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Effect of M&A Strategy on Shareholder Value

Info: 13099 words (52 pages) Dissertation
Published: 20th Dec 2021

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Tagged: BusinessInvestment

The aim of this project is to examine whether the decision of large UK companies looking to pursue a merger/acquisition strategy will affect shareholder value. The data analyzed in this study will determine if there is a positive or negative correlation in shareholder wealth when a merger/acquisition occurs.

The research for this project will be conducted through the analysis of 40 different large UK companies that were merged or acquired by other UK based firms prior to 2002. The data will be obtained from the Bloomberg website. Further research and analysis on the topic will include information obtained from books, journals and reliable internet sources. To test the value of shareholder wealth when a merger/acquisition is pursued, different models will be used which includes Capital Asset Pricing Model, Efficient Capital Markets, Equilibrium Models, and Market Model (Event Studies and Abnormal Returns Methodology). The hypothesis that will be tested in this study is:

H0 = If managers of large sized UK companies pursue a merger and acquisition strategy then shareholder wealth (value) will increase.

H1 = If managers of large sized UK companies pursue a merger and acquisition strategy then shareholder wealth (value) will remain unchanged or will decrease.

The first chapter will give a brief overview of mergers and acquisitions and introduce the reader to recent merger trends in the UK and different types of takeovers. The second chapter will be an in-depth analysis of past research studies which includes: examining different ways a company pays for a bid in a merger, exploring shareholder and managerial wealth perspectives, and analyzing long term post-merger performance of target and bidder firms. Chapter three presents the research methodology used in wealth gain studies and also states the methodology adopted for this dissertation. Chapter four analyzes and discusses the findings in context to wealth gain effects of mergers and acquisitions among the large UK companies chosen for this study. Chapter five concludes this research and highlights possible areas that may require further investigation.


Mergers and acquisitions have become important events in today's rapidly changing business environment and have been the subject of many research studies. Reasons as to why companies may pursue a merger or acquisition strategy could be to reduce costs to achieve economies of scale or to reduce competition due to increased market power. Mergers and acquisitions have also been known to facilitate entry into new markets or industries and increase the level of effectiveness in a company by eliminating inefficient management. Mergers and acquisitions worldwide have tended to follow a pattern of waves, with there being periods of frantic takeover activity followed by relatively calmer periods.

The main objective of financial theory is to maximize shareholder wealth therefore all decisions are taken with the aim of maximizing shareholder value. The purpose of this research is to re-examine the shareholder wealth gain criterion with regards to mergers and acquisitions within the United Kingdom. The objective of this study is to find out if shareholders of large UK companies benefit from the acquisition decisions made by the managers. Past research studies on post-acquisition performance of acquiring and target firms have mixed results. To determine if there is an increase or decrease in shareholder value from corporate takeovers, the Market Model and Event Study Methodology will be used in this study.

The hypothesis developed in this study aims to support the argument that mergers and acquisitions are profitable events and lead to an increase in shareholder value. This study however concluded that merger and acquisitions among the large UK organizations chosen did not lead to an increase of shareholder value for both target and bidder firms. These results might not be entirely accurate due to various reasons such as size effects and the firms chosen in this study are from different industries. Other factors such as acquisition financing and acquisition motives also may have an effect on shareholder value however the testing of these factors is outside the scope of the following study.


The following chapter briefly examines the benefits that a merger is expected to generate for both the target firm and the acquiring firm. The historical pattern of takeover activity in the UK from 1964-1992 is discussed to show merger and acquisition (M&A) trends and recent M&A activity abroad and within the UK will also be highlighted among large UK companies in 2008. In addition, the definition of mergers and acquisitions is provided and the second part of chapter one introduces the reader to different types of mergers used to create value for an organization.

1.1 Benefits to Mergers and Acquisitions Activity

The main objective for an acquiring firm is to grow and expand its assets, sales and market shares. Other specific reasons for entering into a merger bid are reflected in the benefits that are expected to be generated which include:

  • Exploiting scale economies
  • Obtain synergy
  • Enter into new markets
  • To restore growth impetus
  • To acquire market power

To reduce dependence on existing or perhaps risky activities

With the above mentioned benefits to M&A activity, it should also be noted that takeovers most likely to succeed are those approached with a strategic focus, incorporating a detailed analysis of the objectives of the takeover, the possible alternatives and how the acquired company can be integrated in the new parent (Pike and Neale).

1.2 Trends in UK Merger Activity

There has been an increasing trend of M&A activity in the UK over the past few decades, with there being periods of high takeover activity followed by relatively slower periods as can be seen by the graph below.

Figure 1.0 History of UK M&A Activity

Source: National Statistics, 2002

The highest peaks in takeovers are during the period 1984-1989. During this time, the average size of an acquisition had grown significantly from 9.64 million to 20.38 million. As per Sudarsanam (1995) the main reason for this was because the stock market in the UK, along with the harmony with the rest of the world stock markets experienced a strong bull phase which culminated in the October 1987 crash. Furthermore, the 1980s' also experienced divestments on a large scale which meant companies would sell off divisions or subsidiaries to other firms of the divested parts in a management buyout. This increase in acquisitions and divestments had shown significant amount of corporate restructuring in the UK and thus led to new organizational innovations such as management buyouts and management buyins, as well as by financial innovations like high-leverage buyouts and mezzanine finance (Sudarsanam, 1995).As can be seen from the graph above, the UK M&A market has experienced a relatively leaner period, which has continued till date. The main reasons that can be attributed to this are the various world catastrophes and the overall global economic slowdown.

As per the office of National Statistics, the largest significant transaction recorded during the first quarter of 2008 was the acquisition by Imperial Tobacco Group Plc of Altadis S.A. for a press reported value of 9.3 billion. Another significant transaction was the acquisition by Carillion Plc of Alfred McAlpine Plc for a reported value of approximately 0.5 billion. For quarter one in 2008, the number of transactions reported for acquisitions in the UK by UK companies has been the lowest reported since quarter one 2003.

