In this article, we examine acquiring companies’ cash flow performance after a merger in the fifty largest U.S. industrial takeovers from 1979 to mid-1984. In an earlier study, we showed that the mergers in this same sample created new value for the stockholders of the target company and the acquiring company combined.1 But our results here show that the acquirers did not generate any additional cash flows beyond those required to recover the premium paid. However, while the takeovers were break-even investments on average, the profitability of the individual transactions varied widely.

There were two distinct types of takeovers in our sample: (1) friendly transactions that typically involved stock payment for firms in overlapping businesses, which we called “strategic” takeovers; and (2) hostile transactions that generally involved cash payments for firms in unrelated businesses, which we labeled “financial” takeovers.2

Strategic takeovers have several potential advantages over financial transactions. Because they combine firms in related businesses, strategic transactions are likely to offer greater business synergies than financial transactions. Acquiring managers in friendly strategic takeovers are more familiar with the target company’s business and have access to proprietary information in negotiations, which improves their accuracy in valuing the target. Further, stock-financed transactions reduce the cost of valuation mistakes because the stockholders of the target company partially bear some of the consequences of the errors. Finally, friendly takeovers are less likely to experience disrupted operations after the takeover that may destroy the target firm’s intangible assets. For all these reasons, some cite strategic takeovers as potentially more profitable than financial transactions.

On the other hand, if friendly strategic takeovers are manifestations of free cash flow problems, they are likely to be less profitable than financial transactions, which replace inefficient management and reduce agency costs.

Our study results show that strategic takeovers generated substantial gains for acquirers. Financial transactions broke even at best. The premiums in strategic takeovers were lower than in financial deals and the synergies were higher, indicating that strategic acquirers were able to pay less to get more.

We also examine the relation between the profitability of takeover transactions and three transaction characteristics that management controlled.3 Those characteristics were: (1) the target managers’ attitude, (2) the form of payment, and (3) the degree of overlap of the merging firms’ businesses. Paired comparisons showed that friendly takeovers outperformed hostile takeovers, acquisitions with stock payment outperformed cash transactions, and takeovers with a high overlap between acquirers and target companies performed better than those of unrelated businesses. Each comparison showed superior performance because of both higher takeover synergies and lower premiums paid to the stockholders of target companies.

In contrast to our findings, the results of previous empirical studies have not provided consistent evidence that acquisitions are profitable for acquiring firms. Studies of the effects of acquisition announcements on stock prices report mixed results; some show negative or positive stock returns, while others show no stock price effects.4 However, many corporate managers are skeptical of these findings, arguing that the stock market cannot fully understand the consequences of the transactions immediately.5 Studies using long-term stock price data show some evidence of a downward drift in stock returns for acquiring companies after the takeover, suggesting the possibility of poor performance after the announcement.6

We studied the stock market assessment of post-acquisition profitability at the time the takeover was announced. Announcement returns are usually related to the acquirers’ cash flow performance after the take-over. However, stock returns explained only a small fraction of the cross-sectional variation in takeover profitability. In particular, the market did not appear to acknowledge the difference in profitability between strategic and financial transactions.

Examining the fifty takeovers in our sample had several advantages over a random sample. First, the dollar value of the selected takeovers accounted for a significant portion of the dollar value of all takeovers.7 Second, if acquirers did gain economically from takeovers, the gains would most likely be detected if the target firm was large. Third, it was unlikely that the sample acquirers would undertake equally large acquisitions prior or subsequent to the takeover, reducing any confusion in interpreting results. Finally, although there was already evidence of improved performance for the combined firms in the sample, the question remained whether acquirers shared in the gains. If there were no cash flow return improvements for the combined firms, acquirers, which always pay a premium, obviously would lose in the transaction. (For more information on the sample companies, please see the appendix.)

