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The influence of equity overvaluation from 2005 to
2007 on the payment method of European mergers and
acquisitions
Abstract
This thesis examines the effect of the asset-price bubble from 2005 to 2007 on the payment method of European mergers and acquisitions (M&As). Little is known about the influence of equity overvaluation from 2005 to 2007 on the payment method of European M&As. The research consists of a sample of 4,111 M&A transactions from 2002 to 2007 in 15 European countries. Equity overvaluation appears to have had a significant effect on the payment method. The likelihood of a stock-financed deal was lower in the years of the overvaluation. This differed from expectations. In addition, this research has found that the debt ratio, acquirer size, deal size, tender offers, cross-border deals and cross-industry deals have had a significant effect on the payment method.
Nava Bossink 10552499
June 2016
BSc Economics and Business – Economics and Finance University of Amsterdam
Bachelor Thesis
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Statement of Originality
This document is written by Nava Bossink who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
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Table of contents
Title and Abstract 1
Statement of Originality 2 Table of contents 3 1 Introduction 4 1.1 Introduction 4 1.2 Problem discussion 5 1.3 Research question 5 1.4 Overview 6 2 Literature review 7
2.1 The optimal capital structure 7
2.2 The determinants of the payment method in M&As 8
2.3 The impact of equity overvaluation 10
2.4 Hypothesis 12
3 Methodology 13
3.1 Main variables 13
3.2 Control variables 13
3.3 Dropped variables 15
3.4 The regression model 15
4 Data and descriptive statistics 17
4.1 Sample selection 17
4.2 Distribution and descriptive statistics 17
5 Results 19 5.1 Empirical results 19 5.2 Explanation 20 5.3 Robustness test 22 6 Conclusion 23 6.1 Conclusions 23
6.2 Limitations and suggestions 24
References 26
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1. Introduction
1.1 Introduction
Mergers and acquisitions (M&As) have long been a worldwide phenomenon. Today, M&As are an important feature of the business market. The value of M&As deals reached US$3.23 trillion in 2014 (Statistica, 2016). The United States proved to be the largest merger and acquisition market worldwide in that year, with an amount of approximately US$1.41 trillion. Given the large value of M&A transactions, the payment method can have a significant impact on the financial leverage and ownership structure of the acquirer. Thereby, the payment decision is an important aspect of the deal and must be carefully considered.
This thesis examines the effect of equity overvaluation on the payment method of European M&As. The economy experienced an asset-price bubble from 2005 to 2007.
Orlowski (2008) defines an asset-price bubble as an uncontrollable and unwarranted upward movement in prices or an overvaluation of various asset classes attributable to the
continuous reallocation of international liquidity. The asset-price bubble is an important cause of the financial crisis of 2008, according to Orlowski. This bubble led to a major overvaluation of the equity of firms, resulting in high share prices that did not correspond with the true value of those firms. The effect of this asset-price bubble on M&As, especially on the payment method, is examined in this thesis.
The payment method decision depends on a number of factors. Acquirers can pay with only cash, only stock or a mix of both. This thesis provides an overview of the different determinants of the payment method of European M&As from 2002 to 2007. The periods 2002 to 2004 and 2005 to 2007 are compared to examine the effect of the asset-price bubble in 2005 to 2007. The results are based on a sample of 4,111 M&A transactions in this time period. The determinants of the payment method are measured by equity
overvaluation, the debt and cash ratio of the acquirer, the relative acquirer and deal sizes, the presence of a tender offer and whether cross-border and cross-industry deals are present. Based on the existing literature about payment methods in M&As, it is expected that equity overvaluation contributes to a higher likelihood of a stock-financed deal. This research uses a Probit regression. The influence of the cash ratio appears to have no
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significant influence on the payment method. The other variables do have a significant effect on the payment method for European M&As.
1.2 Problem discussion
Each payment method has its own influence on the acquirer’s financial data. If an M&A deal is paid with cash only, the cash reserves will logistically decrease. If the acquirer has borrowed extra money to finance the deal, the level of debt increases. Faccio and Masulis (2005) have argued that, in most cases, cash payments are financed with borrowed money. An increasing debt ratio increases the cost of that debt, which has several
consequences, to be discussed in the next section. A payment with stock affects the acquirer’s equity value, such as the dilution of equity (Asquith & Mullins, 1986). These effects have to be taken into consideration when deciding which payment method is appropriate.
The two main historical theories about the optimal capital structure have contradictory conclusions. Modigliani and Miller (1958) have stated that the way a new investment opportunity is financed does not have an effect on the value of the firm. Myers (1984) have introduced ‘the capital structure puzzle’ and formulated a pecking order theory. This theory states that the way a new investment opportunity is financed does have an effect on the value of the firm, due to information asymmetries. With M&A deals being an important part of the business market, they are interesting to investigate. The method of payment is thereby also an interesting topic, because of the effects on the firm value. The aim of this thesis is to determine whether the asset-price bubble of 2005 to 2007 had a significant effect on the payment method of M&As. Little is known about the influence of equity overvaluation from 2005 to 2007 on the payment method of European M&As, so this research contributes to future decision-making processes. A unique dataset and a unique measure for equity overvaluation have been chosen. This research is also more recent than most studies on the chosen payment method of M&As.
