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Contingent Value Rights: Theory and Empirical Evidence

Sris Chatterjee*
and

An Yan**

First Version: November 2002 Current Version: July 2003

* Associate Professor, Finance Area, Graduate School of Business Administration, Fordham University, 113 West 60th Street, New York, NY 10023, Tel: (212) 636-6120, Fax: (212) 765-5573, email: chatterjee@fordham.edu. ** Corresponding author. Assistant Professor, Finance Area, Graduate School of Business Administration, Fordham University, 113 West 60th Street, New York, NY 10023, Tel: (212) 636-7401, Fax: (212) 765-5573, email: ayan@fordham.edu.

For helpful comments or discussions, we thank Thommas Chemmanur. We alone are responsible for any errors or omissions.

Contingent Value Rights: Theory and Empirical Evidence

Abstract A CVR is a commitment by an issuing rm to pay additional cash or securities to CVR-holders contingent on the issuers share price falling below a pre-specied level. It has been oered together with cash or stock, or both (or with other securities) as a means of payment in a number of recent corporate restructurings such as takeovers, debt restructuring, lawsuit settlements, etc. Since a CVR provides a hedge against downside price risk of the issuing rm, many practitioners argue that a CVR is a way to guarantee a minimum value for the payment package. However, this argument raises the question that, if a rm only intends to guarantee the value of its payment, then why doesnt the rm pay with cash and why does it choose CVRs instead of (or in addition to) cash? In this paper, we develop a theoretical model to address this issue and related questions. We consider a rm making a payment to acquire an asset from outside investors and we assume that the rm has more information about its intrinsic value than outsiders. If the rm is of a higher intrinsic value, then it is concerned about mispricing of its equity in the capital market (in addition to the mispricing of its payment). In this setting, we show that, when the extent of asymmetric information is severe, a higher valued rm can reveal its type by oering CVRs with other securities, but not by oering cash payment. We then test the empirical implications of our model in the context of M&As by using a comprehensive sample of U.S. public acquisitions in which CVRs are used. We nd that, when CVRs are oered in acquisitions, the announcement period abnormal stock return is signicantly more positive than comparable stock deals that involve no CVRs. We also nd that rms oering CVRs in their acquisitions face more severe asymmetric information problem than rms oering cash or rms oering stock with no CVRs. Both ndings are consistent with the implications of our model.

Contingent Value Rights: Theory and Empirical Evidence

Introduction
In the summer and early fall of 1993, Viacom made a friendly takeover bid for Paramount Communica-

tions, which was quickly followed by an unsolicited counter-bid by QVC Network. Although Paramount had initially refused to talk to QVC, the Delaware Chancery Court ruled that the Paramount board must seek the best value for shareholders, and this ruling was followed by a spate of competitive bids and counter-bids by Viacom and QVC. In early 1994, when QVC seemed to have a slight edge in the bidding process, Viacom introduced a somewhat novel element in its bid, called a Contingent Valuation Right or CVR. In addition to CVRs, the Viacom package contained cash and warrants and Viacom B shares. Viacom B shares were trading around $40 at this time, but the CVR would entitle its holder to receive, at the end of the year, the dierence between $48 and the closing price of Viacom B shares as long as the share price was less than $48. In other words, the Viacom CVRs resemble in-the-money European put options.1 A contingent value right (CVR) is a commitment by an issuing company to pay additional cash or securities to CVR holders if the share price of the issuing company falls below a specied level at some future point. CVRs have been used as a means of payments in a number of circumstances. While largely used in M&As (both in continental Europe and North America), CVRs have also been used as a partial compensation in other circumstances such as exchange oers, debt restructuring, chapter 11 reorganizations, lawsuit settlements, etc. For example, in 1999, Abraxas Petroleum Corporation oered CVRs, together with a new issuance of senior secured notes and shares of Abraxas common stock, in exchange for its senior notes outstanding at that time. Many practitioners argue that CVRs help to close a deal when the value of the payment package is uncertain and when there is disagreement between the buyer and the seller about the payment package. However, this argument raises the question that, if a rm only intends to guarantee the value of its payment, then why doesnt the rm pay with cash and why does it choose CVRs instead
1 See Paramount 1993 and Paramount 1994 by Steven N. Kaplan, and Hietala, Kaplan and Robinson ( 2002), for details of the Viacom payment.

of (or in addition to) cash, given that pure cash payments are not subject to any valuation disagreement? Unfortunately, there has been no analysis so far in the literature that would enable us to answer this and related questions. In this paper, we provide an explanation based on an asymmetric information framework and present empirical evidence testing the implications of this theory. In our theoretical analysis, we consider a rm making a payment to acquire an asset from outside investors of the rm (e.g., target shareholders in the case of an acquisition, or bond holders in the case of an exchange oer). We consider a setting of asymmetric information, where rm insiders have more information about the intrinsic value of their rm compared to rm outsiders. We assume that a higher intrinsic-value rm wants to rectify the mispricing of its shares (and the mispricing of its payment). Thus, a higher intrinsic-value rm has an incentive to distinguish itself from a lower intrinsic-value rm. One way to accomplish this is to oer cash. Specically, if the lower valued rm does not have excess cash on hand and has to nance its cash payment by a new issue of risky debt, the lower valued rm would face an increased probability of bankruptcy and consequently an increased cost of nancial distress by paying cash. If such an increase in the nancial distress cost is substantially high, then it is optimal for the lower-valued rm to pay with shares instead of cash. On the other hand, the higher valued rm will pay with cash to separate itself from the lower valued rm, due to the fact that issuing debt to nance its cash payment would only moderately increase its probability of bankruptcy. However, such a clean separation may not take place in all circumstances. Three cases may arise. First, when the extent of information asymmetry is so severe that the benets for the lower valued rm to mimic the higher valued rm by oering cash is substantially large, the cost associated with cash payment (e.g., cost of nancial distress) may become insucient to deter the lower valued rm from mimicking. Second, as documented in Myers (1977), debt may lead to underinvestment in future investment opportunities. Therefore, when the rm has a lot of future growth options, the opportunity cost of issuing debt will become substantially large so that it will preclude the payment of cash. Third, when the lower valued rm has enough internal capital available, oering cash payment may not be prohibitively costly to it. In these cases, contingent value rights emerge as an equilibrium choice for the higher valued rm to achieve separation.2 2

Compared to cash payments which give rise to an increased cost of nancial distress, CVRs add another potential cost for the lower valued rm if it attempts to oer cash payment. This cost arises from future contingent payments even in the absence of bankruptcy in the future. Therefore, this cost of contingent payment, together with the expected increase in the nancial distress cost, eectively prevent the lower valued rm from oering CVRs, thereby achieving separation for the higher valued rm. A simple example may clarify the intuition of this reasoning. Consider two bidders (one high quality and the other low quality) who are both able to pay $10 for an asset in cash or stock or both. Let us assume that the intrinsic value of the rms equity post-acquisition will be $30 for the high quality bidder and $20 for the low quality bidder. Both intrinsic values are private knowledge to the bidders themselves. In this setting, the high quality bidder can add to the $10 payment a CVR with a strike price of $25. Ex-post, the CVR will never be exercised and is costless to the high quality bidder. But the low quality bidder would have to incur a signicant penalty if it attempts to issue a CVR, since its CVR would be exercised and a payment of $5 would be incurred when its true rm type is revealed to the market prior to the maturity of the CVR. Thus, the lower quality bidder will never oer a CVR, and a CVR will provide a separating mechanism. Our model has several implications relevant to a rms choice of CVRs as a means of payment. In particular, we develop predictions regarding the kind of rms that oer CVRs, and the circumstances in which such rms will issue CVRs. Our model predicts that rms oering CVRs have a higher intrinsic value than rms oering only stock. In addition, our model predicts that rms suering from information asymmetry in the capital market are more likely to oer CVRs, while rms facing few asymmetric information problems are more likely to oer all-stock payments. Finally, given that information asymmetry exists in the capital market, our model predicts that rms facing a greater extent of information asymmetry or having more investment opportunities are more likely to oer CVRs to reveal their type, while those rms facing comparatively lesser extent of information asymmetry or lack of protable investment opportunities tend to oer cash payments to do so. Our last prediction suggests that CVRs are oered only as a last resort when
2 We will analyze the rst case in detail in our model, and will provide an intuitive discussion of the other two cases. Even though it is possible to introduce all three cases together in our model, we choose not to do so to minimize modelling complexity and to simplify exposition.

a rm vastly disagrees with the market about the value of its securities. This prediction is consistent with many anecdotal evidences. In practice, it appears that cash payment is the preferred alternative to ensure and reveal rm value, and a rm may oer CVRs in its payment only when cash payment is infeasible but it nevertheless faces a great need to prove its value to investors (e.g., in situations such as debt restructuring, lawsuit settlements, reorganization from Chapter 11, etc.), or to distinguish itself from competitors (e.g., in some cases of acquisitions). A good example is the Viacom-QVC battle over Paramount (mentioned in the beginning) where Viacom nally won the battle by adding CVRs into its proposal.3 The implications of our theory are empirically tested in the context of M&As.4 We rst construct a

comprehensive sample of acquisitions in which CVRs are oered and the CVR issuers are listed in U.S. exchanges. We then compare this sample to a control sample of acquisitions not involving CVRs. Our empirical ndings are consistent with the implications of our theory. We nd that the positive announcement eect for rms oering CVRs in acquisitions is signicantly greater than the announcement eect of rms oering stock without CVRs. We also nd that rms oering CVRs on average experience a lower announcement period abnormal return than rms oering cash, although this result is not statistically signicant. Further, we nd that, compared to stock oers, the likelihood of a rm oering CVRs is greater when the rm faces more severe asymmetric information problem. Finally, we nd that rms are more likely to oer CVRs instead of cash to prove their value, when they face more severe asymmetric information problems or when they have more investment opportunities. Our empirical study on oering CVRs in M&As is related to several strands of nance literature on M&As. Several theoretical papers have examined the acquiring rms equilibrium choices between cash and stock as the method of payments in their acquisitions under the presence of signicant asymmetric information. For example, Hansen (1987) analyzes the choice between cash and stock oers under a two-sided asymmetric information framework in which both acquirer and target have private information about their own values. Under his framework, a stock payment reduces the probability of a successful acquisition since the target
3 4

See, Rival Bidder Diller Says: Its history, New York Times, February 16, 1994.

We choose to test the use of CVRs in acquisitions instead of other situations due to the diculty of constructing control samples in the non-M&A scenarios.

may perceive the stock as overvalued, while an all cash oer increases the overpayment cost to the acquirer since the target will only sell when the targets value (known to itself) is less than the oer made. Fishman (1989) also studies the relative use of stock versus cash, although the benet of cash oers in his framework is dierent from that in Hansens model. According to Fishman (1989), a cash oer signals that the acquirers valuation of his gains from acquiring the target (which is private information to the acquirer) is high, thus deterring competition from the other bidders.5 This theoretical inquiry has been accompanied by a fairly

large body of empirical research on the choice between cash and common stock in various proportions as a means of payment, as well as the wealth eects associated with that choice.6 More recently, many papers

began to go beyond the traditional cash and stock oers, and to investigate the important innovations used in many recent acquisitions. For example, Kohers and Ang (2000) examines the use of earnout payments (i.e., payment contingent on the target exceeding certain performance levels), and nds that earnouts can be used to reduce the misvaluation of targets when the targets have signicant asymmetric information problem.7 In contrast to earnouts which are oered to reconcile the acquirers and the sellers conicting valuation of the target, we also observe that, in many cases, rms use contingent value rights (CVRs) to reconcile the disagreement about the value of the acquirer or the value of synergies. While earnouts have been studied in some detail, to the best of our knowledge, the rationale and empirical attributes of CVRs have not been reported in the literature. This paper tries to ll this gap. The rest of this paper is organized as follows. Section 2 describes the CVR in detail and provides a few more examples; section 3 models the choice of CVRs in acquisitions and shows how CVRs help to achieve a separating equilibrium; section 4 describes sample selection; section 5 reports the empirical results and robustness tests, and section 6 concludes with a summary and a discussion of remaining research issues.
5 Also, see Eckbo, Giammarino and Heinkel (1990) for another theoretical explanation of the choice of methods of payment in M&As. Note that all these theories focus on the equilibrium problems of acquirers and targets, while our model focuses on the interaction between rms oering CVRs and rms receiving CVRs. As we will discuss in the empirical part of the paper, rms oering CVRs can be either acquirers or targets. 6 See, for example, Martin (1996), who nds that the higher the acquirers growth opportunities, the more likely the acquirer is to use stock to nance the acquisition. Also see, for example, Travlos (1987), Berkovitch and Narayanan (1989), Brown and Ryngaert (1991), Ghosh and Ruland (1998), etc. for the studies on the related issues.

