Merger Motives and Target Valuation: A Survey of Evidence from CFOs

Tarun K. Mukherjee Department of Economics and Finance

University of New Orleans New Orleans, LA 70148

Halil Kiymaz*

School of Business and Public Administration University of Houston - Clear Lake

Houston, TX 77058

H. Kent Baker University Professor of Finance

Kogod School of Business American University

Washington, DC 20016

Abstract

This study provides insights on the motives for acquisitions and divestitures and the practices used to value acquisitions during 1990-2001. Based on survey evidence, we find that the primary motivation for mergers and acquisitions is to achieve operating synergies while the top-ranked reason for divestitures is to increase focus. The results also show that most firms believe that diversification is a justifiable motive for acquisitions most notably as a means of reducing losses during economic downturns. Discounted cash flow method is more popular for valuating publicly-held companies compared with closely-held ones but managers also use market multiple analysis. The most surprising finding is that the acquirer’s weighted average cost of capital is used more frequently as the discount rate than the cost of capital for the target.

JEL Classification: G34

Keywords: Mergers; Acquisitions; Diversification, Firm value

July 11, 2003

*Corresponding author: Department of Finance, University of Houston – Clear Lake, 2700 Bay Area Blvd. Houston, TX 77058; Voice: (281) 283-3208; Fax: (281) 283-3951; E-mail: kiymaz@cl.uh.edu

Merger Motives and Target Valuation: A Survey of Evidence from CFOs

1. Introduction The determinants of merger and acquisition (M&A) behavior have long been a topic of

interest to researchers. Stewart, Harris, and Carleton (1984) observe that most of the empirical

studies on M&A behavior has followed one of two general strategies. Some researchers have

examined the differences between the pre-merger and post-merger performance of merged

firms. Others have focused on identifying differences in the characteristics of firms involved in

merger activity and those not involved in merger activity. Despite each having its flaws, both

strategies have produced some valuable insights into M&A behavior. Although voluminous

research on M&As has occurred over the past two decades, the observation made by Stewart,

Harris, and Carleton is still valid today.

In this study, we follow a less well-traveled path to understanding M&A behavior by

asking the decision makers. Unlike most research on M&As, we survey chief financial officers

(CFOs) of U.S. firms to obtain direct evidence of managerial perspectives about M&As. The

scope of our study is somewhat broader than previous academic surveys, such as Baker, Miller,

and Ramsperger (1981a, 1981b) and Mohan et al. (1991), because we include questions on

M&A motives, valuation models, and other pertinent issues. Specifically, the purpose of this

study is to:

(1) identify primary motivations for engaging in M&As and divestitures during 1990-2001;

(2) learn how managers view the relationship between diversification and firm value;

(3) gain insights about valuation techniques used to value target firms; and

(4) find out how managers view some statements about empirical evidence on M&As.

Several reasons underlie the importance of taking a fresh look at M&As by conducting a

new survey on M&As. First, more than a decade has passed since the publication of the last

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academic survey on the topics addressed in our study.1 Second, the largest merger wave in

history occurred during the 1992-2000 period. However, the characteristics of the takeovers in

the 1990s differ greatly from those of earlier periods.2 Third, the importance attached to factors

motivating M&As changes over time. As Sorenson (2000) notes, a generally accepted tenet is

the 1990s merger movement has been motivated by different factors from earlier ones in the

1960s or the 1970s-1980s. For example, Grinblatt and Titman (2002) characterize the 1960s

and 1970s as a period of conglomerate acquisitions primarily motivated by financial synergies,

taxes, and incentives; the 1980s as one of financial acquisitions motivated by taxes and

incentive improvements; and the 1990s as a period in which strategic acquisitions motivated by

operating synergies are becoming increasingly important.

Our findings add to the existing literature on M&As by providing a managerial

perspective on each of the four research issues. In addition, we can learn whether managers

tell us something different from the large-sample scientific studies. As with other approaches

used to investigate M&A behavior, survey research has its strengths and weaknesses.3

Surveys of managers do not replace the two general approaches previously mentioned to

examine M&A behavior, but they complement them and yield additional insights. As Bruner

(2002, p. 50) notes, “The task must be to look for patterns of confirmation across approaches

and studies much like one sees an image in a mosaic of stones.”

1 To our knowledge, Ingham, Kran, and Lovestam (1992) published the most recent academic study on

M&As. As Bruner (2002) notes, however, practitioners have also conducted surveys to assess the

profitability of M&As and he summarizes the results of 13 surveys. 2 During the 1990s, the number of hostile takeovers and leveraged buyouts declined substantially, while

the number cross-border mergers increased. See, for example, Andrade, Mitchell, and Stafford (2001)

and Holmstrom and Kaplan (2001). 3 Bruner (2002) compares the strengths and weaknesses of four research approaches (event studies,

accounting studies, survey of managers and case studies) used to examine the profitability of M&As.

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2. Literature Review

2.1. Motives for M&As

There are probably almost as many motives of M&As as there are bidders and targets.

However, grouping the motives of M&A transactions into various categories is often useful.4

Some common motives include synergy, diversification, tax considerations, management

incentives, purchase of assets below their replacement cost, and breakup value. Although the

rationale may differ from one merger or acquisition to another, Brigham and Ehrhardt (2002, p.

