The Effect of Stock Misvaluation and Investment Opportunities on the Method of Payment in Mergers

Abstract

This paper tests the effect of firms’ mispricing and investment opportunities on the method of payment in mergers. Using a new proxy for investment opportunities and a sample of 1,187 mergers completed between 1990 and 2005 among US publicly traded firms, I find that acquirers lead the decision on the method of payment, thus exploiting short-term market mispricing (in line with both the Shleifer and Vishny (2003) and Rhodes-Kropf and Viswanathan (2004) models). However, target managers believe in the quality of the merger and care about the long-term value of the merged entity’s shares (as predicted by Rhodes-Kropf and Viswanathan (2004) and contrary to Shleifer and Vishny (2003)). I also find that better investment opportunities lead to greater use of stock.