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Table of Contents

1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 2.0 2.1 2.2 2.3 CHAPTER 1 : INTRODUCTION ....................................................................................... 1 BACKGROUND OF THE STUDY ................................................................................ 1 PROBLEM STATEMENT .............................................................................................. 7 OBJECTIVE OF THE STUDY ....................................................................................... 9 RESEARCH QUESTION ................................................................................................ 9 SCOPE OF THE STUDY .............................................................................................. 10 SIGNIFICANCE OF THE STUDY ............................................................................... 10 LIMITATION OF THE STUDY ................................................................................... 12 CHAPTER 2: REVIEW OF LITERATURE .................................................................... 13 INTRODUCTION .......................................................................................................... 13 MISVALUATION ......................................................................................................... 14 DETERMINANTS THAT DIFFERENTIATE ACQUISITION PREMIUM FROM ....... ACQUISITION DISCOUNTS ...................................................................................... 15 2.3.1 2.3.2 2.3.3 2.3.4 2.3.5 ACQUISITION VALUATION .............................................................................. 16 MARKET INEFFICIENCY ................................................................................... 17 MARKET TIMING ................................................................................................ 18 PREVAILING FEE STRUCTURE ........................................................................ 19 THEORY OF THE FIRM SHAREHOLDER WEALTH MAXIMIZATION ...... 20

2.3.6 2.3.7 2.4

PECKING ORDER THEORY ............................................................................... 21 THEORY OF DESPERATION .............................................................................. 22

FACTOR MISEVALUATION USING VARIOUS APPROACH VALUATION ....... 23 COMPARABLE VALUATION ............................................................................. 23 DISCOUNTED CASHFLOW ................................................................................ 24 ASSET VALUATION ............................................................................................ 25 DOES INVESTOR MISVALUATION DRIVE THE TAKEOVER ..................... 25

2.4.1 2.4.2 2.4.3 2.4.4 2.5

AGENCY THEORY ...................................................................................................... 27 FREE CASH FLOW THEORY.............................................................................. 28 HUBRIS THEORY ................................................................................................. 28

2.5.1 2.5.2 2.6

PERFORMANCE ACQUISITION COMPANY IN MALAYSIA ............................... 29 PERFORMANCE ................................................................................................... 29 TOBIN Q ................................................................................................................ 32 LEVERAGE POLICY ............................................................................................ 33 RISK ....................................................................................................................... 33 SIZE ........................................................................................................................ 34 CASH ...................................................................................................................... 34

2.6.1 2.6.2 2.6.3 2.6.4 2.6.5 2.6.6


3.0 3.1 3.2 3.3

CHAPTER 3 : RESEARCH METHODOLOGY .............................................................. 35 RESEARCH DESIGN ................................................................................................... 35 SAMPLING ................................................................................................................... 35 RESEARCH METHODOLOGY ................................................................................... 36 OBJECTIVE 1 : TO INVISTIGATE THE DETERMINANT FACTOR THAT DIFFERENTIATE ACQUISITION PREMIUM FROM ACQUISITION DISCOUNTS ......................................................................................................... 36 3.3.2 OBJECTIVE 2: TO SEE THE IMPACT OF MISEVALUATION USING DIFFERENT OR MULTIPLE APPROACH VALUATION ................................. 38 3.3.3 OBJECTIVE 3: TO EXAMINE THE EFFECT OF MISEVALUATION TOWARDS AGENCY PROBLEM ....................................................................... 39 3.3.4 OBJECTIVE 4: TO STUDY EFFECT OF COMPANY PERFORMANCE .. DUE TO MISEVALUATION ......................................................................................... 42



HYPOTHESIS TESTING .............................................................................................. 43 HYPOTHESIS 1 ..................................................................................................... 43 HYPOTHESIS 2 ..................................................................................................... 44 HYPOTHESIS 3 ..................................................................................................... 45 HYPOTHESIS 4 ..................................................................................................... 46

3.4.1 3.4.2 3.4.3 3.4.4 3.5

VARIABLE OF THE STUDY ...................................................................................... 47

BIBLIOGRAPHY ..................................................................................................................... 49


1.0 1.1



BACKGROUND OF THE STUDY Mergers: A merger is defined as any amalgamation of the undertaking or any part of the undertakings or interest of two or more companies or the undertakings or part of the undertakings of one or more companies and one or more bodies corporate (CAMA 1990 : S.590). Brian Coyle (2000:2) describes mergers as the coming together of two companies of roughly equal size, pooling their recourses into a single business. The stockholders or owners of both pre-merger companies have a share in the ownership of the merged businessAccording to Weston and Copeland (1989), Merger means any transaction that forms one economic unit from two or more previous ones. It occurs when a corporation and or more incorporated or unincorporated businesses are brought together into one accounting entity. The single entity now carries on the activities of the previously separated independent enterprises. One or more companies may also merge with an existing company or they may merge to form a new company. Merger is also referred to as amalgamation. Acquisition: Acquisition also referred to as take-over means the process of combining two or more companies and in which one acquires the assets and liabilities of the other in exchange for cash or shares, goods and or debentures. Section 590 of Companies and Allied Matters Act, 1990 refers to acquisition as take-over. It went ahead to define take over as the acquisition by one company of sufficient share in another company to give the acquiring company control over that other company. The purchase consideration for an acquisition is paid by largely or entirely in cash. Harold Fritz (1993), described acquisition to mean all the processes, terms, conditions and fulfillment adopted to purchase a small firm by a big and well established unit. Acquisitions of companies can be either full or partial. In a full acquisition, the acquirer buys all the stock capital of the purchase company. In partial acquisition, the acquirer obtains a controlling interest, normally above 50% but below 100% Pandey (1997: 885) said using financial ratio namely:

The process of getting the banks in Malaysia to merge

started in earnest in mid 1980s

as a result of economic recession. The policy, however, has always been to allow market forces to dictate the merger pace. In the past, the Government had consistently called on banking institutions to merge. Unfortunately, the call Sciences - Issue 24 (2010) went unheeded as the shareholders of banking institutions were more interested 113 European Journal of Economics, Finance and Administrative in protecting their interest above that of national

consideration. In the mean time, the banking crisis in the mid-1980s propelled a number of weak commercial banks and finance companies into insolvency and financial distress. These institutions were badly hit by the 1985-1986 recession as they were saddled with huge levels of non-performing loans (NPLs), the aftermath of over-lending to the property sector and imprudent exposure to share-based lending during the earlier boom years. In addition, the finance company industry, in particular, was highly fragmented, comprising 47 finance companies. Given the severity of the losses and to maintain integrity of public savings and the stability of the financial system, Bank Negara Malaysia had to implement a rescue scheme. The rescue scheme involved Bank Negara Malaysia acquiring shares in some of the ailing commercial banks and the absorption of the assets and liabilities of the insolvent finance companies by stronger finance companies. As a result of the rescue scheme, the number of finance companies was reduced from 47 to 40. With 71 banking institutions prevailing in the country today, there are 2,712 branches located all over the country. There is clear view that Malaysia is over-banked and some resources are wasted due to duplication of branches in the same locality. While the number of banking institutions in Malaysia remains large, other countries have succeeded in consolidating their domestic banks into a few large and competitive banking groups. For instance, the United Kingdom has four major banking groups, Australia has four major banking groups and Singapore has five. In the case of Singapore, the Government intends to reduce the number to even two. The experience of these countries has proved that consolidation in the financial sector is both viable and desirable. The IMF too had forced countries under their programmes (Indonesia, Thailand and South Korea) to 2

reduce the number of banking institutions by effectively closing them down. Malaysia does not believe that the IMFs prescription of closing down the problem bank is the way to go, as the social costs involved in terms of dislocation of resources are high. A more reasonable approach adopted by us is guided merger, with the central bank playing a proactive role in solving the issues involved and the principle of fairness will be strictly applied to all parties in the merger. Bank Negara 6th Governor, Tan Sri Ali Abul Hassan Sulaiman emphasized the merger programme for domestic banking institutions announced on July 29, 1999 would not, in any way, weaken the financial strength of the merged entities. In fact, the creation of the six domestic financial groups would ensure that the domestic banking institutions would be able to withstand pressures and challenges arising from globalization and from an increasingly competitive global environment. This move towards consolidation was in line with the Government's policy of not to bail out weak companies but to rationalize businesses towards higher productivity. Business consolidation through merger is indeed a common practice globally to achieve economies of scale and higher productivity. In this time and age of globalization, banks must merge to survive the onslaught of greater competition. Bank Negara had justified the consolidation program on grounds that Malaysia needed to build strong banks to compete globally when its financial services market opens up in 2003 under WTO rules. The need to merge is even more imperative in the face of increasing pressure under World Trade Organisation (WTO) for countries to open up their financial markets to further entry of foreign banks. All countries are now moving towards consolidating their banking system and Malaysia cannot be the exception. Malaysia's 54 banks and financial institutions had merged into 10 anchor groups in a sweeping consolidation in 2001 under the auspices of the government. A further overhaul is crucial for banks to expand and become stronger but the process will be market driven which is based on the wishes and aspirations of those who want to take over the banks.