They also nd that earnouts can serve as retention bonuses for target human capital in mergers with feasible contract implementation. Also see Bruner (2001) for the discussions about the use of earnouts.

Description of CVRs
Contingent value rights are known also as value support rights and variable common rights. They

are generally intended to compensate CVR holders for future declines in the issuers stock price. Thus, CVRs eectively hedge downside price risk for outside investors and bridge the value gap between the issuer and outsiders. Usually holders of CVRs can exercise their right only at maturity, and thus, CVRs resemble European put options. Further, most CVRs are transferable securities, although there are also many exceptions. For example, when General Mills acquired Pillsbury from Diageo and paid for the acquisition with stock and CVRs, the CVRs were non-transferable. Typically, CVRs have a maturity of one to three years. At maturity, if the issuers stock is trading below a reference price (similar to the exercise price of a put option), then the holder of each CVR will receive a pre-specied amount of contingent payments. The contingent payments can be made either with cash or with securities, depending on the specications in CVRs, and can be quite complicated in some cases. In most cases, the payment equals the dierence between the reference price and the market price of the issuers stock at maturity, and usually has a ceiling. This ceiling or maximum amount is dened by a oor price for the underlying: if the issuers stock drops below the oor, then CVR holders will only get the dierence between the reference price and the oor (see, e.g., the Viacom CVRs discussed in the introduction).8 On the other hand, in some CVRs, the contingent payment is specied as a xed payment, either a xed cash payment or a xed payment of shares of the issuing rm, instead of being a function of the dierence between the reference price of CVRs and the issuing rms share price at the maturity of CVRs. For example, in the acquisition of CytoRad by Cytogen in November 1994, the merger plan announced by Cytogen entitled each CytoRad share to receive (i) 1.5 shares of Cytogen common stock, (ii) a warrant to acquire one Cytogen share at $8 that expires on January 31, 1997, and (iii) a CVR that confers 1/2 Cytogen share if the aggregate value of 1.5 Cytogen shares and the new warrants averages less than $12 during 45 trading days ending in January 31, 1997. Similar cases of xed cash or stock payments (i.e., digital options) can also be observed
8 In this case, a CVR with a oor resembles a European bearish put spread, while a CVR without a oor resembles a European put option.

in the acquisition of Aramed by Gensia, the acquisition of Diageo by General Mills, etc. In addition to the design of contingent payments, the design of CVRs can also be complicated in other ways. For example, the reference price of some CVRs may have a growth rate, or the issuer may have an option to extend the maturity of its CVRs, etc. The CVR issued by Viacom in its bid for Paramount provides a good example of these additional complexities: the CVR was based on Viacom class B shares, had a maturity of one year, and the reference and oor prices on the rst maturity date were set at $48 and $36, respectively. But Viacom had an option to extend the maturity by another year at the end of the rst year, in which case the reference and oor prices would be $51 and $37, respectively.9 Another complexity of CVRs is the limited redemption rights, which allow the issuer to redeem its CVRs for cash or stock at any time before the maturity of CVRs. For instance, in Markels acquisition of Terra Nova, the Markel CVRs can be redeemed at any time for cash or stock with a value equal to the reference price less Markels stock price at the date of redemption discounted at 6% from the maturity date. This redemption payout implicitly assumes that the Markel share would be trading at the same price level at maturity as that at the date of redemption. Further, CVRs may also include an up and out option. Under this mechanism, an issuer can include in its CVRs an early termination provision. This provision causes the CVRs to expire automatically if the average market price of the underlying stock during a measurement period exceeds the reference price. The measurement period is usually long enough to eliminate the risk that an abrupt spike in the stock price will eliminate the CVRs. Finally, one may wish to compare CVRs to other forms of contingent payments. One such form is a collar which provides price protection to target shareholders in an acquisition.10 However, a collar provides price protection only prior to closing of the deal, while a CVR provides a collar-like protection after the deal closes. Another form of contingent payments is earnouts, which are employed in takeovers when there is
9 Thus, if Viacom class B shares were trading at $40 at the end of the rst year, and the CVR was not extended, then the CVR holder would receive $8. If Viacom B were trading at $30 instead, then the CVR holder would receive $12 (because of the oor). On the other hand, if the CVR were extended and if Viacom class B shares were trading at $40 at the end of the second year, then the CVR holder would receive $11. 10

Also see Fuller (2000), etc. for discussions about collar oers.

substantial disagreement between the acquirer and the target regarding the value of the target. Earnouts are usually contingent on the combined rm achieving certain performance thresholds in the future, and the payo is an increasing function of the dierence between actual performance and the threshold. Thus, for target shareholders, an earnout represents a call option. Compared to earnouts, a CVR represents a put option to the target, protecting the target from the risk of the downside price movement in the future. Accounting Upon issuance, CVRs are typically recorded at their market value as a liability, with subsequent price movements of the CVRs recorded in the issuers P&L and balance sheet. At maturity, if the CVRs are in the money, then the payments paid to CVR holders are oset against the liability. Covenants and Protections: CVRs are governed by an agreement that must qualify under the Trust Indenture Act of 1939. The agreement is between the issuer and a qualied trustee who acts on behalf of CVR holders. The Act provides a number of protections, including a prohibition against amending the CVR without consent from the CVR holders. CVRs have both armative and negative covenants. The armative covenants are similar to those found in debt indentures, and include provision of periodic reports by the issuer to the trustee, denition of default and other duties of the trustee. The negative covenants prohibit the issuer from purchasing the underlying stock during a valuation period.11 This prohibition protects CVR holders from an articial

increase in the underlying stock price and an articial decrease in the CVR payout. In the event of the issuer disposing of all its assets or being acquired by a third party before the maturity of the CVRs, the holder will get paid the present value of the reference price and the oor (unless the company acquiring the issuer has agreed to assume the CVR obligations). CVRs are usually treated as unsecured debt in the issuers balance sheet, but in some cases the issuer may provide security or guarantee to the CVR holders. For example, when Mafco acquired Abex in 1995, Mafcos subsidiary MVR Inc. issued CVRs to Abexs shareholders and Mafco provided a guarantee of its
11 For example, if the payout to a CVR is the dierence between the reference price and the highest average stock price over any 20 consecutive trading days during 60 trading days prior to maturity, the valuation period is 60 trading days.

Entrepreneur, with private information about the firm type (G or B), chooses among stock, cash, and contingent value rights to compensate outsiders for an asset owned by them.

All cash flows are realized and distributed. Contingent value rights may be exercised or expire without payments. In the case when CVRs are exercised, additional payments are distributed to the CVR holders. All asymmetric information is resolved. 1

t=0

Figure 1: Sequences of Events subsidiarys obligations.

The Model
The model has two dates (t = 0, 1) and a risk-neutral entrepreneur owning an all-equity rm. At time

0, the rm makes a payment to outside investors (outsiders hereafter) in exchange for an asset owned by the outsiders.12 The rm can choose from three securities in order to pay for the asset: common stock,

contingent value rights, and cash. At time 1, the cash ows of the rm are realized and distributed to the dierent stakeholders. For simplicity, we normalize the number of total shares of the rms equity to be one. We also normalize the risk-free rate of return to be zero, and assume that all the agents including the entrepreneur and the outsiders are risk-neutral. The sequence of events is depicted in gure 1.

3.1

Cash Flow and Information Structure


There are two types of rms: good (type G hereafter) or bad (type B hereafter). Each type of rms

receives either a gross cash ow of xh (the high cash ow), xm (the medium cash ow), or xl (the low cash ow) at time 1. The dierence between the two types arrives from the ex ante probabilities attached to the high, medium, and low cash ows. The ex ante (time 0) cash ow distribution of the type G is more upward-skewed than that of the type B: i.e., the ex-ante probabilities of receiving a high cash ow xh by a type G rm is greater than that by a type B rm. In particular, we assume that the type G receives a
12 One can view this investment made by the rm either as acquiring all the outstanding equity of a target from target shareholders, or buying back an amount of outstanding debt from debtholders, or paying an amount to settle a lawsuit with plaintis, etc.

t=0 The Type G Firm

Prob. h Prob. m Prob. h

t=1 Cash Flow xh xm xh xm xl

The Type B Firm

Prob. m Prob. l

Figure 2: Cash Flow Structures high cash ow with a probability of h , a medium cash ow with a probability m , and a low cash ow with a probability of l ; h + m + l = 1. On the other hand, the type B receives a high cash ow with a probability h < h , a medium cash ow with a probability m = m , and a low cash ow with a probability l > l ; h + m + l = 1. For simplicity, we assume l = 0. Thus, the intrinsic value of the type G rm is VG = h xh + m xm , and the intrinsic value of the type B rm is VB = h xh + m xm + l xl . The cash ow structure of the two rm types is depicted in gure 2. The rm type is private information to the entrepreneur at time 0, with outsiders knowing only a prior probability distribution over the rm types: at time 0, outsiders believe that the probabilities of any given rm being of a type G or B are 1 and 2 , respectively, 1 + 2 = 1. In contrast, the value of the asset owned by the outsiders, V , is common knowledge to all the players in the market at time 0, xm > V > xl . Thus, in order to successfully acquire the asset, the rm must oer a payment worth at least the fair market price of the asset, V . We assume that acquiring the asset is a positive NPV investment to both types of rms.13 Thus, both the type G and the type B rms are willing to do so. At time 1, the asymmetric information between the outsiders and the entrepreneur is resolved.
13 In the paper, we will not analyze the share of this positive NPV between the rm and the outsiders in the transaction, since it is not the interest of this paper. Thus, what we assume here is that the minimum value of the payments paid by the rm to outsiders captures only the stand-alone value of the asset, V , and does not capture any share of the NPV from the rms utilization of the asset. Note that our results will remain unchanged qualitatively, even if we assume that the value of the minimum payments paid by the rm captures both the stand-alone value of the asset and the value of the share of the NPV which outsiders can exploit in the transaction.

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3.2

Methods of Payment in Acquisitions


The entrepreneur can use one or any combination of three dierent means of payments to acquire the

asset: cash, contingent value rights, and/or stock. We assume that the rm has zero internal capital at time 0.14 Therefore, if the rm chooses to use cash to acquire the asset, it has to borrow a cash amount D (market value of debt) from debtholders by issuing straight debt at time 0, and consequently is obligated to pay the face value of debt to the debtholders at time 1. If the rms cash ow at time 1 is not sucient to pay in full the promised payments to the debtholders, the rm will be forced to declare bankruptcy. In this case, an exogenous deadweight cost of c is imposed on the entrepreneur. On the other hand, if the rm chooses to use stock, it exchanges a fraction n of the total equity of the rm to the outsiders for their asset. Finally, the rm can also choose to oer a contingent value right as part of its payment to the outsiders. In the CVR, a reference price R is specied, so that if the rms market share price P at time 1 is below the reference price, the outsiders (CVR holders) are entitled to receive from the rm an additional amount of cash payment M at time 1.15
16

Otherwise, if the market price of the

rms shares at time 1 exceeds the reference price, the CVR will expire without triggering any payments. In summary, at time 0, the entrepreneur (the rm) chooses among cash, stock, or CVRs to maximize his utility, which is equal to the weighted average of the expected short-term (time 0) and long-term (time 1) values of the equity held by himself, net of any expected bankruptcy cost. We assume that the weights assigned by the entrepreneur to the short-term and long-term equity values are w1 and w2 , respectively; w1 + w2 = 1.
14 Note that we introduce this assumption merely to reduce the model complexity. We will discuss intuitively the case where we relax this assumption in section 3.4. 15 We assume here that the contingent payments are paid in cash. This assumption is only meant to ease exposition of the paper. Note that our qualitative results will remain unchanged even if we include the possibility of paying stock or other securities as the means of contingent payments. 16 Recall that we normalize the total number of the rms shares to be 1. Therefore, in our model, the share price of the rm is the same as the total equity value of the rm, and thus the reference price can be also viewed on a total-value basis.