Other recent major UK mergers & acquisitions (2008) are as follows:

Table 1.0 Recent Acquisitions in the UK by UK Companies


Value in million

Carillion Plc acquiring Alfred McAlpine Plc


Willmott Dixon Ltd acquiring Inspace Plc


easyJet Plc acquiring GB Airways Ltd


iimia MitonOptimal Plc acquiring Midas Capital Partners Ltd


Source: National Statistics, 2008

Table 2.0 Recent Acquisitions abroad by UK Companies


Value in million

Imperial Tobacco Group Plc acquiring Altadis S.A.


Reckitt Benckiser Group Plc acquiring Adams Respiratory Therapeutics


Scottish and Southern Energy Plc acquiring Airtricity Holdings Ltd


SABMiller Plc acquiring Koninklijke Grolsch N.V


Ineos Group Ltd acquiring Kerling AS 429


Standard Chartered Plc acquiring American Express Bank Ltd


Kesa Electricals Plc disposing of BUT SAS


Source: National Statistics, 2008

1.3 Definitions and Different Types of Mergers and Acquisitions

Although the terms 'merger,' 'acquisition' and 'takeover' are used interchangeably, technical differences do exist. A merger is when corporations come together to combine and share their resources to achieve a common set of objectives (Sudarsanam, 1995). The shareholders of the two combined corporations will continue to be joint owners. An acquisition is when one firm purchases the assets or shares of another firm however the shareholders of the acquired firm continue being owners of that firm. A takeover is the acquisition by one company of the share capital of another in exchange for cash, ordinary shares, loan stock or a combination of these (Pike and Neale). This distinction between the three terms is important in certain contexts however they are used by researchers' and authors' interchangeably. In the following dissertation, I too will use these three terms interchangeably.

There are different types of mergers that exist to create value and are classified into three main categories: horizontal, vertical and conglomerate (Pike and Neale).

Horizontal integration: this is when a company takes over the target firm from the same industry and at the same stage of the production process.

Vertical integration: where the target is in the same industry as the acquirer however is operating at a different stage in the production process. This can be either close to the source of materials (backward integration) or close to the final customer (forward integration).

Conglomerate integration: occurs when the target is in a business that is different to the acquirer. The reasons a firm may undergo a conglomerate merger is to reduce risk through diversification, opportunities for cost reduction and improving internal and external efficiencies.

In order to understand whether mergers and acquisitions create or destroy shareholder value, it is important to appreciate and understand few critical aspects of the complex M&A theory. The three areas in helping to answer this question with respects to the impact of shareholder value in my opinion are different modes of financing mergers and acquisitions, motives for M&A activity and post-merger performance. Various researchers in the finance field have conducted a great amount of research on the above mentioned areas and this dissertation will help put into perspective mergers and acquisitions impact on shareholder value currently in the UK.


Mergers and acquisitions are undertaken as a means of corporate growth and expansion but are also an alternative to growth through internal or organic capital investment. The immediate objective of an acquisition is self-evidently growth and expansion of the acquirer's assets, sales and market share (Sudarsanam, 1995). Another objective of acquisitions would be to increase the growth of shareholders wealth aimed at creating a strong competitive advantage for the acquirer. In modern finance theory, shareholder wealth maximization is a strong rational for financing and investment decisions made by management. This leads to the question of wealth gain effects of mergers and acquisitions, specifically among large UK companies. The following chapter introduces various literature regarding wealth gain effects of mergers and acquisitions and highlights the various aspects of mergers and acquisitions which may have an effect on the shareholder value within large UK corporations.

2.1 Modes of Acquisition Financing

There are various modes of financing a takeover which includes: cash (preferred method), issuing of ordinary shares and fixed interest securities (loan stock, convertibles, and preference shares). The way in which a merger and acquisition is financed has different benefits to the target shareholders and bidder shareholders. In addition, cash takeovers may be sufficiently different from non-cash acquisitions and failure to distinguish between them may lead to inappropriate generalizations (Carleton et al, 1983). As per Sudarsanam (1995), there are various ways a firm can bid an acquisition, which is shown in Table 3.0.

Table 3.0 Bid Financing

Bidder Offers

Target shareholders receive


Cash in exchange for their shares

Share Exchange

A specified number of bidder 's shares for each target share

Cash underwritten share offer (vendor placing)

Bidder's shares, then sell them to a merchant bank for cash

Loan stock

A loan stock/debenture in exchange for their shares

Convertible loan or preferred shares

Loan stock or preferred shares convertible into ordinary shares at a predetermined conversion rate over a specified period

Deferred payment

Part of consideration after a specified period, subject to performance criteria

Source: Sudarsanam (1995, p.177)

In addition, a bidder making cash offer can finance it from one or more of the following sources (Sudarsanam, 1995):

Internal operating cash flow

A pre-bid rights issue

A cash underwritten offer, e.g. vendor placing or vendor rights

A pre-bid loan stock issue

Bank Credit

A cash offer has two advantages from the point of view to both the target and acquiring shareholders which includes (Pike & Neale, 1999):

The amount is certain; there is no exposure to the risk of adverse movement in share price during the course of the bid.

The targeted shareholder is more easily able to adjust his or her portfolio than if he or she receives shares, which involve dealing costs when sold. Because no new shares are issued, there is no dilution of earnings or change in the balance of control of the bidder.

In terms of shares being used as a medium of exchange again there are some advantages to both target as well as acquiring shareholders (Arnold, 2002) which are:

For target shareholders use of shares helps avoid capital gains tax.

Target shareholders maintain an interest in the combine entity thus helping preserve as well as increase shareholders value.

Acquiring shareholders gain from the fact that there is no immediate cash outflow.