1.3 Research question
The research question is: Did equity overvaluation from 2005 to 2007 have a significant influence on the method of payment of European M&As?
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1.4 Overview
Chapter 2 contains a review of the relevant literature. The methodology used in this study is then described in Chapter 3, after which the data sources and the descriptive statistics are presented in Chapter 4. Chapter 5 provides the results and finally, Chapter 6 outlines the main conclusions.
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2. Literature review
This section provides an overview of the main theories in the existing literature about the payment method of M&As. The first paragraph discusses the theories about the optimal capital structure before the second paragraph outlines the determinants of the payment method and the third paragraph describes the influence of equity overvaluation. Finally, a hypothesis is formed.
2.1 The optimal capital structure
The existing literature about the optimal capital structure is broad. Modigliani and Miller (1958) offered what was perhaps the first theory about capital structure. They have stated that in a perfect capital market, the value of a firm is unaffected by the way an investment is financed. A perfect capital market refers to a world with rational economic agents, no taxes, no information asymmetries and no other transaction costs.
Kraus and Litzenberger (1973) have reformed this theory with some relaxations of the original, unrealistic assumptions. They included taxation of corporate profits and the existence of bankruptcy penalties as market imperfections. They argued that a tax advantage arises in the case of debt financing since interest expenses are tax deductible. However, default risk increases with a higher debt level, so investors will require a higher interest rate to compensate for this risk. When the level of debt increases, the marginal benefit of the tax advantage declines, and the marginal cost of financial distress increases (Kraus & Litzenberger, 1973). This goes on until the two forces are perfectly offset, and the firm’s value is again independent of the capital structure. This theory is called the tradeoff theory. So with M&A transactions, both theories imply that cash-financed deals and stock-financed deals do not impact the value of the firm. Therefore, according to these theories, equity overvaluation does not have an effect on the choice of payment method.
In 1984, Myers introduced the pecking order theory. The pecking order theory states that, because of asymmetric information, no perfect market exists. Managers know more about a company’s risks and values than investors. This affects choices of financing new investments with debt or equity, resulting in a pecking order. According to Myers, the most preferable choice for financing new investments is the issuance of debt. This signals that the current stock is undervalued and that the board is confident about the investment being profitable. An issuance of equity signals that the stock is overvalued and is also seen as a lack
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of confidence. This would lead to a decline in the share price. This theory states that the way of financing a new investment with debt or equity does affect the firms’ value, and is
thereby inconsistent with Modigliani and Miller (1958) and Kraus and Litzenberger (1973). Several studies have investigated the average market reaction to the announcement of equity issues. The works of Asquith and Mullins (1986), Masulis and Korwar (1986) and Travlos (1987) have all found that equity issues have a significant negative effect on stock prices. Market participants take cash-financed deals as good news while share-financed deals are seen as bad news. Myers and Majluf (1984) have shown that managers, in the case of asymmetric information, have an incentive to issue stock when they perceive it to be overvalued. These studies are all consistent with the pecking order theory.
The pecking order theory and the works of Asquith and Mullins (1986), Masulis and Korwar (1986), Travlos (1987), and Myers and Majluf (1984) imply that in the case of equity overvaluation more deals are paid with stock instead of cash in M&A transactions.
2.2 The determinants of the payment method in M&As
The method of payment depends not only on the stock valuation, but also on a number of different factors. Faccio and Masulis (2005) have investigated the influence of financial leverage, firm size, relative deal size and cross-industry and cross-country effects on the payment method. Looking at 3,667 M&A deals in 13 European countries, with an
announcement date between January 1997 and 2000, they found that acquirers who have high financial leverage prefer to pay with stock. They also found that the average deal size and target size for stock-financed deals was significantly larger than for cash-financed deals. High financial leverage indicates debt-financing constraints for firms because the level of default increases with the level of debt. Higher deal sizes or target values both imply higher financial leverage if the deal is paid with cash, so a stock payment is more likely to occur in that case. Rossi and Volpin (2004) have also found a positive relationship between the target size and a stock payment.
Hansen (1987) has found a greater likelihood of a stock-financed deal when the total acquirer assets were large relative to the total target assets. However, Faccio and Masulis (2005) found a positive relationship between the acquiring firm’s size and the preference for a cash-financed deal. They argue that this is because larger firms have a lower default
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probability and thus a lower cost of debt. Another reason is that a greater amount of total assets is consistent with a higher level of diversification.