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3.3

The Equilibrium
In this section, we will study only the separating equilibrium where the dierent types of rms use

dierent means of payment in their acquisitions.17 Denition of equilibrium. An equilibrium in this model consists of the rms choice at time 0 about the securities to use to acquire the asset (including the terms of the security such as the xed-payment promised to be paid at time 1 in the case of cash payments, ratio of the equity to be exchanged in the case of CVRs or stock payments , the reference price in the case of CVRs, etc.) The choices made by each type satisfy the following conditions: (a) it maximizes the entrepreneurs objective, given his equilibrium belief about the choices of the other types of rms; (b) the beliefs of both types of rms are rational, given the equilibrium choices of the others; along the equilibrium path, these beliefs are formed using Bayes rule; (c) outsiders update their beliefs on the probability distribution over the types of rms, using Bayes rule upon the arrival of new information, and the equity price of the rm in the equity market at various time incorporates all the information available to the public at that time; and (d) we restrict the equilibrium beliefs as well as the beliefs of outsiders in response to o-equilibrium moves by any type of rm to be such that they satisfy the Cho-Kreps intuitive criterion (see Cho and Kreps (1987)). Thus, the equilibrium concept we use is that of the Perfect Bayesian Equilibrium (PBE) (requirements (a), (b), and (c)), satisfying the Cho-Kreps intuitive criterion (d).18 In the following analysis, we dene a
VG VB ,

which measures the dierence in intrinsic values between

the type G and type B rms. Thus, a can be viewed as a factor measuring the extent of asymmetric information in the market: the larger the a, the greater the extent of asymmetric information. Also, we assume throughout that the deadweight cost of bankruptcy, c, is a constant, and c V xl . We rst consider the case where the extent of asymmetric information in the capital market is moderately low. Proposition 1 characterizes the equilibrium in this situation.
17 There may exist other types of equilibria under our model setting, such as the pooling equilibrium in which the type G and type B pool by paying stock. Due to space constraint, we will not discuss those equilibria in the paper. The results related to the equilibria other than the separating equilibria discussed in the paper are available upon readers requests. 18 The Perfect Bayesian Equilibrium (PBE) concept was formally dened for dynamic games with incomplete information by Fudenberg and Tirole (1991).

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Proposition 1 (Separating Equilibrium without Contingent Value Rights) If the extent of asymmetric information is such that a , then there exists a separating equilibrium involving the following:19 The type G rm: It pays a cash amount D = d1 , and a fraction n G = n1 of its equity to the outsiders in exchange for their asset. The cash payment d1 is nanced by issuing straight debt at time 0, which has a face value d1 , and matures at time 1. V The type B rm: It pays a fraction V of its equity to the outsiders in exchange for their asset. B Outsiders: If a rm pays cash to acquire the asset, they infer that the rm is of a type G with probability 1. If a rm pays only stock, they infer that the rm is of a type B with probability 1. In the above equilibrium, each type of rms chooses the combination of securities among cash, stock and CVRs in such a way that the combination not only satises the required payments with the minimum dissipation of the rm value, but also helps to realize the fair market value of the equity held by the entrepreneur. In equilibrium, the type G rm nds it optimal to oer cash as its payments since doing so distinguishes itself from the type B rm, while the type B nds it optimal not to oer cash to mimic the type G. If the type B chose to oer cash, it could be perceived as a type G and benet from the overpricing of its securities. However, by doing so, the type B would also face a probability l to incur a bankruptcy cost at time 1 when it earns a low cash ow at that time. This happens since the low cash ow is not enough for the type B to pay the face value of debt in full. Thus, when this expected cost of bankruptcy exceeds the benet from mimicking the type G, the type B prefers not to do so. Instead, in this case, the type B rm oers an all-stock payment, thereby fully revealing its type. On the other hand, the type G rm expects no cost of bankruptcy by oering cash, given the zero probability for it to earn a low cash ow at time 1. Thus, it is always optimal for the type G rm to oer cash to separate itself from the type B, since, otherwise, pooling with the type B would only cause the type Gs securities to be underpriced, with no benets in return. Proposition 2 (Separating Equilibrium with Contingent Value Rights) If the extent of asymmetric information is such that a , then the equilibrium is a separating equilibrium and involves the following: The type G rm: It pays a fraction n G = n2 of its equity, a cash amount D = d2 , and a CVR to the outsiders in exchange for their asset. The contingent value right has a reference price R (xm , xh ), and is entitled to pay its holder an amount M = m at time 1 if the share price of the rm at that time falls
19 We will dene explicitly the parameters in the equilibrium constraints, such as , and the equilibrium prices of securities, such as d1 and n1 , only in the appendix.

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below the reference price. The cash payment d2 is nanced by issuing straight debt at time 0, which has a face value D , and matures at time 1. V The type B rm: It pays a fraction V of its equity for the outsiders asset. B Outsiders: If a rm oers CVRs as part of its payments, they infer that the rm is of a type G with probability 1. If a rm does not oer CVRs as part of its payment, they infer that the rm is of a type B with probability 1. When the extent of asymmetric information between the rm and outsiders is large so that the type B rm can benet substantially from mimicking the type G rm, the cost of nancial distress (bankruptcy cost) alone is no longer enough to deter the type B from mimicking. In this case, cash payment is infeasible for the type G rm to reveal its type, and CVR payment is the only equilibrium choice for the type G to prevent the type B from mimicking and truly reveal its type. In equilibrium, the type B rm would not choose to oer CVRs since, by doing so, it would face not only a positive possibility of bankruptcy at time 1, but also a large possibility of incurring an additional contingent payment at time 1 even if it does not go bankrupt at that time. The type B rm therefore nds it too costly to mimic the type G, thereby oering only stock in equilibrium to avoid both the possibility of bankruptcy and the possibility of contingent payment. We now discuss in detail the optimization problems faced by each type of rms. The Type G Firms Problem The type G has an incentive to separate itself from the type B so that it can avoid the under-valuation of its equity that would arise if it pooled with the type B. In equilibrium, it can do so by issuing contingent value rights. In particular, the type G can set the reference price of its CVRs at such a level that satises the following two conditions: (1) when a low cash ow xl is earned at time 1, a contingent payment will be triggered so that the rm earning the low cash ow will not be able to pay the payment in full, and (2) when a medium cash ow xm is earned, a contingent payment will be triggered as well, but it will not be sucient to trigger bankruptcy. Remember that the type B has a probability l of earning a low cash ow and m of earning a medium cash ow at time 1. Thus, if the type B mimics the type G by issuing the CVRs designed as the above, it may not only incur a bankruptcy cost (with a probability l ) at time 1, but also incur an additional amount of payments (with probability m ) at that time. When the expected additional payment, together with the cost of nancial distress, is prohibitively costly, it would then prevent the type B from

14

mimicking the type G. Similar to the type B, the type G rm also faces a probability (m ) of triggering the contingent payment (which would occur if it earns a medium cash ow at time 1). However, in equilibrium, given the type Gs rm type being revealed truthfully (due to the oer of CVRs), this expected contingent payment will be fairly valued by the outsiders.20 Therefore, it is optimal for the type G to oer CVRs, since doing so can

signal its type to the market, with no additional cost imposed by the CVRs. Note here that, while cost-free to the type G, CVRs are costly to the type B rm, since the type B faces a larger probability to incur the contingent payments than the type G. In summary, the type Gs optimization problem is: M ax G = (1 nG )[h (xh D) + m (xm M D)], (1)

nG ,D,M,R

subject to the IC constraint that ensures the type B will not mimic the type G: B B |G = w1 (1 nG )[h (xh D) + m (xm M D)] + w2 (1 nG )[ h (xh D) + m (xm M D)] l c, and the following constraints: V xm xl nG [h xh + m (xm M ) D] + D + m M , < R < xh , < M + D < xm , (3) (4) (5) (2)

where G (B ) is the expected payo to the entrepreneur if the rm is of type G (type B) and perceived as a type G (type B); and B |G is the expected payo to the entrepreneur if the rm is of type B but perceived as a type G. Here, the objective function (1) takes into consideration that, when the rm earns a low cash ow at time 1, each CVR holder is entitled to receive an additional payment M . At time 0, investors rationally anticipate debt payments D and a potential contingent payment M to be deducted from
20 This means that, in this case, the type G can complement the CVRs with a smaller fraction of its equity to pay for the asset, compared to the case when it oers stock but not CVRs.

15

the rms value at time 1, thereby expecting the equity value of the rm at time 1 to be xm D M with probability m , and xh D with probability h . Note that, in this objective function, the short-term and long-term values of the type G rms equity are the same, since the type Gs rm type has been revealed at time 0 in equilibrium. Further, IC constraint (2) guarantees that the type B rm will not mimic the type G by oering CVRs. In the constraint, B |G is calculated as the weighted average of the short-term (time 0) and long-term (time 1) values of the equity held by the entrepreneur, where the short-term equity value of the type B rm (when the type B mimics the type G) equals the equity value of the type G rm, h (xh D) + m (xm M D), and the expected long-term equity value of the type B (when the type Bs rm type is revealed) equals h (xh D) + m (xm D M ). The calculation of the type Bs long-term equity value takes into consideration that, in the case where CVRs are issued, the type B would have to pay an additional amount M when it earns a medium cash ow at time 1 (with an ex-ante probability m ); and it would go bankrupt if it earns a low cash ow at time 1 (with an ex-ante probability l ). In addition, constraint (3) ensures that the outsiders are at least break even in the transaction. Constraints (4) implies that the type G sets the reference price so that the contingent payment will be triggered when a low or a medium cash ow is earned, and nally, constraint (5) implies that the contingent payment and debt payment are designed such that they will trigger bankruptcy when a low cash ow is earned by a rm, but not when a medium cash ow is earned. The Type B Firms Problem The type B rms probabilities of attaining the low and medium cash ows are signicantly greater than those of the type G. This means that, if it mimics the type G by oering CVRs, the type B rm will face not only a signicantly higher probability of incurring an extra contingent payment, but also a signicantly higher probability of going bankruptcy in the future. Thus, in equilibrium, the type B oers only an all-stock payment. In summary, the type B maximizes its objective: B = (1 nB )VB , (6)

subject to the type Gs non-mimicry constraint which is trivially satised and the outsiders break-even

16

constraint: nB VB V . Now we will discuss the announcement eect of CVRs in the following. Proposition 3 (Announcement Eect) If a rm oers CVRs as a means of payment in its acquisition of the asset, its abnormal equity return upon the announcement of the acquisition is greater than that if it oers no CVRs but only stock as the means of payment. The abnormal equity return to a rm upon the announcement of CVRs captures the change of the market belief of the rm value around this announcement. Prior to the announcement, the market is unaware of the type of the rm, and thus value the rm at the average of the values of the type G and type B rms. However, when the rm announces to oer CVRs as part of its payments, the market believes that the rm is of type G, and therefore revises the rms value upward accordingly to incorporate such a change of belief. (7)

3.4

Discussion

A. Cost of CVR s In the model presented above, we demonstrated that, in the case when a rm faces a substantially severe asymmetric information problem, CVRs can help the type G rm (higher intrinsic-valued rm) to reveal its type, while pure cash payment cannot. However, in the above setting, contingent payments impose no additional cost to the type G rm, compared to the case of full information. In this part, we will discuss intuitively two possible costs associated with oering CVRs, with some characterization of situations under which these costs will arise.21 First, CVRs may impose a cost of nancial distress to the type G rm, similar to the eect of CVRs on the type B rm. Consider a modied model where the type G has a positive probability of earning a low cash ow at time 1. In this case, by designing the CVRs so that the type B will go bankrupt when it earns a low cash ow at time 1, the type G rm will also face a possibility of nancial distress. However, it can be
21 We choose to discuss the two costs of CVRs briey in the discussion instead of incorporating them in the model, in order to simplify exposition of the paper. The modied (more complicated) model fully capturing these two costs and the explicit characterizations of the equilibria that may arise in such a modied model are available upon readers requests.