970) state, “the primary motivation for most mergers is to increase the value of the combined

enterprise.” However, empirical evidence cannot say whether mergers, on average, create

value. Grinblatt and Titman (2002) view operating synergies as the primary motivation for

M&As during the 1990s. Synergistic effects can arise from various sources including operating

economies, financial economies, tax effects, differential efficiency, and increased market

power.5

Several empirical studies lend support to the importance of synergy as a merger motive.

For example, Bradley, Desai, and Kim (1988) document that a successful tender offer increases

the combined value of the target and acquiring firms by an average of 7.4%. Empirical results by

Berkovitch and Narayanan (1993) show that synergy is the primary motive in takeovers with

positive total gains. Maquieira, Meggison, and Nail (1998) examine 260 pure stock-for-stock

mergers from 1963 to 1996. They document significant net synergistic gains in non-

conglomerate mergers and generally insignificant net gains in conglomerate mergers. Mulherin

and Boone (2000) study the acquisition and divestiture activity of a sample of 1305 firms from

4 See, for example, Trautwein (1990) for several theories of merger motives including efficiency,

monopoly, raider, valuation, empire-building, process, and disturbance theory. Berkovitch and Narayanan

(1993) suggest three major motives for takeovers: synergy, agency, and hubris.

5 See Fluck and Lynch (1999) for a theory of financial synergy.

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59 industries during the 1990-1999 period. The symmetric, positive wealth effects for

acquisitions and divestitures are consistent with a synergistic explanation for both forms of

restructuring.

Eun, Kolodny, and Scheraga (1996) test the synergy hypothesis for cross-border

acquisitions using a sample of foreign acquisitions of U.S. firms during the 1979-1990 period.

Their findings indicate that cross-border takeovers are generally synergy-creating activities.

Seth, Song, and Pettit (2000) also find that the synergy hypothesis is the predominant

explanation for their sample of foreign acquisitions of U.S. firms.

2.2. Diversification and Firm Value

Purely diversifying takeovers offer both potential advantages and disadvantages

(Grinblatt and Titman, 2002). A common argument in support of diversification is that lowering

the risk of a firm’s stock increases its attractiveness to investors and thereby reduces the firm’s

cost of capital. Diversification may also enhance a firm’s flexibility, allow it to use its organization

more effectively, reduce the probability of bankruptcy, avoid information problems inherent in an

external capital market, and increase the difficulty of competitors uncovering proprietary

information. On the other hand, combining two firms can destroy value if managers misallocate

capital by subsidizing money-losing lines of businesses. Another disadvantage is that mergers

can reduce the information contained in stock prices.

Whether there are gains associated with M&As depends partly on whether diversification

helps or hurts firm values. Much empirical work focuses on how corporate diversification affects

shareholder value.6 Servaes (1996) reports that the market’s attitude toward diversification

depends on the period studied. He finds diversification discounts or penalties in the 1960s and

1980s, but not during the 1970s. The prevailing wisdom among financial economists since the 6 See Martin and Sayrak (2003) for a survey of recent development in the literature on corporate

diversification and shareholder value.

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1990s has been that diversified firms sell at a discount relative to the sum of the imputed values

of their business segments. A stream of literature suggests that corporate diversification does

not create value. For example, empirical research by Morck, Shleifer, and Vishny (1990), Lang

and Stulz (1994), Berger and Ofek (1995), Walker (2000), and Lamont and Polk (2002)

suggests that diversification related acquisitions may be value reducing.

Financial economists offer many explanations for the diversification discount. A leading

hypothesis consistent with the notion that diversification destroys value is the inefficient-internal-

capital-market hypothesis. That is, conglomerates tend to misallocate their investment funds by

cross-subsidizing investments in divisions with poor growth opportunities. Alternatives

explanations also exist for the diversification discount. For example, managers may have

pursued a diversification strategy even when it hurt shareholders to reduce their human capital

risk (Amihud and Lev, 1981), entrench themselves (Schleifer and Vishny, 1989), or pursue size

as an end (Ravenscraft and Scherer, 1987). Whited (2001) contends that the diversification

discount stems from measurement error. Graham, Lemmon, and Wolf (2002) attribute the

diversification discount to the performance of recent acquisitions. They show that much of value

reduction occurs because firms acquire already discounted business units, and not because

diversifying destroys value. Mansi and Reeb (2002) argue that this documented discount stems

from risk-reducing effect of corporate diversification.

2.3. Valuation Analysis

Numerous valuation approaches can be used to estimate the value of the target

company.7 Two broad classes include the discounted cash flow (DCF) approach and the

market multiple method. Marren (1993, p. 195) considers DCF analysis as “. . . the most

important valuation technique for estimating the worth of a business to an individual bidder.”

7 See Marren (1993) for a description of the various valuation approaches used to estimate the value of a

company.

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Applying the DCF method requires forecasting post-merger cash flow forecasts and estimating

a discount rate to apply to these projected cash flows. The DCF approach provides a rational

economic framework for valuing acquisitions that the marketplace generally follows. However,

several complexities exist in using the DCF method. For example, DCF models are highly

sensitive to assumptions made for growth, profit, margin, and terminal value. In addition, a

target company’s future cash flows depend on the method of acquisition and the purchase price.

Another weakness of DCF analysis is that it explicitly does not take into account the effects of

leverage, which presents problems in certain situations.