Faccio and Masulis (2005) have found that if a bidder and a target are operating in the same industry, the likelihood of a stock-financed deal is increased. This is because sellers are less risk averse to accepting stock from the buyer when it is in the same industry. Garcia-Feijóo, Madura and Ngo(2012) have showed that there is considerable variation across industries regarding the impact of free cash flow, financial leverage, equity overvaluation and target value asymmetry on the method of payment. They have also found that the influence of firm characteristics changes according to industry conditions.
Cross-border deals are, according to Faccio and Masulis (2005), more likely to happen if the merger or acquisition is financed with cash than when it is financed with stock. They offer the investors’ home-county bias as a possible explanation. This means that investors overvalue investments in their own country and undervalue investments in others.
Moreover, investments in foreign countries can lead to higher trading costs, exchange rate risk, lower liquidity and limited access to information. Consistent with these findings, Rossi and Volpin (2004) have also found a negative relationship between cross-border deals and the likelihood of a stock-financed deal.
Martin (1996) has also examined the effects of different characteristics of the acquirer and the target on the payment method of M&As. He used a sample of 846
acquisitions in the period of 1978 to 1988. Martin found a lower likelihood of stock financing in tender offers. A tender offer is an offer to purchase some or all of the target’s shares. A reason for this is regulatory: tender offers are faster to implement than mergers. So when there is real or potential competition surrounding a target acquisition, the likelihood of a cash-financed deal is greater. Rossi and Volpin (2004) have also found a negative
relationship between tender offers and the likelihood of a stock payment. Heron and Lie (2002) have used a sample of 859 acquisitions between 1895 and 1997. Consistent with Martin (1996) and Rossi and Volpin (2004), they have also documented a significant positive relationship between a cash-financed deal and tender offers. Martin (1996) also found that the financial leverage and relative size of the deal were insignificant. This is not consistent with the findings of Faccio and Masulis (2005). Martin found a positive relationship between a higher cash availability and the likelihood of a cash-financed deal. Heron and Lie (2002)
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have also found evidence for a higher proportion of cash used when the acquirer’s cash balance is higher relative to the total transaction value.
Zhang (2003) has also studied the determinants of the payment method in M&A transactions. He used a sample of 103 acquisitions in the UK in the period from 1990 to 1999. Zhang found a positive relationship between the relative size of the target and a stock-financed deal. This is consistent with the findings of Faccio and Masulis (2005). According to Zhang, there is no clear evidence that the fraction of ownership held by the target and acquirer before the M&A transaction has an influence on the payment method.
Martynova and Renneboog (2009) have found evidence for a positive relationship between the likelihood of a stock-financed deal when investors were positive about the firm’s fundamental value. They also argued that firms with low financial leverage had a higher likelihood of making a payment with cash. This is consistent with the findings of Faccio and Masulis (2005). Another finding of Martynova and Renneboog was that debt financing was more likely when creditor rights were well protected by law and that equity financing increased when the shareholder rights were highly protected.
Based on the studies described above, the control variables for the payment method used in this research are: the cash ratio of the acquirer, the debt ratio of the acquirer, the size of the acquirer, the relative deal size, the presence of a tender offer, cross-industry deals and cross-border deals. This is further described in the next section.
2.3 The impact of equity overvaluation
The potential impact of and methods of measuring the overvaluation of equity are described in this paragraph.
Jensen (2004) has argued that the overvaluation of equity is comparable with heroin; it feels great at the beginning but, after a while, substantial pain arises. In the short run, managers experience several advantages of overvalued equity. If there is some equity-based compensation (options for example), equity overvaluation increases the wealth of managers. Depending on the size of the run up in the stock price (a common measure for
overvaluation), it may generate positive media attention for managers and board members. According to Jensen, overvaluation also provides managers with cheap equity currency to use in acquisitions of firms whose equity is not as highly overvalued.
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However, the main disadvantage is, according to Jensen, that managers will have trouble delivering the necessary performance to justify the high market valuation. If a manager is unable to perform, the damage is out of control. Reputations are ruined and prison sentences are even possible. Due to asymmetric information availability, managers are probably aware of this before investors. They perceive high pressure to be necessary to deliver the high expectations, and begin taking actions that appear to have a positive effect but can actually destroy the firm. Another disadvantage discussed by Jensen is that equity overvaluation leads to excessive issues of both equity and debt, due to the reduced cost of capital. When the overvaluation diminishes, many firms cannot handle the high level of debt they find themselves with. This will have a devastating effect on the firm’s value.
There are several studies about the effects of overvalued equity on the payment method of M&As and the overvaluation is measured by the run-up in bidder stock price in most. Martin (1996) has found a positive relationship between equity overvaluation and the likelihood of a stock-financed deal. This is consistent with the pecking order theory and with Myers and Maljuf. Faccio and Masulis (2005) have also used the run up in bidder stock price as a proxy for equity overvaluation and their findings were consistent with those of Martin. Hansen (1987) has found evidence for a higher likelihood of a stock-financed deal as the probability of overvaluation increases. This is also the case when there is information asymmetry about the true target value.