Nickolaos Travlos (1987) study titled Corporate Takeover Bids, Method of Payment, and Bidding Firms' Stock Returns was to examine the role of the method of payment in determining common stock returns of bidding firms at the announcement of takeover bids. The analysis in the study was to show the valuation effects on two common methods of payment which are common stock exchanges and cash offers. The results showed that bidding firms had normal returns in cash offers however experienced significant losses in pure stock exchange acquisitions. Other literature studied by Asquith and Mullins (1986), Kalay and Shimrat (1987), Masulis and Korwar (1986) and Mikkelson and Partch ( 1986) show that common stock issues have negative stock price when there are new common stock offerings. These results were supported by various other studies such as Henri Servaes's (1991) study titled Tobin's Q and gains from takeovers. Agrawal, Jaffe and Mandelkar (1992) found post-acquisition returns to be lower for share-financed acquisitions in comparison to cash-financed acquisitions. They further went on to prove that shareholders of acquiring firms suffered a statistically significant loss of about 10% over the five-year merger period.

The bidding firm's method of payment provides valuable insight to the market. If the bidding firm's managers possess information about the intrinsic value of their firm, independent of the acquisition, which is not fully reflected in the pre-acquisition stock price, they will finance the acquisition in the most profitable way for the existing stockholders (Travlos, 1987). Myers and Majluf (1984) model states that management will prefer cash offerings if they believe their firm is under-valued however a common stock exchange offer will be preferred if they believe their firm is over-valued. In addition, market participants will strongly favor a cash offer as good news while the opposite holds true for a common stock exchange about the bidding firm's true value. If such information is important in the market, then the bidding firm's stock price change at the proposal's announcement will reflect both the gain from the takeover (weighted by the probability that the takeover bid will go through) and the information effects (Nickolaos, 1987). Jensen and Ruback (1983) state that most tender offers are financed by cash however merger proposals are financed by the exchange of common stock therefore the information argument states that larger target residuals occur in tender offers rather than in mergers. In their study conducted, they determined that for mergers, the weighted abnormal target firm return is 16.3% over the month before announcement however for tender offers; the weighted target return is 30.9% over the two-month period surrounding the announcement dates.

Cash is by far the most widely used form of payment in mergers and acquisitions. There are many reasons as to why there is an increased use of cash in financing mergers. One possible explanation for the increasing use of cash depends on market imperfections and/or agency considerations (Carleton et al, 1983). Another reason for why bidding firms use cash in financing mergers is the increase in the number of hostile mergers. Cash not only signals a high value for the target, but also preempts other firms from bidding (Martin, 1996). These findings were also found in the literature of Eckbo, Giammarino and Heinkel (1990) which include a role for mixed financings in which higher-valued bidders are more likely to use more cash to finance the acquisition.

As can be seen from the literature above the mode of payment in an acquisition may be driven by various motives and can have various effects on the bidders and acquirers stock price. This can have a major impact on shareholder value during corporate acquisitions as well as value gain studies. A study by Loughran and Vijh (1997) formed an association between the mode of acquisition (merger and tender offer) and the method of payment (cash or stock). They studied this relationship in the context of wealth gains from acquisitions and concluded that the post-acquisition returns of acquirers are related to both the mode of acquisition as well as form of payment. This was also proved by various other researchers (mentioned above) thus making the method of payment during an acquisition all the more important. Reason being, post-acquisition returns are what tend to effect shareholder value the most therefore the knowledge and distinction of the various modes of financing an acquisition is very relevant and essential.

2.2 Motives for Mergers & Acquisitions - A Dual Perspective

Tender offers allow for an in-depth analysis of agency relationships since the best interests of the principal (target firm shareholders) and agent (target firm managers) are often in conflict. Managers of the target firm are often in conflict of interest between their fiduciary responsibilities to the shareholders and their own personal wealth. For this reason, tender offers allow for the analysis of agency conflicts between shareholders and management of the target firm.

According to Sudarsanam (1995) there are two main perspectives for acquisition motives which are:

Shareholder wealth maximization perspective

Under the shareholder wealth maximization perspective, all firms' decisions including acquisitions are made with the objective of maximizing the wealth of the shareholders of the firm. In mergers and acquisitions, management of the target firm will oppose bidding firms to takeover if they believe this action would not be in the best interest of its shareholders. Target managers that oppose a bid defend their reasoning by claiming that the bid price is not adequate enough.

Managerial wealth perspective

Under the managerial wealth perspective, target managers may face an uneasy choice between obligations to current shareholders and those who aspire to such a position (Walkling and Long, 1984). For many target managers, if they sense a possibility of a loss in compensation from the merger or acquisition, conflict of interest will then increase. If self interest is pursued by target managers, there is a possibility that a bad acquisition may occur and/or a loss of shareholder wealth.

According to Sudarsanam (1995), managers may undertake acquisitions for the following reasons:

To pursue growth in size of their firm, since their salary, prerequisites, status and power are a function of firm size. (Empire-building syndrome)

In order to deploy their currently underused managerial skills. (self-fulfillment motive)

To diversify risk and minimize costs of financial distress and bankruptcy. (job security motive)

To avoid being taken over. (job security motive)

The managerial wealth perspective motive is one of survival. Not only do managers tend to seek motivation from sustained growth but also seek job security. Managers unlike shareholders cannot diversify to spread their risks since they are tied to one company. If that company is acquired, managers have a high probability of losing their jobs. A study conducted by Firth (1991) tests to see if executive reward increases when an acquisition takes place. In a sample of 254 UK takeover offers during 1974-1980 found that the acquisition process leads to an increase in managerial remuneration, and that this is predicated on the increased size of the acquirer and concludes that the evidence is 'consistent with takeovers being motivated by managers wanting to maximize their own welfare'(Firth, 1991).