17

shown that, when this expected cost of nancial distress is outweighed by the benet from oering CVRs (i.e., avoidance of underpricing of its securities), it is still benecial for the type G to oer CVRs. Second, CVRs may also lead to agency problems. Such problems may occur since, after issuing CVRs, the issuing rm may want to minimize the contingent payments instead of maximizing the rms value. Recall that contingent payments in most CVRs are payable in a variable scale, i.e., the payments are smaller when the market price of equity at the maturity of CVRs is larger. Thus, by manipulating its performance and boosting its share price in the short-term, the issuing rm can minimize its contingent payments and, in some cases, may even avoid these payments. This incentive for short-term price manipulation is likely to be more pronounced if the CVR has an up and out option that causes the CVR to automatically expire in the event of a stock price spike (see previous description of CVRs in section 2). The fact that issuers are prohibited from buying their own shares during the valuation period also indicates the intention of shortterm price manipulation by the issuer. Such manipulative behavior may result in the adoption of non-value maximizing policies and hence agency costs. To understand the intuition more clearly, consider the following modied (and generalized) version of our model. First, we modify the model by assuming that there exist continuous types of rms with dierent intrinsic values. Higher intrinsic-valued rms have larger cash ows realized at each time period than low intrinsic-valued rms. Second, assume that there are three periods: at time 0, the type of each rm is private information to the rm itself; at time 1, given that the market can observe rms total cash ows, it can update its belief about the probability distribution of the rm types based on this information; and at time 3, all the asymmetric information is resolved. Now, consider a higher intrinsic-valued rm which, after issuing CVRs to distinguish itself from lower intrinsic-valued rms, chooses between two investment projects between time 0 and time 1: a large-NPV long-term investment project with cash ows realized only at time 2 and a small-NPV short-term investment project with cash ows realized only at time 1. Clearly, the ecient investment policy for the rm is to invest in the long-term project. However, the rm may not follow this ecient investment policy if the cash ows from individual project is unobservable. In this case, if the rm chooses the short-term investment, it could generate more cash ows at time 1, thus pool with those rms 18

which have higher intrinsic values (and more cash ows from the other projects in each period) than the rm itself. This pooling implies that the rms share price would be over-valued at time 1, and its contingent payments due at that time can be minimized or even avoided. Therefore, when this benet of choosing the short-term project is substantially large to the rm, it would prefer to investing in the short-term project, even if the short-term project is less protable than the long-term project. The agency costs of CVRs provide an explanation of why CVR oers are more costly and less frequently used than cash oers. Both CVR oers and cash oers can help rms ensure their type to the market. However, according to the above analysis, if a rm pays by cash to acquire the asset, it will invest eciently in the long-term project. In comparison, if a rm issues CVRs as part of its payment, it will invest in the short-term project and thus incur an agency cost. Rationally expecting this agency cost, outside investors therefore will price CVRs accordingly to incorporate this agency cost, which certainly makes a CVR payment a more costly payment than a cash payment. B. The case when the rm has internal capital available In the model discussed in the previous section, we assume that the rm has zero internal capital, which implies that the rm has to nance cash payment with debt and potentially incur a substantially large cost of nancial distress. This assumption is only meant to capture the notion that there is a cost associated with cash payment. In the following, we will relax this assumption and provide a brief and intuitive discussion of the equilibrium consequences. When the type B rm has internal capital available to nance its cash payment, oering cash will only moderately increase the rms probability of nancial distress. In this case, if the cost of nancial distress is the only cost that the type B rm could face by oering cash (i.e., we ignore the other types of cost associated with cash payment), then this cost alone can not prevent the type B rm from mimicking the type G (by oering cash). Thus, in equilibrium, the type G rm will choose to oer CVRs instead of cash to reveal its true type. Recall that, if the type B oered CVRs, it would have a higher probability of paying the contingent payment in the future compared to the type G, which in turn discourages the type B from oering CVRs in equilibrium. 19

However, there could exist other types of cost associated with cash payments, in addition to the cost of nancial distress. For example, a rm may have to cut back investment in its valuable projects if it nances cash payment from its internal capital. If we take into consideration of all the costs associated with cash payment, then our results in the previous section can be reinterpreted as that: (1) if the extent of asymmetric information is not severe and if the cost of cash payment to the type B (lower-valued) rm is suciently larger than that to the type G rm, the type G rm oers cash payment to acquire the asset;22 and (2) if the extent of asymmetric information is extremely severe, or if the cost of cash payment to the type B is only moderately larger or even smaller than that to the type G rm, then cash payment is infeasible to reveal the type G rms type, thereby CVR will be oered in equilibrium by the type G. One testable implication that we can derive from these modied results is that, given the extent of asymmetric information and the cost of cash payment to the type B rm, the type G rm is more likely to issue CVR if the cost of cash payment to the type G itself is greater, e.g., if the type G has a lot of growth opportunities so that the opportunity cost (to foregone those investment opportunities) is larger.

3.5

Implications of the Model


In this section, we will discuss two implications of our model: rst, the announcement eects of acqui-

sitions with contingent value rights, and then, the choice of contingent value rights. Implication 1: Announcement eects of contingent value rights. Our model predicts that those rms oering contingent value rights in their payments experience a greater announcement eect (i.e., a larger abnormal equity return) than those rms oering only stock. This implication follows directly from proposition 3. Implication 2: Choice of contingent value rights. Our model predicts that those rms suering from information asymmetry in the capital market are more likely to oer contingent value rights, while those rms facing no asymmetric information problem are more likely to oer all-stock payments. This implication follows from proposition 2. When there exists asymmetric information about rm values, the higher intrinsic-value rm
22 Note in propositions 1 and 2, we focus only on the extent of asymmetric information, since there we assume that the type G rm has zero probability of incurring a low cash ow, while the type B rm has a positive probability and that the deadweight cost of bankruptcy is substantially large. Under these two assumptions, the cost of cash payment to the type B in propositions 1 and 2 (i.e., the bankruptcy cost) is large while the cost of cash payment to the type G is zero.

20

(type G in the model) chooses to include CVRs as part of the methods of payment to separate itself from the lower intrinsic-value rm. In comparison, when there is no asymmetric information about rm values, the higher intrinsic-value rm would be indierent between oering CVRs and oering only stock without CVRs.23
24

Our model also predicts, given the existence of asymmetric information problem, those rms facing a greater extent of asymmetric information are more likely to oer contingent value rights in their payments, while those rms facing a comparatively lesser extent of asymmetric information are more likely to oer cash payments. This implication follows by comparing propositions 1 and 2. When the asymmetric information regarding the rm type is more severe, higher intrinsic-value rms nd it infeasible to use cash payments to signal their type. Instead, they will choose to oer CVRs to signal their type. Finally, our model predicts that rms with more valuable investment opportunities are more likely to oer CVRs.

Empirical Evidence
In this section, we will test empirically the two implications of our model in a sample of mergers and

acquisitions where CVRs are oered. We choose not to test our model in the other situations where CVRs are oered, such as exchange oers, lawsuits, etc., since the control samples in those situations are dicult to be constructed. Here, to derive testable hypotheses in the M&A scenario, we can conceptualize our model in a framework where an acquiring rm chooses among cash, stock, and CVRs as the means of payments to acquire the equity of the target rm from target shareholders. Three hypotheses follow immediately: (H1) Those rms oering CVRs in their acquisitions experience a greater announcement eect than those rms oering only stock. (H2) In a sample of stock oers and CVR oers, those rms facing more severe asymmetric information
23 If we consider the agency cost of CVRs analyzed in section 3.4, the higher intrinsic-value rm would prefer to oer stock without CVRs instead of oering CVRs in this case. 24 According to our model, the lower type rm (i.e., the type B rm in the model) always oer stock in its acquisition. Thus, if a rm oers stock only, it can be either a lower type rm or a higher type rm facing a lower extent of asymmetric information; and if a rm oers CVRs, it is a higher type facing a greater extent of asymmetric information. Considering this, we expect to nd the relation between asymmetric information and CVR oerings as long as the distribution of the extent of information asymmetry for lower intrinsic-valued rms does not dier signicantly from the distribution for higher intrinsic-valued rms.

21

problem are more likely to oer CVRs, while those rms facing less severe asymmetric information problem are more likely to oer an all-stock payment. (H3) In a sample of CVR oers and cash oers, those rms having more severe asymmetric information problems or more valuable investment opportunities are more likely to oer CVRs to reveal their types, while those rms facing comparatively less severe asymmetric information are more likely to oer all-cash payments.

4.1
4.1.1

Data and Sample Selection


The CVR Sample

We identify our initial sample from keyword searches of all the business news published on the Wall Street Journal Index and the Lexis-Nexis. We rst select those issues that are described as contingent value rights and those issues where the securities involved either resemble contingent value rights or include features similar to contingent value rights, such as contingent value preferred stock and variable common rights. Then, we exclude from our initial sample those issues in which the underlying stocks are not listed in the U.S. exchanges, and those issues that are not associated with M&As. After this, we carefully read the announcement statements and the proxy statements of the remaining issues in our sample to ensure that each issue included in our nal sample provides a downside price protection (a put option) in the long term, i.e., each issue should promise an additional payment if the share price falls short of a reference price at a certain future date beyond the completion date of the acquisition.25 Finally, we extract nancial

statement information for the rms in our CVR sample from Standard & Poors Compustat database and from individual annual reports. Data on stock prices come from the CRSP tapes, and data on nancial analyst forecasts come from the I/B/E/S database. Our nal sample (CVR sample hereafter) includes 24 issues of contingent value rights, 2 issues of contingent value preferred stocks, and 2 issue of VCRs. Among these 28 issues, 23 were completed and 5
25 Many CVRs or other similar securities provide a call option enabling the receiving investors to benet from the better performance of the issuing rm in the future, rather than a put option outlined in the paper. For example, in the recent acquisition of Indigo by HP in 2002, HPs CVRs entitled Indigo shareholders to receive between $0 to $4.50 in cash in 2005 to the extent that HP achieves certain cumulative revenue milestones during the three-year period after the completion of the oer. In this case, the HPs CVRs resemble call options, instead of put options. We exclude those cases from our sample.

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were failed. In these failed issues, CVRs were rst announced to be oered, but later were cancelled either because the corresponding acquisitions failed, or because they were replaced with other securities in later oers. Table 1 lists the CVR issues taking place in M&As, together with the selected CVR issues taking place in non-M&A scenarios. Our sample shows that CVRs are issued in both tender oers and non-tender acquisitions. In particular, 21% (6 issues) of the CVRs in our sample are oered in tender oers while a majority (79%) of the CVRs are not. Further, most CVRs are issued together with either common stock or preferred stock, with only two exceptions in which CVRs are issued without any stock directly involved. Both exceptions occur in tender oers.26 Finally, most CVRs in our sample are proposed in the rst round oer in acquisitions. Only 21% in our sample (6 cases) of CVRs are proposed in the later round oers. In those cases, either there exists other competitive bid(s) in the market, or there exists discrepancy (about the value of considerations oered) between the target and acquirer, so that CVRs are proposed in the later rounds to bridge the dierence between them and help the acquisition go through. According to our CVR sample, the CVR issues in our sample can be grouped into three dierent categories, depending on which entity (i.e., acquirer or target) issues CVRs and which entity serves as the underlying security upon which the CVRs value is based. In the rst category (comprising 21 issues), an acquirer takes over a target, and a new joint rm is formed under control of the acquirer. CVRs, in this case, are issued by the acquirer to original target shareholders, compensating them an extra amount if the equity value of the joint rm declines in the future after the acquisition. In the second category (2 issues), an acquirer obtains voting control of a target through newly issued shares of the target. However, the target remains an independent public rm after the acquisition and original target shareholders maintain their original equity holdings in the target. In this case, CVRs are issued by the acquirer to the target shareholders, entitling them a payment if the share price of the target fails to reach a certain level at a certain date in
26 The rst exception is the Rhone Poulencs acquisition of Rorer. In this acquisition, Rhone Poulenc rst acquired 50.1 percent of Rorers outstanding common shares in a cash tender oer, and keeps Rorer as an independent public rm after the acquisition. Then in the second step, Rhone Poulenc issued CVRs to the shareholders of Rorer (other than Rhone Poulenc) to exchange for certain amount of new shares of Rorer. The CVRs value depends on the share price of Rorer in the future. In the second exception, CVRs were proposed together with cash and warrants by Castle Harlan Partners to take over Regency Cruises in a tender oer which failed in the end.

23

the future after the acquisition. Finally, in the third category (5 issues), an acquirer acquires a fraction of a targets equity which is not sucient to ensure its complete control of the target. In this case, the target rm remains an independent public rm after the acquisition, and CVRs are issued by the target to the acquirer, compensating the acquirer an extra amount if the targets equity value declines in the future after the acquisition. Although CVRs in the above three categories are issued in dierent scenarios, they share the same two characteristics: rst, all the CVRs are issued as part of considerations to shareholders who are outsiders of the issuing rm; and second, the value of CVRs is based on the share price of the issuing rm in the future, no matter whether the issuing rm is a target or an acquirer. These two common characteristics of CVRs suggest that CVRs are issued to provide an insurance to outsiders against the decline of the issuers share price in the future when outsiders are uncertain about the true value of the issuer.27 Since issuers of CVRs in acquisitions do not correspond exactly to acquirers or targets, in the following analysis, we will group the rms involved in acquisitions based on whether they oer or receive CVRs. In particular, we dene oerors of CVRs as those rms that oer CVRs in acquisitions and oerees of CVRs as those rms that are entitled to receive CVRs.28 Based on this denition, the value of CVRs is a function of the future share price of

oerors, and oerees are insured against the price decline of the oerors stock. Panels A and B of table 2 provide summary statistics of several selected nancial variables for oerors and oerees of CVRs respectively, and panels C and D report the announcement period abnormal equity returns for oerors and oerees of CVRs respectively. We calculate abnormal returns using the event study procedure described in Dodd et al (1984). We rst estimate the market model parameters for the oeror and oeree in each acquisition, based on a period of over 200 days ending 15 days prior to the announcement of the acquisition. Then, we use those parameters to estimate the cumulative abnormal return for each oeror and
27 Note that the setup of our model in the previous section is consistent with the CVR issues in the rst category. However, the intuitions and implications of our model will go through unchanged even if we modify our model to be consistent with the other two categories of CVR issues, since the only crucial assumption we need in our model is that the issuer has private information on the future value of itself while outsiders who receive CVRs dont know the issuers future value. 28 We group rms in acquisitions based on oerors and oerees of CVRs, instead of acquirers and targets, since our model implications are based on rms oering CVRs. Note that oerors of CVRs can be either acquirers or targets in acquisitions, as we discussed above.

