigate the determinants of payment methods in M;A deals. However, a review of the studies shows that only some specific hypotheses related to the methods of payment have been documented. Moreover, little has been done in this respect attempting to find out and analyze the financing trend in the UK market in the 1990s. The main objective of this paper is intended to fill the lacuna by exploring what determines the payment methods in M;A deals chosen by both participants—bidders and targets.
To investigate the determinants of payment methods in mergers and acquisitions, a number of hypotheses related to these determinants are addressed. Accordingly, statistics analyzed methods of factor analysis and discriminant analysis are employed in this study. The paper is set out as follows. The next section reviews recent theoretical developments and empirical research concerning payment methods in M;A deals with critical comments. Section 3 proposes testable hypotheses in this study.
Section 4 describes data selection, data sample, and presents descriptive statistics for the sample and sub-samples. Empirical results from applying factor analysis and discriminant analysis are presented in Section 5. Finally, Section 6 draws conclusions from the study and makes suggestions for further research. 2. Review of Previous Research Over the past two decades, many different theories explaining the payment alternatives in M;A transactions have been developed in the literature. Among these, the financing methods chosen in M;A deals have been identified as being of practical importance.
According to these theories of financing acquisitions, quite a number of propositions, which are viewed as payment method dependent, have been advanced and tested in the previous literature. Asymmetric Information Proposition A framework based on the existence of asymmetric information is developed and used to interpret financing alternatives in M;A by Myers and Majluf (1984). The Asymmetric Information Theory says that there exists asymmetric information between the management and market participants.
As a result, different payment methods in M;A deals may signal different types of valuable information to the investors. Myers and Majluf (1984) find that, in a world of asymmetric information, the bidding firms’ alternative payment methods in an acquisition announcement deliver different information about the bidders. For example, when share exchange is announced as the payment method, it signals that the bidder’s existing assets are overvalued; otherwise, if a cash offer is used as the medium of exchange, the assets are generally considered to be undervalued.
As a result, the market participants take the cash offer as the good news while the share exchange is viewed as bad news concerning the value of the bidding firm’s assets. Hansen (1987) employs the adverse selection and Nash Bargaining Equilibrium theories to explore the importance of the asymmetric information proposition in the M&A financing market. He re-exams the data set which was used by Carleton et al. (1984), and looks into 61 additional transactions obtained from the Federal Trade Commission’s merger series for 1978. His enlarged data set covers 106 transactions for manufacturing and mining firms for the period between 1976 and 1978.
The findings by Hansen show that the bidders would prefer a share exchange under the hypothesis of the target firm’s asset overvaluation, thus it can benefit the bidders through sharing the overvaluation with target firms. With respect to studies dealing with, in acquisition financing alternatives, asymmetric information, there are other researchers whose findings are consistent with the above. Travlos (1987) exams annual data from 1972 to 1981 by employing an event study analysis and finds that share exchange as the means of payment usually results in significant losses to the shareholders of bidding firms.
This result confirms his hypothesis that share exchange delivers negative information for the valuation of bidding firm’s assets. Fishman (1989) runs a model of pre-emptive bidding to exam the asymmetric information hypothesis. His findings indicate that cash offers in M;A deals convey positive information about the valuation of the bidder’s asset. In this regard, target management is more likely to reject a share exchange or potential competitors (if there exists more than one bidder in a contested bid) are more successfully deterred by cash offer as compared with share exchange.
However, Cornett and De (1991) discover a different result concerning the relation between bidder’s choice in acquisition finance and its returns in inter-state bank mergers compared with non-bank mergers. They exam 132 inter-state bank mergers in US stretching from 1982 through 1986 and find that the abnormal returns to the shareholders of bidding firms are positive and significant at the 1% level for cash, share and the combination of the two methods.
This result is contrary to those obtained by other researchers and seems inconsistent with the asymmetric information proposition. The possible explanation of these findings is, according to the authors, as follows: one is that there might be less severe effect with the assets of banking firms than those of non-banking firms with regard to overvaluation or under valuation and information asymmetry. That is to say, information asymmetry does not play an important role in banking undertakings as those of non-banking.
The other is that share-exchange financing may convey a positive signal that the bidding banks possess the soundness of asset management practice since, according to various regulatory rules, an inter-state bank merger requires approval by these regulatory bodies, the announcement of the merger by bidding bank, therefore, indicates that it has met kinds of relevant requirements. In this context, share exchange in bank mergers signals positive information about the bidders.