Accounting Performance after Takeover

We examined the acquiring company’s accounting performance after the takeover, rather than stock returns when the takeover was announced, to evaluate whether takeovers were profitable investments for the acquiring companies. Post-takeover accounting performance measures represent actual economic benefits generated by takeovers, whereas takeover announcement returns represent investors’ expectations of takeover benefits. If managers have private information about takeover benefits, or if both managers and investors are uncertain about those benefits, takeover announcement returns for acquirers are likely to be confusing or misleading estimates of the acquisition’s value.

Using actual post-takeover data potentially increases the validity of our tests but creates some research design challenges. First, the post-takeover measures of economic benefits from takeovers are affected by the assets employed, so it is difficult to compare them across time and across firms. Second, accounting performance measures are affected by the methods of takeover accounting and financing. Finally, actual performance measures after takeover are affected by unexpected economy and industry factors that reduced the tests’ validity. To mitigate these potential problems, we used the acquiring firm’s pretax operating cash flow returns on beginning assets, adjusted for contemporaneous industry performance.

We defined operating cash flows as sales, minus cost of goods sold, and selling and administrative expenses, plus depreciation and goodwill expenses.8 We measured assets by the market value of equity plus book value of net debt. We estimated cash flow returns for acquiring firms in each of the five years before the takeover (years –5 to –1) and in the five subsequent years (years 1 to 5).

Scaling Takeover Benefits

Deflating accounting measures of the takeovers’ economic benefits by the assets employed allowed us to compare results across time and firms. We measured assets employed using market values, which represent the opportunity cost of the assets. In our opinion, market-based measures of asset values simplify comparisons across time and companies.

This market-based measure has a potential limitation. An efficient stock market capitalizes the value of any expected after-takeover improvements in an acquiring company’s performance at the takeover announcement. If we included these equity revaluations in the asset base, measured cash flow return performance should not show any abnormal increase, even though the takeover results in an increase in operating cash flows.9 We therefore excluded the change in the acquiring firms’ equity values at the takeover announcement from the asset base in the years after takeover. We measured this from five days before the announcement of the acquirer’s first offer to the date of the target’s removal from public exchanges.

Several studies have shown that acquiring firms’ post-takeover stock returns are systematically negative, indicating that investors overvalue takeover benefits to acquirers during the takeover announcement period. Such an overvaluation would cause our measure of the market value of assets to be undervalued, and our cash flow returns after takeover to be biased upward. To examine this possibility, we tested whether investors systematically devalued acquirers’ equity after the take-over. The results showed that there was no systematic post-takeover revaluation for our sample.

We also used three alternative cash flow deflators that were not sensitive to market revaluations of equity after takeover — contemporaneous sales, the market value of assets in the year before the merger, and a quasi-market value of assets at the beginning of each year. The results using these alternative scaling variables were very similar to those reported in this paper.

Eliminating Effects of Takeover Accounting and Financing

Using cash flow, rather than earnings, to measure economic benefits from takeovers mitigates the effect of accounting differences for the takeovers in our performance measure. In our sample, thirty-eight takeovers (76 percent) used the purchase method of accounting for the takeover, and the remaining twelve used the pooling of interests method. Purchase accounting, which involves asset write-ups, typically resulted in lower post-takeover earnings and higher post-takeover assets than pooling of interests. In addition, purchase accounting requires that the target company’s results be consolidated with the acquirer’s from the date of the takeover, whereas the pooling method consolidates the two firms’ results from the beginning of the take-over year, regardless of when the takeover occurred. Our cash flow measure excluded the effect of goodwill amortization and depreciation. Also, because we measured assets using market values, they were unaffected by asset write-ups or goodwill. Finally, we excluded the year of the takeover in our analysis because of the timing differences between the purchase and pooling methods in the consolidation of the target and the acquiring companies.

