In theorizing and rationalizing the relationship between takeovers and misvaluation, it is of primary importance to examine why such a relationship occurs. This relationship does not appear accidentally. It should be driven by the motives, of utilizing such misvaluation, shown by both parties involved in takeover transactions (i.e. bidders and targets). Accordingly, literature, on both why a bidder considers misvaluation in making takeover decisions and why a target would like ly accept such a misvaluation-driven-offer, is reviewed in this section.
In examining why bidders would likely engage in takeovers in the presence of misvaluation, three explanations have been provided: i) exploiting the benefits of
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overvaluation, ii) agency costs of overvalued equity, and iii) the opportunity of revaluation via information dissemination.
Firstly, the potential benefits of overvaluation can encourage a firm to engage in takeovers in the presence of misvaluation. The ‗Tobin‘s Q Theory‘ suggests that a high stock price is a reflection of a firm‘s strong growth opportunities (Tobin, 1969). In line with this, it is predicted that overvaluation should correspond to more corporate investments. More specifically, firms exploit the advantage of overvaluation by issuing equities (Baker et al., 2003). These inflated equities are then invested either under the ‗passive financing mechanism‘, which is purchasing fairly priced securities, or under the ‗active financing mechanism‘, which is proceeding with projects that would have negative NPV without overvaluation (Chirinko and Schaller, 2006)18. Accordingly, takeovers, being a corporate investment activity, should be exposed to these overvaluation effects.
As indicated by the ‗passive financing mechanism‘, stock overvaluation suggests a low cost of equity finance. The overpriced shares are used as cheap currency to buy less overvalued real securities and assets, for example target firms in the context of corporate takeovers, to preserve some of the inflated value.
Developed upon this, the Shleifer and Vishny (2003) model is introduced to explain why, in investing the proceeds from new equity issue in the presence of overvaluation, takeovers are preferred. They suggest that takeover synergies being
18 The rat ionale underlying the ‗active financing mechanis m‘ is that overvaluations lower the costs of
equity financing, and in turn WACC. Since WACC is generally used as the discount rate of future cash flow in assessing the NPV of an investment, the lowered discount rate increases the possibility that the NPV of the investment will be evaluated positively.
positively perceived by the market19, as well as the potential earning growth, which can justify high valuations, make takeovers a favorable choice for rational managements. Accordingly, this model proposes that the likelihood of merger and acquisition transactions is positively related with overvaluation. Moreover, this rational managerial decision to merge brings positive long-run incremental returns to acquirers‘ shareholders and thus serves their best interests.
Exploiting this line of research, Ang and Cheng (2006) further examine this takeover motivation, in relation to misvaluation, by testing the hypothesis that stock bidders‘ shareholders are at least as well off as the shareholders of similarly overvalued non-acquiring firms. They report that when the rationality condition20 is satisfied, acquiring firms outperform their counterparts on the same misvaluation scale, regardless of whether their stock abnormal returns are measured around announcement periods or over the long-run. In line with Shleifer and Vishny (2003), this empirical result suggests that exploiting the benefits of overvaluations is a possible incentive underlying bidders‘ takeover decisions. Takeovers driven by this motivation generate beneficial outcomes for acquiring firms.
Secondly, agency costs of overvalued equity can encourage a firm‘s engagement in takeovers in the presence of misvaluation. Although, under both the ‗passive financing mechanism‘ and the ‗active financing mechanism‘, firms issue new equities by timing the stock market and further finance their investments with the proceeds, the
19 .
The synergies estimation is under the influences of market valuation. Synergies tend to be overestimated when the market valuation is high (Rhodes-Kropf and Viswanathan, 2004). For e xtensive discussion on this issue, see section 2.1.2.
20. The rationality condition is when ―an opportunistic stock acquirer ga ins only if its overvaluation
exceeds the target‘s overvaluation and the merger premiu m. That is: Acquirer‘s overvaluation > target‘s premiu m−adjusted overvaluation‖ (Ang and Cheng, 2006, p.200).