Using asymmetric information theory in explaining the payment methods in M;A deals implies that shareholders can be indifferent to the means of payment used in a complete market. However, the capital market does possess the feature of information asymmetry. The relevant internal information of both parties – the bidder and target is, therefore, released through the particular forms of payment methods used in the deal. Taxation Implication Proposition It is reasonable to link the methods of payment with the taxation status when a particular form of payment is employed.
It is well known that any capital gains must be realized immediately for tax purposes. Therefore, cash offer in M;As could, in theory, bring about higher premiums when compared with share exchange. In other words, due to the existence of different tax treatments, the acquirer must pay a higher acquisition price in the case of cash offer to offset the tax burden of the target shareholders. This proposition has long been addressed and confirmed by earlier studies. Wansley, Lane and Yang (1983) link their study with the relationship between the tax status and payment methods.
They utilize the market model to exam the influence of payment alternatives on target firms’ cumulative average abnormal returns (CAARs). For the 41 working days examined after the acquisition announcement, they find that the target CAARs are 33. 54%, 17. 47%, and 11. 77%, when financed by cash, share and the combination of the two, respectively. The possible explanation of this result, especially for the big difference between cash offer and share exchange is, consequently, contributed to the taxation implication theory.
They conclude that the fact of the substantially higher returns to target shareholders when financed by cash offer indicates that acquirers need to pay the additional tax burden for the targets under such a circumstance. In this respect, a share exchange financing will defer the tax consequences until the share is eventually sold. The same results that cash offer leads to higher CAARs for the target are obtained by Harris, Franks and Mayer (1987). They examine a large sample of 2,500 acquisitions in the UK and US spanning the period 1955 – 1985. Further evidence of their study is provided as follows: (a).
For both countries, all-cash offers and all-share exchange financing have been the most widely used payment methods in M&A deals. The reason for this phenomenon is that shareholders who care about the liability of paying the capital gains taxes will be willing to accept share exchange offer; but others who are not interested in combining their portfolio with the bidder’s paper will be glad to receive cash. Harris, Franks and Mayer call this as tax and transaction cost efficiency. As for the form of cash-share combination, it is more commonly used in the UK rather than in the US.
(b). There seems to be no clear evidence showing that the capital gains taxes are the main concern of the acquisition financing when cash is used in this circumstance. Due to the wide span of the study, which is stretching over a 30-year period, there had some changes in tax laws and accounting standards in both countries within this period. Take the UK as an example, since the law in terms of capital gains taxes was introduced in 1965, the study by Harris, Franks and Mayer shows that, from 1965 to 1969, cash financing in this period did decline (with a percentage of 18.6%) when compared with that of the previous period 1960 – 1964 (with a percentage of 29. 2%).
However, this trend was reversed from 1975 to 1979 with the proportion of cash financing rising to 33. 6%. As a result, empirical evidence does not show a strong linkage between the capital gains taxes and the use of cash as the medium of exchange. (c). Their empirical findings also show that cash offer generates a better post-acquisition performance for acquirers than all-share exchange offers, which are consistent with the prediction of the overvaluation proposition in an asymmetric market.
Huang and Walking (1987) find the same results as previous studies in terms of target firm’s post-acquisition performance. Through a study of 204 pairs of mergers in the period of 1977 – 1982, they find that the CAARs for cash offer, share exchange and the combination of cash and share are 29. 3%, 14. 4%, and 23. 3%, respectively. The significantly higher CAARs for cash financing is also attributed to the taxation implication theory as discussed earlier. Managerial Ownership Proposition The choice of financing alternatives in M&As must be related to the managerial ownership fraction of both parties – acquirer and target.
Generally speaking, managerial ownership refers to the percentage of equity held by management and insiders in the acquiring and target firms. It is often viewed that the greater the management’s share of acquiring or target firms, the more likely cash financing is adopted. One explanation of this strategy in M;A deals is that the managers of both parties offer (or accept) cash as the medium of exchange in order not to dilute their already existing control after the acquisition. Stulz (1988) examines the relationship between the choice of payment methods and the managerial ownership of acquiring firms.
His study shows that the larger the fraction of the ownership held by the acquiring firms, the less likely an acquisition is financed by using share exchange. Under such a circumstance, the management of the bidder is reluctant to offer share as the payment medium in order not to dilute their original control after the acquisition. Meanwhile, Stulz finds in his study that if the fraction of target managerial control of voting rights is high, the probability of a hostile takeover is low since the target with a higher fraction of ownership will want more rights before the deal is completed.