When using the DCF approach, some debate exists over the appropriate discount rate to

use. According to Rappaport (1986), using the acquirer’s cost of capital as the appropriate rate

for discounting the target’s cash-flow stream is only appropriate when the target’s risk is

identical to the acquirer’s risk. Marren (1993) recommends using the weighted average cost of

capital (WACC) of the target, assuming a given capital structure for the target company. Others

such as Brigham and Ehrhardt (2002) indicate the most appropriate discount rate is the target’s

cost of equity, not that of either the acquiring firm or the consolidated post-merger firm. Two

principal models for calculating the cost of equity capital are the capital asset pricing model

(CAPM) and arbitrage pricing theory (APT). Once the target company’s beta is determined, it

can then be adjusted to the new expected capital structure for the target company. Further, the

discount rate used should reflect the riskiness of the cash flows.

Valuing a target company using market multiple analysis involves applying a market-

determine multiple to net income, EBITDA, earnings per share, sales, book value, or other

measure. This approach helps to identify a value range for the target and is useful when there

are no acceptable comparable transactions or comparable public companies.

Several surveys provide evidence about techniques used to value target firms. For

example, Baker, Miller, and Ramsperger (1981a) report that firms primarily use discounted cash

flow analysis to determine the value of takeover targets. Mohan et al. (1991) find that managers

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place high importance on discounted cash flow and market value approaches compared to

alternative techniques, especially liquidation and book value.

2.4. Motives for Divestitures

Several research studies report that companies often subsequently divest previous

acquisitions. For example, Kaplan and Weisbach (1992), who study a sample of large

acquisitions completed between 1971 and 1982, find that these acquirers have divested almost

44% of the target companies by the end of 1989. They characterize the ex post success of the

divested acquisitions and consider 34% to 50% of classified divestitures as unsuccessful.

Although diversifying acquisitions are almost four times more likely to be divested than related

acquisitions, they do not find strong evidence that diversifying acquisitions are less successful

than related ones.

Firms have a wide variety of reasons for divestitures. For example, a common reason is

to increase a firm’s focus. Recent empirical work has documented a trend toward corporate

focus (Comment and Jarrell, 1995). John and Ofek (1995) find that asset sales lead to an

improvement in the operating performance of the seller’s remaining assets following the asset

sale. They find that the improvement in performance occurs primarily in firms that increase their

focus. Borde, Madura, and Akhigbe (1998) find evidence that valuation effects are more

favorable when foreign divestitures are for strategic reorganization purposes.

Another reason for divestitures is to divest a low-performing division or business. That is,

a firm can unload losing assets that would otherwise drag the company down. An example of

such a business would be one resulting from an unsuccessful prior acquisition. By divesting the

business, especially one in unrelated areas resulting from a previous conglomerate merger, a

company may be able to recreate the value destroyed at the time of an earlier acquisition. Allen

et al. (1995) examine the correction-of-a-mistake hypothesis with a sample of 94 spin-offs that

occurred over the 1962-1991 period. Their results suggest that managers who undertake poor

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acquisitions can redeem themselves, at least partially, by subsequently divesting the unwise

acquisition.

A third reason for divestitures is to increase managerial efficiency. By spinning-off parts

of the business, for example, managers may be able to operate more efficiently alone in the

spun-off firm than together in the parent firm. Johnson, Klein, and Thibodeaux (1996) find

evidence consistent with the notion that spin-offs create value by improving investment

incentives and economic performance.

A fourth reason is to achieve a specific organization form such as through a spin-off or

carve-out. By splitting the firm into its component businesses, the market may be able to value

the components more accurately then when they are combined. According to Nanda and

Narayanan (1999), when firms are undervalued due to unobservability of divisional cash flows,

they may resort to divestiture to raise capital.

3. Research Design

The research design consists of three elements: the survey instrument, sample, and

limitations of this study.

3.1. Survey Instrument

During March-April 2002, we pre-tested a preliminary version of our survey by sending it

to seven CFOs in the Houston area. Based on the feedback from five CFOs, we made changes

to the wording on some questions. The final version of the four-page survey consists of 23

questions (hereafter referred by Q#). We focused on asking closed-end questions to lessen the

subjectivity involved with classifying responses to the open-ended question. The survey

contains five areas of inquiry. The first area involves background data on the number and

average size of the acquisitions (Q1 - Q2). The next group of questions concerns motives for

making M&A decisions including questions on synergy- and diversification-related M&As (Q3 -

Q8). The third area of inquiry concerns methods used to value publicly-held and closely-held

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targets (Q9 - Q11). The fourth area examines divestures (Q12 – Q14). The final part of our

survey asks respondents to indicate their level of agreement or disagreement with nine

statements involving M&As (Q15 – Q23). The respondents use a five-point, equal-interval scale

where +2 = strongly agree, +1 = agree, 0 = neither agree nor disagree (no opinion), -1 =

disagree, and -2 = strongly disagree. For these nine questions, we use one-sample t-tests to

determine whether the level of agreement or disagreement differs significantly from zero, which

represents a “no opinion” response.

In our survey, we address four major research questions and advance empirical

predictions in response to each of them. First, what are the primary motives behind corporate

M&As and divestitures? We expect that the primary motivation for M&As is synergy. This

finding would be consistent with empirical research involving the increasing importance of

synergy as a merger motive since the 1990s. Although we expect diversification to an important

motive to some firms, we do not expect it to be the top-ranked motive. Evidence suggests that

diversifying takeovers have been viewed much more negatively since the 1980s.

