Growth options, risk dynamics, and cost of capital: Evidence from U.S. corporate control transactions

Abstract

We provide empirical evidence on recent models on the evolution of systematic risk around growth option exercise related to takeover announcements. Consistent with theory, the risk differential between the merging firms influences the evolution of bidder systematic risk. We find that the cost of capital decreases (increases) when the growth option’s underlying assets (i.e., the target firm) are less (more) risky than the bidder’s assets in place. Furthermore, the impact on the cost of capital is larger, the bigger the difference between the pre-transaction risk of the bidder and the target. Firm characteristics such as the relative size of the firms and information asymmetry affecting the bidder also impact risk dynamics. Our findings help clarify conflicting predictions in the finance literature, thus allowing for more informed capital structure decisions by financial managers when considering growth option exercise.