Abstract
Empirical evidence indicates that termination fees in merger agreements discourage competition from higher-valuing bidders but do not necessarily harm target shareholders' returns. We present a signaling theory that explains these findings by treating the presence of a termination fee as a signal of the acquirer's high valuation of the target; this, in turn, discourages potential bidders from competing and thereby saves bidding costs which are shared between the merger parties. The credibility of termination fees as signals is derived from the information asymmetry between the target and the acquirer regarding the acquirer's valuation of the target.
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