24

oeree in ve event windows: (0), (0, 1), (-1, 1), (-3, 3), and (-5, 5), where date 0 denotes the announcement date, date 1 denotes one day after the announcement date, etc. As we discussed before, in most cases, CVRs are proposed at the same date when the acquisition is announced, while, in some cases, CVRs are proposed at a later date after the acquisition is announced. In the former cases, event windows are identied around the announcement of acquisitions. Thus, the announcement eect calculated in these event windows can be viewed as the sum of the announcement eect of CVRs and that of the corresponding acquisition. In the latter cases, we rst calculate separately the abnormal return upon the announcement of the acquisition and the abnormal return upon the announcement of CVRs, and then add these two abnormal returns together as if the CVRs in these cases were announced together with the announcement of the acquisition. By doing so, we intend to ensure the consistency of our calculation of abnormal returns across the whole CVR sample. According to panel A of table 2, oerors of CVRs experience an average (median) cumulative abnormal return of 6.6% (1.5%) at the announcement date, 5.4% (2.7%) in event window (0, 1), 4.4% (1.5%) in event window (-1, 1), 6.3% (2.8%) in event window (-3, 3), and 6.1% (2.4%) in event window (-5, 5). The tstatistics show that the cumulative abnormal returns in event windows (0), (0, 1), and (-3, 3) are statistically signicant at the 10% level, while the average abnormal returns in the other event windows are insignicant. Table 2 also provides p-values from the Wilcoxon signed-rank test to test the signicance of the abnormal returns non-parametrically. The p-values show that most of the abnormal returns of oerors are insignicant under the Wilcoxon test. On the other hand, as shown in panel B of table 2, oerees of CVRs experience an average (median) abnormal return of 12.3% (10.1%), 14.8% (17%), 16.2% (20.3%), 19.0% (22.2%), and 18.4% (20.1%) in event windows (0), (0, 1), (-1, 1), (-3, 3), and (-5, 5), respectively. All of these abnormal returns are statistically signicant at the 1% level based on both the t-test and the Wilcoxon test. Note that the announcement returns provided in table 2 are the returns incorporating both the market reaction to the acquisition and that to the methods of payments.

25

4.1.2

The Control Sample

We construct the control sample in order to select matching rms for each oeror of CVRs in our empirical studies. The control sample consists of those rms involved in acquisitions where CVRs are not oered. In particular, we draw the initial control sample from the Securities Data Corporation (SDC) database. We include in our control sample both takeovers (where an acquirer acquires a stake of a targets equity that can ensure control in the combined rm or the target rm) and partial acquisitions (where an acquirer acquires a non-controlling fraction of a targets equity). As we will discuss in the next section, we use takeovers and partial acquisitions to control for the dierent categories of CVR issues. Then, we decide on our nal control sample based on the following criteria: (1) the acquisition must be announced between 1989-2001;29 (2) at least one rm involved in the acquisition should have data available from CRSP, Compustat, and I/B/E/S; and (3) either stock or cash or both are oered in the acquisition. Thus, our nal control sample includes rms from 1592 takeovers and 451 partial acquisitions, among which 1764 deals are completed and 279 are failed. Table 3 provides the announcement eects of acquirers and targets, grouped by takeovers and partial acquisitions, and by cash oers (where only cash is oered in acquisitions) and stock oers (where only stock is oered in acquisitions).

4.2
4.2.1

Empirical Tests and Results


Announcement Eect

In this part, we test H1 by comparing the announcement eects between rms oering CVRs and rms oering only stock (without CVRs). Our model suggests that rms oering CVRs are of better quality than rms oering only stock, thus predicts a positive dierence of the announcement eects between these two groups of rms. However, other factors that are not related to rm quality may also contribute to the dierence of announcement eects. For example, as widely documented in the literature, targets typically experience a larger price reaction than acquirers. In addition, the announcement eect of complete takeovers may dier substantially from that of partial acquisitions (as we documented in table 3). Hence we control for
29 We select the control sample from 1989 - 2001 because the earliest CVR issue in our CVR sample occurred in 1989 and the latest CVR issue in the CVR sample occurred in 2001.

26

these two factors in our test. In particular, we rst select rms involved in acquisitions where stock is oered as the only means of payment, and then further screen these rms to construct a matching sample for each oeror of CVRs, based on whether the rm involved in the acquisition is an acquirer or a target and whether the transaction is a takeover or a partial acquisition.30 After matching, we calculate the average cumulative abnormal return for the matching sample of each oeror, and then test H1 based on the pair-wise dierences between the abnormal returns of the oerors in our CVR sample and the average abnormal returns of their corresponding matching samples. Panel A of table 4 presents the results of the above test under column (I). We nd that the mean and median dierences in the abnormal returns between the sample of CVR oerors and the matching samples are 6.6% and 1.9% respectively at the announcement date, and they are 5.5% and 2.2% in the two-day (0,1) event window. Both dierences are signicant at the 5% level in both the t-test and the Wilcoxon signed-rank test. Also, we nd positive mean and median dierences for other event windows. The mean dierences in these event windows are signicantly positive in at least the 10% level in the t tests, and most of the median dierences are signicant at 10% level in the Wilcoxon tests. Next, in order to check the robustness of the above results, we construct a new matching sample for each oeror of CVRs based on the industry in which the oeror is operating, together with the criteria discussed above. In particular, we begin with the matching sample constructed before, and further screen the sample based on the SIC code of each oeror of CVRs. We rst screen by the four digits of the SIC code. In order to avoid the eect of outliers, we require the new matching sample for each CVR to include at least four rms. Thus, if the resulting new matching sample from the industry screening has less than 4 rms, then
30 As we discussed before, CVR issues in acquisitions can be grouped into three categories. For CVRs oered in the rst category (in which the acquirer controls the joint rm after the acquisition and CVRs are issued based on the price of the joint rm), we select the matching sample for each oeror based on: (i) the transaction is a takeover (i.e., the acquirer controls the joint rm after the acquisition); and (ii) the selected rm in the matching sample is an acquirer in the acquisition. For CVRs oered in the second category (in which the acquirer controls the target, and CVRs are issued based on the price of the stand-alone target after the acquisition), we select the matching sample so that: (i) the deal is a takeover (i.e., the acquirer acquires enough equity to ensure control of the target); and (ii) the selected rm is a target in the acquisition. For CVRs oered in the third category (in which the fraction of the targets equity acquired by the acquirer cannot ensure the acquirers control of the target, and CVRs are issued based on the price of the target), we select the matching portfolio so that (i) the deal is a partial acquisition (i.e., the acquirer acquires a fraction of the targets equity, which, together with its original holding of the targets equity, is less than 50% of the targets total outstanding shares); and (ii) the rm selected is a target. Thus, the matching sample consists of 661 rms for CVRs in the rst category, 613 rms for CVRs in the second category, and 264 rms for CVRs in the third category.

27

we re-screen the sample by using the rst three digits of the SIC code, or the rst two digits, or even the rst digit, until the new matching sample for each oeror has at least 4 rms. The results of the comparison between the CVR sample and the new matching samples are presented under column (II) in panel A of table 4. We nd that the mean and median dierences are positive both at the announcement date (6.6% and 2.0%, respectively) and in event window (0, 1) (5.5% and 2.5% respectively), and both dierences are signicant at the 5% level according to the t-test and Wilcoxon tests. The mean dierences in the other event windows are positive and signicant as well, while the median dierences in the other event windows are positive but insignicant. The above results are generally consistent with H1, suggesting that rms oering CVRs in their acquisitions experience a larger announcement eect than those rms oering stock but no CVRs. Note that the dierence estimated above can be viewed as the announcement eect of CVRs as well. Thus, our results in the test of H1 also suggest that the announcement eect of CVRs is signicantly positive. Our model does not have any direct testable implications on the dierence of the announcement eects between rms oering CVRs and rms oering only cash in acquisitions. However, from a purely empirical perspective, it may still be interesting to know whether any such dierence exists between the CVR sample and the sample of cash oers. In this comparison, the sample of cash oers includes those acquisitions selected from the control sample where cash is the only means of payment, and the CVR sample here excludes the ve CVR oerors involved in partial acquisitions, since matching rms for these oerors are not available in the sample of cash oers.31 Thus, our CVR sample in this test has 23 oerors. We then construct the

matching sample for each oeror by screening the sample of cash oers based on the following criteria: (i) the transaction is a takeover (i.e., the acquirer obtains control of the joint rm upon which the value of CVRs is based); and (ii) whether the rm selected is an acquirer or a target in the acquisition. As a result, the matching sample for each oeror consists of 300 rms on average. Column (I) of panel B in table 4 presents these results. We nd that, for all event windows, the dierences of announcement period abnormal returns
31 Note that, in partial acquisitions, the oerors (targets in this case) oer CVRs together with stock in exchange of cash from acquirers. Thus, to nd matching rms for CVR oerors in this case, we need to look for targets in partial acquisitions who oer cash to acquirers, which is impossible.

28

between CVR oerors and their matching rms selected from the sample of cash oers are not statistically dierent from zero at any meaningful signicance level. We also construct a new matching sample for each CVR oeror by further screening the matching rms selected above on the basis of the industry (SIC code) of each oeror. The results from comparing the CVR sample and the new matching samples are presented in the column (II) of panel B. Still, both the mean and median dierences are insignicant. These results suggest that the announcement eect of rms oering CVRs is not signicantly dierent from the announcement eect of rms oering cash but no CVRs. 4.2.2 Firms Choice of Oering CVRs

In this section, we test hypotheses (H2) and (H3). In both tests, we construct the proxies for the extent of asymmetric information based on the analyst forecasts in the nal month of the scal year prior to the announcement date.32 As Elton et al. (1984) has demonstrated, the dierences or errors in forecasts near

the end of a forecasting period arise primarily from the rm-specic information rather than economy-wide or industry-wide information. This makes the analyst forecast characteristics at the end of the scal year good proxies for assessing the extent of asymmetric information across rms. The rst proxy we use for information asymmetry is NUMBER, which is calculated as the number of analysts following the rm. This proxy measures the supply of information about a rm, therefore larger analyst followings can be viewed as an indication of the reduced extent of information asymmetry. The forecast error, ERROR, measures the accuracy of consensus forecasts. It is calculated as the absolute dierence between actual earnings and the average forecast deated by the market price at the end of the scal year prior to the announcement date. Firms with greater extent of information asymmetry between managers and outsiders regarding the rms earnings are expected to have larger forecast errors. Further, we use DISPERSION to measure the dispersion among analyst forecasts. This variable is constructed as the standard deviation of analyst forecasts, deated by the average of analyst forecasts. Since dispersion among analyst forecasts could result from a lack of information about a rm, the greater dispersion could imply larger extent of information problems. In
32 The way we construct the proxies of asymmetric information is similar to that in Thomas and Fee (2002) and Krishnaswami and Subramaniam (1999).