We expect that the two major motives for divestitures are to increase focus and to divest

a low-performing division. Comment and Jarrell (1995) document a trend toward corporate

focus and away from conglomeration (diversification). Allen et al. (1995) show that firms often

unwind unsuccessful prior acquisitions.

Second, what views do managers have about the relationship between diversification

and firm value? Matsusaka (1993) notes a dramatic reversal in sentiment toward diversification

– positive in the 1960, neutral in the 1970s, and negative in the 1980s. However, we posit that

the majority of responding managers views diversification as a justifiable motive for M&As.

Third, what methods do managers use to value the target firm? We expect that the

discounted cash flow method is the most common approach used to value both publicly-held

and closely-held target firms.

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Finally, do managers generally agree with statements about empirical evidence on

M&As? We expect that respondents, on average, agree with these statements.

3.2. Sample

Our initial sample contains the largest 100 mergers and acquisitions reported by

Mergers and Acquisitions in each year during the period of 1990-2001, yielding 1200

acquisitions. We adjusted the sample for multiple acquisitions by the same firms and firms

acquired by other firms in subsequent years. The final sample consists of 721 firms that

engaged in acquisitions during 1990–2001. The names and mailing addresses of CFOs are

obtained from FIS and Hoover’s Online. To increase the response rate, we included a self-

addressed, postage-paid envelope along with a personally addressed cover letter with each

survey. Of the 721 surveys, 85 were returned undelivered. In addition, about 30 firms either

returned the survey blank or e-mailed or telephoned us to express their unwillingness to

participate, mostly for the reason of insufficient time. Our final sample consists of 75 usable

responses, which represents 11.8% of the 636 delivered surveys. This response rate is similar

to that reported in other academic studies of financial executives. The length, difficulty, and

confidential nature of the subject matter may help to explain the participation rate.

3.3. Limitations

Our study has several potential limitations. One limitation is the possibility of non-

response bias. This is true despite taking the normal precautions to avoid such bias including

ensuring confidentiality. To test for non-response bias, we compared characteristics of the

responding (sample) firms with those of the population.8 Having similar characteristics between

these groups would lessen the concern about potential non-response bias and the ability to

8 We could not compare characteristics of responding and non-responding firms because we assured

anonymity to the respondents as a means of increasing the response rate.

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generalize the results. Based on t-tests, our sample closely conforms to asset sizes of the

population as well as their industrial affiliations.9

Accepting that non-response bias may be small, concerns may still exist about the

survey data. For example, the respondents may not have answered truthfully or carefully.

Given that we guaranteed anonymity to respondents, we believe that the former problem is

minimal. We believe that respondents would not take the time to complete the survey if their

intent was to be untruthful. Despite our efforts to design and pre-test the questions, respondents

might not properly understand some questions. Other questions might not elicit the appropriate

information. Given that we pre-tested the survey, we also believe that the questions, as a whole,

are well crafted. Finally, we could have asked more questions or asked questions in a different

manner to gain even greater insight into the attitudes and opinions of managers. Given the

tradeoff between survey length and the probability of realizing a high response rate, we chose to

limit the number of questions. Little can be done to change this situation without conducting a

follow-up survey, which is impractical at this time. Having said this, we believe that these data

are representative and provide useful managerial perspectives about M&As.

4. Survey Results

4.1. Characteristics of Responding Firms

Tables 1 show the results involving the number and average asset size of acquisitions

(Q1 and Q2), respectively. The findings show the involvement of most of the responding firms

in multiple acquisitions during 1990-2001. For example, 46.7% of the responding firms engaged

in more than 10 acquisitions during this period. Table 1 also shows that 66.7% of the acquired

firms is less than $500 million in asset size. We computed the Spearman rank correlation (rs)

between the asset sizes of acquiring firms and the average size of the acquired firms. The

9 These tests are available from the authors upon request.

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results show that large firms become larger through repeated acquisitions of relatively large

firms (rs = 0.320 significant at the 0.05 level).

(Insert Table 1 about here)

4.2. Motives for M&As

Table 2 reports the results involving the top-ranked reasons for acquiring another firm

(Q3). We gave respondents seven choices plus an “other” option. Consistent with our

expectations, the most important motive is synergy, which received 37.3% of the top-ranked

responses. We do not know, however, whether the purported synergies are real or merely a

convenient rationale offered by managers. The second highest-ranked motive is diversification,

which was chosen by 29.3% of the firms in the sample. Although synergy and diversification

represent almost two thirds of our responses, companies engage in mergers for other reasons.

Overall, our findings lend support to the notion that the rationale for M&As varies across firms

and may depend on their circumstances and characteristics.

(Insert Table 2 about here)

Anticipating the importance of synergy as a motive, we asked two other questions about

synergy-related mergers. One question (Q7) asked respondents to indicate whether their firms

were directly or indirectly involve in synergy-related mergers. Of the 75 respondents, 69

(92.0%) answered “yes.” The other question (Q8) instructed these respondents to indicate the

most important source of the merger-related synergy among four choices (operating economies,

financial economies, differential efficiency, and increased market power) plus an “other” option.

Only 62 of the 69 respondents provided an answer. As Table 3 shows, the overwhelming

source of synergy is operating economics, chosen by 89.9% of the respondents. Although we

did not investigate the specific type of operating economy that served as the source of synergy,

it could result from economies of scale in management, market, production, or distribution.