Agency conflicts arise whenever differing incentives cause managers to take actions that benefit themselves but harm shareholders. In the context of acquisitions, agency conflicts may lead to a reduction in shareholder wealth if managers pursue expansion for nonprofit-maximizing reasons. According to past literature, large target shareholder wealth gains are experienced during the announcement of a takeover and large shareholder wealth losses occur when a takeover bid fails (Jensen and Ruback, 1983). This implies that target management interests are not always achieved by accepting bid offers. In addition, target managers may lose compensation and other perks if they are replaced after a successful bid offer. These findings are also confirmed by Walkling and Long (1984) and Martin and McConnell (1991), all of whom reported above-average managerial turnover after a successful takeover bid. The study findings show that in addition to lost compensation, managerial turnover may also be associated with loss of status. Martin and McConnell (1991) further go on to say that the mergers and acquisitions market plays an important role in controlling the non-value maximizing behavior of managers of large corporations.

As shown from the literature above, the shareholder wealth perspective and managerial wealth perspective may conflict with one another. With respects to mergers and acquisitions, the managerial motives and a manger's reaction to a takeover bid may have an impact on the shareholder wealth maximization criterion. The extent to which it would impact shareholder value will be decided by the amount of control managers' have within the organization.

2.3 Post Merger Performance Debate (Targets and Bidders)

There has been considerable interest in the post merger performance on shareholders returns in the target and bidder firms. Typical findings by researchers show three patterns: (1) target shareholders earn significantly positive abnormal returns from all acquisitions, (2) acquiring shareholders earn little or no abnormal returns from tender offers and (3) acquiring shareholders earn negative abnormal returns from mergers. Overall, the results of post merger performance have been mixed.

According to Langetieg (1978) and Asquith (1983), their research concluded that acquired firms experience significantly negative abnormal returns over one to three years after the merger. In the research study conducted by Agrawal, Jaffe and Mandelker (1992) titled The Post-Merger Performance of Acquiring Firms: A Re-examination of an Anomaly found that stockholders of acquiring firms experience a statistically significant wealth loss of approximately 10% over five years after the merger completion date.

Research conducted by Franks, Harris and Titman (1991) found that no significant underperformance of stockholders returns exist over a three year period after the acquisition. Franks et al concluded that the previous findings of poor performance post-acquisition were likely to be due to benchmark errors rather than inconsistencies with the Efficient Market Theory (EMH) or mis-pricing at the time of the takeover. Similar results that underperformance of stockholders returns do not exist over a three year period after acquisition is also concluded by Bradley and Jarrell (1988).

A few studies have analyzed value gains during merger and acquisitions with respect to various classes of merging firm's security holders. A study was carried out by Dennis and McConnell (1986) namely, Corporate Mergers and Security Returns and their results indicated mergers on average to be value creating activities for the acquired and the acquiring company individually. They found by other previous studies that on average common stockholders of acquiring firms earn positive returns but are usually not statistically significant. Their results also indicated that convertible preferred stockholders (of acquiring firm) received positive and statistically significant returns post-merger; however, non-convertible preferred stockholders received positive but not statistically significant returns post-merger. The combination of the above mentioned results lead to an overall increase in the value of the firm therefore presenting us with the reason as to why corporations go ahead with mergers which do not earn statistically significant returns to common stockholders of the acquiring firms'. Research results by Asquith and Kim (1982) also confirm what other investigators found for mergers: abnormal returns to the common stocks of acquired firms are positive and statistically significant; abnormal returns to the common stock of acquiring firms are not significantly different from zero.

In the study Do Long-term Shareholders Benefit Corporate Acquisitions? by Loughran and Vijh (1997), found that post acquisition returns of acquirer's stock are related to both the form of payment as well as the mode of acquisition. They concluded in the overall sample of 947 cases, acquirers that make merger bids earn, on average, 15.9 percent less than matching firms whereas acquirers that make tender offers earn 43.0 percent more than matching firms during a five-year period after acquisition. In addition, stock acquirers earned 24.2 percent less however cash acquirers earn 18.5 percent more with respects to matching firms. Furthermore, conclusions show that during a five year period following the acquisition, on average, firms that completed stock (share) mergers earned significant negative returns of -25 percent whereas firms that completed cash tender offers earned significant positive excess returns of 61.7 percent. Similar results were also concluded by Ikenberry, Lakonishok and Vermaelen (1995).

Sudarsanam (1995) also summarized various results of a number of UK wealth gains studies as follows:

Table 4.0 Abnormal Returns for Target and Bidder Shareholders Surrounding UK Takeover Announcements

Study, Period and Sample Size



Target (%)

Bidder (%)

Firth (1980): 1969-1975: 486 targets

Announcement month





Franks and Harris (1989): 1955-1985 1445 targets

Announcement month

Monthly Returns



Limmack (1991):1977-1986: 462 Targets

Bid Period

Monthly Returns



Sudarsanam et al. (1993): 1980-1989: 171 Share Offers

-5 to +5 days around announcement day 0




Source: Sudarsanam (1995, p.217)

Table 4.0 examines the abnormal returns of targets and bidders in completed takeover contests reported in four major UK studies. The researchers report on the short-term gains/losses experienced surrounding the merger period therefore making it clear that in the short event window surrounding the bid, the target shareholders are clear winners, whereas the bidder shareholders either lose or just about scrape through. These results are consistent with previous studies mentioned above.

Sudarsanam (1995) also summarized the post-merger performance of acquirers from three of the above mentioned UK studies, results of which are presented in the table below:

Table 5.0 Post-Merger Performance of Acquirers

Study period and sample size





Firth(1980):1969-75 434 acquirers

+1 to +36 months



Franks and Harris (1989): 1955-1985 1048 acquirers

+1 to +24 months



Limmack (1991): 1977-86:

448 acquirers

+1 to +24 months



Source Sudarsanam (1995, P.218)

From the above results, it can be seen that post-merger acquirers earn either no return or statistically significant negative returns. This result is positively correlated with previous other wealth gain studies. Sudarsanam (1995) summarized the UK evidence as follows:

Takeovers are at best neutral in overall value creation for the shareholders together, and at worst modestly value destroying.