The final 10 anchor banks during the merger process are Malayan Banking Bhd, Bumiputra-Commerce Bank Bhd, RHB Bank Bhd, Public Bank Bhd, Arab-Malaysian Bank Bhd, Hong Leong Bank Bhd, Perwira Affin Bank Bhd, Multi-Purpose Bank Bhd, Southern Bank Bhd and EON Bank Bhd Back in December 2000, under stewardship of Tan Sri Mohd Saleh Sulong, DRB HICOM sold its 25.8% stake in Proton to national oil giant Petroliam Nasional Berhad (Petronas) for RM981 million or RM7 per share as part of its restructuring process. Regardless of whichever party takes over Proton, a key issue will be the cost of doing so. Research company notes that is lower than Kazhanah entry cost of RM7.50 to RM9.00 per share. They has put a fair value of RM5 per Proton share. It also mention that 30% stake in Proton at RM8 per share would cost RM1.3 billion. Protons net asset per share as at Sep 30 was RM9.81. Acquisition has become a choice for a firm to grow inorganically. Despite the drawback of acquiring another company in order to grow, it still becomes the preferred and fastest choice (Solovan, 2004). After all, it also proven to be profitable, not only for the target shareholder, but also the acquirer shareholder, if the valuation process as part of the negotiation process is done correctly (Bruner, 2003) How stock market levels may influence managerial acquisition decisions and acquisition quality. The question been raised Are acquisitions that are announced when the market is booming fundamentally different from those that are initiated during market troughs? From the study they conclude they are different. The stock and operating performance of acquisitions initiated when markets are booming (high-valuation markets) and when they are depressed (low-valuation markets), and find that market valuations at the time acquisitions are initiated are correlated with acquirer performance in a way that is consistent with the theories. Although announcement returns are significantly better for acquisitions announced in high-valuation markets relative to those announced in lowvaluation markets, this finding is reversed in the long run.

Consistent with existing theory, acquirers buying in high-valuation markets significantly underperform relative to acquirers buying during low-valuation markets in the two years following the acquisition They find that the underperformance of acquirers buying in high-valuation markets cannot be explained by overpayment, and does not seem consistent with market timing. For overall conclusion that acquirer performance is

correlated with the state of the market is consistent with recent evidence that stock prices affect corporate decisions.

There is ample evidence that managers attempt to time

markets when making financing decisions.2 Following the sky-high stock valuations of the late 1990s, researchers expanded on that notion, turning their attention to the role of equity prices in mergers and acquisitions (M&A) The industry portfolios for both bidders and targets show positive serial correlation in returns over the same estimation periods. Targets have lower implied long-run returns than bidders, indicating lower valuations than bidders. There is some evidence that target returns are also lower than their industries, but only marginally so. The results suggests bidders are overvalued while targets are undervalued, or at least less overvalued than bidders, supporting Shleifer and Vishny (2003). In todays dynamic environment, acquisitions offer an important growth strategy. There is a rich literature stream investigating market reactions to acquisition announcements with respect to the stock prices of bidding and target firms, as well as the post-acquisition performance of the combined entities (for reviews, see Datta, Pinches, and Narayanan, 1992; King et al., 2004).

Source : 2007 , Market Valuation and Acquisition Quality: Empirical Evidence, Christa H. S. Bouwman, Kathleen Fuller, Amrita S. Nain, Oxford University Press on behalf of The Society for Financial Studies

See Meyers (1977), Meyers and Majluf (1984), Jung, Kim and Stulz (1996) and Baker and Wurgler (2002) and Franks and Goyal (2003), among others.

Acquisition strategies need to be based on following motives (Damodaran, 2001): 1. Acquire undervalued firms: The acquirer gain the surplus difference between the value and the purchase price, which is at discount because the firm is undervalued. 2. Diversify to reduce risk: In a private firm, the owner may acquire other firms in other businesses to diversify risks. 3. Create operating or financial synergy. Synergy is a stated motive in many acquisitions. The existence of synergy implies that the combined firm will become more profitable or grow at a faster rate after the merger than will the firms operating separately. In today market, the purchase price of an acquisition will nearly always be higher than the intrinsic value of the target company. An acquirer needs to be sure that there are enough cost savings and revenue generators synergy value to justify the premium so that the target companys shareholders dont get all the value that the deal creates (Eccles et al, 1999). A rational buyer will purchase an asset only if the actual value of future incomes expected from that asset, discounted to present value, is equal or higher than the purchase price. On the opposite side, a rational seller will not sell an asset if future incomes expected from that asset discounted to present value are greater than the offered price.

There is no single, correct value. Forecasting future events is subjective in nature because of an embedded uncertainty and cannot be measured with safety. That is the reason why estimated values are expressed as either a single monetary amount (e.g. in euros) or a range (from to). Estimations of value are based upon the information at hand on a certain day the effective date of the appraisal. Obviously, the offered price is a very important decision factor but not necessarily the only one for deal making or deal breaking. In any case, buyers should know what maximum price they are willing to pay for target companies 6

Hence, a systematic approach to acquisition valuation by using different methods is highly recommended. The acquisition value of a target should be presented as a range. Strict appraisal guidelines in place at acquiring companies should help in consummating deals at the right price. Professional acquisition valuations can help acquiring companies to get the right value for their money. 1.2 PROBLEM STATEMENT We believe that a corporate investor might find certain companies attractive at substantial premiums over current market values because its assumptions of risk, time horizons, and motivations in maximizing shareholder wealth and the welfare of the corporate manager(s) are all different from those of the typical outside passive investor, during the present period of non equilibrium in the economy. Historically, acquisition premiums have been paid over current market levels in order to obtain control. However, over the last several years, we have seen premiums average in excess of 50 percent, far above the 20 to 25 percent normally associated with control. Such disparities in valuation are the result of a number of factor such as acquisition

valuation will consist of Intrinsic, Market, Synergy Value and Acquisition Price. Factor of Misevaluation using different approach will determine acquisition premium or discount. The popularity of the multiple valuation methods can be attributed to their relative simplicity compared to other company valuation methods like discounted cash flow techniques . Most large corporations evaluate alternatives by using discounted cash flow (DCF) methods. These are similar to the methods used in contemporary securityvaluation models. Other things being equal, the present value is sensitive to both the discount rate and the time horizon. A stock's price/earnings ratio is also sensitive to investors' time horizons. Corporations may be less willing than outside passive investors to discount or truncate the projected future returns from a business. A long term posture is often more appropriate for the corporation, chartered in perpetuity, than for the institutional investor with short-term anxieties and specific performance. Asset valuation method will discover that the way companies are required to measure earnings can be completely unrelated to the way they make decisions aimed at maximizing shareholder 7

value. For example, although companies are permitted to capitalize and then amortize investments in plant and equipment over time, they must immediately expense almost all outlays for research and development, advertising and promotion, and other investments with a longer-term payoff. Conflict between top chief executive and shareholder either to payout dividend or use excess cashflow to acquire company that will review in agency theory. The capital asset pricing model (CAPM), used increasingly in investment portfolio management, links the returns on risky assets to returns on the market portfolio. CAPM is only a one-period rate-of-return model and it assumes equilibrium in the capital markets. Such a one-period capital asset pricing model is not easily reconcilable with longer-term capital budgeting decisions. Acquisitions are non equilibrium in nature. The company performance can be influence by leverage, risk, size and cash. Acquiring corporations can intervene in the operations of the acquired firms and change their earnings potential by improving management and productivity and by changing their capital structure. There may, in fact, be synergy that will increase future earnings and cash flows in a way that outside investors were not anticipating prior to the merger [Bradley and Korn 1982]. In todays world this may prove to be a big hazard and we would rather stay with a firmer foundation of rational investing. It teaches us not to pay more for an asset than it is worth, although a discussion on valuation can be made philosophical in nature by arguing the assumptions (Vaid, 2002). Valuation is done in too many instances with an already set price in mind. The decision to acquire a target precedes acquisition valuation of that target. We argue that without precise quantification of control and synergy, we cannot determine the worth of a target and therefore tend to over-pay.