Sudarsanam and Mahate (2003) have investigated the effects of glamour acquirers on the payment method of M&As. They define glamour acquirers as acquirers that are highly valued as a result of their prior stock market performance. In their sample of 519 takeovers, Sudarsanam and Mahate found that glamour acquirers were more likely to pay with equity. The research of Rau and Vermaelen (1998) has also focused on glamour acquirers. Their findings for a sample of 336 glamour and 212 value acquirers were that 54% of the glamour acquirers used stock in their financing, where of the non-glamour acquirers only 38% used stock in their financing.
This research uses another measure for equity overvaluation. As described in the introduction, the economy from 2005 to 2007 experienced an asset-price bubble that led to the major overvaluation of equity. Therefore, if an M&A announcement was made in 2005, 2006 or 2007, equity overvaluation was probably present. When an M&A announcement was made in 2002, 2003 or 2004, there will probably not be equity overvaluation. Combining
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the theories described in this section, the equity overvaluation will probably lead to an increase in stock-financed deals.
2.4 Hypothesis
The main variables of interest in this thesis are the payment method and equity overvaluation. Faccio and Masulis (2005) and Martin (1996) have used the run-up in bidder stock price as a proxy for equity overvaluation. This research used the asset-price bubble from 2005 to 2007 as a proxy for equity overvaluation. Following the pecking order theory and the studies of Travlos (1987), Myers and Majluf (1984), Faccio and Masulis (2005) and Martin (1996), it is expected that, controlling for other effects, the likelihood of a stock-financed deal increases in the asset-price bubble. This leads to the following hypothesis:
H1: M&A deals that were announced from 2005 to 2007 have a greater likelihood of a
stock-financed deal than M&A deals that were announced in 2002 to 2004, due to the asset-price bubble from 2005 to 2007.
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3. Methodology
This section describes the variables and the regression model that is used. In the first paragraph, the main variables are explained. The second paragraph describes the control variables while the third paragraph is about the dropped variables. The last paragraph describes the regression model.
3.1 Main variables
In order to investigate the effect of equity overvaluation on the method of payment of European M&As, the dependent variable (Paymentmethod) is formed as a binary variable. This research focuses on the presence of a stock-financed deal instead of a cash-financed deal, and therefore the dependent variable equals 1 when the payment method includes equity (mixed or only deals), and 0 if the deal is solely paid in cash. Mixed and equity-only deals are merged in this case because when a mixed payment occurs, the acquirer does not always define the actual percentage of equity financed. The main independent variable is the year of the M&A announcement (After). This is also a binary variable and takes the value of 1 if the announcement date is after 2004 and 0 otherwise. For this sample, After equals 1 if the announcement date is between 1 January 2005 and 31 December 2007, and 0 if the announcement date is between 1 January 2002 and 31 December 2004. From the literature review it is expected that the likelihood of a stock-financed deal is higher when the announcement date is after 2004.
3.2 Control variables
There are some other variables that have an effect on the payment method in M&As, but are not the main focus of this thesis. These are the control variables. The control
variables used in this thesis are the cash ratio of the acquirer, the debt ratio of the acquirer, the size of the acquirer, the relative deal size, the presence of a tender offer, and cross-industry and cross-border deals.
The cash ratio of the acquirer is measured by dividing the amount of total cash and short-term investments by the total assets at the time of the announcement (Cashratio). This variable controls for the amount of cash available to the acquirer. Martin (1996) and Heron and Lie (2002) have found a positive relationship between the acquirer’s cash
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is less likely in the case of a stock-financed deal. The debt ratio of the acquirer is measured by dividing the total amount of debt by the total assets at the time of the announcement (Debtratio). This variable controls for the financial leverage. Faccio and Masulis (2005) and Martynova and Renneboog (2009) have found that firms with higher financial leverage were more likely to pay with stock. It is expected that a higher debt ratio will lead to a higher likelihood of payment made with stock. The size of the acquirer is measured by taking the natural logarithm of the total assets at the time of the announcement (Size). Faccio and Masulis (2005) have argued that larger firms were more likely to pay with cash because of their lower debt costs, whereas Hansen (1987) has found the opposite effect. This thesis follows the theory of Faccio and Masulis and therefore expects that acquirer size has a negative relationship with the likelihood of a stock payment.