We used return on assets as the performance metric to ensure that our results were not sensitive to the method of takeover financing. If an acquisition is financed by debt or cash, the acquirer’s profits after acquisition will be lower than if the same transaction is financed by stock because income is computed after deducting interest expenses (the cost of debt) but before allowing for any cost of equity. Because the differences in earnings reflect the choice of financing, not differences in economic performance, it is misleading to compare reported accounting earnings, which are computed after interest income and expense, for firms that use different methods of takeover financing. This was a serious concern to us because there was considerable variation in the methods the companies used to finance transactions. We therefore used a performance metric that was unaffected by the choice of financing — operating cash flows before interest expense and income from short-term investments, scaled by the sum of equity and net debt.

Controlling for Effects of Economic and Industry Factors

We used industry-adjusted cash flow returns to control for events in the economy and industry that were unrelated to the takeover. We calculated industry-adjusted performance measures for each firm-year by subtracting the industry median from the acquirer’s value.10 We excluded target and acquiring firms’ performance measures from the industry computations. Before the takeover, industry values for the sample firms were median values for the acquiring firms’ industries. In the post-takeover years, we used industries of both the target and acquiring firms. We constructed the post-takeover industry values by weighting industry median performance measures of the target and acquiring companies by the relative assets of the two firms one year before the takeover.11

Because we examined the largest acquisitions, the median firms in the industry were likely to be systematically smaller than the acquiring firms. To assess any size-related bias in our industry returns, we used value-weighted industry returns as an alternative benchmark. The results were similar to those reported in this paper.

Are Takeovers Profitable?

The significant industry-adjusted cash flow returns after takeover, which we computed assuming that no premium was paid to target companies, indicated that takeovers do improve performance. However, the insignificant industry-adjusted cash flow returns after takeover, given actual takeover premiums, indicated that this improved performance was insufficient for the acquirer to earn returns beyond those required to justify the premium. We interpret these findings as evidence that, on average, acquisitions were zero net present value investments for acquiring firms. However, there was considerable cross-sectional variation in the acquirers’ gains from takeovers. The median industry-adjusted cash flow return during the five years after takeover ranged from 19 percent to –20 percent.

For summary statistics on industry-adjusted cash flow returns for acquiring firms before and after takeovers, see Table 1. Part A shows that median returns for acquirers and the percentage of positive industry-adjusted returns were not statistically reliable in four of the five years before the takeover. The overall median annual return before takeover was only 0.5 percent for acquiring firms, which was statistically insignificant.12 These insignificant industry-adjusted returns before takeover suggest that our method of defining the asset base and our industry controls led to effective measures of normal and abnormal returns.

Returns Assuming No Takeover Premium

The measure of the cash flow returns assuming no premium paid to target company stockholders was identical to the cash flow returns for the combined firm that we reported earlier.13 It shows that, after the takeover, acquiring firms would generate substantially higher cash flow returns than their industries if they could avoid paying any premium for the target’s assets (see Table 1, part B). The median industry-adjusted cash flow return was statistically significant in years one, two, three, and four. The median industry-adjusted cash flow return of the five-year period after the take-over was 2.8 percent, and 73 percent of the industry-adjusted cash flow returns were positive.

To investigate whether industry-adjusted cash flow returns changed after the takeover, we estimated abnormal industry-adjusted cash flow returns following the takeover, controlling for prior cash flow performance. Abnormal industry-adjusted returns adjust post-acquisition cash flow returns for any correlation in performance before and after takeover. The estimated abnormal return for our sample was 2.8 percent (in the last line of part B), which was statistically significant, indicating that takeovers improved profitability, if we ignore the premium paid to target companies.

Returns Given Actual Takeover Premium

The cash flow returns in part C show that the merged firms did not have superior operating performance relative to their industries once we included the premium in the asset base. Median industry-adjusted operating returns for acquirers were insignificant in years one, three, four, and five. The percentage of industry-adjusted returns that were positive was also not significantly different from that expected by chance (50 percent) in these years. Only in year two was there any evidence that acquirers outperformed their industries after takeovers. The median industry-adjusted return in year two was 2.9 percent, and 70 percent of the sample firm returns were positive, both highly significant. The overall median annual return for acquirers in the five years after takeover, however, was insignificantly different from their industry returns. Also, the abnormal industry-adjusted return after takeover was statistically insignificant.