OBJECTIVE OF THE STUDY Two keys to success in pricing an acquisition are to make sure that the assumptions used for calculating a targets synergy value are realistic. The second is to ensure that the acquirer pays no more than it should (Eccles, 1999). Specific objective are as follows : 1.3.1 to investigate the determinant factor that differentiate acquisition premium from

acquisition discounts in Malaysia. 1.3.2 1.3.3 1.3.4 1.4 to see the impact of misevaluation using different or multiple approach valuation to examine the effect of misevaluation towards agency problem to study the effect of company performance due to misevaluation

RESEARCH QUESTION This study to attempts to answer the following research question. 1.4.1 How should companies evaluate major investment opportunities, particularly

acquisition candidates? 1.4.2 Do acquisitions have to be EPS-accretive to be value-adding, or is there some

more reliable means of assessing an investments value than pro forma EPS effects? Does the discounted cash flow valuation method always offer a better guide to value than the method of comparables used by Wall Street dealmakers? What is the impact using different approach.? 1.4.3 1.4.4 Is there any agency problem exist during acquisition process? What happen to the company after acquisition? Are they worth for acquisition? 9


SCOPE OF THE STUDY The research will focus on the factor that determine acquisition premium and acquisition discount. The study will only be focus on valuation based on three common approach which is Discounting, Comparable and Underlying Asset. The other approach such as Real option will be not discussed in this research. One of the problem or limitation with the typical cash flow model is that it does not take into account the personnel effects of acquisitions; the cash flow estimates may not materialize due to demoralized employees. To assess the personnel factor in valuation analysis, financial people performing the cash flow analysis need more contact with the managers responsible for operating results who are not necessarily the top executives Focusing only on company cash flow either manager want to retain, payout as dividend or expand by acquisition will be discussing on agency theory and free cash flow review. Other than that, the impact of company performance will be examine either is it worth for acquire the company.


SIGNIFICANCE OF THE STUDY Given the potential impact of corporate take-overs, knowledge on ownership structure, the motives for take-overs, determinants of premiums paid and their consequences are important for a host of decision makers as follows: (i) Investors - especially the non-controlling shareholders and other retail investors who supply funds in exchange for risk capital, would be interested to know the impact of the take-overs. This study provides knowledge on the determinants of post take-over performance. Investors may also use the models to price and evaluate tender offers and formulate appropriate investment strategies. (ii) Potential bidders who are interested in pursuing external growth strategy would benefit from insights on the motives for take-overs and their consequences under different ownership structure and the levels of premiums paid. This knowledge would assist managers to make more informed managerial decisions, increase their bargaining power and thus increase the likelihood of more efficient take-overs.


(iii) Government policy makers and regulatory agencies such as Bank Negara Malaysia (BNM), Securities Commission (SC), and others would be interested in information on take-overs, and distribution of ownership for planning and regulating economic development. This thesis provides insight on the issue, and effects of large shareholdings as well as pricing behaviour of the corporate control market. Thus, it would help the authorities to revisit the adequacy of the current listing requirements especially with regard to ownership distribution and the Malaysian Code on Take-overs and Mergers to enhance the Malaysian equity market as an attractive avenue for investment. (iv) Researchers would benefit from this study as the findings of this study relates to managerial theories such as agency conflicts and the performance of firms in a developing country such as Malaysia. The theoretical contribution of this study includes advancing the knowledge of the agency theory and efficiency theory in relation to M&A in the context of a developing country. Specifically, it provides further evidence in explaining the conflict of interests (or alignment of interest) between controlling shareholders and minority shareholders in developing countries. The unique institutional background of Malaysia provides an alternative view on the effect of concentrated corporate ownership and family owned firms in corporations involved in take-overs. It also offers a model for bid premium valuation, and lastly contributes to the knowledge in efficiency theory (Mueller, 1995; Trautwein, 1990) by operationalising the motives for take-overs in Malaysia.



LIMITATION OF THE STUDY The scope of study is only confines to Malaysian public listed companies. This study will focus into 2 categories which is financial sector and non financial sector. Many financial sector acquisition happened after asian turmoil between 1998 till 2000. For non financial sector acquisition happened recently. Some of the company time frame not enough to be include in this study which is between 2000 until 2012. All financial and non financial sector from the list will be identified carefully. At the same time, beta adjustment should be made. This study will include only the relevant variable based on the theoretical considerations or finding from previous research. The finding and the inclusion of new variable hopefully will be applied to other future research


2.0 2.1



This chapter provides a comprehensive review of the literature, theory and empirical evidence that serve as the theoretical framework for understanding the determinants of misevaluation, factor of misevaluation using different method, agency problem of public listed firms in Malaysia and performance after acquisition . Hence, in order to relate the misevaluation with acquisition premium and acquisition discount and their negative impact on firm value, theories in finance such as the Shareholder wealth maximization, Pecking order and desperation theory will be reviewed. Besides that, multiple approach will be used to determine either the company make overpayment or underpayment to acquire company. Agency theory will also be discussed in this study, where free cash flow as a corporate mechanism could be considered pertaining to agency conflict and corporate governance issue in relation to misevaluation. The other effect of acquisition will be measure by Company performance. With the completion of this review process, it is hoped that this study would have established the necessary theoretical framework and research methodology for studying this particular issue. This chapter is divided into four sections. Section 2 explains on determinants differentiate between acquisition premium from acquisition discount , Section 3 factor of misevaluation using different approach. Section 4 will be discussing regarding agency conflict between manager and maximize shareholder wealth. Finally, section 5 discusses the effect of company performance due to misevaluation



MISVALUATION The price of making a mistake can be greater than the price of missing an opportunity. One of the reasons why acquisitions fail to create value is high acquisition price. Herewith high acquisition price it is not referred to in absolute terms, i.e. in euros, but rather to what acquisitions are really worth to acquiring companies. So what is the right acquisition price? Valuing acquisitions correctly is very important knowing the fact that too many deals fail in the real world We argue that perception of value has to be supported by a sound investing principle, which implies that a purchase price (the price actually paid) should relate to the worth of a target, i.e. cash flows expected to be generated by the business. As logical as that seems to be, it is often forgotten in the world of acquisition

In the late 1990s, the US and world economies experienced a large wave of mergers and acquisitions, most of which were for stock (Andrade et al.,2001). This wave of acquisitions was very different from the hostile takeover wave of the 1980s, when many acquirers were financiers, and the medium of payment was often cash rather than stock (Shleifer and Vishny, 2003). Besides that, Loughran and Vijh (1997) find that the market does not react correctly to the news of a merger, with acquirers making cash tender offers earning positive long-run abnormal returns, and those making stock acquisitions earning negative long-run abnormal returns. Rau and Vermaelen (1998) show that this pattern of returns remains even after the correction for size and book-tomarket ratio as recommended by Fama and French (1993). Also, Myers and Majluf (1984), Fishman (1989), Brown and Ryngaert (1991), Yook (2003) and Dong et al. (2006) suggest that the means of payment may reflect differing managerial motivations and/or returns about the bid. Furthermore, recent evidence suggests that inefficient market valuations influence levels of investment (Polk and Sapienza, 2004) and the sensitivity of investment to cash flow (Baker et al., 2003), which proves that stock misvaluation affects corporations investment decision.


Nancy Mohan, M. Fall Ainina, Daniel Kaufman and Bernard J. Winger (1991) provides and study insights on practices used by financial managers to value acquisitions and divestitures. They find that managers place high importance on discounted cash flow and market value approaches for valuation, a result consistent with textbook

recommendations. Also, acquiring companies appear to offer, and pay, amounts close to those derived from discounted cash flow estimates. Hence, the results suggest that the problem of overvaluation may arise from faulty inputs to discounted cash flow analysis. Projected acquisition/divestiture values derived from discounted cash flow models are affected by estimates of cash flows and cost of capital. Because of the potential variability of such estimates and because acquisition/divestiture decisions often involve large sums of money, they found a heavy reliance on sensitivity analysis and frequent adjustments made to forecasts provided by target firms. Surprisingly, sensitivity analysis was considered more important for acquisitions than for divestitures. An equally surprising finding is that the acquirer's cost of capital, or top management's judgment of such value, is used more frequently than the cost of capital for the target. Finally, survey indicate that near-term earnings is an important determinant of offering price. 2.3 DETERMINANTS THAT DIFFERENTIATE ACQUISITION PREMIUM FROM ACQUISITION DISCOUNTS Several studies have shown the presence of competition to be related to higher premiums paid for targets (Varaiya and Ferris, 1987; Varaiya, 1988; Slusky and Caves, 1991). This evidence is consistent with the "winner's curse" phenomenon (Capen, Clapp, and Campbell, 1971; Bazerman and Samuelson, 1983), in which the winner of an auction is the party that most overestimated the true value of the object being auctioned. It is not too surprising that premiums vary widely when one considers that deciding how much to pay for another company can be a difficult decision, subject to varying levels of uncertainty. There are likely to be situations in which it is unclear what premium level would convince target management and shareholders to turn over the control of their company to the acquiror, discourage competitive bids, and yet still reflect the value of the company that is being bought. Competitive bids require decisions about whether to raise the bid or 15