(Insert Table 3 about here)

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4.3. Diversification and Firm Value

Table 4 provides the responses to three questions (Q4 – Q6) involving diversification

and firm value. As shown in Panel A, when asked if they agree with the statement (Q4) “Some

say that diversification is not a justifiable motive for merger”, only 22.7% of the respondents

agree with this statement. Panel B shows that their rationale for this belief is about evenly

distributed across three reasons (Q5): shareholders can diversity on their own, the parent

company can lose its focus by diversifying, and a firm should stay in the business it knows best.

The overwhelming majority (77.3%) of the respondents believe that diversification can be a

good reason to merge (Q6). As Panel C shows, half of these respondents agree that

diversification provides protection during economic downturns because not all of the firm’s

segments are equally affected.

(Insert Table 4 about here)

4.4. Valuation Analysis

Table 5 provides responses to three questions (Q9 – Q11) involving valuation

techniques. Panel A shows that 37 of the 75 responding firms (49.3%) employ the DCF model

and another 25 firms (33.3%) use this model along with the market multiple method to value a

target. Thus, almost 83% of acquiring firms apply DCF models to determine the value of target

firms. This practice is consistent with our expectations as well as past surveys.

As shown in Panel B, 38 of 62 firms (61.3%) using DCF models employ their own WACC

as the discount rate. Few companies use either the target’s WACC (8.1%) or cost of equity

(1.6%) as the discount rate as recommended by theory. Theory suggests that the appropriate

discount rate is the target's cost of equity. Mohan et al. (1991) report similar findings in their

survey. These results may indicate the inability to derive a discount rate for the target or a lack

of sophistication in valuation analysis.

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Panel C reports the results about valuation models used by the 64 responding firms that

report acquiring closely-held firms. Almost half (48.4%) of these firms indicate that they use

DCF models, while 37.6% use industry multiple approach. A lower use of the DCF technique in

valuing closely-held firms, compared to valuing publicly-held firms, is reasonable because

reliable data are not equally available for these targets.

(Insert Table 5)

4.5. Divestiture Types and Motives

Of the 75 responding firms involved in acquisitions during 1990-2001, 46 of these firms

(61.3%) also report divestures (Q12). Panels A and B present the results on two other questions

(Q13 and Q14). As Panel A of Table 6 shows, the types of divestitures consist of sale of an

operating unit to another firm (50.0%), outright liquidation of assets (43.5%), and spin-offs

(6.5%). Because individual divestitures may not necessarily fit nearly into any one motive, we

asked respondents to check all motives that apply to their company’s divestitures. Panel B

provides the main reasons the responding firms engaged in divestitures. The evidence shows

that the top top-ranked reasons are to increase focus (35.9%) and divest a low-performing

division (35.9%). These findings are consistent with our expectations.

(Insert Table 6 about here)

4.6. Other Views on M&As

Table 7 shows the extent to which the respondents agree or disagree with nine

statements about M&As (Q15 – Q23). We rank the responses from the highest to lowest mean

response based on a five-point scale. The literature generally provides support for each of the

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nine statements.10 As predicted, the respondents, on average, agree with most of the

statements, except Q15 and Q19. However, only four of the nine statements (Q17, Q18, Q20,

and Q22) show a positive mean value statistically different from zero (no opinion) at the 0.05

level or above using a one-sample t-test.

At least 75% of the respondents agree with two statements. The first statement (Q17) is

“a hostile takeover often results in higher payment to the acquired company than a friendly

mergers.” Agreement with this statement is consistent with the results reported in several

previous studies such as Asquith (1983) and Dennis and McConnell (1986). Chen and Cornu

(2002) also find that merger premiums in tender offers are significantly higher than the

premiums in friendly mergers, which is consistent with numerous studies. The second

statement (Q18) is “acquisition in a related industry is worth more than an acquisition in a non-

related industry.” Maquieira, Meggison, and Nail (1998) report net synergistic gains occur in

non-conglomerate mergers and generally insignificant net gains in conglomerate mergers.

The majority of respondents agree with the statement (Q22) “most of the gains from

M&As usually accrue to shareholders of the acquired firm.” Researchers typically agree that

takeovers increase the wealth of the shareholders of target firms as reflected by the favorably

stock price reactions to takeover bids. Debate exists, however, as to whether mergers benefit

the acquiring firm’s shareholders. For example, Roll (1986) and Bradley, Desai, and Kim (1988)

and report that average returns to bidding shareholders from making acquisitions are at best

10 See, for example, Jensen and Ruback (1983), Copeland and Weston (1988), Weston, Kwang, and

Hoag (1990), and Grinblatt and Titman (2002) for summaries of empirical evidence on the effects of

mergers on value.

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slightly positive, and significantly negative in some cases. The combined market value of the

shares of the target and bidder, on average, go up around the time of the announced bids.11

The final statement (Q20) on which substantial agreement exists among the

respondents is that “an all-cash offer is more effective in a hostile merger than in a friendly

merger.” Several studies such as Travlos (1987) and Franks, Harris, and Mayer (1987) find that

announcement returns to bidding firms making cash offers are higher than when making stock

offers. This result may reflect the relatively negative information about the bidder’s existing

business signaled by the offer to exchange stock. Based on a sample of takeover offers in the

1981-1986 period, Brown and Ryngaert (1991) find that the returns for cash offers are

significantly higher than the returns for all stock or mixed offers.