Which Takeovers Are More Profitable?

In this section, we focus on identifying the characteristics of acquisitions that led to superior or inferior performance (see Table 2). We first examine the relation between post-takeover performance and the three transaction characteristics that the managers of the acquiring firms controlled: attitude, degree of business overlap, and financing. The transactions tended to follow two common patterns, strategic and financial, and the transaction characteristics were not independent of each other. We also examine the relative profitability of the two transaction types.

Takeover Characteristics

· Attitude.

This characteristic determined whether the target company’s management was hostile to the successful acquiring company’s takeover offer. Attitude generally predicted the acquirer’s plans for the target firm’s assets. If the acquirer planned to continue the target managers’ direction and retain key managers, it was presumed to be friendly. Hostile takeovers presumably occurred when the acquirer planned substantial changes in the target firm and its management. The relative performance of friendly and hostile deals after takeover therefore depended on the value of the target’s strategy and management before takeover. If the pre-takeover strategy or management was ineffective, a hostile takeover that replaced management and abandoned a failed strategy would be superior to a friendly transaction that did not make changes. However, if the pre-takeover strategy and management was effective, the management change, organizational disruption, and change in direction associated with a hostile take-over would reduce performance after takeover.

Friendly deals exhibited a statistically significant median industry-adjusted cash flow return of 4.2 percent, assuming no premium was paid to the target (see Table 2). In contrast, the hostile transactions had insignificant improvements in cash flow returns. These data suggest that friendly transactions generally created more take-over gains for acquirers than hostile transactions. Furthermore, the takeover premium was lower for friendly transactions, implying that acquirers had to pay less for targets that led to better performance. When we considered the actual target premium, friendly transactions showed significant positive industry-adjusted cash flow returns of 2.6 percent; hostile takeovers had no performance improvements. The takeover gains therefore appeared to be split across target and acquiring firms in friendly transactions.

· Degree of Business Overlap.

We classified high, medium, and low business overlap between the target and acquiring firms.14 For example, we classified the combination of Best Products and Modern Merchandising, both catalog showroom retailers, as a high overlap transaction. We considered the takeover between Holiday Inns and Harrahs as a transaction with medium overlap because Holiday Inns operates a hotel chain and Harrahs operates casinos and associated hotels. Exxon’s acquisition of Reliance Electric was an unrelated transaction: Exxon is an oil company and Reliance Electric produces industrial equipment.

A high degree of overlap between the target and the acquiring firm’s businesses was likely to give acquirers opportunities for synergistic gains. Also, an acquirer would have greater expertise in managing a target firm in businesses similar to its own. Cash flow returns assuming no premium paid to targets were higher for takeovers with a high degree of overlap. After paying target premiums, the median cash flow return after takeover for acquirers of highly overlapping targets was 2.7 percent, and 85 percent of the returns were positive. In contrast, for unrelated target companies, the acquirers’ actual median cash flow return was an insignificant –0.6 percent, and less than half the acquirers’ cash flow returns were positive.

· Financing.

Myers and Majluf have shown that when managers have private information about a firm’s value, investors interpret the use of equity to finance new investments as bad news because it indicates that managers view the firm’s stock as overvalued.15 Takeover announcement returns for acquirers that use equity to finance takeovers therefore reflect both the unanticipated value of the takeover to the acquirer, and the effect of negative information from equity financing. Studies of stock prices confirm this prediction. Huang and Walkling, and Asquith, Brunner, and Mullins have shown that acquirers using equity to finance acquisitions have systematically negative takeover stock returns.16

If acquiring firms use equity financing in anticipation of a performance decline, the cash flow returns after takeover will be lower for equity-financed transactions. But our results were inconsistent with this prediction (see Table 2). The industry-adjusted cash flow returns before the target premium were a statistically significant 4.4 percent when the transaction used stock and debt securities. The comparable returns for other forms of payment were not statistically significant. Furthermore, the premium was lower for the stock and debt securities, leading to higher cash flow returns after the premium of 3.2 percent, with 82 percent of the takeovers showing some improvement in cash flow returns after the takeover.