Amihud, Lev and Travlos (1990) use a sample of 209 US acquisitions during the years 1981 – 1983 to investigate whether there exists a relationship between insider ownership and financing methods. They find that in cash financing deals the top five officers and directors of the firm hold about 11% of the company’s shares, while for the share financing, there are less than 7% held by them. This result indicates that managers with relatively higher share holdings in their firms prefer financing acquisitions with use of cash to share.
In the explanation of this phenomenon, they point out that the reason for the use of cash rather than share financing by the acquiring firms is that they do not want to increase the risk of losing control after the acquisitions. Song and Walkling (1993) study a sample of 153 target firms and 153 non-target firms containing all acquisition-related announcements in the US from 1977 to 1986 to explore: (1) the relation between managerial ownership and the probability of becoming a target; and (2) the effect of managerial ownership on target shareholders’ returns.
Initially, Song and Walkling calculate separately the mean and median of the managerial ownership for the target firms, industry-matched non-targets, and randomly selected non-targets in the sample. They find that target managerial ownership is significantly lower than industry-matched non-targets, which implies that the firm with a lower managerial ownership is more likely to be an acquisition target.
Their study also shows that, in contested offers, the average level of managerial ownership is just 6.4%, which is significantly different from the corresponding average level of 18. 7% for industry non-targets. This result indicates that a target with a lower level of managerial ownership has a higher probability to be contested by bidders. With reference to the relationship between managerial ownership and the forms of acquisition (contested or uncontested), their findings show that in uncontested acquisitions, the average level of managerial ownership for successful cases is 15. 2%, which is significantly higher than the 8.6% level of unsuccessful cases.
They conclude that a target with high level of managerial ownership is more likely to be attempted by the uncontested acquisition. Furthermore, they employ a logistic regression analysis to examine the impact of target managerial ownership on the likelihood of an acquisition attempt. They find that the probability of being a target is inversely related to managerial ownership, which means that firms with a high level of managerial ownership are less likely to be attacked by the outsiders.
Finally, inspecting the relation between managerial ownership and target shareholders’ daily abnormal returns surrounding the first announcement date (from day -5 to +5), their results show that, in a successful acquisition where the target’s managerial ownership is low, the average abnormal returns are 29. 5%; while in an unsuccessful case where the target’s management holds a high level of shares, the average abnormal returns are only 5. 2%. To explain this phenomenon, Song and Walkling regress CAARs on managerial ownership and other variables.
The regression results indicate that there is a highly positive relationship between target managerial ownership and abnormal returns in contested and ultimately successful acquisitions. As for all uncontested offers and in contested but not ultimately successful acquisitions, this relationship seems insignificant. In summary, the findings by Song and Walkling suggest that the likelihood of being a target and the accomplishment of the deal is associated with the level of target managerial ownership.
A more recent study by Ghosh and Ruland (1998) has also confirmed the proposition concerning the positive relationship between the acquirer’s managerial ownership and cash financing. Ghosh and Ruland examine a sample of 212 successful US acquisitions for the period 1981 – 1988. They group the entire sample into three categories – offer by cash, share and the combination of cash and share. The data panel in their study clearly reveals that, with share exchange financing, the target firms’ average managerial ownership is significantly higher; while with cash financing, the acquirers’ managerial ownership is relatively high.
The initial findings by them suggest that acquirers would prefer cash financing for acquisitions rather than share financing when their managerial ownership is relatively high. As for targets, they are more preferable to be financed by share if the management of the target still has a desire to possess voting influence in the combined firm. Furthermore, Ghosh and Ruland apply multinomial logistic regression analysis to explore the impact of managerial ownership on the likelihood of share financing. They divide the acquirers’ percentage of managerial ownership into three segments in order to adjust their multinomial logistic model.
These segments are 0-3%, 4-25%, and above 25%, respectively. As for the target, they employ the same method to cut off and categorize the managerial ownership but limit the cut-off point at 3%. The results from multinomial logistic regression has confirmed their propositions, that is, the managers with large percentage ownership in target firms prefer receiving share payment in order to maintain their job in the combined firm; while managers with large percentage ownership in acquiring firms are more preferable to use cash as means of payment in order not to dilute their ownership in the combined firm.