Investor Misvaluation Effect Merger and Acquisition Activity - Literature review Example

?Market/Investor Misvaluation Effect Merger and Acquisition Activity Literature Review: Introduction: When a company under take another company and it clearly established under the new owner is called as acquisition of company. When two companies same size and doing same business agreed to go forward as a new single company it is called as merger of companies. Merger and acquisition are done by the companies with the purpose expand the market share; acquire new technologies, sales and distribution opportunities etc. In acquisition and merger some companies make payments in cash or stocks or the combination of the two. When firms decided to merge or acquire it faces many issues among them one of the important problem is its valuation or the payments. Sometimes the companies may make misevaluation in its stock misevaluation of stock means artificially increase the value of share. Overvalued firm use their overvalued shares to purchase comparatively undervalued firm. If managers are confident regarding the performance of the firm after the merger market valuation is less matter. “If bidder managers are overconfident, market valuation should matter less, because overconfident managers would not perceive their firms as overvalued by the market. In this case, target preferences would probably be of primary importance” (Giuli 2007, p. 8). According to Todd A. Brown in his article called, “Managerial Optimism and Market Misvaluation: the Effects on Mergers and Acquisitions” says that, Mergers and acquisitions between the companies can be viewed as a one of the most efficient device for correcting the inefficiency of the market. One of the major assumptions behind this is that markets are basically inefficient or ineffective, so some of the organizations are valued wrongly. In this particular circumstance, managers of the organizations are unbiased and they take benefit of that ineffectiveness of the market. Therefore market valuations can drive M&A. (Managerial Optimism and Market Misvaluation: The Effects on Mergers and Acquisitions by Todd A. Brown). According to Berkovitch, E. and Narayanan in his article called, “Motives for takeovers: An empirical investigation,” published in the Journal of Financial and Quantitative Analysis says that, three main reason for merger between the organizations that are, managerial hubris, agency problem and synergies. (Motives for takeovers: An empirical investigation by Berkovitch) “Overvalued firms are more likely to conduct stock mergers, have high pre-merger but negative post-merger excess long-run returns and receive negative market reaction to their acquisition announcements” (Akbulut 2004, p. 1). According to Shleifer and Vishny in his article called, “Equilibrium short horizons of investors and firms”, talks about the model on the basis of relative mispricing in which they think that majority of the acquirers are overvalued compared with their targets. “By acquiring tangible assets from the target with their overvalued stock, acquirers reduce the severity of their overvaluation and the amount of the eventual move toward their fundamental value. Since the model assumes that management is unbiased and aware of the stock’s current fundamental value” (Brown & Zorn n.d., p. 7). He also says that, market timing method model proposes that overvalued companies always wish to offer their own stock in acquisitions. The model also forecasts that cash or money acquirers always receive positive long-term income at the same time as stock acquirers receive only the negative long-term income. (Equilibrium short horizons of investors and firms by Shleifer and Vishny). According to Dong, Hirshleifer, Richardson, and Teoh in their article called, “Does investor misvaluation drive the takeover market?” discover that all the overvalued acquires are pay a high premium for targets and provide share payment and experience negative announcement or statement day income.( Does investor misvaluation drive the takeover market by Dong, Hirshleifer, Richardson, and Teoh). According to Christa in his article called “Stock Market Valuation and Mergers” says that, “based on short-sun stock performance, target firm shareholders are the “big winners” in M&A, earning significant, positive abnormal returns. Acquiring firm’s shareholders are the “losers”, earning zero or negative abnormal returns” (Bouwman et al. 2003). Organization and market valuation obviously affect the strength of merger action intensity and the following performance of the mergers. While some of the other studies argue that Organization and misevaluation of market drives the outcomes, more study must be done to cautiously establish the causation and to establish if other types of misvalution measures. (Stock Market Valuation and Mergers by Christa) Over valued stock would create negative effective in long run the company with high past growth are expected to continue the same in the future also but the overvalued stock would make pressure on the managers as they cannot achieve this expectation and also creates problems in the share holders therefore the overvalued acquirer suffer significant post decline their stock value. “Firms may rationally merge to pre-empt their partner merging with a rival. Even if a merger reduces profits compared to the initial situation, it may increase profits compared to the relevant alternative—in this case, another merger” (Fridolfsson & Stennek 2005). Merger and acquisition are done by the companies for expanding their business for getting new technologies, new market and for new strategies etc. this paper asses how misvaluation of stock effect merger and acquisitions. “Mergers involving securities