29

addition to the forecast characteristics, we also use DIVERSE, a proxy for the degree of diversication, to measure the extent of information asymmetry. The variable takes a value of 1 if an acquirer takes over a target operating in an industry dierent from the industry of the acquirer, and zero otherwise. We use the rst two digits of SIC codes to dene industries. Thus, DIVERSE is equal to 1 if the SIC code of the acquirer has dierent rst two digits from that of the target. Since the target has less information about the acquirer if the acquirer operates in a dierent industry, the asymmetric information problem is more acute in this case. In addition to information asymmetry, other factors may also impact a rms choice of oering CVRs. Thus, we control for these factors in our tests of H1 and H2. For example, rm size (SIZE) is expected to aect a rms decision of oering CVRs. On the one hand, large rms are more likely to have stabilized cash ows and less volatile stock prices in the future, which implies that CVRs are less likely to be oered as an insurance of the stock price by large rms. On the other hand, large rms, especially diversied conglomerates, are less transparent to outsiders and may be subject to more acute asymmetric information problems, which implies that CVRs are more likely to be oered by large rms.33 In view of both eects, it is ambiguous how rm size aects a rms choice of oering CVRs. We measure SIZE by the log of market value of total assets which is equal to the book value of assets minus the book value of common equity plus the market value of common equity. A rms investment opportunity set may also aect the rms choice of CVRs. As in Jung, Kim and Stulz (1996), managers with lots of growth opportunities prefer to raise capital with equity in order to have more discretion over the funds raised. Following this argument, we conjecture that rms with more growth opportunities are less likely to oer CVRs in acquisitions. This is because, by oering CVRs, a rm may face a certain probability of making contingent payments, which may lead to under-investment in good opportunities as documented by Myers (1977). Instead, if the rm chooses to oer stock without CVRs, it can avoid this potential under-investment. We measure a rms investment opportunity set by
33 These two eects are similar to the transparency hypothesis and information diversication hypothesis brought out in Thomas (2002).

30

using market-to-book ratio (MTOB), which is calculated as the ratio between the market value and the book value of total assets. Following Martin (1996), we also include business cycle variables in our regressions as control variables. However, the eect of business cycles on a rms choice of oering CVRs is uncertain. Increased economic activities will bring more promising investment opportunities, thus reducing the adverse selection cost and increasing the likelihood for higher-intrinsic-value rms to pool with lower-intrinsic-value rms by oering stock without CVRs in their acquisitions. However, a boom economy also increases the likelihood of a stock being over-valued, which increases the likelihood of CVRs being oered as a protection against the decline of the stocks future price. We calculate the business cycle factor, BUS, as the logarithm of [SP(-1)/SP(-12)], where -1 and -12 refer to one month and twelves months respectively prior to the announcement month, and SP refers to the Standard and Poors 500 Index.34 Further, according to Jensen (1986), we expect that rms with large amount of free cash ows are more likely to nance acquisitions with cash, while rms with less free cash available and large amount of debt burden are more likely to oer CVRs to defer cash payments. We use LEVERAGE, the ratio between the book value of debt and the market value of equity to measure a rms debt burden, and we use DIVIDEND to proxy a rms liquidity constraint. DIVIDEND is equal to 1 if the rm pays cash dividends to its shareholders and zero it does not. We expect that rms paying no cash dividends are more likely to be nancial constrained, and thus more likely to oer CVRs. We also use return on assets, ROA, to proxy a rms current ability to generate cash. ROA is dened as operating income before interest, taxes, depreciation and amortization, divided by the book value of assets. A rm with a smaller return on assets may have diculty to raise enough cash (either internally or externally) to facilitate its acquisition, therefore is more likely to oer CVRs to defer cash payments. Also, a rm with a smaller return on assets may believe that the market is blinded by its temporary lack of protability and is undervaluing its securities. This belief therefore would motivate the rm to oer CVRs to signal its value and bridge the dierence on the valuation
34 We have also tried alternative specications using the other business cycle variables proposed in Martin (1996), such as those calculated based on Moodys Baa bond rate, etc. The qualitative features of our results in the paper do not change, even if we use these alternative specications.

31

of its securities between the market and itself. Finally, rms with less tax shields may have more incentive to issue debt (cash) in their acquisitions. To account for this tax eect, we control in our tests a dummy variable, TAXLOSS, which is equal to one if a rm has any tax-loss carry-forwards, and zero otherwise. A. Univariate comparisons In the test of H2, we compare the extent of asymmetric information between oerors of CVRs and rms oering only stock (without CVRs) in acquisitions. Similar to the test of H1 discussed in the previous section, we construct a matching sample from the control sample for each oeror of CVRs based on the steps we discussed before in the test of H1. Panel A of Table 5 presents the results for this univariate test. In column (I) of panel A, we present the results comparing the CVR sample with the matching samples selected without the industry screening, and in column (II), we present the results based on the matching samples selected with the industry screening. The results in both columns are quite similar and consistent with H2. In particular, the dierence of NUMBER between oerors and their matching samples is signicantly negative in both columns (I) and (II) (at the 1% level in both the t test and the Wilcoxon test), suggesting that oerors of CVRs have less analyst followings compared to rms oering only stock in their acquisitions. Similarly, the mean and median dierences of ERROR are both signicantly positive at the 1% level in both the t test and the Wilcoxon signed-rank test. The dierence of DISPERSION is also positive and signicant at the 1% level in the Wilcoxon test. These two results suggest that analysts make more errors and disagree with each other more often on the earnings forecasts of CVR oerors than on the forecasts of rms oering only stock. Further, we nd that the dierence of DIVERSE is positive as well. It is signicant at the 1% level in the Wilcoxon test when comparing the CVR sample with the matching rms without industry matching (as shown in column (I)), and at the 5% level when comparing with the matching rms with industry matching (as shown in column (II)). This result implies that rms are more likely to oer CVRs if they merge with a rm operating in a dierent industry. All of the above ndings are consistent with H2, suggesting that rms oering CVRs face more asymmetric information problems than those rms oering stock without CVRs in their acquisitions. In the test of H3, we compare the extent of asymmetric information between oerors of CVRs and 32

their corresponding matching samples where only cash is oered (without CVRs) in acquisitions. Still, we follow the same procedure introduced in the previous section to select the matching sample for each CVR oeror. Columns (I) and (II) in panel B of table 5 report the results based on the matching sample without industry matching and that with industry matching, respectively. As expected, both the mean and medium dierences of NUMBER between oerors and their matching samples is signicantly negative at the 1% level in both the t test and the Wilcoxon test. The mean and medium dierences of DISPERSION are positive and signicant at the 1% level in both tests as well. Further, the mean and medium dierences of ERROR are signicantly positive at the 10% level. All these results are consistent with our hypothesis H3, suggesting that rms oering CVRs face more severe asymmetric information problem than rms oering cash in their acquisitions. Table 5 also provides comparisons of control variables between rms oering CVRs and rms not oering CVRs. It shows that, compared to rms either oering only stock (as shown in panel A) or oering only cash (as shown in panel B), rms oering CVRs are less likely to pay dividends and on average have a smaller return on assets. It also shows that, compared to rms oering cash only, rms oering CVRs are more likely to have tax-loss carryforwards. All the above results are signicant at either the 5% or 10% levels in Wilcoxon tests. They suggest that rms oering CVRs are more likely to be nancially constrained and have more tax shields available. They also suggest that rms oering CVRs have poorer operating performances than their comparable rms, and thus may need a stronger signal to prove their value to the market. B. Multivariate regressions In this part, we test H2 and H3 by running the following logit regressions: Log [ P (y = 1) ] = 0 + 1 IN F O + 2 X + . 1 P (y = 1) (8)

where the dependent variable y takes a value of 1 if a rm oers CVRs in its acquisition, and 0 if it does not; INFO refers to a vector of proxies for asymmetric information including NUMBER, ERROR, DISPERSION, and DIVERSE; and X refers to a vector of control variables including SIZE, MTOB, BUS, DIVIDEND, TAXLOSS, LEVERAGE, ROA, TARGET, and SOURCE. Here, the control variable TARGET

33

takes a value of 1 if a rm is a target in its acquisition, and 0 if it is an acquirer; and SOURCE takes a value of 1 if a rm is involved in a takeover where the acquirer takes over more than 50% of the targets shares, and 0 if it is involved in a partial acquisition where less than 50% of the targets shares are acquired. In the test of H2, the sample we use in the regression combines both the CVR sample and those rms oering only stock in acquisitions (selected from the control sample). We expect, in order to be consistent with our model, that the coecient of NUMBER be negative and the coecients of other asymmetric information proxies be positive. The results of the regressions are presented in table 6. In the rst four columns of table 6, we regress on the four proxies of information asymmetry one by one separately. As predicted, we nd that the coecient of NUMBER is negative and signicant at the 10% level in a twotailed t-test, and that the coecients of ERROR and DISPERSION are signicantly positive at the 1% level. Then, in column 5 of table 6, we regress on all the proxies of information asymmetry. Our results show that the coecients of DISPERSION and ERROR are signicantly positive at the 1% and 5% levels respectively and the coecient of NUMBER is signicantly negative at the 10% level. However, in this regression, we lose 5 oerors due to the missing values of DISPERSION on these 5 oerors. Thus, in the last column of table 6, we choose to exclude DISPERSION and regress on all the other proxies of information asymmetry, so that we can avoid the loss of these 5 oerors in our regression. Still, we have the similar results as before: both the coecient of ERROR and that of NUMBER are signicant and follow the expected signs. In general, our test results are consistent with hypothesis H2, suggesting that rms facing more asymmetric information are more likely to oer CVRs in their acquisitions, compared to rms oering only stock in their acquisitions. In the test of H3, we use a sample combining both the CVR sample and those rms oering only cash in their acquisitions. The results of the regressions are presented in table 7. In the rst three columns of table 7, we regress on the proxies of information asymmetry one by one separately, and then include all the proxies in the regression in the column 4. As shown in column 4, the coecient of NUMBER is negative and signicant at the 10% level in a two-tailed t-test; the coecient of DISPERSION is positive and highly signicant at the 1% level; and the coecients of ERROR is positive and signicant at the 10% level. We then exclude DISPERSION and regress only on the other proxies of information asymmetry in order to avoid 34

the loss of observations due to the missing values on DISPERSION. The result from this new specication is presented in the last column of table 7: the coecients of NUMBER and ERROR still follow the expected signs and become more signicant compared to the results shown in column 4. In general, our results are consistent with hypothesis H3, suggesting that the rms facing more asymmetric information are more likely to oer CVRs in their acquisitions to distinguish themselves from the other rms, rather than oering cash to do so. Finally, as expected, table 7 shows that the coecient of MTOB is positive in all the specications and is signicant at least the 5% level. This result is consistent with our model as well, suggesting that rms with more growth opportunities are more likely to oer CVRs, while rms with fewer growth opportunities are more likely to oer cash. 4.2.3 Robustness Tests

Choice between oering CVRs and oering cash as part of considerations In the test of H3, we studied a rms choice between oering CVRs and oering only cash. However, in many cases, rms also oer cash combined with stock in their acquisitions, which may also enable them to signal their values to the market. Thus, unlike the previous section where we only consider the CVR oers and all-cash oers, in this part, we also include in the test of H3 a sample of rms oering cash as part of considerations. We still use econometric model (8) for the regression here. The dependent variable now is equal to 1 if a rm oers CVRs and zero if a rm oers cash (either pure cash or cash combined with stock) in its acquisitions. And the independent variables include the same proxies of asymmetric information and control variables which are included in the previous regressions. The results are presented in table 8. It can be seen that all the results are similar to those in table 7: All the coecients of the proxies of asymmetric information follow the expected directions and are signicant except NUMBER. Probit regressions In this part, we check the robustness of our results by testing H2 and H3 by using probit regressions instead of logit regressions. Here, we use the same sample and the same independent variables (i.e., proxies

35

for information asymmetry and control variables) as those used in the logit regressions. The regression results of H2 using the probit regression are presented in the left columns of table 9, and the regression results of H3 are presented in the right columns of table 9. As suggested by the econometric literature, results from a probit regression potentially may be dierent from results from a logit regression, if the sample used is substantially unbalanced. However, according to the evidence presented in table 9, we nd similar results in the probit regressions compared to those in the logit regressions. All the coecients of the proxies of asymmetric information follow the expected signs and are signicant except DIVERSE, suggesting the robustness of our results on the tests of H2 and H3.

Conclusion
This paper provided a theoretical explanation for the use of CVRs as a means of payment in acquisitions.

The model showed how CVRs achieve a separating equilibrium in the presence of information asymmetry regarding the acquirers true value. We then constructed a comprehensive sample of all CVRs involving U.S. public acquisitions and we tested the empirical implications of the model. We found that, in a sample of acquisitions with stock as part of means of payment, the announcement eect of the rms oering CVRs is greater than the announcement eect of the rms that do not oer CVRs. We also found that rms oering CVRs face more severe asymmetric information problem or have more growth opportunities than rms oering no CVRs. Both ndings are consistent with our model. We expect that CVRs will be used more frequently in future because of the recent change in merger accounting rules. The relative popularity of the Pooling method may have hindered the growth of CVRs in the past: Pooling would be disallowed in the presence of CVRs. Now Pooling is no longer an alternative and all mergers and acquisitions must follow the Purchase method of accounting, which will encourage increased use of CVRs. We leave these issues for future research.