The relative deal size is measured by dividing the total transaction value by the total market capitalization of the acquirer 1 day prior to the announcement plus the total
transaction value (Dealsize). Faccio and Masulis (2005) have found that a higher deal size increases the likelihood of a stock payment. Therefore, it is expected that the relative deal size will have a positive effect on the likelihood of a stock payment. The presence of a tender offer is a binary variable and takes the value 1 if the offer is a tender offer and 0 if otherwise (Tenderoffer). According to Martin (1996), Rossi and Volpin (2004) and Heron and Lie (2002), the presence of a tender offer decreases the likelihood of a stock-financed deal. This variable controls for this effect, which is caused by regulations. It is expected that the presence of a tender offer lowers the likelihood of a stock payment.
Cross-industry deals are measured by a binary variable taking the value 1 if the target operates in another industry than the acquirer and 0 if otherwise (Crossindustry). The
industries are categorized according to their North American Industry Classification System code (NAICS-code). See Appendix A for an overview of the NAICS-codes. The NAICS-codes are preferred over the Standard Industrial Classification codes because the NAICS-codes had a better match with the Capital IQ database. Faccio and Masulis (2005) have stated that if the target and acquirer are operating in the same industry, the likelihood of a stock-financed deal increases due to risk aversion. This variable controls for this effect. It is therefore
expected that cross-industry deals will have a negative effect on the likelihood of a stock-financed deal. Cross-border deals are measured by a binary variable taking the value 1 if the target operates in another country than the acquirer and 0 if otherwise (Crossborder). Faccio
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and Masulis (2005) and Rossi and Volpin (2004) have each found a negative relationship between cross-border deals and the likelihood of a stock payment, due to a home-country bias. This variable controls for that effect. It is therefore expected that cross-border deals will have a negative effect on the likelihood of a stock payment.
3.3 Dropped variables
Because of multicollinearity, variables should be dropped if they have a high
correlation with other variables, especially with the main variable. See Appendix B for a table of the correlation coefficients. Based on this table, no variable was removed because of high correlation with other independent variables.
The binary variable Atmosphere, taking value 1 if the atmosphere is friendly and 0 if the atmosphere is hostile, was dropped. This is because the final sample consisted of only three hostile takeovers. It is impossible to draw conclusions about such a small sample.
The variable Targetsize, defined by the natural logarithm of the total assets of the target at the time of the announcement, was also removed because there was insufficient data about this variable.
3.4 The regression model
In this regression model, the dependent variable is a binary variable. Therefore a normal ordinary least squares regression is not possible in this case. There are different approaches possible for the determination of a dependent binary variable. The approach also differs in the existing literature about the determinants of the payment method in M&As. Martin (1996) has used a Logit model, Faccio and Masulis (2005) have used an Ordered Probit Model and Heron and Lie (2002) have used a Tobit model. The Ordered Probit Model is appropriate when the dependent variable can take more values than two, and the Probit and Logit model are appropriate when the dependent variable can only take two values (Stock & Watson, 2015). The Tobit model is appropriate when the dependent variable is positive or negative. In this research, the dependent variable is binary so the Probit or Logit regression is preferred over the Ordered Probit Model and the Tobit model. The difference between the Probit and Logit model lies in the distribution of the error terms. The Probit regression uses the standard normal cumulative distribution function (c.d.f.), and
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the Logit regression uses the standard logistic c.d.f. (Stock and Watson, 2015). In this research, a Probit regression is used. The Probit regression looks like this in formula form:
Pr(Y = 1| X) = Φ(β0 + βiXi + εi)
Where Φ indicates the standard normal c.d.f. The coefficients are estimated by maximum likelihood. With all the variables described above, the following regression model is made: 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑚𝑒𝑡ℎ𝑜𝑑 = β0 + β1𝐴𝑓𝑡𝑒𝑟 + β2𝐶𝑎𝑠ℎ𝑟𝑎𝑡𝑖𝑜 + β3𝐷𝑒𝑏𝑡𝑟𝑎𝑡𝑖𝑜 + β4𝑆𝑖𝑧𝑒 + β5𝐷𝑒𝑎𝑙𝑠𝑖𝑧𝑒 + β6𝑇𝑒𝑛𝑑𝑒𝑟𝑜𝑓𝑓𝑒𝑟 + β7𝐶𝑟𝑜𝑠𝑠𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦 + β8𝐶𝑟𝑜𝑠𝑠𝑏𝑜𝑟𝑑𝑒𝑟 + ε
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4. Data and descriptive statistics
This section describes the data sample and descriptive statistics. The first paragraph explains how the sample is formed and the second paragraph provides the distribution and main characteristics of the data.
4.1 Sample selection
The initial sample consisted of 10,965 transactions and was downloaded from the Capital IQ database. The sample consisted of all M&As from the period 1 January 2002 until 31 December 2007. The acquirer and target firms are listed in one of the following European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden or the United Kingdom. Deals classified as leveraged buyouts, spinoffs, privatizations, repurchases, minority stake
purchases, recapitalizations, self-tenders, divestitures, bankruptcy sales, squeeze outs, and transactions with terms not disclosed were excluded from the sample. Furthermore, rejected deals, deals with no response, cancelled, dismissed, withdrawn or liquidated deals were also excluded from the sample. The last criterion was that the percentage sought must be greater than 50%, otherwise there would be no change of ownership.