withdraw, and the consequences of continuing or withdrawing are usually unclear. Managers are routinely advised not to pay too much and to avoid the winner's curse (e.g., Allen, 1990; Reichheld and Henske, 1991). But how does one go about not paying too much? The financial evaluation of acquisitions has been the subject of much work in finance and accounting (e.g., Bing, 1980; Copeland, Koller, and Murrin, 1990). The conditions surrounding evaluation decisions, however, can be uncertain and open to judgment (Trautwein, 1990). If the financial condition of the target is highly variable, for example, then managers have to attempt to find the causes of the variance and then decide how to adjust the premium to allow for this. In takeover process, acquirers have to decide upon the following key questions: _ What is the fair market value of a target? _ What price to offer? _ When to place the offer?

2.3.1 ACQUISITION VALUATION Value is an imprecise term because it varies with the situation (Fishman et al., 2004). Hereafter, we provide some basic definitions of value that are stated in acquisition valuations (Eccles et al., 1999):

Intrinsic value, Market value ,Synergy value


Figure 1. Value Sharing Among Shareholders of Acquiring and Target Company (Adapted from Eccles et al, 1999)

2.3.2 MARKET INEFFICIENCY The fundamental assumption of Shleifer and Vishny (2003) is that financial markets are inefficient, leading to mispricings. In their model , bidders have private information

about the degree of misevaluation which they try to exploit through a form of arbitrage (i.e. M&A). They argue that managers of overvalued firms expect negative long-run returns because of the overvaluation This market inefficiency is also the underlying premise of Rhodes-Kropf and Viswanathan (2004), though it is precisely the lack of perfect knowledge about the inefficiency that leads to acquisition. They develop a model where bidder and target valuations deviate from true value. They decompose the misvaluation into firm-specific and market-value components. Bidders have private information about their own value and the potential value of merging with a target. Targets, on the other hand, have limited information about the components of misvaluation, and thus have difficulty assessing the value of synergies from merging. When the market is overvalued, the target is more likely to overestimate the synergies because he underestimates the shared component of misvaluation due to an inability to accurately assess the market-wide versus firm-specific 17

effects. In this setting, market-wide overvaluation tends to make bids look more attractive to the target, while firm-specific overvaluation tends to make bids look to low. The model explains why target firms would accept overvalued equity as payment. Shleifer and Vishny (2003) and Rhodes-Kropf and Viswanathan (2004) develop models which suggest that stock market misvaluations drive merger activity. In their models, the fundamental assumption is that financial markets are inefficient and therefore some firms are valued incorrectly, while bidder managers are completely rational, understand market misvaluations and, hence, time the market to make profits. During 1990s period, the Malaysian market was characterised as being highly speculative (SC, 2004, p.58). Retailed investors who accounted for 70 percent of the total transactions dominated the Malaysian capital market (SC, p.58). Besides the speculative activities by the market players, insider trading (Mat Nor and Mohd Zin, 1996), as well as improper disclosure and dissemination of false information were also prevalent (SC, 2004, p.55). These activities have distorted the pricing efficiency that is required in an efficient market. 2.3.3 MARKET TIMING Shleifer and Vishny (2003) suggest that if valuations are driven by beliefs, it is possible that managers may make more acquisitions, especially those financed using stock, during inefficient periods of optimism because these offer good opportunities to take advantage of and issue large amounts of stock at an overvalued price (market timing theory). In this context, managers are prompted to use their overvalued stock to buy real assets through mergers and hence more acquisitions should take place in stock market booms3. Under this framework, target managers with short time horizons would accept the bidding firms overvalued equity and seek to secure their earnings before this equity returns closer to its fundamental value.

New stock issues could also abide with this logic, as overvalued firms can raise funds more efficiently. Of course, as Rosen (2006) argues: there is no reason to believe that, during hot markets, stock issued to purchase capital goods will be less overvalued than stock issued to finance a merger, all else equal. However, it may be difficult to find a worthwhile capital project that involves as much expenditure as a major acquisition. That is, mergers are an efficient way to make large capital purchases with stock.


Rhodes-Kropf and Viswanathan (2004) provide an alternative behavioral model, in which rational targets lack perfect information and would accept more offers from overvalued targets during bullish markets, because they overestimate the potential synergies of the merger.4 2.3.4 PREVAILING FEE STRUCTURE The prevailing fee structure provides investment banks with an obvious economic interest in closing M&A deals. Buying and selling companies typically pay fees that are tied to the closure of the deal and to the ultimate acquisition price. For example, in Campeau's acquisition of Federated Department Stores in 1988, First Boston received a $12 million success fee for closing the deal versus $8 million for the actual advice and representation The three investment banks that advised Federated (Shearson Lehman Hutton, Goldman Sachs & Company, and Hellman Friedman) split $54 million in fees, based on the size of the final bid, as well as receiving flat retainers. For years, commissions have been calculated on the basis of the Lehman Formula, which applies a decreasing sliding scale against the selling price. The scale starts at 5 percent for the first $1 million of the purchase price, 4 percent for the second $1 million, and declines to 1 percent for all values over $4 million. For large transactions, many investment banks used the fee structure of Morgan Stanley as a benchmark: fees were set at, respectively, 1percent for a $100 million acquisition, 0.5 percent for a $500 million acquisition, 0.4 percent for a $1 billion deal, and 0.23 percent for a $4 billion deal (or $9.2 million). In the late 80s, following the boom of large M&A deals, Morgan Stanley raised its fee structure by almost 15 percent for acquisitions valued at $100 to $900 million.

When the market-wide overvaluation is high, the estimation error associated with the synergy is high too, so the offer is more likely to be accepted. Thus, when the market is overvalued the target is more likely to overestimate the synergies because it underestimates the component of misvaluation that it shares with the bidders.


Any fee structure that ties a bank's commission to the acquisition price clearly serves the interests of the seller. However, this same fee structure induces an acute conflict of interest between the investment bank and its buyer-client. In essence, buyers pay more as their investment bank is less effective. This observation was confirmed by a recent study of 77 medium-size and large M&A transactions, ranging in size from $410 million to $13.23 billion, between 1983 and 1990. The study found that the advisory fees received by investment banks representing either selling or buying companies were positively related to the acquisition premium, the difference between the final price per share paid for the target company and the target's stock price before the acquisition negotiations started. The investment banks reaped higher fees as they negotiated higher acquisition prices, regardless of the party (buyer or seller) they represented. This is especially troublesome for buying companies, which have an interest in keeping the acquisition price low, represented by agents who benefit directly from higher prices.

2.3.5 THEORY OF THE FIRM AND SHAREHOLDER WEALTH MAXIMIZATION The threat of takeovers is generally seen as an incentive for management to perform in the stockholders best interest. If management fails to maximize shareholders value, then a takeover mechanism (merger, acquisition or proxy) can be used to replace current management. Therefore, takeovers can enhance efficiency of both the market for management and the capital market if the threat of a merger (possible loss of job to the manager) increase managerss incentive to maximize shareholders wealth5

Some mergers may be the result of managers not acting in the best interest of the firms existing shareholders. In this case, if the market for corporate control is efficient, the firm making the non-value maximizing merger may become a target. In fact ,Jensen (1988b) claims that acquisition can be both the syptom and the solution to the conflict between managers and shareholders.


