Undervalued Firms Research Articles

Why are Cash-Rich Firms More Likely to Pay for Acquisitions with Stock?

We examine why cash-rich firms prefer to use stock to make acquisitions. Consistent with prior literature, we find that cash-rich firms are more likely to attempt acquisitions than other firms. However, cash-rich acquirers are more likely to employ stock as the method of payment. We investigate this finding further and show that cash-rich firms use overvalued equity to make acquisitions. Moreover, there is no evidence that firms waste excess cash on acquisitions; cash-rich firms that pay with cash actually acquire undervalued firms. Finally, in the post-acquisition period, cash-rich firms that acquire with stock are at least as likely to maintain high levels of excess cash as non-bidder cash-rich firms.

Do Firms Set Free Cash Free? Misallocation vs. Opportunism in Acquisitions

We examine the impact of excess cash on the decision and method of payment in acquisitions. Consistent with prior literature, we find that firms that have excess cash do make more acquisitions. However, those acquisitions frequently use stock as the method of payment. We investigate this finding further and show that cash-rich firms use overvalued equity to make acquisitions. Moreover, there is no evidence that firms waste excess cash on acquisitions; cash-rich firms that pay with cash actually acquire undervalued firms. Our results suggest that with respect to acquisitions, managers are opportunistic with the firm’s financial resources; both its equity and its cash.

Capital Market Imperfections and the Sensitivity of Investment to Stock Prices

AbstractPrior studies argue that investment by undervalued firms that require external equity is particularly sensitive to stock prices in irrational capital markets. We present a model in which investment can appear to be more sensitive to stock prices when capital markets are rational, but subject to imperfections such as debt overhang, information asymmetries, and financial distress costs. Our empirical tests support the rational (but imperfect) capital markets view. Specifically, investment–stock price sensitivity is related to firm leverage, financial slack, and probability of financial distress, but is not related to proxies for firm undervaluation. Because, in our model, stock prices reflect the net present values (NPVs) of investment opportunities, our results are consistent with rational capital markets improving the allocation of capital by channeling more funds to firms with positive NPV projects.

Information Asymmetry and Bidders' Gains

Abstract: Undervalued firms with high information asymmetry may announce takeover bids to attract the attention of investors with a view to increasing the share price through revaluation. Announcement period returns to such bidders should include both revaluation and synergy gains although the revaluation gains should be confined to early bids and decline with the number of bids announced within a reasonable period. Our results offer strong support to these predictions. Undervalued firms with high pre‐bid information asymmetry gain the most from early bids and the gains decline with the number of bids announced. These findings are robust to methods of payment, relative size of deals, target status, relatedness of businesses, domicile of target, M&A activities and alternative measures of information asymmetry, and confirm that gains from early bids include revaluation as well as synergy gains, especially in the cases of undervalued firms with high information asymmetry.

Capital Budgeting vs. Market Timing: An Evaluation Using Demographics

An ongoing debate in corporate finance pits capital budgeting-equity and debt issuance are dictated by investment opportunities -against market timing-equity issuance exploits market mis-valuation. A difficulty in evaluating these theories is finding exogenous proxies for investment opportunities and for mis-valuation. In this paper, we suggest that demographic variables provide proxies for both, allowing for an evaluation of the two theories. We consider age-sensitive industries that are affected by (forecastable) shifts in cohort sizes, such as toys, beer, and nursing homes. We compare industries in which demographics induces positive demand shifts and in which it induces negative demand shifts. According to capital budgeting, industries affected by contemporaneous positive demand shifts should raise capital with IPOs and equity issuance to increase production through investment. We rely on the finding in DellaVigna and Pollet (2005) to motivate a test of market timing. Because demographic shifts 5 to 10 years ahead are not fully incorporated into asset prices, industries affected by positive demand shifts 5 to 10 years ahead are more likely to be undervalued. Hence, market timing suggests that these undervalued firms should be less likely to raise capital with IPOs and equity issuance. We find evidence to support both capital budgeting and market timing: IPOs and equity issuance respond positively to demand shifts up to 5 years ahead, and negatively to demand shifts 5 to 10 years ahead. Debt issuance and investment respond positively to demand shifts up to 5 years ahead. Capital budgeting and market timing both appear to play important roles in equity and debt issuance.