Strategic versus Financial Takeovers

We compared industry-adjusted cash flow returns before and after takeover for the fourteen strategic and twelve financial takeovers in our sample (see Table 3). As we discussed earlier, strategic acquisitions were friendly transactions that involved stock payment for firms in overlapping businesses. Financial takeovers were hostile transactions of unrelated businesses using cash payments.17

Before the takeover, both strategic and financial acquirers had cash flow returns similar to companies in their industries (see Table 3, part A). Industry-adjusted cash flow returns for strategic takeovers excluding the effect of the takeover premium ranged from 3 percent to 4 percent in the five years after takeover (see part B). The median industry-adjusted cash flow return for the five years after the takeover was 4.4 percent, and 86 percent of these returns were positive, both statistically reliable. In contrast, the returns for financial transactions before takeover premium ranged from –1.5 percent to 5.7 percent. The overall median after takeover was 1.1 percent, and only 58 percent of the returns were positive.

To test whether there was a difference in abnormal industry-adjusted cash flow returns for these sub-samples, we estimated regression equation (1) including a dummy variable that took the value one for strategic takeovers and zero for financial transactions. The estimated coefficient on the dummy thus represented the difference in abnormal industry-adjusted returns for the two subsamples, controlling for performance before takeover. The estimated dummy coefficient was 5 percent and statistically significant, indicating that the strategic acquisitions produced greater synergies than the financial transactions did.

Strategic acquisitions also outperformed financial transactions after factoring in the takeover premium (see part C). The median industry-adjusted return for strategic takeovers in the five years after the takeover was 3.2 percent, but –1.2 percent for financial deals. As many as 79 percent of the strategic transactions had positive returns, compared to 42 percent for financial takeovers.18 The difference in abnormal returns for strategic and financial takeovers was 4.4 percent, which was statistically reliable. Thus the higher synergies in strategic takeovers were not completely paid in acquisition premiums to target shareholders. In fact, strategic acquirers seemed to pay less to earn more (see part C). The median target premium for strategic takeovers was only 29 percent, whereas the premium for financial acquisitions was 50 percent.

The difference in profitability between strategic and financial takeovers may be due to the increased competition that hostile financial acquirers faced, which may have led financial acquirers to pay higher premiums and show lower returns after takeover than strategic acquirers. Strategic takeovers had an average of 1.1 bidders, whereas the average for financial takeovers was 3.3. However, the difference in the number of bidders cannot fully explain the differences in premium and rate of return. For the whole sample, there was no significant difference in the average premium for transactions with one bidder (41 percent) and those with multiple bidders (43 percent), which suggests that the number of bidders was an imperfect measure of competition among bidders; it reflected only actual, not potential, competition.

The difference in pretax profitability for strategic and financial acquisitions may also have occurred because the new value for financial acquirers came largely through increased interest tax shields or tax step-ups in asset bases, whereas strategic acquirers created value primarily through changes in operations. To explore this possibility, we computed industry-adjusted average tax rates (tax outlays as a percentage of earnings before tax) and taxes as a percentage of the market value of assets for acquiring firms before and after takeover. To control for the effect of any noncash deferred tax accruals, we used the current tax expense as a measure of tax outlay. We found no significant differences in average tax rates or taxes to assets for the two subsamples either before or after the merger, suggesting that use of pretax measures of performance does not bias against financial deals.

How Do Investors Interpret Takeover Announcements?