The only statement (Q15) about which a majority of respondents disagrees is “cash (or

cash combined with stock exchange) payment requires a higher premium in M&As than a

straight stock-exchange transaction.” This finding is inconsistent with results reported in several

empirical studies. For example, Huang and Walking (1987) show that valuation effects are

larger for cash offers than stock exchange offers. Sullivan, Jensen, and Hudson (1994)

subsequently confirmed this finding.

5. Conclusions

We survey CFOs of U.S. firms engaged in M&As to learn their views about acquisitions

and divestitures and how they value the target firm. Based on the survey evidence, we find that

the primary motivation for M&As is to achieve operating synergies while the top-ranked reason

for divestitures is to increase focus. Both results are consistent with other empirical evidence

11 Based on the evidence from 14 informal studies and 100 scientific studies from 1971 to 2001, Bruner

(2002, p. 48) concludes “the mass of research suggests that target shareholders earn sizable positive

market-returns, that bidders (with interesting exceptions) earn zero adjusted returns, and that bidders and

target combined earned positive adjusted returns.”

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that strategic acquisitions are the dominant form of acquisitions during the 1990s. Strategic

mergers are typically horizontal mergers that achieve operating synergies by combining firms

that were former competitors or whose products or talents fit well together. Our results also

show that most firms believe diversification is a justifiable motive for acquisitions, most notably

as a means of reducing losses during economic downturns.

Not surprisingly, we find that the discounted cash flow method is more popular for

valuing publicly-held companies than closely-held ones. In addition, managers also use market

multiple analysis, especially to value closely-held companies. Perhaps the most surprising

finding is that the acquirer’s weighted average cost of capital is used more frequently as the

discount rate than the target’s cost of capital. These responses do not appear to fit the theory of

linking risk to the appropriate discount rate. Previous survey research by Mohan et al. (1991)

reports a similar finding.

On average, managers generally agree with statements involving research evidence and

issues about M&As. Only four of the nine statements, however, show a level of agreement that

is statistically different from “no opinion.” Although managers may not have direct knowledge of

the specific research studies serving as the basis for these statements, they apparently

understand, perhaps by experience, the nature of such evidence.

18

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Table 1 Characteristics of Responding Firms: Number and Average Size of Acquisitions

This table shows the number of M&As undertaken by the responding firms during 1990-2001 and the average asset size of the target firms acquired during this period. Characteristics n % Panel A. Number of Acquisitions 1 - 3 Acquisitions 14 18.7 4 - 7 Acquisitions 17 22.7 8 - 10 Acquisitions 9 12.0 Above 10 Acquisitions 35 46.7 Total 75 100.1 ___________________________________________________________________________ Panel B. Average Asset Size of Acquired Firms Less that $500 million 50 66.7 $500 million - $1.5 billion 15 20.0 $1.5 billion - $5 billion 5 6.7 Over $5 billion 5 6.7 Total 75 100 __________________________________________________________________________

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Table 2 Motives for M&As This table shows the most important reasons that responding firms gave for their M&As during 1990-2001. Respondents could indicate more than one reason but this table reports only the top-ranked motive. ____________________________________________________________________________ Motives n % Take advantage of synergy 28 37.3 Diversify 22 29.3 Achieve a specific organizational form as part of an ongoing restructuring program 8 10.7 Acquire a company below its replacement cost 6 8.0 Use excess free cash 4 5.3 Reduce tax on the combined company due to tax losses of the acquired company 2 2.7 Other 5 6.7 Total 75 100.0 ___________________________________________________________________________

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Table 3 Sources of Synergy This table presents the source of synergy for those firms directly or indirectly M&A-related synergy. Of the 75 total respondents, 69 stated that they were directly or indirectly involved in synergy-related M&As. Although respondents could indicate more than one source, this table reports only the top-ranked source. ____________________________________________________________________________ Source of Synergy n % Operating economies (resulting from greater economies of scale that improve productivity or cut costs) 62 89.9 Financial economies (resulting from lower transaction costs and tax gains) 4 5.8 Increased market power (due to reduced competition) 3 4.3 Differential efficiency (due to the acquiring firm’s management being more efficient) 0 0.0 Total 69 100.0 ___________________________________________________________________________

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Table 4 Diversification and Firm Value This table presents the responses on whether or not diversification is a justifiable merger motive and the reasons underlying these views. The total responses in Panels B and C exceed the number of “yes” and “no” responses in Panel A because respondents could indicate more than a single response. ____________________________________________________________________________ Statement n % __________________________________________________________________________ Panel A. Diversification as a Merger Motive Some say that diversification is not a justifiable motive for a merger? Do you agree? Yes 17 22.7 No 58 77.3 Total 75 100.0 Panel B. Diversification: Not Justified as a Merger Motive Diversification through mergers does not create value because: Shareholders can diversify on their own 15 35.7 The parent loses its focus 13 31.0 A firm should stay in the business it knows best 11 26.2 Other (e.g., does not contribute to the firm by itself) 3 7.1 Total 42 100.0 Panel C. Diversification: Justified as a Merger Motive Diversification can be a good reason to merger because it: Reduces losses during economic downturns 36 50.0 Takes advantage of the seasonality of the production cycle 10 13.9 Affords internal capital allocation 9 12.5 Other (e.g., expand customer and product base, acquire expertise) 17 23.6 Total 72 100.0