Target shareholders gain almost exclusively from takeover contests.

There is some evidence of wealth transfer from the acquirer to acquired shareholders. This follows from the negative returns to acquirer shareholders and the broad neutrality of the overall effect.

2.4 Hypothesis Development

Mergers and acquisitions is a very vast, complex and dynamic area in financial management which has always warranted a lot of interest, fascination and research. Majority of the shareholder wealth effects studies with regards to mergers and acquisitions were carried out between 1970- 1997 therefore it would be interesting to know whether the situation has changed in the UK currently or do mergers and acquisitions still have the same effects on shareholder value as they have had in the past decades.

The purpose of this dissertation is to examine the impact of acquisitions on shareholder wealth of large UK companies prior to 2002. There are potential gains that accrue from acquisitions and from following an acquisition strategy therefore the following hypothesis will be tested:

H0 = If managers of large sized UK companies pursue a merger and acquisition strategy then shareholder wealth (value) will increase.

H1 = If managers of large sized UK companies pursue a merger and acquisition strategy then shareholder wealth (value) will remain unchanged or will decrease.


Chapter two discussed major empirical studies and provided a literature review on shareholder wealth gain effects during M&A activity; however, the testing of shareholder value is not viable without an empirical framework. The objective of this chapter is to develop the framework based on previous empirical research methods on mergers and acquisitions. Majority of the empirical studies done on mergers and acquisitions and the impact on shareholder wealth focus on two types of methods: Efficient Capital Markets and Event Studies. This chapter will briefly review both empirical methods and will lead to the development of the dissertation method and the gathering of data for hypothesis testing.

3.1 Efficient Capital Markets and Equilibrium Models

The purpose of capital markets is to transfer funds between lenders and borrowers efficiently and is the most frequently used mode of analysis when determining shareholder value before and after a takeover. A reference to efficient capital markets with respects to finance means that security prices fully reflect all available information to everyone. When assuming an efficient capital market, the two risk models used are the Market Model and the Capital Asset Pricing Model (CAPM).

3.1.1 Event Studies and Abnormal Return Methodology (Market Model)

A common approach to measuring shareholder wealth changes is the use of the Abnormal Returns methodology. Under this methodology, the returns to shareholders of both bidders and targets during a period surrounding the takeover announcement are compared to the 'normal' returns from a period unaffected by the 'event'. An event can include a takeover announcement, rights issue, divestment or dividend payments (Sudarsanam, 1995). This methodology is thus known as an 'event study'. In order to determine whether or not the performance of a security is abnormal due to the occurrence of a company specific event, it is important to develop a benchmark, namely a control return. This normal return is the return of the security had the event not taken place.

As per Sudarsanam (1995) the abnormal return (AR) due to the acquisition event is calculated as follows:

AR = R- E(R) (1)

Where R = Actual return measured during the event period

E(R) = Benchmark return expected in the absence of the event

The most common model according to Sudarsanam (1995) used to estimate the benchmark return is the 'Market Model'. This model depicts the relationship between an individual stock's return and the return on the market as follow:

Rit = αi + βi Rm t + ei t (2)

Where Rit = Return on company i's stock

Rmt = Market return

αi = Intercept

βi = Companies Beta

Within the market model, αi and βi are estimated by running a regression of Rit and Rm t over an appropriate estimation period. These estimated parameters are then used to calculate normal return E(R) for each company and the abnormal return as follows:

ARit = R it - E(Ri) (3)

ARit = R it - { αi + βi Rm t } (4)

If the takeover event is expected to create additional value for the shareholders then AR must be positive however AR will be zero if the effect of the takeover is neutral (Sudarsanam, 1995). To determine whether the event has generated positive returns, statistical tests are done with a sample of takeovers.

Having calculated the abnormal return on security 'i' during period't' for every security, they are then assembled into one portfolio of N outstanding securities by calculating the mean (equation 5).


i = 1

i t



AR i = Σ AR (5)

Finally, the ARi 's are added over the time period being studied, from the initial t = I through to the final t = z as seen below in equation (6) in order to determine the cumulative abnormal return (CAR).


I =1

CAR = Σ ARi (6)

3.1.2 Capital Asset Pricing Model (CAPM)

A stock's risk consists of two components: market risk (systematic risk) and diversifiable risk (unsystematic risk). According to CAPM, the marketplace (stock market) compensates investors for bearing systematic risk however not for bearing specific risk because specific risk can be diversified. When an investor holds the market portfolio, each individual asset in that portfolio has a specific risk, but through diversification the investor's net exposure is just the systematic risk of the market portfolio.

The equation of the CAPM expressing the expected return on a particular security is as follows:

E(Ri) = Rf + [E(Rm) - Rf ] βi (7)

Where: E(Ri) = Expected return on security I (Benchmark return)

Rf = Risk free rate of return

E(Rm) = Expected return on the market

βi = Relative measure of risk for security I (Beta)

A firm's benchmark return can be calculated with the help of the CAPM thus having calculated a firm's benchmark return; it can be inserted into equation 3 above in order to calculate a firm's abnormal return.

3.2 Summary Statistics

During any research analysis, it is very important to check the validity and statistical significance of the conclusion and results; therefore, I intend to use descriptive statistics to describe my results. The various measures of central tendencies that I will be using to check the validity of my results in this research are:

Mode: In the case of the following dissertation, it would be the most frequently occurring individual abnormal return.

Median: I will apply this technique to the calculated abnormal returns for individual bidder as well as individual target firms.

Arithmetic mean: I will take the individual abnormal return figures and add them together, and then divide their sum by the total number of abnormal return figures (N=50) in order to analyze the mean abnormal return.

Geometric mean: I will take the abnormal returns and multiply them together and divide the nth root of their product by N=40.