Stepping Up to the Edge: Delisting Pressure in a Frontier Emerging Market

Preventing minority shareholders expropriation by major shareholders and facilitating the emergence of a strong private sector were two of the main priorities recommended in the OCDE 2001 Report on corporate governance in Romania. In this study we show that the companies' delisting, strongly encouraged in the above mentioned report, involves mainly undervalued firms and comes at the expense of small shareholders. Delisting is more likely to occur when (1) the block obtained by circumventing the market is higher; (2) the companies are less scrutinized by investors and hence market prices are less informative and; (3) the scope for employing the company's resources without the need to demonstrate performance is larger. These findings are derived from the consideration of governance and market attributes of a sample of 131 companies that were delisted from the Romanian OTC market RASDAQ and a sample comparable in size of still public firms. The study reveals that the protection of minority shareholders can be dissimulated behind the recommended benchmarks for establishing fair compensations to the small shareholders involved in going to private transactions. Its main objective is to stimulate serious reflection about the need of integrating the peculiarities of corporate governance arrangements when adopting regulation from developed countries.

Evolving Corporate Governance and Equity Prices: The Recent Evidence

The U.S. corporate failures in 2001-2002 led to intensified and persisting public concern over corporate governance practices, increased shareholder activism, and new regulations. The 2002-2005 period serves as a rich ground for studying how firms' changes in governance practices relate to their performance. First, how corporate governance momentum, an aggregate measure of a firm's change in corporate governance quality through time, is related to stock returns is studied. Our empirical evidence indicates that firms gaining positive governance momentum outperform firms gaining negative governance momentum in stock returns, and the evidence is concentrated in large firms. Next, the interaction between governance momentum and equity mispricing is investigated. The empirical evidence that, for undervalued firms, gaining positive governance momentum shortens the time to correct equity mispricing is concentrated in relatively large firms. Furthermore the evidence that, for overvalued firms, gaining negative governance momentum shortens the time to correct equity mispricing is concentrated in relatively small firms. Our findings suggest that, for firms undervalued or overvalued by the market, pursuing or keeping the best corporate governance practices is particularly important in their quest to improve shareholder value.

Bank Equity Investments: Reducing Agency Costs or Buying Undervalued Firms? The Information Effects

Abstract: This paper analyses the relevance of two different reasons for banks to acquire firms’ stock: the increase of agency costs in the lending relationship (the agency costs hypothesis), and participation in the expected profits of undervalued firms (the information asymmetry hypothesis). Results indicate not only that banks make equity investments for both reasons but also that the market exploits their lending decisions to learn which of the two motivations was in play. Bank equity investments concurrent with reductions in bank debt are consistent with the agency costs hypothesis, whereas bank equity investments concurrent with increases in bank debt are consistent with the information asymmetry hypothesis.

Capital Market Imperfections and the Sensitivity of Investment to Stock Prices

Prior studies argue that investment by undervalued firms that require external equity is particularly sensitive to stock prices in irrational capital markets. We present a model in which investment can appear to be more sensitive to stock prices when capital markets are rational, but subject to imperfections such as debt overhang, information asymmetries, and financial distress costs. Our empirical tests support the rational (but imperfect) capital markets view. Specifically, investment-stock price sensitivity is related to firm leverage, financial slack, and probability of financial distress, but is not related to proxies for firm undervaluation. Because, in our model, stock prices reflect the NPVs of investment opportunities, our results are consistent with rational capital markets improving the allocation of capital by channeling more funds to firms with positive NPV projects.

Market Misvaluation and Merger Activity: Evidence from Managerial Insider Trading

This paper tests the empirical predictions of the market misvaluation theory of mergers advanced by Rhodes-Kropf and Vishwanathan (2004) and Shleifer and Vishny (2003) using data on managerial insider trading around merger announcements. I first present evidence of opportunistic insider trading by acquirer-firm managers prior to mergers. Acquirer-firm managers abnormally increase their selling prior to stock mergers suggesting those deals might be overvalued. I then construct a misvaluation measure based on the magnitude and direction of managerial trades prior to the merger and use it to test the empirical predictions of the misvaluation theory. To the extent that managerial trading is motivated by misvaluation, I find consistent differences in the merger characteristics and long-run returns of overvalued and undervalued firms. Overvalued firms are more likely to conduct stock mergers, have high pre-merger but negative post-merger excess long-run returns and receive negative market reaction to their acquisition announcements. My results support the theory that market misvaluation affects merger activity.