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Table 5. Valuation Techniques Used for Target Firms This table presents responses on the valuation techniques used to value publicly-held and closely-held target firms. The table also shows the discount rate used to value a target firm. _______________________________________________________________________ n % _______________________________________________________________________ Panel A. Valuation of a Publicly-Held Target Firm Discounted cash flow approach 37 49.3 Discounted cash flow approach plus market multiple analysis 25 33.3 Market multiple analysis only 9 12.0 Other 4 5.3 Total 75 99.9 ______________________________________________________________________ Panel B. Discount Rate Used to Value a Target Firm Acquiring firm’s weighted average cost 38 61.3 Acquiring firm’s cost of equity 7 11.3 Target’s weighted average cost 5 8.1 Other (e.g., target’s cost of equity) 12 19.4 Total 62 100.1 _____________________________________________________________________ Panel C. Valuation of a Closely-Held Target Firm Discounted cash flow approach 31 48.4 Apply industry price-to-earnings multiple to the target 20 31.3 Apply industry price-to book value multiple to the target 4 6.3 Other (e.g., cash flow multiple, comparable firms, EBITA multiple, price/revenue multiple, internal projections, customer base and long-term contracts) 9 14.1 Total 64 100.1 ____________________________________________________________________

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Table 6. Divestitures Types and Motives This table presents the responses of the 46 firms involved in divestitures during the 1990-2001 period. The number of responses in Panel B exceeds the number of firms engaging is divestures because respondents could indicate more than a single response. ____________________________________________________________________________

n % ___________________________________________________________________________ Panel A. Types of Divestitures Sale of operating unit to another firm 23 50.0 Outright liquidation of assets 20 43.5 Spin off 3 6.5 Equity carve out 0 0.0 Total 46 100.0 ___________________________________________________________________________ Panel B. Motives for Divestitures Increase focus 33 35.9 Divest a low-performing division 33 35.9 Increase managerial efficiency 9 9.8 Achieve a specific organizational form 7 7.6 Others (e.g., increase cash position, take advantage of high market value, reallocate capital, antitrust considerations) 10 10.9 Total 92 100.1 _________________________________________________________________________

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Table 7 Level of Agreement/Disagreement with Statements Involving M&As This table reports the level of agreement/disagreement of the respondents to nine statements involving M&As based on a five point scale: +2 = strongly agree, +1 = agree, 0 = neither agree nor disagree, -1 = disagree, and –2 = strongly disagree. The one-sample t-value indicates whether the mean is statistically different from zero (no opinion). ____________________________________________________________________________ Agee Disagree t- Q# Statement n +2 +1 0 -1 -2 Mean Value ____________________________________________________________________________ 17 A hostile takeover often results in

higher payment to the acquired 74 25.7% 50.0% 18.9% 5.4% 0.0% 0.959 10.087*** company than a friendly merger.

18 An acquisition in a related industry

is worth more than an acquisition 74 23.0 52.7 18.9 2.7 2.7 0.905 8.866*** in a non-related industry.

22 Most of the gains from M&As usually accrue to shareholders 75 6.7 49.3 21.3 20.0 2.7 0.373 3.335*** of the acquired firm. 20 An all-cash offer is more effective in a hostile merger than in a 72 5.6 40.3 31.0 20.8 1.4 0.278 2.598**

friendly merger.

21 Poison pills usually represent non- wealth-maximizing behavior. 74 9.5 29.7 31.1 28.4 1.4 0.176 1.514 23 M&As may increase shareholders’ wealth at the expense of bond- 73 2.7 26.0 52.1 16.4 2.7 0.096 1.021 holders, especially in leveraged- buyout situations. 16 Cash (or cash combined with stock) exchange) requires a higher premium 74 5.4 32.4 31.1 23.0 8.1 0.041 0.331 because of tax consequences to the shareholders of the acquired firm. 19 Suppose A and B are two target companies in two different countries. The economy of A’s country has much lower correlation (than B’s 72 1.4 13.9 55.6 26.4 2.8 -0.153 -2.024** country) with the economy of the United States. All else the same,

a higher premium is justified for A . 15 Cash (or cash combined with stock exchange) payment requires a higher premium in M&As than a straight 74 10.8 18.9 17.6 37.8 14.9 -0.270 -1.872*

stock-exchange transaction. ___________________________________________________________________________ The percentages for each question may not add to 100 due to rounding.

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***,**, *, indicates statistical significance at the 0.01, 0.05 , and 0.10 levels, respectively.

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SURVEY ON MERGER AND ACQUISITIONS (M&As)

[THIS SURVEY APPLIES ONLY TO FIRMS THAT ACQUIRED OTHER FIRMS] 1. My company was involved in _____ M&As during the period January 1, 1990 - December 31,

2001 (Please check only one.) 1-3 4-7 8-10 above 10

2. The following choice most closely describes the average asset size of the companies we

acquired during the last 12 years. (Please check only one.) Less than $500 million $500 million - $1.5 billion $1.6 billion - $5 billion Over $5 billion

3. Provided below are some of the reasons that are offered for acquiring another company.

Which of these motives best explain your firm’s acquisitions in the last 12 years? (If you check more than one choice, please rank them, with 1 being the most important reason.)