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use of inflated equities is not the sole motive of corporate investments in the presence of misvaluation. For example, managers may overinvest to stimulate optimistic market expectations (Jensen, 2005). Specifically, managers have the ability to correct any overvaluation; yet this will consequently disappoint the market. Therefore, eliminating overvaluation is likely to cause a substantial loss for existing shareholders and other stakeholders. Due to this pressure, they are prone to meet the market expectation and further to manipulate a high growth and value-creating illusion. This is achieved by engaging in excessive investments, which may even have negative net present value. An expansion in takeover activity, and the high possibility of engaging in value destroying acquisitions, is a likely outcome of this overinvestment.
Accordingly, contrary to the value maximization view of mergers and acquisitions suggested by the Shleifer and Vishny (2003) model, Jensen (2005) argues that acquisitions, motivated by the agency costs of overvalued equity, tend to be detrimental to shareholders of bidding firms. Moeller et al. (2003) and Song (2007) support this argument by providing empirical evidence of overvalued bidders exhibiting poor long-term stock returns and operating performances. They rationalize this finding by appealing to the market realizing the created illusion. More specifically, since the created growth illusion by an overvalued bidder cannot constantly convince the market, not only will the overvaluation disappear but it will also prove detrimental to the value of the bidder‘s shareholders. This further leads to a violent drop in the firm‘s value.
Thirdly, revaluation via information dissemination can encourage a firm to engage in takeovers in the presence of misvaluation. Both the ‗passive financing mechanism‘ and agency costs of overvalued equity associate takeover motives with
overvaluation. Conversely, information dissemination hypothesis suggests undervaluation as a driving force of takeover activities. If information asymmetry impedes a firm from revealing its potential to the market, this firm is likely to have undervalued securities. Managers of this firm, once recognizing the undervaluation, have strong motives to release good news to the market and thus attract the attention of the investment community. Investors then reappraise the firm‘s value based on the arrival of new information. This revaluation process will eventually drive up the firm‘s share price. Applying this information dissemination hypothesis in a takeover context, Draper and Paudyal (2008) suggest that corporate takeover announcements, compared with additional information release, can guarantee a wide coverage and secure the occurrence of such a revaluation process. Accordingly, managers from a bidding firm, with undervalued equities, will take this opportunity of revaluation to announce takeovers and disseminate firm information to the market.
As already mentioned, both the low cost of equity finance and the agency costs of overvalued equities stimulate overvalued firms to take part in the takeover market. But why would a target likely accept the overvalued offer? Two explanations, based on correlated misinformation and different managerial horizons respectively, have been proposed.
The managerial decisions, on whether to accept an offer or not, are partly based on their estimated synergies from available information. Accordingly, the willingness of managers from a target firm to accept an overpriced offer may stem from their mis-estimated synergies of the combined unit. This synergy-estimating error, as suggested by Rhodes-Kropf and Viswanathan (2004), can be magnified by a high
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market valuation. Mangers from a target firm, although fully aware whether the bidder is overvalued, are not able to deconstruct the market-, sector- and firm-components of misvaluation. As information at a market level is more transparent and accessible, they naturally overestimate the market-component of misvaluation and hence the created synergies, especially when the market valuation is high. Therefore, these overrated synergies increase the possibility of accepting a bid.
Even if managers from a target firm can successfully weigh each component of misvaluation, there is still a chance that they will accept the inflated offers. This is because, managers, who are self- interested and concern themselves with short-term gains, may hope that the overpriced equity can be cashed out quickly (Shleifer and Vishny, 2003). In this case, shareholders from the target firm may not suffer a loss from holding these overvalued shares during the takeover announcement period, yet almost no gain can be seen in the long-run.
In addition to the relatively shorter managerial horizon, managers from target firms are likely to accept the overvalued offers if there are extra benefits for them to capture. Acquirers may pay them for agreeing to the deals in the forms of stock options, severance pay, reservations of top positions (e.g., Shleifer and Vishny, 2003), or personal wealth increase (e.g., Hartzell et al., 2004).
In summary, literature on misvaluation in the takeover market consistently suggests that acquiring firms are inclined to engage in takeovers in the presence of a high market valuation or an overvaluation, although such an inclination comes from different motivations. On the other hand, acquired firms are prone to accept the offers
announced by overvaluation motivated bidders, although their willingness to accept these offers stems from different considerations.
3.2.2 Relevance of Misvaluation to the Intensity and the Value Effects of