After correcting for these criteria and removing transactions with missing data, the final sample consisted of 4,111 transactions.
4.2 Distribution and descriptive statistics
Appendix C gives an overview of the distribution of the M&A transactions over the geographic locations of the acquirer and the target. For both the acquirer and the target, the greatest number of the transactions took place in the United Kingdom. The lowest number of transactions took place in Luxembourg and Portugal.
The main point of interest in this thesis is equity overvaluation. Table 1 shows how the payment method is distributed over the years 2002-2004 and 2005-2007. The largest part of the sample consists of cash-financed deals announced from 2005 to 2007. The percentage of mixed and equity-only deals decreased in the period 2005 to 2007 from 35% to 30%. The percentage of deals paid with cash increased in the period 2005 until 2007 from 65% to 70%. These findings are inconsistent with the hypothesis.
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Table 1: Distribution of the sample
This table shows the distribution of the payment method over the two investigated periods.
Table 2 includes some descriptive statistics of the independent variables in this research.
Table 2: Descriptive statistics by payment method
This table shows the descriptive statistics per payment method. The value of the variable equals 1 for mixed and equity-only deals and 0 for cash-equity-only deals. After is another binary variable takes the value 1 if the announcement date falls between 2005 and 2007 and 0 if the announcement date falls between 2002 and 2004. Cashratio is calculated by dividing the cash reserves of the acquirer by the total assets. Debtratio is calculated by dividing the total debt of the acquirer by the total assets. Size is measured by the natural logarithm of the acquirer’s total assets, Dealsize is calculated by the total transaction value divided by the acquirer market capitalization plus the total transaction value. Tenderoffer is a binary variable equaling 1 if there is a tender offer and 0 otherwise. Crossindustry is also a binary variable and takes the value 1 if the target and acquirer are operating in a different industry and 0 otherwise, and Crossborder is a binary variable equaling 1 if the target and acquirer are operating in a different country and 0 otherwise. The pseudo R2 is 0.1450.
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5. Results
This section provides an overview of the main results of the regression. The first paragraph shows the results in a table and the next paragraph gives a further explanation. The last paragraph provides a robustness test.
5.1 Empirical results
Table 3 provides an overview of the results of the Probit regression. In a stepwise method, one variable was added in every regression to obtain a multinomial Probit model. The pseudo R2 is highest for the model with all variables included, so this is the model that was used for this research. The Probit regression assumes a standard normal c.d.f., so the variables were tested on significance by a Z-statistic. Table 3 shows the marginal values of the regression, because only marginal values can be used for interpretation in a Probit regression. Table 3 shows that the variable Cashratio is not significant. The variable After is only significant at the 5% and 10% level, and the variable Crossindustry is only significant at the 10% level. All the other variables are significant at any level.
Table 3: Empirical results
This table shows the results of a Probit regression on the payment method where the value of the variable equals 1 for mixed and equity-only deals and 0 for cash-only deals. Another binary variable After takes the value 1 if the announcement date falls between 2005 and 2007 and 0 if the announcement date falls between 2002 and 2004. Cashratio is calculated by dividing the cash reserves of the acquirer by the total assets. Debtratio is calculated by dividing the total debt of the acquirer by the total assets. Size is measured by the natural logarithm of the acquirer’s total assets, Dealsize is calculated by the total transaction value divided by the acquirer market capitalization plus the total transaction value. Tenderoffer is a binary variable equaling 1 if there is a tender offer and 0 otherwise. Crossindustry is also a binary variable and takes the value 1 if the target and acquirer are operating in a different industry and 0 otherwise, and Crossborder is a binary variable equaling 1 if the target and acquirer are operating in a different country and 0 otherwise.
20 *** P<.01, ** P<.05, * P<.10
5.2 Explanation
Based on the results in Table 3, it can be concluded that the variable Cashratio is not significant at any significance level equal to or below 10%. The variables Debtratio, Size, Dealsize, Tenderoffer and Crossborder are significant even at the 1% level. After is significant at the 5% and 10% level and Crossindustry is significant only at the 10% level.
The variable After appears to be significantly negative. This is not consistent with the hypothesis. A potential cause for the deviating results is a measurement error. It is likely that the equity overvaluation did not start exactly on January 1st, 2005 and end on December 31st, 2007. It is difficult to state when an asset-price bubble exactly began. It is also possible that acquirers were not aware of the asset-price bubble and did not realize that the equity was overvalued, especially when the bubble had just begun to form. Another potential reason for the negative sign is the excessive lending of the banking sector in the years prior to the financial crisis of 2008 (Crotty, 2009). This was one of the most important causes of the crisis. The acquirer firms may also have benefited from this excessive lending and decided to pay M&A deals with borrowed money. This could have led to a higher likelihood of a cash-financed deal in the period from 2005 to 2007. Another potential cause for the deviating results is that the equity of both the target and the acquirer were exposed to overvaluation in the asset-price bubble. Martin (1996) and Faccio and Masulis (2005) have
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focused on the situation where only the equity of the acquirer was exposed to overvaluation.