Prior studies have relied on stock returns at the announcement of the merger as indicators of takeover profitability. This methodology assumes that an investor is able to assess accurately the expected benefits of the takeover. While this assumption may be valid for evaluating the benefits to target company shareholders, who receive financial assets, it is less obvious for evaluating the consequences to acquiring firms. How acquiring managers deploy the physical assets they have purchased influences cash flows to the acquiring firm. Investors’ estimates of these cash flows are likely to be uncertain when the takeover is announced, especially given the potential for distorted information shared between managers and outsiders. Next, we examine how investors’ expectations were related to the subsequent results of the takeovers.

Unexpected Value Changes

We used the acquirer’s market-adjusted stock returns to measure unexpected changes in equity value at the takeover announcement.19 We measured returns from five days before the acquirer announced the offer to the date the acquisition was completed and the target firm was removed from trading on public exchanges. The changes in equity value for our sample were mixed (see Table 4). The mean unexpected equity value change was insignificant, similar to findings reported by earlier studies. The median equity value change, however, was –3.6 percent, which was significantly different from zero at the 5 percent level. Only 40 percent of acquirers showed an unexpected equity value increase at the takeover.

Our tests examined the relation between the change in equity values for acquiring companies when the takeover was announced and cash flow return improvements after the takeover. Earlier, we measured post-takeover performance using cash flow return on assets; the takeover announcement returns computed above are equity value changes. Therefore, before we correlated value changes at takeover announcement and cash flow improvements after takeover, we computed asset value changes at takeover announcements from equity values to ensure that the anticipated gains from takeovers and measured gains after takeover were comparable.

Assuming that the value of debt did not change at takeover announcements, asset value changes equal the equity value changes multiplied by the equity-to-assets ratio.20 We used leverage at the beginning of the year of the takeover announcement to compute the equity-to-asset ratio. For summary statistics on the estimated asset value changes at the takeover announcement for the target firms, acquiring firms, and combined firms, see Table 4. The mean and median asset returns for the bidding firm were insignificant.

Relation between Value Changes and Cash Flow Returns

To examine how investors value acquisitions for acquirers at takeover announcements, we estimated the relation between changes in acquirer cash flow returns following the acquisition, and changes in market values of assets at the takeover announcement. We measured market asset value changes,, as un-leveraged market-adjusted stock returns for the acquirer at the takeover announcement, which we discussed earlier. Changes in cash flow returns following the acquisition, IACRpost, are the median annual industry-adjusted operating cash flow returns following the takeover. We also controlled for pre-acquisition performance using median annual industry-adjusted operating cash flow returns prior to the acquisition, IACRpre . The model used to test the relation between cash flow returns and anticipated stock market values is therefore the following:Sinceis the capitalized value of future cash flow return improvements, and IACRpost is the pretax cash flow return improvement per year, the coefficientin equation (1) should equal the pretax capitalization rate. For example, if the cash flow return improvements are permanent and the pretax capitalization rate is 20 percent, the coefficientwould be 0.20. Although equation (1) does not have a constant, we estimated a regression equation with an intercept and tested whether it was zero.

For the regression results, see model 1 in Table 5. The estimated model explained 22 percent of the variation in post-takeover cash flow returns. The estimated slope coefficient on asset returns at the takeover announcement was 0.17 and was statistically reliable, implying that if cash flow return improvements were permanent, the pretax discount rate for the sample firms was 17 percent. This estimated discount rate was economically plausible, similar to the pre-tax cost of capital for our sample firms, assuming a 9 percent pretax risk-free rate and an 8 percent risk premium. The estimated coefficient on pre-takeover performance was insignificant. Finally, as predicted by equation (1), the intercept was insignificant. These findings are evidence that we can largely attribute the stock price gains at the takeover announcement to rational expectations of subsequent cash flow improvements. However, there is considerable variance in performance after takeover that investors did not anticipate at the takeover announcement.