are inherently different from cash takeovers as they involve valuation problems” (Kropf 2002, p. 1). When one company acquires another company the acquirer may offer either cash or the stock. If companies’ offering the cash it is constant instead the company offers the stock company may over value their stock in the market artificially. The over value can make only a short term gain to the company it will quickly identified by the investor as the company cannot generate the expected profit. “The probability of stocks being as the payment method significantly increases with the acquirer’s over valuation. Long term abnormal returns of the combined firms in the stock mergers are negative” (Burner, 2004, p. 78). Sometimes the acquiring manager would be optimistic regarding the company so he would he would offer larger premium to share holders more over their company’s stock is overvalued they may also be likely to over pay in merger. Optimism of manager in acquiring company that he can lead the company well and can operate the company higher level such managers would be ready to over pay for taking the company it is done on the basis of his expectation that he can lead the company in to the successes likewise Optimistic acquiring manager usually prefer cash for the payment in merger. “Confidence, hope and optimism are necessary to some degree and useful for M&A success but when managers strive for the impossible or the unlikely they are simply being overconfident” (Steger & Kummer 2007, p. 10). Generally if stock price is in peak stage there would be more mergers in the industry it is based on the assumption that the company is in good position and earning good profit. Under this circumstance the companies can expand their market share and can increase their business as industry is in an optimistic stage. If merging is done by the companies belonging to different industries this merging would be little riskier as these companies are engaged in different business. The merger announcement of companies would significant reaction in company’s stock price this is due to the uncertainty regarding the about new formed company. “Market participants receive no signal on acquisition announcement day regarding the acquiring firm. In case of target firms, information regarding deal premium is available on announcement day” (Shaheen 2006, p. 4). In the article called Market Misvaluation, Managerial Horizon, and Acquisitions by Huasheng Gao says that corporate acquisitions are the significant actions for the corporations. They engage big dedication of money and have deep impacts on both managers and shareholders welfare. Additionally, acquisition decisions are vulnerable to the acute conflicts of interest between different set of agents, including long term shareholders, short term shareholder and mangers. “The misvaluation on the acquirer’s stand-alone value, on the target’s stand-alone value and on the synergy, is known to the acquiring CEOs, but unknown to the market. Those CEOs also know that it will take two periods for the market to correct the mispricing” (Gao 2008, p. 11). Mergers and acquisitions can be analysed as an effective method for suitable market inefficiencies. The significant statement is that markets are inefficient, for that reason some firms are valued wrongly. In this case, managers are impartial and take benefit of those inefficiencies in the market. Therefore market valuations can drive M & A. According to Isil Erel, Rose C. Liao and Michael S. Weisbach in his book called World Markets for Mergers and Acquisitions says that Valuation differences among acquirers and targets can be separated into three components they are dissimilarities in country-level stock market activities, dissimilarities in firm-specific stock price actions relation to country-level indices, or depreciation or appreciation of the currencies in which targets’ and acquirers’ securities are traded. All of these elements potentially reflect an alternative basis of valuation dissimilarity that could motivate mergers. Differences in estimation can influence merger tendencies during two main channels. Froot and Stein (1991) suggest that differences in wealth that happen due to exchange rate or other shocks give a financing benefit, lowering the price of a probable acquisition. A richer country effectively has a lesser cost of capital, leading its organizations to purchase possessions outside the state, including other firms. More normally, global acquisitions give a method in which newly richer shareholders can boost their exposure globally without buying foreign stocks. In a global context the deviation from mergers could happen for mainly two causes: “First, overall investor sentiment could vary across countries, creating a wedge in firm values in the local-currency across countries. Second, the currencies in which the companies are valued can appreciate or depreciate more than is warranted by changes in underlying economic conditions, leading the companies to be relatively misvalued” (Erel et al. 2009, p. 3). He also says that currency actions predict mergers mainly for within-region country-pairs and also emerge to be most significant when the obtaining country is richer than the target. This model is reliable with the view that companies in richer countries purchase industries in poorer nearby countries for the reason that they are comparatively inexpensive following currency depreciation. And the assessment dissimilarities in country-level stock market forecast mergers mainly when the obtaining country is richer than the target, reliable with the view that industries in richer countries buy foreign firms following a refuse in the poorer country’s stock market. There are two possible descriptions for the stock-return