The coefficient of the Cashratio variable is negative. This is consistent with the findings of Martin (1996) and Heron and Lie (2002). However, the variable is not significant. A potential cause for this is a selection bias or a lack of observations. The coefficient of the Debtratio is significantly negative. This is not consistent with what was expected. A potential cause for this is the equity overvaluation. According to Jensen (2004), in a period of equity overvaluation, firms issue excessive amounts of both debt and equity. In the equity
overvaluation from 2005 to 2007, acquirer firms could have borrowed more easily because of their lower cost of debt due to that overvaluation, resulting in a bias for the variable Debtratio. This may have led to a higher likelihood of M&A deals financed with cash instead of stock. The excessive lending of banks is also an explanation for the negative sign in this case. Another explanation for the negative sign is an omitted variable that has a positive effect on the likelihood of a stock-financed deal and a negative correlation with the variable Debtratio (Stock & Watson, 2015).
The variable Size is significantly negative. This is consistent with the findings of Faccio and Masulis (2005), but not with the findings of Hansen (1987). The coefficient of the
variable Dealsize is significantly positive. This is also consistent with the findings of Faccio and Masulis (2005), but not with the findings of Martin (1996). He found that the relative deal size was insignificant. The coefficient of the variable Tenderoffer is significantly positive, where it was expected to be negative. A potential cause for this is an omitted variable that has a negative effect on the likelihood of a stock-financed deal and a positive correlation with the variable Tenderoffer (Stock & Watson, 2015). Moreover, the final sample consisted of only 97 tender offers. That is a percentage of 2% of the total sample, consisting of 4,111 transactions. This percentage may be too low to draw conclusions on and can cause biased results.
The variable Crossindustry is negative, but only significant at the 10% level. The negative sign is consistent with the findings of Faccio and Masulis (2005). A potential reason for the low significance is that risk-aversion is not very high across industries. The last variable, Crossborder, is significantly negative. This corresponds with the findings of Faccio and Masulis (2005) and Rossi and Volpin (2004).
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5.3 Robustness test
Mixed payments can consist of 99% cash and 1% equity, so when this is classified as an equity payment the results could be biased. To test the robustness of the previous regression, a regression with equity-only and cash-only deals is included. With this robustness test, only the complete model used in this thesis is included. See Table 4 for results. Only the marginal values are shown. Comparing the results of the robustness test with the original results, the variable Cashratio is now significant. The variables Debtratio and Crossindustry are not significant and de Pseudo R2 is lower than in the previous regression. A potential cause for these differences is less observations. Excluding mixed payments decreased the total observations by 713, which is equal to a decline of almost 18%. The robustness test does not show crucial changes towards the original regression, in this regression the results are also in contrast with the hypothesis.
Table 4: Empirical results
This table shows the results of a Probit regression on the payment where the value of the variable equals 1 for equity-only deals and 0 for cash-only deals. Another binary variable After takes the value 1 if the announcement date falls between 2005 and 2007 and 0 if the announcement date falls between 2002 and 2004. Cashratio is calculated by dividing the cash reserves of the acquirer by the total assets. Debtratio is calculated by dividing the total debt of the acquirer by the total assets. Size is measured by the natural logarithm of the acquirer’s total assets, Dealsize is calculated by the total transaction value divided by the acquirer market capitalization plus the total transaction value. Tenderoffer is a binary variable equaling 1 if there is a tender offer and 0 otherwise. Crossindustry is also a binary variable and takes the value 1 if the target and acquirer are operating in a different industry and 0 otherwise, and Crossborder is a binary variable equaling 1 if the target and acquirer are operating in a different country and 0 otherwise.
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6. Conclusion
6.1 Conclusion
This thesis investigates the influence of the equity overvaluation from 2005 to 2007 on the payment method of European M&As. The research question is: Did equity
overvaluation from 2005 to 2007 have a significant influence on the method of payment of European M&As? The sample consists of 4,111 M&A transactions announced from 2002 to 2007 and was downloaded from the Capital IQ Database. Most existing studies have used the run up in bidder stock price as a proxy for equity overvaluation, whereas this thesis uses the asset-price bubble from 2005 to 2007.