2.3.6 PECKING ORDER THEORY Myers and Majluf (1984) suggest that the capital structure can help to mitigate inefficiencies in a firms investment program that are caused by information asymmetries. They show that managers use private information to issue risky securities when they are overpriced. This results in an interaction between investment and financing decisions. Because market participants cannot separate information about new projects from information about whether the firm is under- or overvalued, equity will be mispriced by market participants. If firms are required to finance new projects by issuing equity, underpricing may be so severe that new investors capture more than the net present value of the new project, which would result in a net loss to existing shareholders. Even a positive net present value project will be rejected, leading to yet another underinvestment problem. The information costs associated with debt and equity issues has led Myers (1984) to argue that a firms capital structure reflects the accumulation of past financial requirements. There is a pecking order of corporate financing: (i) firms prefer internal finance; (ii) if internal finance is not sufficient and firms require external finance, they issue the cheapest security first. In this case, they start with debt, then possibly hybrid securities such as convertible bonds, and issue equity only as a last resort. In contrast to the trade-off theory, there is no well-defined target leverage ratio in the pecking order theory. There are two kinds of equity, internal and external; one is at the top of the pecking order and one at the bottom. Hence, as argued by Baker and Wurgler (2000), a firms leverage ratio thus reflects its past cumulative requirement for external finance. Most important, the pecking order theory can explain why the most profitable firms tend to borrow less; they simply do not need external funds. Less profitable firms issue debt because they do not have sufficient internal funds and because debt has lower flotation and information cost compared to equity. Debt is the first source of external finance on the pecking order. Equity is issued only as a last resort, when the debt capacity is fully exhausted. Tax benefits of debt are a second-order effect. The debt ratio changes when there is an imbalance between internal funds and real investment opportunities. 21

2.3.7 THEORY OF DESPERATION Desperation is triggered when managers perceive their firms current level of organic growth to be much slower than the other firms in the referent group, which in turn influences managers risk preferences and behaviors. Managers who are desperate for growth, because of their firms very low organic growth compared with their peer firms, will become particularly motivated to seize growth opportunities. Such firms are more likely to take on high-risk strategiessuch as paying a much higher price than the market value for a target or what other firms paid for a similar targetin an attempt to boost their growth. Consequently, they will be more willing to pay significantly higher acquisition premiums than firms that are not desperate, even if paying a high acquisition premium exposes their firms to higher risk and uncertainty. In contrast, firms with strong organic growth relative to their peer firms are under less severe growth pressure and hence are less likely to overpay for a target. Thus the magnitude of the acquisition premium will increase as a firms organic growth relative to its peer firms decreases, but the relationship between a firms relative organic growth and acquisition premiums is not likely to follow a simple negative linear pattern.

As the negative gap between a firms organic growth and the organic growth of its peer firms significantly widens, managers become increasingly desperate to achieve the level of growth they desire. They will become extremely mindful of their dire situation and dramatically increase their focus on the growth problem they are facing (Ocasio, 1997; Adner and Levinthal, 2001). Because managers tend to take on more risk when faced with potential losses, the rate at which risky actions are taken to avoid or reduce losses increases as performance decreases (Kahneman and Tversky, 1979). Thus once managers become desperate, they may act aggressively to remedy their problem quickly, often taking on extraordinarily high-risk strategies and actions. Hence we expect that the acquisition premiums that acquirers are willing to pay in an acquisition will increase at an increasing rate to the extent enabled by a firms financial resources as the negative gap between their organic growth and the organic growth of their peer firms increases. 22



2.4.1 COMPARABLE VALUATION Comparable valuation methods consist in the comparison of valuation multiples and operating metrics for a target company to those of different firms in a peer group. Peers may be grouped based on different criteria, such as industry, company size, or growth, this being the base of the benchmarking process. The popularity of the multiple valuation methods can be attributed to their relative simplicity compared to other company valuation methods like discounted cash flow techniques. As will show, think that the two methods can be combined to achieve goal, especially in case of a company whichs stocks is not traded on any stock exchange and is part of a young industry whose companies are not listed on stock exchanges. Several studies and surveys demonstrate that practitioners frequently use financial ratios or multiples for the valuation of companies (see Graham and Harvey, 2001, Manigart et al., 2000, Lie and Lie, 2002, Liu et al., 2002, Courteaua, 2003, Asquith et al., 2005, Roosenboom, 2007, Fidanza, 2008, Mnjin_, 2009). It also turns out to be surprisingly successful in comparative empirical studies by Kaplan and Ruback (1995) and Gilson et al. (2000). In his study focusing on equity valuation using multiples, Fernandezs (2001) basic conclusion is that multiples almost always have a broad dispersion, which is why valuations performed using multiples may be highly debatable. However, Fernandez shows that multiples are useful in a second stage of any valuation: after performing the valuation using another method, a comparison with the multiples of comparable firms enables financial analysts to gauge the valuation performed and identify differences between the firm valued, and the firms it is compared with.

These are the two approaches that I would like to merge in our valuation method: usage of financial ratios while utilizing another valuation method. Dittmann and Weiner (2006) investigate the which comparables selection method generates the most precise forecasts 23

when valuing companies with the enterprise value to EBIT multiple, while Henschke and Homburgs study (2009) addresses the problem of differences between firms and the impact on valuations based on multiples. They investigate the extent to which industrybased multiples ignore additional firm- specific information and develop measures for identifying peer groups that are not comparable with the target firm. They find that differences between firms lead to systematic errors in the value estimates of different multiples but that these errors can be predicted very accurately by comparing the financial ratios of the target firm with the financial ratios of its peer group. They show that when adequately controlling for differences between firms, valuation accuracy is improved substantially and all considered value drivers perform almost equally well. Mnjin_s paper (2009) examines the valuation performances of seven multiples on a sample of Bucharest Stock Exchange-listed firms. Mnjin_ founds that accuracy levels of multiple valuations are generally lower than those obtained using the same methods on more developed capital markets.

2.4.2 DISCOUNTED CASHFLOW As any corporate or Wall Street analyst will tell you, forecasting future earnings is very difficult. But what most people dont understand is that its even harder to predict actual cash flows than to predict earnings or other more traditional accounting measures. Cash flow accounting is especially confusing in the case of multinational corporations where, because of all sorts of currency complications, even something as simple as cash on the balance sheet is typically not cash that is available in the shareholders currency. Manager reported operating cash flow is far easier for them to manipulate than earnings. All they have to do is securitize some receivables one minute before your quarter ends, and significantly increase reported operating cash flow or they can put off paying for trade receivables by one dayand unless they draw attention to these things, no one will have any idea what they have done.


2.4.3 ASSET VALUATION The manager problem with GAAP accounting is its potential to distort managerial decision-making. There is two school of thought which is if you take a class in corporate finance at any business school, you will be taught that the job of corporate managers is to make decisions that maximize the values of their companies. You will be introduced to a concept called the net present value rule, which says that managers should invest capital in all projects that are expected to produce a rate of return that at least equals the cost of capital. But when you take the accounting courses, you will be taught something very different. You will discover that the way companies are required to measure earnings can be completely unrelated to the way they make decisions aimed at maximizing shareholder value. For example, although companies are permitted to capitalize and then amortize investments in plant and equipment over time, they must immediately expense almost all outlays for research and development, advertising and promotion, and other investments with a longer-term payoff. Many companies also use LIFO rather than FIFO inventory costing, report deferred taxes they never expect to pay, and take depreciation charges that are far higher than the annual expected cost of replacing assetsall of which, in the name of accounting conservatism, causes financial statements to understate companies economic profit

2.4.4 DOES INVESTOR MISVALUATION DRIVE THE TAKEOVER We examine the misvaluation hypothesisthat inefficient stock market misvaluation is an important driver of the takeover marketand the Q hypothesisthat high quality bidders improve bad targets more than bad bidders improve good targetsusing contemporaneous measures of the valuations of bidders and targets, namely, price-tobook (P/B ), and the ratio of price to residual income valuation (P/V ). The P/V variable helps us evaluate whether a relation between market valuations and takeover characteristics is due to mispricing or other effects deriving from growth opportunities or from the quality of bidder and target management. Several empirical patterns emerge. With one or both measures, bidders are more highly valued relative to their targets in the 25

full sample, especially among equity offers and merger bids. More highly valued bidders are more likely to use stock and less likely to use cash as consideration, are willing to pay more relative to the target market price, are less inclined to use a tender offer rather than a merger bid, and earn lower announcement-period returns. Low valuation targets receive higher premia relative to market price, are more likely to be hostile to the offer, are more likely to receive tender offers rather than merger bids, have a lower probability of being successfully acquired, and earn higher announcementperiod returns. Most of the effects we identify are stronger in the 1990s subsample than in the 1980s. In addition, the evidence is broadly supportive of both the Q and misvaluation hypotheses in both periods, but tends to be more supportive of the Q hypothesis in the 1980s, and of the misvaluation hypothesis in the 1990s. The cross-sectional tests we offer here filter away any effects of aggregate valuations and disentangle the effects of bidder versus target misvaluation. Our findings raise the question of whether market valuations drive aggregate patterns of takeover activity. Some recent papers examine aggregate valuation and the takeover market (Bouwman, Fuller, and Nain (2004), Verter (2003)). These papers confirm that there are long-term swings in market valuation and aggregate takeover activity, and offer independent support for the view that valuations affect takeover activity. A challenge for this literature is the fact that the effective sample size is reduced by the low frequency of merger waves, and the fact that aggregate measures mix the effects of bidder and target valuations. Our tests are therefore complementary with those of these papers. A challenge for distinguishing between alternatives is that the misevaluation and Q hypotheses share several implications. Furthermore, each hypothesis is ambiguous with respect to some takeover characteristics. We suggest how each approach can rationalize different findings, and which results present the greatest challenges to each approach. Further theoretical work will be valuable in developing further predictions that distinguish between alternative hypotheses more sharply.