In making M&A decisions, our primary motive(s) was (were) to acquire a company below its replacement cost. to reduce tax of the combined company due to tax losses of the acquired company. to use excess free cash. to diversify. to take advantage of synergy. to realize gains from breakup value of the acquired firm. to achieve a specific organizational form as part of an ongoing restructuring program. Other(s) (Please fill in.)__________________________________________________________

4. Some say that diversification is not a justifiable motive for merger. Do you agree?

Yes No

If the answer to question #4 is “No,” please skip to question #6. If the answer is “Yes,” please answer #5 and skip #6.

5. (Please check all that apply). Mergers through diversification do not create value because

a firm does not need to diversify as its shareholders can diversify on their own; diversification results in the parent company losing its focus; a firm should stay in the business it knows best; Other (Please fill in.) ____________________________________________________________

6. (Please check all that apply.) Diversification can be a good reason to merge because It reduces/avoids the need for external capital by transferring capital internally; It results in much less devastating effect on the firm during economic downturns as not all sectors

of a firm are expected to perform equally poorly during such downturns; It takes advantage of the seasonality of the production cycle; Other (Please fill in.) ____________________________________________________________

7. My firm was directly or indirectly involved in synergy-related mergers.

Yes No

If the answer to #7 is no, please skip to question #9.

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8. Merger-related synergy is said to derive basically from the following sources: A. Operating economies (resulting from economies of scale) B. Financial economies (lower transaction costs/ more coverage by security analysts) C. Differential efficiency (acquiring firm’s management is more efficient) D. Increased market power (lower degree of competition).

The following source(s) most closely describes my firm’s M&As during the period January 1, 1990 – December 31, 2001. (If more than one source was relevant, please rank the sources, 1 being the most important.) Operating economies Financial economies Differential efficiency Increased market power Other (Please fill in)_____________________________________________________________

9. My firm determines the share price of a publicly-held target firm in the following manner.

We primarily use a discounted cash flow model (i.e., we determine the expected post-merger cash flows that will accrue to my firm’s shareholders and then discount such cash flows at an appropriate discount rate).

We combine the discounted cash flow model with the following model(s). (Please fill in.) _____________________________________________________________________________

We use market multiple analysis. (Please fill in.)

_____________________________________________________________________________

We use the following model(s) (Please fill in.) _____________________________________________________________________________

(If your firm does not use a discounted cash flow model in evaluating mergers, please skip question #10.)

10. When employing the discounted cash flow model, we determine the discount rate in the

following manner: We use my firm’s average cost of capital as the discount rate. We use the target firm’s average cost of capital as the discount rate. We use my firm’s cost of equity capital as the discount rate. We use the target firm’s cost of equity capital as the discount rate. We determine the discount rate by the following method. (Please fill in.)

_____________________________________________________________________________ 11. When the target happens to be a closely-held (private) company, we determine the offer price

in the following manner. This question does not apply to my firm because we did not acquire any private company. Applying industry price to earning multiple to the earnings of the company to be acquired; Applying industry price to book value multiple to the earnings of the company to be acquired; Discounted cash flow approach. We use the following method to determine the offer price for a closely-held company. (Please fill

in.) _____________________________________________________________________________

12. During January 1,1990 - December 31, 2001 my company ________ involved in divestitures. Was Was not

(If the answer to #12 is “was not,” please skip to question #15. If the answer is “was,” please continue.)

33

34

13. My firm was involved in the following type(s) of divestitures. (Please check all that apply.) Outright liquidation of assets Sale of an operating unit to another firm Spin-offs Equity carve-outs Other (Please fill in.) __________________________________________________________

14. (Please check all that apply.) The main motive(s) for my company’s divestitures was (were)

to increase focus. to divest low-performing division. to increase managerial efficiency to lower the cost of external financing to achieve a specific organizational form to reward the manager of the division that is being spun off other motive (Please fill in.) _____________________________________________________

MISCELLANEOUS. Please indicate the extent of your agreement or disagreement by checking the appropriate column. (SA = Strongly Agree, A = Agree, NAND = Neither Agree nor Disagree, D = Disagree, SD = Strongly Disagree.)

STATEMENT SA A NAND D SD 15. Cash (or cash combined with stock exchange)

payment requires a higher premium in M&As than a straight stock-exchange transaction. ____ ____ ____ ____ ____

16. Cash (or cash combined with stock exchange) requires a higher premium because of tax consequences to the shareholders of the acquired firm. ____ ____ ____ ____ ____

17. A hostile takeover often results in higher payment

to the acquired company than a friendly merger. ____ ____ ____ ____ ____

18. An acquisition in a related industry is worth more than an acquisition in a non-related industry. ____ ____ ____ ____ ____

19. Suppose A and B are two target companies in two different countries. The economy of A’s country has much lower correlation (than B’s country) with the economy of the United States. All else the same, a higher premium is justified for A . ____ ____ ____ ____ ____

20. An all-cash offer is more effective in a hostile merger than in a friendly merger. ____ ____ ____ ____ ____

21. Poison pills usually represent non-wealth- maximizing behavior. ____ ____ ____ ____ ____

22. Most of the gains from M&As usually accrue to shareholders of the acquired firm. ____ ____ ____ ____ ____

23. M&As may increase shareholders’ wealth at the expense of bondholders, especially in leveraged-buyout situations. ____ ____ ____ ____ ____

THANK YOU FOR YOUR KIND PARTICIPATION

(PLEASE ATTACH YOUR BUSINESS CARD IF YOU WISH TO RECEIVE THE FINAL REPORT)