Having described my individual results, I then intend to use the following measures of variation on the calculated individual abnormal returns:

Range: The main purpose of this statistical measure is to indicate the highest and the lowest value of a particular set of results. I intend to use this measure to point out the highest and the lowest level of abnormal returns resulting from acquisitions within my study.

The formula to calculate range is: Range = Highest Score - Lowest Score.

Standard Deviation and Variance: This is a statistical measure of deviation of probable outcomes of a mean value and can be used to calculate total risk.

The formula for standard deviation and variance are as follows:


Standard deviation = √S (ri - r)2/ n-1 (8)



Variance = S (ri - r)2/ n-1 (9)


Where r= Average return

ri = return for the ith outcome

n = sample size.

Before performing statistical tests, it is important to state the criterion for statistical significance, which is accept and reject regions. These regions are determined by selecting an appropriate alpha level. For example, an alpha level of 0.05 determines the probability of selecting a score at random that falls either in the lower 2.5 percent of the distribution or the upper 2.5 percent of the distribution. Obtained t values are compared to critical t values determined by specific alpha levels chosen, and a null hypothesis can be accepted or rejected. When a null hypothesis is rejected, it is due to the fact that it is the most reasonable conclusion given the obtained sample mean however in the field of infernal statistics there is always the chance of error. There are two types of errors that can be committed when rejecting or accepting the null hypothesis. A type I error is committed when a true null hypothesis is rejected and a type II error is committed when a false null hypothesis is retained.

3.3 Data and Adopted Methodology

In order to understand the wealth effects on shareholders in a takeover activity in the UK, the data and methodology adopted to analyze the effect is detailed below. The first step in the analysis was to identify forty large UK-based companies that were merged or acquired by other UK based firms prior to 2002. The merger/ acquisition data was obtained from the Bloomberg website. The deal value of more than 95 million USD was taken as the selection criterion for the analysis. The acquisition/ merger announcement dates and the de-listing dates for each of the chosen companies were also identified. The announcement and completion dates were also obtained from Bloomberg.com. As defined by Bloomberg, the completion date indicates the date the deal has been consummated. A publicly traded targets completion date coincides with the de-listing date." All of the de-listing dates obtained from Bloomberg were cross-checked from "Citytext London Interface." (www.citytext.com)

All the month-end share price data required for the analysis was collected from Bloomberg. For the target company, the share price data is provided from one year prior to the announcement date till the company is de-listed (i.e., completion date as defined by Bloomberg). For the acquirer company, the data is provided from one year prior to the announcement date to two years post completion date. Companies listed less than one year prior to the announcement date have not been included in the analysis.

The Abnormal Returns methodology was the main methodology used during the analysis. The model used to estimate the benchmark return was the Market Model. Abnormal return is defined as return over and above the benchmark rate of return, which in turn is the return expected in the absence of the event. Relationship used was Rit = α + β*(Rmt), where Rit is the return of the company's stock, α is the intercept, β is the beta value and Rm is the market return. The abnormal return for the target companies and acquired companies were calculated separately. The return was calculated (percentage change in monthly share price) on target company's stock for a period starting from one year prior to the announcement date to the time the share got de-listed. In the case of an acquirer company, the return was calculated for a period starting from one year prior to the announcement date to two years post the announcement date. The market return was calculated as the percentage change in month-end index value (FTSE 350) of the London Stock Exchange. This data was also obtained from Bloomberg.

The return expected in the absence of the event (the benchmark return) was calculated by developing a linear relationship between the market return and the benchmark return on the share price data for the last thirteen months. MS Excel was used to conduct the regression analysis. The abnormal return was calculated by subtracting the benchmark return from the actual return measured during the event period. The mean abnormal return was calculated for the post-acquisition period in order to create a portfolio of abnormal returns for target and acquiring companies. The same was done for the pre-acquisition period for both target and acquiring firms with their normal returns in order to facilitate a comparison of returns pre-acquisition and post-acquisition.

3.4 Expected Results, Outcomes and Problems

In terms of expected results and outcomes, I do not expect my results to be different from previous studies. The results of previous studies were as follows:

Target shareholders earn significantly positive abnormal returns from all acquisitions.

Acquiring shareholders earn little or no abnormal returns from tender offers.

Acquiring shareholders earn negative abnormal from mergers.

As per Dimson and Marsh (1986), event studies that use the CAPM methodology produce results that are biased because of the size effect therefore the size effect occurs if stocks experience an event with a probability less than proportional to their capitalization. Due to the fact that I am analyzing large UK companies and my methodology does require the CAPM, I expect my results also to be slightly biased. In order to try and reduce this bias, I intend to try and adjust my Market Model to incorporate the size effect.


The aim of the previous chapter was to develop a framework for the testing of shareholder value. The following chapter will be summarizing the main results obtained from the event study for both the target and acquiring firms. This chapter also provides an analysis of all the findings and will provide reasons for the various results obtained.

4.1 Summary of Results

Having conducted the event study and Abnormal Returns methodology using the Market Model, an analysis of the results is essential. During this study, two sets of results were calculated. The first calculation was the mean normal returns for both target and acquiring firms prior to acquisition (-13 to -1 months). The second was the calculation of the mean abnormal returns for both target and acquiring firms post-acquisition. The time periods for the abnormal returns were +1 to +24 months for the acquiring firms and +1 to +12 months for the target firms. The reason for a shorter time period in the case of target firms was because of the de-listing of these firms soon after the acquisition.

4.1.1 Target Firms Returns (Normal and Abnormal Returns)

The following returns depicted in Figure 2.0 are the returns, which were generated by the target firms not including the event (merger/acquisition).

Figure 2.0 Target Firms Normal Returns

From the graph above, it is seen that the target firms normal returns a year prior to the takeover (-13 to -1 months) has not been stable since there are fluctuations found in the target firms normal returns prior to the takeover. The key reason that can be attributed to such a trend would include factors such as market expectations, speculation and various rumors afloat in the market place prior to the actual takeover. The important fact to highlight at this point would be that prior to the acquisition, target firms were earning a positive return therefore a positive impact on the target firms shareholder value was present. For a more detailed explanation of the results, please see Appendix 1.