There is no reason to believe that the influence of market valuations (rational or otherwise) on managerial decisions is limited to the takeover market. As discussed earlier, recent research provides evidence that financing, repurchasing, reporting, and investment decisions are related to valuation measures. Our evidence contributes to an emerging theme in the recent literature that valuations (and, some have argued, misvaluations) may be important for many of the decisions that firms make. The recently emerging misvaluation perspective offers an alternative to the traditional approaches to corporate finance, including the Q theory, which are premised upon the efficient markets hypothesis. Initial steps haven been taken toward incorporating misvaluation into the theory of takeover transactions (see Shleifer and Vishny (2003)), financing, and investment decisions (Stein (1996),Daniel et al. (1998)). The emerging indications of possible misvaluation effects suggest that further theoretical analysis of how firms can exploit misevaluation may be fruitful


AGENCY THEORY Managers have personal incentives (e.g minimize risk, increase income and power) to diversify the corporate business portfolio and to grow the firm beyond the point that optimize shareholder value (Jensen and Meekling 1976, Amihud and Lev 1981: Murphy, 1985). In particular the choice between retaining or distributing earning creates a major conflicts between managers and shareholders. Retention of excess cash flow allows manager to avoid monitoring by the financial market and to invest in expansion diversification and organizational slack which yield below market returns. Competition in the product market would normally preclude such as inefficiency and waste of resources. However firms with free cash flow are by definition earning return in excess of their opportunity cost. Return above opportunity cost can arise from economic rents (e.g monopolistic and oligopolies the markets). Thus the disciplinary forces of the capital and product market are often weak in firms that generate significant free cash flows.


2.5.1 FREE CASH FLOW THEORY Jensens free cash flow theory is based on the agency costs incurred when a firm generates cash flow in excess of the funds needed to finance all positive net present value projects and management does not wish to pay these excess funds to shareholders. Manager may reluctant to pay out free cash flow because it reduces the amount of corporate wealth that they have control over as well as the potential of future perquisite consumption. A pay out of free cash flow because it reduces the amount of corporate wealth that they have control over as well as the potential of future perquisite consumption. A payout of free cash flow also subjects the manager to monitoring by the capital market when they must obtain new capital. Thus, a conflict exists between shareholders, who demand a required rate of return on their investment for a given level of risk and managers who desire to mantain control of the excess resources. Jensens free cash flow theory of takeovers views mergers as mechanism to : (1) motivate efficient use of resources: (2) create an organizational change: and (3) protect shareholders when the normal internal control fail. Therefore, mergers provide a means to resolve conflicts between shareholders and management, as well as provide more efficient allocations of resources in the economy. 2.5.2 HUBRIS THEORY Indeed, one possible definition of irrational or aberrant behavior is independence across individuals (and thus disappearance from view under aggregation). Psychologists are constantly bombarding economists with empirical evidence that individuals do not always make rational decisions under uncertainty. For example, see Oskamp (1965),Tverskyand Kahneman (1981),and Kahneman, Slovic, and Tversky(1982).

Among psycholo- gists, economists have a reputation for arrogance mainly because this evidence is ignored; but psychologists seem not to appreciate that economists disregard the evidence on individual decision making be- cause it usually has little predictive content for market behavior. Corporate takeovers are, I believe, one area of research in which this usually valid reaction of economists should be abandoned; takeovers reflect individual decisions. 28

Although some firms engage in many acquisitions ,the average individual bidder/manager has the opportunity to make only a few takeover offers during his career. He may convince himself that the valuation is right and that the market does not reflect the full economic value of the combined firm. For this reason, the hypothesis being offered in this paper to explain the takeover phenomenon can be termed the "hubris hypothesis." If there actually are no aggregate a in sin takeover, the phenomenon depends on the overbearing presumption of bidders that their valuations are correct. This explanation the hubris hypothesis is very simple : decision makers in acquiring firms pay too much for their targets on average in the sample we observe. The samples, however are not random. Potential bids are abandoned whenever the acquiring firms valuation of the target turns up with a figure below the current market price. Bids are rendered when the valuation exceeds the price. If there are really are no gains in takeovers, hubris is necessary to explain why managers do not abandon these bids also since reflection would suggest that such bids are likely to represent positive errors in valuation. Finally, I should mention several issues that have arisen as objections by others to the hubris idea.



2.6.1 PERFORMANCE Most accounting studies address both the pre-acquisition performance of the target and the acquiring companies and the post-acquisition performance of the acquiring company. The post-acquisition performance studies that use financial accounting data seek to determine whether, on average, acquisitions are followed by changes in profitability. Firstly, these studies investigate the profit potential of the acquired companies, as manifested in their pre-acquisition earnings. Since the targets annual account information is absorbed into that of the acquirer, it can be expected that the preacquisition performance of a target company will influence, in a positive or negative sense, the post-acquisition performance of the acquirer. This works well when the 29

acquired company is reasonably large relative to the acquirer, but when the target is small relative to the acquirer, weighted average profitability gains are less likely to show through in the results of the combined firm (Cosh and Hughes, 1994; Higson and Elliott, 1994). Gaughan (1994, 2002) and Megginson and Smart (2004) highlighted that in the 1990s, expected synergies were regarded as the primary motives for take-overs in order to improve efficiency and achieve better corporate performance. In the process, the acquirer often paid a premium over the market value of the targets assets and technologies for the expected synergies if the two firms were combined. Past studies have showed M&A can add value to the combined entity. However, a high level of wealth gain was enjoyed by targets' shareholders while the shareholders of acquiring firms were no better off or even lost upon the announcements of the business combinations. In the long run, acquirers lost even more as highlighted by Agrawal, Jaffe and Mandelker (1992), and Franks and Harris (1989). Conflicting results however were found in accounting-based studies in assessing the post-take-over performance. Ravenscraft and Scherer (1989) and Ghosh (2001) who examined earnings performance concluded that merged firms had no operating improvement whereas Healy, Palepu, and Krishna (1992), Abdul Rahman and Limmack (2004), Powell and Stark (2005), and Song et al (2005) found positive cash flow returns as a result of the business combination Generally, most studies reveal that the short-term performances of the bidders using the event study method are negative (Dodd, 1980; Jarrell and Poulsen, 1994; Hubbard and Palia, 1995; Agrawal, Jaffe and Mandelker, 1992; Walker, 2000; Sudarsanam and Mahate, 2003). A summary of the results of the United States (US) M&A by Andrade et al (2001) for the past 30 years indicates that targets consistently earn about 16 percent upon announcement and 24 percent till the close of the deal. In contrast, bidders earn negative returns of -0.3 to 1 percent upon announcement and about four percent till the close of the deal. However, the combined gains of bidders and targets are positive at about 2 percent. In Malaysia, similar trends were found by Mat Nor and Mohd Zin (1996) and Ali and Moore (1999) in the 1980s samples.


Given the negative reactions and some inconclusive findings to the M&A announcements as highlighted in the literature, the motives for M&A to justify the exante performance remain debatable. The aim of almost every post-acquisition study is to answer the following question: do acquiring firms show better performance after the acquisition, or should they better have not engaged in a costly acquisition? Based on an overview of 130 studies, Bruner (2002) indicates that most researchers agree that market returns to target shareholders are positive. Indeed, most empirical work on event studies, seems to find significant target price increases (gains averaging 28%). Notwithstanding the fact that researchers do not find a consensus concerning acquirers gains, bidders mostly seem to earn on average zero adjusted returns. Dodd (1980) shows small but significantly negative returns at announcement date. Agrawal et al. (1992) find that acquirers experience negative abnormal returns of about 10% over the 5 year post-merger period. In a more recent paper Agrawal and Jaffe (2000) conclude that the long-run performance is negative after a merger, though following tender offers the performance does not seem to be negative and might even be positive. Mulherin and Boone (2000) also confirm the small magnitude of bidder returns. In the long term, prior studies of post-merger share-price performance report significant negative abnormal returns that challenge and raise questions about the validity of announcement gains as accurate estimates of the gains from merging. Franks et al. (1991) found that the previous findings of poor performance after the acquisition are likely to be due to benchmark errors rather than to mispricing at the time of acquisition. Jensen and Ruback (1983), Franks and Harris (1989) and Caves (1989) also find that acquirers appear to show no gains around announcement date, but they stress the fact that they neither find evidence of significant losses.