36

References
Berkovitch, E., and M. Narayanan, 1989, Competition and the Medium of Exchange in Take-overs, Review of Financial Studies, 3, 153-174. Brown, D., and M. Ryngaert, 1991, The Mode of Acquisition in Takeovers: Taxes and Asymmetric Information, Journal of Finance, 46, 653-669. Bruner, R., 2001, Technical Note on Structuring and Valuing Incentive Payments in M&A: Earnouts and Other Contingent Payments to the Seller, Darden Case UVA-F-1322-SSRN. Cho, I.-K. and D. Kreps, 1987, Signalling Games and Stable Equilibria, Quarterly Journal of Economics, 102, 179-222. Elton, E. J., M. J. Gruber, and G. N. Mustafa, 1984, Professional Expectations: Accuracy and Diagnosis of Errors, Journal of Financial and Quantitative Analysis, 19, 351-363. Eckbo, B. E., R. M. Giammarino, and R. L. Heinkel, 1990, Asymmetric Information and the Medium of Exchange in Takeovers: Theory and Tests, Review of Financial Studies, 3, 651-675. Fishman, M. J., 1989, Preemptive Bidding and the Role of the Medium of Exchange in Acquisitions, Journal of Finance, 44, 41-57. Fudenberg, D. and J. Tirole, 1991, Perfect Bayesian Equilibrium and Sequential Equilibrium, Journal of Economic Theory, 53, 236-60. Fuller, K. P., 2000, Why Some Firms Use Collar Oers in Mergers, working paper. Ghosh, A., and W. Ruland, 1989, Managerial Ownership, the Method of Payment for Acquisitions, and Executive Job Retention, Journal of Finance, 785-798. Hansen, R. G., 1987, A Theory for the Choice of Exchange Medium in the Market for Corporate Control, Journal of Business, 60, 75-95. Hietala, P., Kaplan, S.N. and D. T. Robinson, 2002, What is the Price of Hubris? Using Takeover Battles to Infer Overpayments and Synergies, NBER working paper 9264. Jensen, M., 1986, Agency Cost Of Free Cash Flow, Corporate Finance, and Takeovers, American Economic Review, 76, 323-329. Jung, K., Y. Kim, and R. Stulz, 1996, Investment Opportunities, Managerial Discretion, and the Security Issues Decision, Journal of Financial Economics, 42, 159-185. Kaplan, S.N., 1996, Paramount Communications, Inc. - 1993, Casenet, South-Western College Publishing. Kaplan, S.N., 1996, Paramount Communications, Inc. - 1994, Casenet, South-Western College Publishing. Kohers, N. and J. S. Ang, 2000, Earnouts in Mergers: Agreeing to Disagree and Agreeing to Stay, Journal of Business, 73. Krishnaswami, S., and V. Subramaniam, 1999, Information Asymmetry, Valuation, and the Corporate Spin-o Decision, Journal of Financial Economics, 53, 73-112. Martin, K. J., 1996, The Method of Payment in Corporate Acquisitions, Investment Opportunities, and Management Ownership, Journal of Finance, 51, 1227-1246.

37

Myers, S. C., 1977, Determinants of Corporate Borrowing, Journal of Finance, 5, 147-175. Thomas, S. E., and C. E. Fee, 2002, Firm Diversication and Asymmetric Information: Evidence from Analysts Forecasts and Earnings Announcements, Journal of Financial Economics, 64, 373-396. Travlos, N. G., 1987, Corporate Takeover Bids, Methods of Payment, and Bidding Firms Stock Returns, Journal of Finance, 42, 943-963.

38

Appendix
Proof of Proposition 1. The type G rms optimization problem by oering cash is: M ax G = (1 nG )(VG D) (A1)

D, nG

subject to the following incentive compatibility (IC) constraint and the break-even constraint: B V B|G = w1 (1 nG )(VG D) + w2 (1 nG )[ h (xh D) + m (xm D)] l c, nG (VG D) + D, and xl D V . (A2) (A3)

Here, IC constraint (A2) guarantees that the type B rm will not mimic the type G by oering cash. In this constraint, B |G is the expected payo to the entrepreneur if the rm is of type B but perceived as a type G. It equals the entrepreneurs share of residual cash ow after paying D to the debtholder at t=1, net of the expected bankruptcy cost. Further, constraint (A3) ensures that the value of the payments to the outsiders in exchange for their asset should exceed the fair market value of the asset. It takes into account that the face value of debt D is less than the medium cash ow xm , and thus the market value of debt is equal to the face value of debt D. The type B rms optimization problem is given by objective function (6) and constraint (7). Here, we will rst derive the solution, assuming (A2) is satised, and then later derive the equilibrium condition under which (A2) is satised. In the case when (A2) holds, it is easy to show that the equilibrium choice for the type B n B = equation: V = nG (VG D) + D. Write (A5) in terms of nG . Then, constraint (A2) can be rewritten as l c w1 (VG V ) (VB V ) + w2 VG V (VB l xl h D m D). VG D (A5) (A4)
V VB ;

and the equilibrium choice for the type G, D and n G , satisfy the following

Note that xl D V . (A5) can be satised only if w1 (VG VB ) l c w2 l (V xl ). Dene 1+


l cw2 l (V xl ) . w1 VB

Thus, given c V xl , when , (A5) is satised. In this case, n G = n1 39

VG D VG D ,

VG V and D = d1 [D1 , V ] where D1 arg [w1 (VG VB ) w2 (VB V )+ w2 V [ h (xh D)+ m (xm D)] = l c]. G D D

Proof of Proposition 2. oers a fraction of equity n B =

The type Bs optimization problem by oering stock is straightforward: it


V VB

to acquire the asset from the outsiders. Similar as that in the proof of

proposition 1, the equilibrium choices of the type G in its optimization problem are such that inequality (3) is satised as an equality, i.e., V = nG [h xh + m (xm M ) D] + D + m M . Write (A6) in terms of nG . Then, constraint (2) can be rewritten as VB V w1 (VG V ) + w2 VG V [ h (xh D) + m (xm D M )] l c. VG D m M (A7) (A6)

It can be shown that the type G prefers to set the contingent payment as large as possible. Note that xl D +M xm , and from (A6), D +m M V . Thus, (A7) can be satised only if w1 (VG VB ) l c w2 l (V xl )+ w2 ( m m + l m )M ax(xm ,
V m ). m + l m )Max(xm ,V /m ) Dene 1+ l cw2 l (V xl )+w2 (m . Thus, w1 VB VG D VG D m M ,
mM

when , (A7) is satised. In this case, n G = n2


D

M = m M in(xm ,

V m ),

and

G V D = d2 [D2 , V m M ] where D2 arg [w1 (VG V ) + w2 VG V D

[ h (xh D) + m (xm D M )]

w2 (VB V ) = l c]. Proof of Proposition 3. Before time 0, the market value the equity of a pooling joint rm at

V1 = 1 VG + 2 VB . If a rm oers CVRs in its acquisition of the asset, the market re-values the joint rm at VG . If a rm oers only stock and no CVRs, the market re-values it at VB . It is easy to show that VG V1 > 0 > VB V .

40

Table 1: Selected Lists of CVR Issues


Part A: Selected companies that have issued contingent value rights in M&As Issuer / Joint firm General Mills Markel Mafco Consolidated Cytogen Viacom Rhone-Poulenc Rorer Dow Chemical Acquirer General Mills Markel MacAndrews & Forbes Cytogen Viacom Rhone Poulenc Dow Chemical Target Pillsbury (Diageo) Terra Nova Abex CytoRad Paramount Rorer Marion Merrell Dow Ann. Date Ann. Date CVR Status of CVRs of M&As 17-Jul-00 17-Jul-00 outstanding 26-Jan-00 21-Nov-94 29-Jul-94 18-Jan-94 18-Jan-90 18-Jul-89 16-Aug-99 21-Nov-94 24-May-94 9-Sep-93 18-Jan-90 18-Jul-89 expired expired expired exercised exercised exercised Considerations Offered Cash, Stock, CVR Cash, Stock, CVR Stock, CVR Stock, Warrant, CVR Cash, Stock, CVR, Convertible Cash, CVR Cash, Stock, CVR Form of M&A acquisition acquisition acquisition acquisition tender offer tender offer tender offer

Part B: Selected companies that have announced the offer of CVRs in M&As, but either failed in M&As or revised the offer to exclude CVRs Ann. Date Ann. Date Form of Issuer Acquiror Target CVR Status Considerations Offered of CVRs of M&As M&A Carolco Pictures Carolco Pictures Live Entertainment 10-Jun-91 10-Jun-91 Stock, CVR acquisition Regency Cruises Castle Harlan Regency Cruises 16-Sep-92 16-Sep-92 Cash, Warrants, CVR tender offer Hilton Hilton ITT 27-Jan-97 27-Jan-97 Cash, Stock, Contingent Preferred tender offer Part C: Selected companies that have issued CVRs in the non-M&A senarios. Issuer Abraxas Dominion Bridge Riviera California Micro Devices LTV Details of the issue CVRs were issued as part of the considerations to exchange for the Abraxas Senior Notes CVRs were proposed by the Committee to Revitalize Dominion Bridge as part of the corporate restructuring plan CVRs were issued by Riviera as part of the escrow when Riviera terminated its merger with R&E Gaming Corporation CVRs were issued as part of the payment in the settlement of the lawsuit against CMD. CVRs were issued by LTV to Pension Benefit Guaranty as part of plan of reorganization from Chapter 11 Ann. Date 18-Nov-99 2-Jul-97 29-May-98 16-Sep-96 25-Jun-93

* Foreign firms with ADRs listed in American Exchanges ** In this sample, the acquirors use cash or firm assets to purchase the majority of the target's equity and, in the same time, receive CVRs issued by the target. The firms after the acquisition are managed by the original target management.

Table 2: Characteristics of Firms in the CVR sample: Panel A of this table reports selected financial variables for offerors of CVRs; panel B reports selected financial variables for offerees of CVRs; panel C reports announcement period abnormal returns for offerors of CVRs; and panel D reports announcement period abnormal returns for offerees of CVRs. Offerors of CVRs are defined as CVR-issuers whose stock prices provide the reference that the CVRs are based upon; and offerees of CVRs are defined as firms receiving CVRs. The CVR sample includes 24 issues of contingent value rights, 2 issues of contingent value preferred stocks, and 2 issue of variable common rights. However, we only have 17 offerees in panel B and 18 offerees in panel D due to missing data in Compustat or CRSP. Market value of firm is calculated as the book value of liabilities plus the market value of equity; market-to-book ratio is calculated as the ratio between market and book values of firm; leverage is calculated as the ratio between book value of debt and market value of equity; and return on asset is calculated as earnings before interest, tax, depreciation and amortization divided by book value of assets. The announcement period abnormal returns are calculated using the event study procedure described in Dodd et al. (1984). The significance of means is determined based on t-tests and the significance of medians is determined based on Wilcoxon sign-rank tests. One, two and three asterisk(s) in superior indicate(s) 'significant difference' from zero at the 10%, 5%, and 1% level, respectively. Variables # of Obs. Mean Median Panel A: Offerors of CVRs: Selected Financial Variables Market Value of Firm 28 $ 25,136 million $655 million Market-to-book Ratio 28 2.94 2.47 Leverage 28 0.39 0.18 Return on Asset 28 0.025 0.070 Panel B: Offerees of CVRs: Selected Financial Variables Market Value of Firm 17 Market-to-book Ratio 17 Leverage 17 Return on Asset 17 Event Windows # of Obs. Panel C: Offerors of CVRs: Announcement Effect (0) 28 (0,1) 28 (-1,1) 28 (-3,3) (-5,5) Panel D: Offerees of CVRs: Announcement Effect (0) (0,1) (-1,1) (-3,3) (-5,5) 28 28 18 18 18 18 18 $ 5,887 million 7.31 0.34 0.024 Mean 0.066** 0.054* 0.044 0.063* 0.061 0.123*** 0.148*** 0.162*** 0.190*** 0.184*** $ 706 million 2.65 0.16 0.079 Median 0.015* 0.013 0.015 0.028 0.024 0.101*** 0.170*** 0.203*** 0.222*** 0.201*** Standard Error 15,642 1.11 0.10 0.047 2,960 3.09 0.12 0.10 Standard Error 0.031 0.027 0.026 0.033 0.041 0.027 0.034 0.033 0.039 0.041