Graph 3.0 shows the target firms mean abnormal returns post-acquisition:

Figure 3.0 Target Firms Abnormal Returns

The above graph depicts the target firms abnormal returns post-acquisition. The time period analyzed was +1 to +24 months however for target firms, this had to be restricted. The reason for this is the de-listing of the target firms from the stock exchanges a few months after the acquisitions took place. From the graph above, it can be seen that post-acquisition abnormal returns have varied from 15 percent (Month +1) to -10 percent (Month +12). In general, the majority of the time period post-acquisition has yielded negative abnormal returns between -2.5 percent to -10 percent. For a more detailed explanation of the results, please see Appendix 2.

If the acquisition is likely to create additional value for the shareholders then Cumulative Abnormal Return (CAR) should be positive. CAR will be zero if the effect of the takeover on shareholder value is neutral and CAR will be negative if the takeover event has damaged shareholder value.

In order to determine whether the acquisitions have created, maintained or destroyed shareholder value for the target firms, an analysis of the cumulative returns is important. It would also be helpful to look at the normal returns prior to the event to get a more complete picture. The cumulative normal and abnormal returns were as follows:

Table 6.0 Target Firms Returns (Normal and Abnormal)


Target Firms

Cumulative Normal Return

0.009%= approx 1%

Cumulative Abnormal Return

-.034% = approx -3.4 %

Prior to acquisition, the cumulative normal return was approximately equal to 1 percent however post-acquisition the cumulative abnormal return equals -3.4 percent. From this analysis, one could conclude that the takeover activity has destroyed the shareholder value for the target firms. This conclusion above may not be the most accurate from the obtained results since contributory factors may exist which may have led to biases in the analysis. In addition, there is the possibility that these negative returns may eventually become positive after a certain period of time.

4.1.2 Acquiring Firms Returns (Normal and Abnormal)

Figure 4.0 Acquiring Firms Normal Returns

The following returns shown in Figure 4.0 are the returns generated by the acquiring firms in the absence of the event (merger/acquisition). From the graph above, acquiring firms normal returns a year prior to the takeover (-13 to -1 months) have not been stable which is similar to target firms results. One will notice many peaks in the graph depicted for the acquiring firms normal returns prior to the takeover. One of the main reasons for this can again be attributed to a trend such as the market expectations, speculation and various rumors afloat in the market place prior to the actual takeover. The important fact to highlight would be that prior to the acquisition, acquiring firms were earning a positive normal return during the entire one year period prior to the acquisition. This would therefore imply that prior to the acquisition; there was a positive impact on the target firms shareholder value. The range for normal returns for the acquiring firms has been +2.4 percent to + 4.8 percent. Please see Appendix 1 for a detailed analysis of the results.

The graph below shows the acquiring firms mean abnormal returns post-acquisition:

Figure 5.0 Acquiring Firms Abnormal Returns

The above graph illustrates the acquiring firms abnormal returns post-acquisition. The time period analyzed was +1 to +24 months. On analyzing the above graph, it can clearly be seen that post-acquisition abnormal returns have been negative for almost the whole two years period post-acquisition. The only time positive abnormal returns occurred was during month three post-acquisition. The range of the negative abnormal returns pertaining to the acquiring firms was between -0.3 percent to -5.2 percent. For a more detailed explanation of the results, please see Appendix 2.

Again in order to determine whether the acquisitions have created, maintained or destroyed shareholder value for the acquiring firms, an analysis of the cumulative returns is needed. It would also be useful to analyze the normal returns before the event to get a more comprehensive picture. The cumulative normal and abnormal returns were as follows:

Table 7.0 Acquiring Firms Returns (Normal and Abnormal)


Acquiring Firms

Cumulative Normal Return

1.1%= approx 1%

Cumulative Abnormal Return

-.53.2% = approx -53 %

Prior to acquisition, the cumulative normal return was approximately equal to 1 percent and post-acquisition the cumulative abnormal return equals -53 percent. The cumulative abnormal return for the acquiring firms post-acquisition has come to be negative thus one could conclude that the takeover activity has destroyed the shareholder value for the acquired firms involved in the following analysis. The conclusion drawn from the obtained results may not be the most accurate of conclusions since many contributory factors could exist, which may have led to biases in the analysis. In this instance, such a large negative cumulative abnormal return does perhaps appear to be a bit inaccurate. In addition, there is the possibility that these negative returns may eventually become positive after a certain period of time. A more detailed explanation of results is provided in the next section of this chapter. An in-depth analysis of the results can be viewed in Appendix 2.

4.2 Analysis of Results

Having discussed the summary of results, it is now important to analyze the gathered results in depth. The purpose for this is to appreciate and evaluate further reasons that may have led to the results obtained through the event study and the Market Model used in the event study. The CAR results obtained are most helpful when deciding whether a merger or acquisition has led to an increase or decrease in shareholder value. In this study, the CAR for target and acquired firms were as follows:

Table 8.0 Cumulative Abnormal Returns (Target & Bidder Firms)

Type of Firm

Target Firms

Acquiring Firms

Cumulative Abnormal Returns (CAR)



Form the above results, it was concluded that merger and acquisition activity among large UK corporations led to a destruction of shareholder wealth for both target and bidder firms.

Various contributory factors exist which help to explain the obtained results in this study. An in depth analysis of other contributory factors that may have effected this study is provided below.