The second model examines whether investors anticipate the finding that strategic takeovers are more profitable afterward than financial transactions. To maximize the validity of the test, we estimated the model using only the twenty-six strategic and financial transactions. We reestimated equation (1) including a dummy variable that was one for strategic takeovers and zero for financial transactions. If investors had recognized the post-takeover superiority of strategic takeovers, the dummy would have had an insignificant coefficient. However, the estimated coefficient was positive and significant, suggesting that investors underestimated the profitability of strategic deals (see Table 5, model 2).

Summary

The results of our study show that the acquiring companies did not generate any additional cash flows beyond those needed to recover the premium paid. However, while takeovers were usually break-even investments, the profitability of individual transactions varied widely.

We found a significant relation between the profitability of takeover transactions and three transaction characteristics that were under management control. Friendly takeovers outperformed hostile takeovers; takeovers with payment of stock and debt outperformed cash transactions; and takeovers involving highly overlapping acquirers and targets performed better than those in unrelated businesses. In each comparison, there was superior performance because of both higher takeover synergies and lower premiums paid to target stockholders.

Our results showed that strategic takeovers generated substantial gains for acquirers. Financial transactions, however, barely broke even. The premiums in strategic takeovers were lower than in financial deals and the synergies were higher, indicating that strategic acquirers were able to pay less to get more. These results suggested that the transaction characteristics that were under management control substantially influenced the ultimate payoffs from takeovers.

We also examined how well the stock market assessed profitability after acquisition at the time the takeover was announced. On average, announcement returns were related to acquirers’ cash flow performance after takeover. However, stock returns explained only a small fraction of the cross-sectional variation in takeover profitability. In particular, the market did not seem to recognize the difference in profitability between strategic and financial transactions.

Our findings raise several interesting questions for future research. How do strategic acquirers both negotiate lower takeover premiums and integrate target firms more effectively to realize larger synergies? Why do financial acquirers pay such large premiums for target companies, given few immediate operating cash flow improvements? Do financial deals improve operating cash flows, but after the five years we’ve examined here? Or do financial transactions reduce value?

Appendix

We drew our sample firms from the 382 companies that were removed from the Center for Research in Securities Prices database from January 1979 to June 1984 due to takeovers. We identified the acquiring company’s name from the Wall Street Journal Index. The sample consisted of the fifty largest targets for which the acquirer was a U.S. company listed on the New York Stock Exchange or American Stock Exchange, and the target and acquirer were not financial or regulated companies (see list).

We computed target firm size from Compustat as the market value of common stock plus the book values of net debt and preferred stock at the beginning of the year before acquisition. We deleted acquisitions from the sample if the acquirers were non-U.S. or private companies because acquirers’ financial information before and after the takeover was not available. We deleted regulated companies (railroads and utilities) and financial firms because they are subject to special accounting and regulatory requirements, making them difficult to compare with other firms.

The sample acquirers and targets represented a wide cross-section of Value Line industries. The acquiring firms came from thirty-three industries, and the target firms belonged to twenty-seven industries. The transactions were almost evenly distributed over the sample years: eight acquisitions in the sample were completed in 1979, seven in 1980, twelve in 1981, ten in 1982, eleven in 1983, and two in 1984.

References

1. P.M. Healy, K.G. Palepu, and R.S. Ruback, “Does Corporate Performance Improve after Mergers?,” Journal of Financial Economics, volume 31, 1992, pp. 135–176.

2. We label takeovers as strategic and financial, following the popular usage of these terms in the financial press.

3. For an examination of the relative profitability of different types of takeovers, see:

R. Morck, A. Shleifer, and R. Vishny, “Do Managerial Motives Drive Bad Acquisitions?,” Journal of Finance, volume 45, 1990, pp. 31–48;

L. Lang, R. Stultz, and R. Walking, “A Test of the Free Cash Flow Hypothesis: The Case of Bidder Returns,” Journal of Financial Economics, volume 29, 1991, pp. 315–336;

D. Ravenscraft and F.M. Scherer, Mergers, Sell-offs, and Economic Efficiency (Washington, D.C.: The Brookings Institution, 1987);

M. Porter, “From Competitive Advantage to Corporate Strategy,” Harvard Business Review, volume 65, May–June 1987, pp. 43–59; and

S. Kaplan and M. Weisbach, “The Success of Acquistions: Evidence from Divestitures,” Journal of Finance, volume 47, 1992, pp. 107–138.

