Determinants of Takeover Premium in Cash Offers: An Option Pricing Approach

Abstract

Abstract: In takeovers bidders offer a premium to target firm shareholders but the determinants of such premium are not clearly identified. Among the factors previously examined in the literature are prior target undervaluation, expected synergy and overpayment due to behavioural biases like hubris. In this paper we use an option pricing approach to decompose the observed takeover premia. We also test the implications of recent real options‐based models of takeover premia and risk changes surrounding takeovers. We model the observed target stock price as a portfolio of unobserved stock price and a put option whose value depends on a number of target and deal characteristics that impinge on the probability of bid success. For a sample of over 200 UK cash takeover bids during 1990–2004, we estimate the put value using the Black‐Scholes option pricing model and find that target firm revaluation accounts for a substantial part of the observed takeover premium and the put value accounts for a smaller, but still significant, proportion. The latter is higher in hostile, failed and longer bids. The put option value is also significantly correlated with the relative riskiness of bidders and targets, and synergy as predicted by Lambrecht (2004). Movements in betas in the run up to takeover announcements and in the post‐announcement period are consistent with the real options‐based predictions of Hackbarth and Morellec (2008). This study contributes to a better understanding of the true determinants of takeover premium and demonstrates the usefulness of option pricing models and provides a preliminary test of real options models in understanding and measuring the impact of UK takeovers on firm risk and shareholder gains.