Size Effect

According to Dimson and Marsh (1986), results obtained during event studies are usually biased due to an effect known as the size effect. According to their study Event Study Methodologies and The Size Effect, size differences can distort performance measures and hence event studies. Furthermore to their study, market adjustments, the CAPM and the Market Model with equally or capitalization weighted indexes all produce biased results. They went on to prove that event studies are most exposed to such biases when the measurement interval is long; event securities differ systematically in size or weighting from the index constituents and when CAPM-type methodologies are used. Due to the size effect, the obtained CAR results in this study may be biased and not entirely accurate; especially knowing that there was a -52.3% CAR obtained for acquiring firms. The main problem of this study on wealth effects of mergers and acquisitions among large UK organizations was the non-adjustment for the size effect. In addition to this study, the size of the target to acquiring firm did increase therefore this could have also contributed to the negative abnormal returns obtained.

Post-Merger Performance (previous studies)

Some of the major previous studies from Langetieg (1978) and Asquith (1983) have concluded significantly negative abnormal returns over one to three years after the merger. Jensen and Ruback (1983) stated that the post-outcome negative abnormal returns are inconsistent with market efficiency and suggest that changes in stock prices during takeovers overestimate the future efficiency gains from mergers. The results from this study on acquisitions among large UK organizations agree with the conclusions made by Langetieg (1978), Asquith (1983), and Jensen and Ruback (1983). The hypothesis test of this study suggests that shareholders experience a loss in wealth two years after acquisition due to managers pursuing an M&A strategy. Furthermore, the negative abnormal returns are inconsistent with market efficiency and that share prices over-estimate future efficiency gains from an acquisition.

Organizations form different industries

Another factor that may have led to the results in this study is the fact that the chosen organizations are from different industries. The effect of this has led to peaks and troughs of various industries therefore resulting to considerably inaccurate results. The reason for using organizations from different industries was due to the lack of M&A activity within a particular industry. By using organizations within a particular industry, this would have led to a very small sample size and would also have lead to even more inconclusive results.


The birth of new companies through mergers and acquisitions is quite beneficial for the economy but not always for the shareholders of the companies involved (target and acquiring). Managers of large companies must pursue a M&A strategy only if it leads to an increase in shareholder wealth however this is not always the case in the corporate world.

This study set out to examine whether shareholder wealth increases from mergers and acquisitions among larger UK corporations. Chapter 2 presented previous studies of mergers and acquisitions, which tend to affect shareholder value of a firm post-acquisition. The chapter also highlighted the two major motives for pursuing a merger and acquisition strategy which are the shareholder and managerial wealth maximization perspectives. In addition, various acquisition financing methods and their affects on post-acquisition returns were also briefly reviewed.

The appropriate methodology was developed in Chapter 3 to test the research hypothesis and draw conclusions. The profitability parameter chosen was CAR for both target and acquiring firms. The data used monthly stock returns to compute the cumulative abnormal returns which were collected one year pre-acquisition until two years post-acquisition however with respects to the target firms post acquisition, returns could only be found until the firm got de-listed post-acquisition. The computation of these values provided an accurate measure of determining the acquisitions impact on shareholder value. Furthermore, this computation has been the most widely used methodology in previous wealth gain studies.

Having tested all the parameters the research hypothesis If managers of large sized UK companies pursue a merger and acquisition strategy then shareholder wealth (value) will increase is not supported. Managers of the large UK firms must independently asses the results and analyze whether shareholder value will be destroyed and if so what can be done in the long run to avoid this problem. The research hypothesis is rejected through the computed cumulative average returns. In the case of the target firms, the CAR was calculated approximately -3.4 percent whereas the CAR for the acquiring firms was approximately -52.4 percent. As per financial theory, both sets of results signify a reduction in shareholder value. Although the results show a decline in shareholder wealth, this might not be entirely conclusive and accurate due to various reasons. The main reason for biased results is due to the size effect which is a concept devised by Dimson and Marsh (1986). The size effect would have affected the results in the following study due to the use of CAPM-type methodologies. The negative abnormal returns are not very surprising since a large number of previous research studies have also obtained similar results and have come to similar conclusions. Some of the major previous studies on the long-term performance of merging firms have concluded significant negative abnormal returns over one to three years post-acquisition.

As mentioned in the previous chapter, one of the limitations of this study was that the chosen companies were from different industries therefore fluctuations from different industries, occurring at different times, could have diluted the quality of the data used. There also exists a limitation in the development of the methodology since this study does not investigate method of payment for the acquisition. If the level of debt in the newly formed company was to increase, then the firm's financial risk would in turn increase. In addition, the more debt required to fund the acquisition the greater the increase in the company's systematic risk (beta). The implication of the increase in the company's risk is that shareholders would require a greater premium for that level of risk and would therefore require a greater return however it is beyond the scope of this study to investigate such changes in systematic risk due to an acquisition. Although beta was not statistically tested, the changes in beta of the sample obtained did not reflect large changes in beta. Consequently, although this is a weakness it should make little difference to the results and conclusions drawn from the study.

Like majority of the past empirical studies involving large mergers and acquisitions and their effect on shareholder value, this study also concentrated on large UK companies. The exact motivations behind the mergers and acquisitions are unknown in this study however the sample reveals a destruction of shareholder value. Assuming that the managers of the companies selected have undertaken mergers and acquisition with shareholder wealth maximization in mind, they have not been able to achieve this wealth for the shareholders. This goes on to prove that a merger and acquisition strategy is not always associated with positive shareholder wealth effects.

If managers were to pursue a merger and acquisition strategy, they must not become overly optimistic about the strategic and economic benefits of an acquisition therefore managers must thoroughly analyze the potential benefits and costs during the pre-acquisition period. The acquiring firm usually will have to pay a premium over the current market value of the target firm and managers must be able to justify this premium in terms of future cash flows since such added value will be reflected through an increase in earnings and cash flows. In order for synergies and economies of scale to be fully accommodated, integration problems such as merging companies cultures, employee retention and transforming the newly created entity must be overcome quickly in a takeover activity.


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Website: http://www.statistics.gov.uk/pdfdir/ma0608.pdf

Bloomberg.com Website: www.bloomberg.com

Citytext London Interface Website: www.citytext.com

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