The first two studies use acquiring firms’ announcement returns, and the last three examine post-takeover divestitures by acquirers to assess the relative success of different types of acquisition. In contrast, we analyze post-takeover cash flow performance.

4. See: M.C. Jensen and R.S. Ruback, “The Market for Corporate Control,” Journal of Financial Economics, volume 11, 1983, pp. 5–50.

5. This suggestion is not unreasonable, given the market’s apparent difficulty in interpreting routine information, such as quarterly earnings announcements. See:

V.L. Bernard and J. Thomas, “Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings,” Journal of Accounting and Economics, volume 13, 1990, pp. 305–340.

6. For a summary of evidence on negative post-merger abnormal stock returns for acquirers, see:

Jensen and Ruback (1983).

Franks et al. argue that these findings are spurious and are caused by earlier errors in the market benchmark used to compute abnormal returns. See:

J. Franks, R. Harris, and S. Titman, “The Postmerger Share-Price Performance of Acquiring Firms,” Journal of Financial Economics, volume 29, 1991, pp. 81–96.

7. The aggregate market value of equity of the fifty target firms in our sample one year prior to the acquisition is $43 billion.

8. Strictly speaking, our measure is working capital from operations and not operating cash flow. It excludes all noncurrent accruals but includes some current accruals, such as accounts receivables and payables. However, we believe that our measure reflects long-term operating performance with less noise than a strict cash flow measure.

9. For an illustration of this point, see: Healy et al. (1992).

10. We used Value Line industry definitions to control for the industry effects.

11. We collected industry data from Compustat Industrial and Research files.

12. To calculate the sample median pretax operating cash flow return for years –5 to –1, we first computed the median return in these years for each sample firm. The reported sample median was the median of these values. Sample median returns in the post-merger period were calculated in the same way. Throughout the paper, we used a two-tailed test and a 5 percent or lower cutoff significance level. This is equivalent to a 2.5 percent cutoff one-tailed test for the many cases where the hypotheses examined are directional.

13. Healy et al. (1992).

14. We evaluated the merging firms’ annual reports, takeover prospectuses, Value Line reports, and Moody’s Industrial Manuals. For a complete description of the business overlap classifications for each sample transaction, see:

Healy et al. (1992).

15. S.C. Myers and N.S. Majluf, “Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have,” Journal of Financial Economics, volume 13, 1984, pp. 187–222.

16. Y. Huang and R. Walkling, “Target Abnormal Returns Associated with Acquisition Announcements: Payment, Acquisition Form, and Managerial Resistance,” Journal of Financial Economics, volume 19, 1987, pp. 329–349; and

P. Asquith, R. Brunner, and D. Mullins, “Merger Returns and the Form of Financing” (Cambridge, Massachusetts: MIT Sloan School of Management, working paper, 1988).

17. Twenty-four of the sample firms did not fall within our classifications of strategic and financial takeovers.

18. When the post-takeover cash flow returns are ranked for all fifty sample transactions, ten of the fourteen strategic takeovers are in the top half of the sample; only four of the twelve financial takeovers are in the top half of the sample.

19. Risk-adjusted returns, computed using premerger announcement market model estimates, are similar to the market-adjusted returns reported in this paper.

20. For evidence consistent with this assumption, see:

P. Asquith and E.H. Kim, “The Impact of Merger Bids on Participating Firms’ Security Holders,” Journal of Finance, volume 37, 1982, pp. 1209–1228.