In accounting studies of acquisitions, the question whether acquisitions create or destroy value is usually addressed by comparing the performance of the combined entity (i.e. the acquiring plus the target company) with control groups. These control groups are of two main types: before-and-after comparisons and comparisons with units that had no merger but are similar in size, industry, etc. One might expect accounting studies to confirm the conclusions of the event studies. However, as Caves (1989) put forward, accounting studies are resoundingly negative on the average productivity of mergers and sharply at variance with the findings of event studies. Most accounting studies find a great percentage of firms with below average profitability in the years following the merger or acquisition.6

2.6.2 TOBIN Q Lang, Stulz, and Walkling (LSW) (1989) document that the abnormal returns in tender offers are related to the Tobin's q ratios of the targets and the bidders. In particular, they find that target, bidder, and total returns are higher when takeover targets have high q ratios and bidders have low q ratios where one is used as a cutoff point to separate high q firms from low q firms. In fact, bidders with high q ratios have significant positive abnormal returns when they engage in takeover, while bidders with low q ratios have significant negative abnormal returns. The best takeovers, in terms of value creation, are those where a high q firm takes over a low q firm. The opposite scenario holds for the worst case takeoverslow q firms taking over high q firms. If q is interpreted as a measure of managerial performance, these findings imply that better performing firms also make better acquisitions and that more value can be created from taking over poorly performing companies.

For an excellent summary of earlier accounting studies,see Chatterjee and Meeks (1996).


While the results of LSW are insightful, they leave a number of questions unanswered. Their sample consists only of tender offers. Several studies have documented that the returns to targets in mergers are smaller than those in tender offers (see Jensen and Ruback (1983) and Huang and Walkling (1987)]. It would therefore be useful to see whether the LSW (1989) results hold for a larger sample which includes both mergers and tender offers. 2.6.3 LEVERAGE POLICY Leverage Modigliani-Miller theorem suggests that the value of a firm is affected by the capital structure it employs. Leverage is borrowing money in addition of existing funds. Modigliani- Miller theorem based on perfect capital market where there is no transaction costs, no bankruptcy costs and perfect information exist. MM model suggests that capital structure is irrelevant in perfect market, but when we relax the conditions we find its relevance. The trade-off theory of capital structure reports the existence bankruptcy cost and Pecking order theory proposed by Myers captured the costs of information asymmetry. Myers (1984) argued that equity is less preferred means to raise capital. And lastly we have agency cost as well. Hence we conclude that leverage is an important factor to influence the firm's performance 2.6.4 RISK Richard Roll (1986), a financial economist, was among the first to invoke the idea that confidence is a major ingredient in executive risk taking. With no other explanation available for why CEOs make large acquisitions, even though it is well known that most acquisitions destroy shareholder value. Roll set forth his "hubris hypothesis": CEOs make acquisitions because they believe they have the ability to make better deals and to manage acquisitions better than their peers. Since Roll's work, a number of studies, particularly in finance and economics, have treated "overconfidence" as a general human tendency (Kyle and Wang, 1997; Odean, 1998; Daniel, Hirshleifer, and Subrahmanyam, 2001).


2.6.5 SIZE Kitching's (1967) early study indicated a strong positive relationship between the size of a target firm relative to an acquiring firm and organizational performance. Later interviews by Kitching (1974) with CEOs involved in acquisitions supported this finding. The executives suggested that prospects for success are improved if a target firm is larger rather than smaller relative to an acquiring firm. Other studies support these contentions. Waldman (1983) reported that the larger an acquiring firm relative to the size of a target, the more managerial diseconomies. Biggadike (1979) found that largescale entries into new ventures resulted in better performance than small-scale entries. These results are inconsistent with the belief that it is desirable to enter a new area in a small way, learn, and expand (Lubatkin, 1983). In contrast, Kuehn (1975) suggested that acquiring a large firm requires more integration effort and, additionally, may strain the financial position of a purchaser. Newbould, Stray and Wilson (1976) found no relationship between relative size in acquisitions and return to shareholders. More recently, Kusewitt (1985) found significant negative relationships between relative size of acquiree to acquirer and two performance measures, but some evidence that a peaked (quadratic) relationship exists. Kusewitt concluded that excessively small or large acquisitions should be avoided. 2.6.6 CASH Jensens (1986 ) free cash flow theory posits that firms generating excess cash are likely to make value-destructive investment decisions. This seminal paper has spawned a literature that generally supports Jensens conclusions. Pinkowitz andWilliamson (2002 ) find that a firms cash balance has a contemporaneous value that varies based on the firms investment opportunities and level of financial distress; the market places a lower value on cash holdings for distressed firms and firms with fewer growth opportunities. Richardson (2006 ) finds that firms with high levels of free cash flow are more likely to over-invest. Oler and Picconi (2005 ) show that firms with extremely high cash levels suffer significantly negative future returns


3.0 3.1



RESEARCH DESIGN In this part, the study will explain in details the way data is constructed to get accurate and adequate data. In addition, the methodology and models that used to analyze the data will also be discussed and each of the variables will be defined in details with respect to the objectives of the study.


SAMPLING To identify the targets, the initial M&A announcement list was identified from the Investors Digest published by KLSE. The investigation of this study on the firm takeover performance focused on the corporate take-overs in the 1990s as earlier data was mostly unavailable. Only successful take-overs were used in the analysis. For non-listed targets, which were relatively small, only those with 100 percent acquisition stakes or fully integrated target firms were included. For public listed targets, only those with more than a 33 percent purchase stake were included as a 33 percent purchase stake would result in a change in control of the target firm and trigger a Mandatory General Offer. Minority buyout or the purchases of the remaining shares of the associate or subsidiary companies were excluded, as the impact of this form of acquisition was not as apparent. The target should have at least RM20 million in assets as too small a target would not have any significant impact on the acquiring firms (Abdul Rahman, 2002; Seth, 1990). Furthermore, under the Code of Take-over and Mergers (1998), although the scope of governance by the SC includes take-overs of public listed companies, whether or not they were listed on any stock exchange, it included private limited companies having shareholders funds of RM10m or more and where the purchase consideration was not less than RM20m (Loh, 1996).


The pre-take-over performance data were collected for three years prior to takeoverannouncement and 4 years for the post-take-over performance. The ownership data was obtained one year prior to M&A. If the dominant owner was a company, the owner of the dominant owner was traced further in order to identify the ultimate owner. If the ownership chain included any non-public listed companies, the records kept by the Commission of Companies Malaysia (CCM, formally Registrar of Companies) were used


RESEARCH METHODOLOGY In practice, different valuation methods have evolved for estimating the targets value.

3.3.1 OBJECTIVE 1 :


DIFFERENTIATE ACQUISITION PREMIUM FROM ACQUISITION DISCOUNTS IN MALAYSIA The researcher would like to know what factor determine acquisition valuation. In this case, the researcher sets a dummy variable that takes the value one for AP (acquisition premium) and zero for AD (acquisition discount). The first step in this empirical work will be run means comparison and Wilcoxon rank sum tests to check the differences between the two categories factor. Then, the researcher will use a Logit model to determine acquisition premium. The researcher adopts Logistic regression model because some variables are non-linear. The use of logit model is more robust. Furthermore, it produces highest accuracy rate (Huson et. al, 2000). The model to test the probability of observing an acquisition premium:


Model 1: P (AP) = + P (AP) = f (Price, Market Value, Time, Cash, Capex, DebtR, Growth) (EQ1) (EQ1a)

P (AP) = + 1PRICE+ 2MKTV + 3TIME + 4CASH + 5 CPEX + 6DEBTR + 7GROWTH + Where: = intercept = response coefficients AP = probability of acquisition premium firm which based on public listed companies, use dummy variable (AP = 1, AD= 0) PRICE = acquisition price MKTV = based on price on stock market TIME = the acquisition announcement till completed LCASH = the natural log of the cash CPEX = capital expenditure which is a proxy for firms investment, total fixed asset divided by total asset DEBTR = ratio of total debt divided by total asset, measure firms financial leverage GROWTH = compounded annual growth (CAGR) In this study, the researcher is interested to know what elements are / variables that acquisition premium from acquisition discount firm based on public listed company in Malaysia. (EQ1b)


