Week 2 - Rhodes-Kropf, Robinson and Viswanathan (2005).

Question 1

What are the main ideas of the paper?

Answer 1

• Market valuation (S&P500) and merger-waves are highly and positively correlated
• The effect of mis valuation on merger activity: high M/B (market-to-book) ratios coincide with periods of
  intense merger activity
• Market-to-book ratio is deconstructed into three parts: (1) firm-specific deviation from short-run industry
  pricing; (2) sector-wide, short-run deviation from long-run pricing; (3) long-run pricing to book.

Question 2

What are the theories behind the paper?

Answer 2

• Neoclassical Q theory: there is no mis valuation in the market, high M&A activity during high M/B ratios is an evidence that assets are being redeployed towards more productive uses. However, this theory excludes the possibility that managers incorrectly value firms
• Mistakenly overestimated synergies: Merger waves occur during high valuation waves because ex-post, target synergies are mistakenly overestimated. It states that managers are rational but information asymmetry is a problem, they can’t distinguish between firm-specific mispricing and sector (or market)-wide overvaluations.
• Behavioural theory: acquirers are overvalued and look to preserve value for long-term shareholders by acquiring less overvalued targets with overvalued stocks (buy cheap). Whereas, target managers have short-horizons, or get paid for agreeing to the deal.

Question 3

What predictions they test?

Answer 3

o The relative level of mis valuation across transactions: (1.1) overvalued firms buy relative undervalued firms when both are overvalued; (1.2) firms in overvalued sectors buy firms in less overvalued sectors.
o The relative level of mis valuation and payment methods: (2.1) cash targets are more undervalued than stock targets; (2.2) cash acquirers are less overvalued than stock acquirers
o Creating merger waves (intensity predictions): (3.1) increasing mis valuation increases the probability that a firm is in a merger, is the acquirer, and uses stock as the payment method; (3.2) increasing sector
mis valuation increases merger activity, and the use of stock as a payment method, in that sectors.
o (4.1) High sector mis valuation increases merger activity

Question 4

What is the conclusion of the paper?

Answer 4

• Acquirers with high firm-specific error use stock to buy targets with lower firm-specific
  error at times when both firms benefit from positive time-series sector error.
• Cash targets are undervalued relative to stock targets.
• Cash acquirers are less overvalued than stock acquirers.
• Misvaluation level positively correlates with merger intensity.
• Low long-run value-to-book firms buy high long-run value-to-book targets (growth
  prospects).
• Why target shareholders would accept this?
  Splitting up the conclusions per category:
  1. Level of merger activity:
• Activity during merger waves dominated by highly overvalued bidders.
• Acquirers and targets cluster in overvalued sectors.
• Misvaluation explains about 15% of merger activity at the sector level.
• Neoclassical theories also highly relevant (like productivity shocks).
  2 Which company is acquirer and which one is target?
• Acquirers have significantly higher firm-specific error in M/B than targets.
• Firms with higher firm-specific error act as acquirers and use stock payments.
  3 Transaction medium:
• Cash targets are undervalued, while stock targets are overvalued.
• Cash acquirers are less overvalued than stock acquirers (both overvalued).
  4 Long-term effects:
• Low long-run value-to-book firms buy high long-run value-to-book firms.