Agency Costs of Controlling Minority Shareholders

Agency Costs of Controlling Minority Shareholders (coauthored with Henrik Cronqvist) estimates the agency costs of controlling minority shareholders (CMSs) using a panel of Swedish listed firms. CMSs are owners who have a control stake of the firm’s votes while owning only a minority fraction of the firm’s equity. The study documents that families in control are almost exclusively CMSs through an extensive use of dual-class shares. The results show that increased ownership of votes by a controlling owner is associated with an economically and statistically significant decrease in firm value, but that the decrease in firm value is significantly larger for firms with family CMSs than for firms with financial institutions or corporations in control. This indicates that the agency costs of family CMSs are larger than the agency costs of other controlling owners.Family Ownership, Control Considerations, and Corporate Financing Decisions: An Empirical Analysis analyzes the relation between concentrated family control and firms’ choice of capital structure for a panel of Swedish listed firms. The results suggest that the capital structure choices made by firms with families in control are influenced by the controlling families’ desire to protect their control, and that the resulting capital structures are likely to increase the agency costs of family control. The Choice between Rights Offerings and Private Equity Placements (coauthored with Henrik Cronqvist) analyzes the determinants of the choice between rights offerings and private equity placements using a sample of rights offerings and private placements made by listed Swedish firms. The results indicate that control considerations explain why firms make uninsured rights offerings. The evidence also suggest that private placements, and to some extent underwritten rights offerings, are made by potentially undervalued firms in order to overcome underinvestment problems resulting from asymmetric information about firm value. Furthermore, private placements are frequently made in conjunction with the establishment of a product market relationship between purchaser and seller, which is consistent with equity ownership reducing contracting costs in new product market relationships. Why Agency Costs Explain Diversification Discounts (coauthored with Henrik Cronqvist and Peter Hogfeldt) studies diversification within the real estate industry, in which firms can diversify over property types and geographical regions. Similar to previous studies, this essay documents the existence of a diversification discount. However, the major cause of the diversification discount is not diversification per se but anticipated costs due to rent dissipation in future diversifying acquisitions. Firms expected to pursue non-focusing strategies do indeed diversify more, are valued ex ante at a 20% discount over firms anticipated to follow a focusing strategy, and are predominantly family controlled. The ex ante diversification discount is, therefore, a measure of agency costs. The Difference in Acquirer Returns between Takeovers of Public Targets and Takeovers of Private Targets shows, for a sample of Swedish takeovers, that the average acquirer abnormal return is positive and significant when the target firm is privately held but insignificant when the target firm is listed on a stock exchange. These results are robust when controlling for sample selection problems and other variables capable of explaining acquirer returns. The evidence is consistent with greater acquirer bargaining power and resolution of information asymmetries in takeovers of private targets.

How do Young Firms Choose Among Different Modes of Investor Communications?

This paper analyzes how managers of young firms choose among various modes of investor communications, using data on analyst presentations, management earnings forecasts, press releases and corporate finance disbursements for a sample of 645 post-IPO firms. Firms that plan to access capital markets initiate investor communications through analyst presentations. Firms with high return volatility make management earnings forecasts as their first act of investor communications. Firms with low return volatility and increasing earnings communicate by initiating dividends. Undervalued firms use repurchases to initiate their communication. Further, firms in poor information environments are more likely to use corporate financial disbursements to solve information asymmetry problems. The results show that the modes of investor communications differ from each other, with firms choosing the mode that best suits their communications objective.

Strategic Considerations, the Pecking Order Hypothesis, and Market Reactions to Equity Financing

Myers and Majluf (1984) showed that in a world of asymmetric information, managers of overvalued firms issue equity, while managers of undervalued firms use cash, if available. This paper shows that, in a multiperiod world, managers of undervalued firms may find it optimal to issue stock, even though cash is available. Consequently, the market does not interpret all announcements of equity issues as signals of firm overvaluation. The paper also generates predictions regarding the effect of information asymmetry and investment oppor? tunities on i) dividend policy, and ii) the cross-sectional distribution of market reactions when an equity issue is announced.