The acquisition premium is expected to be positively related Acquisition Valuation, Market inefficiency, Market timing, Prevailing Fee Structure, Theory of the firm, Shareholder wealth maximization, Pecking Order theory and Theory of Desperation

3.3.2 OBJECTIVE 2:


DIFFERENT OR MULTIPLE APPROACH VALUATION Model 2: AV = + + * AP + (AV) = f (CV, DCF, COST) AV = + 1CV+ 2DCF + 3COST + Where: = intercept = response coefficients AV = probability of acquisition valuation which based on public listed companies, use dummy variable (AP = 1, AD= 0) (AP=Acquisition Premium, AD=Acquisition Discount) CV = Financial Ratio DCF = based on Net present value (NPV) COST = asset valuation or book value (EQ2) (EQ2a) (EQ2b)

The acquisition valuation is expected to be either premium or discount based on which method they evaluate target company. 38

3.3.3 OBJECTIVE 3:


TOWARDS AGENCY PROBLEM The researcher try to examine the effect of misevaluation towards agency problems among public listed Malaysian firms in order to achieve the third objective of study. Abnormal return and standard event study methodology will be used. Standard event study methodology will be incorporated in this study to assess the impact of acquisition announcements on stock returns. The commonly used event-study methodology is based on market model described by Fama (1976). In terms of calculating the return, the actual return of the stocks for year t and Kuala Lumpur Composite Index (KLCI) for year t will be determined by the amount differences from end of the year stock or market price and beginning of the year stock or market price divided by price in the beginning of the year which can be described as follows: Rit = Pt - Pt-1 / Pt-1 Where: Pt= share price at the end of year t Pt -1 = share price at the end of year t -1 Rit =the daily stock return of i th security on year t (1)

Beta also will be examined in this study to measure the assets sensitivity of the assets returns to market returns, its non-diversifiable risk, its systematic risk or market risk. On an individual asset level, measuring beta can give clues to volatility and liquidity in the marketplace. Beta and intercept for Malaysia firms will also be calculated in the same way.


In terms of beta adjustment, beta and intercept for Malaysian firms will be calculated as follows: Beta of a security, a = Where: Ra= rate of return of the asset R m= rate of return of the market Cov (Ra , R m ) = covariance between rates of return (R m ) = variance of market return Cov (Ra , R m ) / (R m ) = Risk Coefficient (2)

To study the stock price reaction towards acquisition announcements, it can be estimated by using the market model. Abnormal return (AR) and cumulative abnormal return (CAR) will be examined. Abnormal returns are the differences between a single stock or portfolios performance in regard to the average market performance over a set period of time. For example, if a stock increased by 5%, but the average market only increased by 3%, then the abnormal return is 2% (5% - 3% = 2%). If the market average performs better than the individual stock, then the abnormal return will be negative. Abnormal return will be computed as follows: AR = Rit (ai + bi Rmt ) Where: Rit ai bi Rmt = Return of individual stock = Intercept = Beta = Market Return (3)


Cumulative abnormal return (CAR) is the sum of all abnormal returns up to time t . If no event occurs, then cumulative abnormal return (CAR) equals to zero. ARt = Sum from i = 1 to N of each ARit / N. Here ARit is the abnormal return at time

of security i.

Cumulative abnormal return (CAR) is the sum of all abnormal returns (ARs). For both abnormal return (AR) and cumulative abnormal return (CAR) in case of Malaysian firm, it is calculate from days before announcement day until days after announcement day where day 0 is announcement day. t1 Before Announcement (t=0) Announcement Day t2 After Announcement

Figure 3.2: Event-Window Dividend Announcement Dates for Malaysia Firms The standard deviation also examines before finds the T-test of the study. It is the square root of the variance. It is most commonly used to measure spread of data. Before compute the T-test, both abnormal return (AR) and cumulative abnormal return (CAR) should average. T-test will be used to test the significance of the hypothesis using this formula as follows: T-test = Average / Standard Deviation (4)

In this study, event period is define as day t = 0 and day t = +1. This technique will be adopted in order to cater for late announcement release (after market close) during announcement day (Faccio, Lang and Yeung, 2002). By doing this, it allows stock price to fully absorb the information on the announcement day. The market parameters i and bi will be estimated over estimation period relative to the announcement day. The abnormal return is the difference between the realised returns, Rit and the expected returns based on the level of systematic risk. Given the Market Model parameter estimates, abnormal returns can be measured as follows: ARit = Rit (i + i Rmt) (5)

i is adjusted beta using Dimson's market model and Fowler-Rorke's corrections (DFR method) 41

3.3.4 OBJECTIVE 4:


DUE TO MISEVALUATION Model 4 : TOBQ = + + * AP + (TobinQ) = f (DebtR, Risk, Size, Cash) TOBQ = + 1AP+ 2DEBTR+ 3RISK+ 4LSIZE + 5LCASH + = intercept = response coefficients AP = probability of acquisition premium firm which based on public listed companies, use dummy variable (AP = 1, AD= 0) TOBQ = market value of equity plus total debt divided by total asset, a proxy for firms performance DEBTR = ratio of total debt divided by total asset, measure firms financial leverage RISK = standard deviation of the variances of daily stock returns, a proxy for total risk LSIZE = the natural log of the total asset LCASH = the natural log of the cash TOBQ is incorporated in this study to measure firms performance which is also known as Tobin Q. A set of firm specific control variables will also be included. AP is a dummy variable for pyramidal acquisition premium and it is equal to one (1) and zero (0) otherwise. DebtR, Risk, size, cash, tobinQ, are proxies for firm leverage policy, risk taking, firm size, free cash flow and corporate performance respectively. These variables will be described in the following section. 42 (EQ4) (EQ4a) (EQ4b)





The determinant factor that differentiate acquisition premium from acquisition discounts in Malaysia.


The probability of acquisition premium is positively related to Acquisition Valuation


The probability of acquisition premium is positively related to Market inefficiency


The probability of acquisition premium is positively related to Market timing


The probability of acquisition premium is positively related to Prevailing Fee Structure


The probability of acquisition premium is positively related to Theory of the firm and shareholder wealth maximization


The probability of acquisition premium is positively related to Pecking Order theory


The probability of acquisition premium is positively related to Theory of Desperation


1) Comparable Transaction Value approach


The acquire company is undervalued if the purchase price is below the market during acquisition. Null hypothesis = Purchase price < Comparable value


The acquire company is overvalue if the purchase price is above the market during acquisition Alternate hypothesis = Purchase price > Comparable value

2) Discounting approach


The acquire company is undervalued if the purchase price is below the market during acquisition. Null hypothesis = Purchase price < NPV


The acquire company is overvalue if the purchase price is above the market during acquisition Alternate hypothesis = Purchase price > NPV


3) Underlying Asset/Liquidation Value Approach


The acquire company is undervalued if the purchase price is below the market during acquisition. Null hypothesis = Purchase price < Liquidation value


The acquire company is overvalue if the purchase price is above the market during acquisition Alternate hypothesis = Purchase price > Liquidation value



There is the effect of misevaluation towards agency problem


The probability of manager may reluctant to pay out free cash flow because it reduces the amount of corporate wealth that they have control over as well as the potential of future perquisite consumption


The probability of executives desire to enhance their personal power or to maximize their personal wealth often at the expense of the firms shareholders




There is the effect of company performance due to misevaluation


There probability company performance is positively related to Leverage.


There probability company performance is positively related to Risk.


There probability company performance is positively related to Size


There probability company performance is positively related to Cash





Descriptions of Variables and Units of Measurement:


Based on public listed companies in Malaysia. (AP = 1, AD = 0).


Standard deviation of the variances of daily stock returns. (SD = 1/N n i=1(x1- )2 ).


Cash availability within the firm. (The cash variables are proxies by their natural log to standardise cash data with other data).


Represented by the total asset. (The total assets are proxies by their natural log to standardise total assets data with other data).



Show the firms performance. ((Market Value of Equity + Total Debt) / Total Assets)).

Debt Ratio

Measure firms financial leverage. (Total Debt / Total Assets).

Acquisition Valuation

Acquisition Price

Market Inefficiency

Market Price/Value


Announcement date till completed

Fee Structure

Advisory Fee pay to investment bank to acquire company

Maximize wealth

shareholder Dummy Variable will be use. (Shareholder=1, Stakeholder=0)

Stock Liquidity

Yearly average of daily bid ask spread (BASP) is used to compute the stock liquidity. (BASP = (Ask - Bid) / [(Ask + Bid) / 2] * 100).


CAGR (Compound Annual Growth Rate)



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