Derived from previous studies described in the literature review, it was expected that the asset-price bubble from 2005 to 2007 had a positive influence on the likelihood of stock-financed deals. This is because, in the case of equity overvaluation, investors prefer to pay with stock instead of cash. A Probit regression was carried out in this thesis because the dependent variable defined by Paymentmethod was binary. This study focuses on the presence of a stock-financed deal instead of a cash-financed deal so that the value of the dependent variable equals 1 for mixed and equity-only deals and 0 for cash-only deals. The main variable of interest is the variable After, which is also a binary variable that takes the value 1 if the announcement date falls between 2005 and 2007 and 0 if the announcement date falls between 2002 and 2004. The control variables are the acquirer cash and debt ratio, acquirer size, relative deal size, tender offers, cross-border and cross-industry deals.
The control variable Cashratio did not have a significant influence on the payment method. The variable Crossindustry is only significant at the 10% level and the main variable After is significant at the 5% and 10% level. All other variables are significant even at the 1% level. The significant negative sign of the variable After is remarkable. The hypothesis expected this sign to be positive. Potential reasons for this deviation are a measurement error on the equity overvaluation and the excessive lending of the banking sector in the years prior to the financial crisis of 2008 (Crotty, 2009). Another potential cause for the deviating results is that in this study it is assumed that the equity of both the target and the acquirer were overvalued, where other studies have investigated the situation where only the equity of the acquirer was overvalued. The Debtratio variable also has a different sign than expected. The excessive lending of banks is also a possible explanation for this negative
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sign. Moreover, in a period of equity overvaluation, firms can borrow more easily because of their lower cost of debt (Jensen, 2004). Due to omitted variables and measurement errors, the variable Tenderoffer also has a different sign than expected. The regression model used in this research explains 14.5% of the variability in M&A payment decisions.
In conclusion, the equity overvaluation from 2005 to 2007 had a significant impact on the payment method of European M&As. Therefore the answer on the research question is positive. However, the observable impact was the opposite of what was expected in the hypothesis; the asset-price bubble led to a higher likelihood of cash-financed deals instead of stock-financed deals.
6.2 Limitations and suggestions
One of the limitations of this research is omitted variables. There are several other factors that determine the payment method of M&As which are not included in this research, resulting in an omitted variable bias. As a consequence, the error term is correlated with some independent variables. An omitted variable causes the model to compensate for the missing variable by over- or underestimating the effect of this variable (Stock & Watson, 2015). If more variables are included, the regression will be more reliable. As a result, the coefficients will probably all show the expected sign in the regression. The pseudo R-square is now 14.5% and with the inclusion of other relevant variables it will increase. A higher pseudo R-square leads to a greater explanation for the variability in the payment method of M&A deals. An important criterion for additional variables is that they are relevant. If the variables are not relevant, their inclusion will also lead to a bias.
According to Stock and Watson (2015), a variable is relevant if it is correlated with both the dependent variable and one or more included independent variables.
Another limitation is that this research only focuses on the asset-price bubble of 2005 to 2007. In the past, several other asset-price bubbles have occurred. To increase the
reliability of this research, it would have been better to investigate several other asset-price bubbles to see if there is the same effect on the payment method as found in this specific price bubble.
Moreover, the chosen dependent variable is also a limitation. The Probit model is appropriate when the dependent variable can only take two values. Equity payments and mixed payments were mixed in this research because the percentage paid with equity or
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cash was not always defined by the acquirer. The combination of equity and mixed
payments may have caused biased results. Faccio and Masulis (2005) used an Ordered Probit model with a dependent variable that can take three values. A comparison of these two regressions to see the differences would have reduced this bias.
A limitation of the Probit regression is that it requires normal distributions for all variables (Stock & Watson, 2015). It cannot be stated with certainty that all the variables have a standard normal cumulative distribution function, so the results could be biased.
The asset-price bubble in 2005 to 2007 led to a higher likelihood of cash-financed deals instead of stock-financed deals. This prompts a suggestion for further research into the effects of equity overvaluation on the payment method chosen during M&As. Several other asset-price bubbles can be investigated to see if there is the same effect on the payment method as found in this specific price bubble. It is also possible to investigate other geographic locations, such as the United States. A potential hypothesis is: Do asset-price bubbles have a significant influence on the method of payment of American M&As?
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Appendix B: Table of correlations
After takes the value 1 if the announcement date falls between 2005 and 2007 and 0 if the announcement date falls between 2002 and 2004. Cashratio is calculated by dividing the cash reserves of the acquirer by the total assets. Debtratio is calculated by dividing the total debt of the acquirer by the total assets. Size is measured by the natural logarithm of the acquirer’s total assets, Dealsize is calculated by the total transaction value divided by the acquirer market capitalization plus the total transaction value. Tenderoffer is a binary variable equaling 1 if there is a tender offer and 0 otherwise.
Crossindustry is also a binary variable and takes the value 1 if the target and acquirer are operating in a different industry and 0 otherwise, and Crossborder is a binary variable equaling 1 if the target and acquirer are operating in a different country and 0 otherwise. The number of observations is 4111.
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