differences among targets and acquirer previous to the acquisitions. Firstly, the incomes can influence alterations in the relative possessions of the two countries. Secondly, the incomes can reflect differential deviation from basics. There are two probable reasons for the relation among assessment and merger tendencies. Increases in comparative valuation, either through stock cost increases or money appreciation, could reflect actual increases in possessions, leading to better industries abilities to finance acquisitions. On the other hand, the alteration in relative valuation could reflect mistakes in valuation, in which case company should reasonably take benefit of this misvaluation to purchase comparatively cheap assets that is firms in another country that are not as overrated. (World Markets for Mergers and Acquisitions by Isil Erel, Rose C. Liao and Michael S. Weisbach.) “An integrated examination of equity issuance and investment offers insight into whether the effect of misvaluation on investment occurs because managers inherently seek to boost the stock price” (Dong et al. 2007, p. 3). In the journal called ‘The Effects of Merger and Acquisition on the Price of Insurance and Firm Performance in the U.S. Property-Liability Insurance Industry’ by Jeung Bo Shim says that the market timing theory shows that firm takeover action can happen because of stock market estimation issues. The market timing theory does not involve that M & A s could not be activated by technological innovations, corporate governance issues or changes in regulation etc. Fairly, the market timing theory says that stock market misevaluation impacts merger waves irrespective of the fundamental inspiration for the mergers. The market timing theory suggests that the stock market valuation for probable targets can deviate from true principles. “The merging firm employs its relatively overvalued stock as currency to purchase the target firm’s stock. Such stock market driven M & As may have poor long run stock performance due to the correction of misvaluation” (Shim 2007, p. 45). He also says that Market timing theory forecast that stock deal acquirers underperform cash deal obtains in the long run that industries with overrated equity might be able to create acquisitions whereas firms with undervalue or relatively less overrated equity turn into takeover targets. Conclusion: This literature review analyzed the effects of Market or investor misvaluation of merger and acquisition activity. Merger and acquisition are done by the firms with the reason increase the market share; acquire new technologies, distribution and sales opportunities etc. An examination of CEO investment in their own industry was utilized as a proxy for professional optimism. The outcome signifies that optimistic acquiring managers are probable to demand an upper premium. Market misevaluation, conversely, has a strong power in determining the process of payment used in mergers either cash or stock. Reference List Akbulut, ME. 2004. Market Misvaluation and Merger Activity: Evidence from Managerial Insider Trading. Marshall School of Business. Available at [Accessed 17 Oct. 2011]. Bouwman et al. 2003. Stock Market Valuation and Mergers. MIT Sloan Research Review. Available at < http://faculty.weatherhead.case.edu/bouwman/downloads/StockMktValuationAndMergersMITSloan.pdf> [Accessed 17 Oct. 2011]. Brown, TA. & Zorn, TS. n.d. Managerial Optimism and Market Misvaluation: The Effects on Mergers and Acquisitions. Department of Economics and Finance. Available at < http://69.175.2.130/~finman/Orlando/Papers/Mergers_and_Misvaluation.pdf> [Accessed 17 Oct. 2011]. Burner, RF. 2004. Applied Merger and Acquisitions. John Wiley & Sons, Inc. Available at < http://books.google.co.in/books?id=LO0qEUXpx80C&pg=PA78&dq=how+mis+valuation+effect+merger+and+acquisition&hl=en#v=onepage&q&f=false> [Accessed 17 Oct. 2011]. Dong et al. 2007. Stock Market Misvaluation and Corporate Investment. Merage School of Business. University of California. Available at < http://mpra.ub.uni-muenchen.de/3109/1/MPRA_paper_3109.pdf> [Accessed 17 Oct. 2011]. Erel et al. 2009. World Markets for Mergers and Acquisitions. National Bureau of Economic Research. Available at [Accessed 17 Oct. 2011]. Fridolfsson, SO. & Stennek, J. 2005. Why Mergers Reduce Profits and Raise Share Prices - A Theory of Preemptive Mergers. The Research Institute of Industrial. Available at < http://homepage.univie.ac.at/besim.yurtoglu/papers/p_4.pdf> [Accessed 17 Oct. 2011]. Gao, H. 2008. Market Misvaluation, Managerial Horizon, and Acquisitions. University of British Columbia. Available at < http://www.mfa-2008.com/papers/Horiozn%20012908.pdf> [Accessed 17 Oct. 2011]. Giuli, AD. 2007. The Determinants of the Method of Payment in Mergers. Bocconi University. Job Market Paper. Available at [Accessed 17 Oct. 2011]. Kropf, MR. 2002. Market Valuation and Merger Waves. Graduate School of Business. Columbia University. Available at [Accessed 17 Oct. 2011]. Shaheen, I. 2006. Stock Market Reaction to Acquisition Announcements Using an Event Study Approach. Department of Economics. Available at < http://dspace.nitle.org/bitstream/handle/10090/4167/Shaheen.pdf?sequence=1> [Accessed 17 Oct. 2011]. Shim, JB. 2007. The Effects of Merger and Acquisition on the Price of Insurance and Firm Performance in the U.S. Property-Liability Insurance Industry. Georgia State University: Digital Archive @ GSU. Available at [Accessed 17 Oct. 2011]. Steger, U & Kummer, C. 2007. Why Merger and Acquisitions (M & A): Waves Reoccur – The Vicious Circle from Pressure to Failure. Alcan Chair of Environmental Management. Available at < http://www.imd.org/research/publications/upload/Steger_Kummer_WP_2007_11.pdf> [Accessed 17 Oct. 2011]. Read More