Table 3: Announcement Period Abnormal Returns of Firms in the Control Sample: This table reports announcement effects of firms in the control sample, grouped by position of a firm in its acquisition (target or acquirer); type of the transaction (takeover or partial acquisition); and method of payment (cash offer or pure stock offer). The control sample includes firms involved in acquisitions that were announced between 19892001 and did not involve CVRs. The significance of means is determined based on t-tests and the significance of medians is determined based on Wilcoxon sign-rank tests. One, two and three asterisk(s) in superior indicate(s) 'significant difference' from zero at the 10%, 5%, and 1% level, respectively. Takeovers Partial Acquisitions # of Obs. Mean Median # of Obs. Median Mean Event Window Panel A: Acquirers in cash offers where cash is offered as the only method of payments (0) 448 0.015*** -0.002 -0.002 216 0.027*** -0.000 -0.001 216 0.030*** (0,1) 448 0.015*** 0.001 0.001 216 0.042*** (-1,1) 448 0.026*** -0.003 -0.001 216 0.042*** (-3,3) 448 0.027*** -0.003 -0.003 216 0.044*** (-5,5) 448 0.025*** Panel B: Acquirers in stock offers where stock is offered as the only method of payments 422 -0.013*** -0.012*** 6 0.039 (0) 422 -0.014*** -0.012*** 6 0.057 (0,1) 422 -0.019*** -0.018*** 6 0.050* (-1,1) 422 -0.021*** 4/18/91 6 0.075 (-3,3) 422 -0.023*** -0.024*** 6 0.110*** (-5,5) Panel C: Targets in cash offers where cash is offered as the only method of payments (0) 0.112*** 341 0.156*** 255 341 0.180*** 255 (0,1) 0.144*** (-1,1) 0.227*** 341 0.239*** 255 (-3,3) 0.253*** 341 0.261*** 255 341 0.274*** 255 (-5,5) 0.265*** -0.001 -0.000 0.000 0.001 -0.000 0.022* 0.033 0.059 0.093 0.096** -0.000 -0.001 -0.001 0.001 0.001 -0.018 -0.000 -0.007 0.002 0.017

Panel D: Targets in stock offers where stock is offered as the only method of payments 382 0.099*** 2 -0.018 (0) 0.070*** 382 0.115*** 2 -0.000 (0,1) 0.091*** 382 0.148*** 2 -0.007 (-1,1) 0.130*** 382 0.164*** 2 0.002 (-3,3) 0.146*** 382 0.162*** 2 0.017 (-5,5) 0.157***

Table 4: Comparison of Announcement Effects Between the Sample of CVR Offerors and the Matching Samples: Panel A of this table reports announcement period abnormal equity returns of offerors of CVRs, the differences of announcement period abnormal equity returns between the CVR sample and the matching samples which consist of firms offering only stock and no CVRs in their acquisitions. Panel B reports announcement period abnormal returns of offerors, and the differences of abnormal returns between the CVR sample and the matching samples which consist of firms offering only cash and no CVRs in their acquisitions. The selection of the matching sample for each offeror in column (I) is based on position of a firm in the acquisition (target or acquirer); type of the transaction (takeover or partial acquisition); and method of payment (cash offer or stock offer). The selection of the control sample for each offeror in column (II) is based on the criteria used in column (I) plus the industry where the offeror operates (i.e., the industry effect). The significance of means is determined using t-tests and the significance of medians is determined using Wilcoxon sign-rank tests. P-values are provided in parentheses. One, two and three asterisk(s) in superior indicate(s) 'significant difference' from zero at the 10%, 5%, and 1% level, respectively. CVR Offerors Mean Median CVR minus Control (I) Mean Median CVR minus Control (II) Mean 0.066**
(0.028)

Event Windows

Number of obs.

Median 0.020**
(0.023)

Panel A: Matching sample consists of firms offering only stock in their acquisitions 0.066** 0.015* 0.066** 0.019** (0) 28
(0.038) (0.054) (0.028) (0.014)

(0,1) (-1,1) (-3,3) (-5,5)

28 28 28 28

0.057* (0.074) 0.044 (0.104) 0.063* (0.063) 0.061


(0.142)

0.021 (0.216) 0.015 (0.155) 0.028 (0.208) 0.024


(0.384)

0.055**
(0.037)

0.022**
(0.028)

0.055**
(0.040)

0.025**
(0.048)

0.043*
(0.077)

0.025*
(0.092)

0.041*
(0.094)

0.027
(0.118)

0.063**
(0.045)

0.044*
(0.079)

0.059*
(0.067)

0.043
(0.118)

0.063*
(0.093)

0.05
(0.208)

0.066*
(0.080)

0.052
(0.184)

Panel B: Control sample consists of firms offering only cash in their acquisitions 0.046* 0.011 0.023 0.003 (0) 23
(0.066) (0.197) (0.231) (0.390)

0.019
(0.314)

0.001
(0.555)

(0,1) (-1,1) (-3,3) (-5,5)

23 23 23 23

0.035
(0.204)

0.21
(0.516)

0.010
(0.652)

0.009
(0.702)

0.011
(0.613)

0.102
(0.680)

0.031
(0.227)

0.013
(0.297)

-0.005
(0.806)

-0.007
(0.977)

-0.004
(0.831)

0.003
(0.977)

0.049
(0.152)

0.02
(0.373)

0.011
(0.708)

0.004
(0.883)

0.019
(0.487)

0.028
(0.814)

0.057
(0.239)

0.015
(0.595)

0.019
(0.634)

0.017
(0.860)

0.048
(0.174)

0.016
(0.208)

Table 5. Difference in the Extent of Information Asymmetry between the CVR Sample and the Matching Sample: This table reports the difference of proxies of asymmetric information between the CVR sample and the matching sample. Panel A compares the CVR sample with the matching firms selected from the sample of all-stock offers, while panel B compares the CVR sample with the matching firms selected from the sample of all-cash offers. The matching firms for each offeror in column (I) is constructed based on position of a firm in the acquisition (target or acquirer); type of the transaction (takeover or partial acquisition); and method of payments (cash offer or stock offer). The selection of the matching firms for each offeror in column (II) is based on the criteria used in column (I) and the industry where the offeror operates. The proxies of asymmetric information include NUMBER, measured as the number of analysts following the firm; DISPERSION, measured as the standard deviation of all analysts' earnings forecasts scaled by the mean forecast; ERROR, measured as the absolute difference between the forecast earnings and the actual earnings per share, scaled by the price in the end of fiscal year; and DIVERSE, a dummy for diversification, which takes a value of 1 if a firm diversifies in its acquisition and zero otherwise; SIZE, measured as the log of the market value of firm; MTOB, calculated as the ratio between market value and book value of firm; DIVIDEND, which equals to 1 if the firm pays dividend and zero otherwise; LEVERAGE, the ratio between book value of debt and market value of equity; TAXLOSS, a dummy equal to 1 if a firm has positive taxloss carryforward, and 0 otherwise; ROA, measured as EBITDA divided by book value of assets. A firm diversifies if the target's first two-digit of SIC code is different from the acquirer's. The significance of means and medians is determined using t-tests and Wilcoxon sign-rank tests, respectively. P-values are provided under the means and medians. One, two and three asterisk(s) indicate(s) 'significant difference' from zero at the 10%, 5%, and 1% level, respectively. CVR Offerors CVR - Control (I) Mean (%) Median (%) Mean (%) Median (%) Characteristics Number of Obs. Panel A: Control sample consists of firms offering stock without CVRs in their acquisitions -6.271*** -7.855*** NUMBER 25 7.40 5.00
(0.001) (0.004) (0.001) (0.002)

CVR - Control (II) Mean (%) Median (%) -7.786***


(0.001)

-9.000***
(0.001)

DISPERSION ERROR DIVERSE SIZE DIVIDEND MTOB LEVERAGE TAXLOSS ROA

20 25 25 28 28 28 28 28 28

0.167 0.108 0.571 7.161 0.321 2.941 0.387 0.357 0.025

0.118 0.012 1 6.485 0 2.469 0.181 0 0.070

0.121*** 0.104*
(0.052)

0.075*** 0.008***
(0.001)

0.117***
(0.005)

0.071***
(0.003)

0.103*
(0.053)

0.008***
(0.001)

0.143
(0.137)

0.415***
(0.003)

0.188*
(0.065)

0.311**
(0.046)

-0.792
(0.138)

-1.102
(0.142)

-1.124**
(0.041)

-0.761
(0.067)

-0.203**
(0.035)

-0.519***
(0.003)

-0.239**
(0.017)

-0.381**
(0.013)

-0.693
(0.535)

-1.436
(0.534)

-1.003
(0.382)

-1.557
(0.107)

0.192*
(0.066)

0.012
(0.314)

0.189**
(0.037)

0.041
(0.176)

0.147
(0.115)

-0.126
(0.471)

0.187*
(0.054)

-0.071
(0.325)

-0.140***
(0.006)

-0.095***
(0.003)

-0.120**
(0.015)

-0.028**
(0.014)

Panel B: Control sample consists of firms offering only cash in their acquisitions NUMBER DISPERSION ERROR DIVERSE SIZE DIVIDEND MTOB LEVERAGE TAXLOSS ROA 21 18 21 23 23 23 23 23 23 23 8.047 0.171 0.066 0.54 7.444 0.304 3.112 0.357 0.435 0.026 6.00 0.118 0.011 1 7.097 0 2.589 0.207 0 0.075 -4.349**
(0.013)

-4.769**
(0.131)

-8.646***
(0.001)

-10.5***
(0.002)

0.128***
(0.006)

0.077***
(0.002)

0.128***
(0.006)

0.073***
(0.002)

0.059
(0.133)

0.006**
(0.032)

0.060
(0.130)

0.002**
(0.047)

0.024
(0.820)

0.496
(0.414)

0.095
(0.424)

0.333
(0.326)

-0.497
(0.346)

-0.407
(0.232)

-1.162**
(0.032)

-0.791*
(0.072)

-0.328***
(0.004)

-0.671***
(0.000)

-0.277**
(0.029)

-0.545**
(0.039)

0.533
(0.239)

-0.104
(0.535)

0.139
(0.752)

0.165
(0.953)

0.039
(0.229)

-0.111
(0.357)

0.131
(0.167)

-0.053
(0.535)

0.227**
(0.043)

-0.206
(0.149)

0.286**
(0.014)

0.000**
(0.013)

-0.135**
(0.021)

-0.090***
(0.010)

-0.120**
(0.035)

-0.038**
(0.027)

Table 6: Logistic Regressions on the Likelihood of Offering CVRs Rather Than Stock in Acquisitions: This table presents results from logistic regressions of firms' choice between offering CVRs and offering only stock and no CVRs in acquisitions. The sample used in regresssions includes offerors of CVRs (28 observations) and the matching samples of offerors (671 observations). The exact number of observations in each regression may vary slightly due to the unavailability of information. The dependent variable is one for firms offering CVRs and zero otherwise. The independent variables include NUMBER, measured as the number of analysts following the firm; DISPERSION, measured as the standard deviation of all analysts' earnings forecasts scaled by the mean forecast; ERROR, measured as the absolute difference between the forecast earnings and the actual earnings per share, scaled by price; and DIVERSE, dummy for diversification, equals 1 if the firm diversifies in its acquisition and zero otherwise. The control variables include SIZE, measured as the log of the market value of firm; MTOB, calculated as the ratio between market value and book value of firm; BUS, the business cycle factor, measured as In[SP(-1)/SP(-12)], where -1 and -12 refer to the month relative to the announcement month, and SP refers to the Standard and Poor's 500 Index; DIVIDEND, which equals 1 if the firm pays dividend and zero otherwise; LEVERAGE, the ratio between book value of debt and market value of equity; TAXLOSS, a dummy equal to 1 if a firm has positive taxloss carryforward, and 0 otherwise; ROA, measured as EBITDA divided by book value of assets; TARGET, equal to 1 if a firm is a target in the acquisition, and 0 if it is an acquirer; and SOURCE, equal to 1 if a firm is involved in a takeover where the acquirer takes over more than 50% of the target's shares and 0 if it is involved in a partial acquisition where less than 50% of the target's shares are acquired. Coefficients of TARGET and SOURCE are not reported. Neither are coefficients of SP, TAXLOSS and LEVERAGE, since they are insignificant for all regressions. Standard deviations are provided under the coefficient estimates. *, **, and *** indicate significance at the 1%, 5%, and 10% levels, respectively, in Chi-square tests. Dependent Variable Is Equal to 1 for Firms Offering CVRs in Acquisitions Explanatory Variables (1) (2) (3) (4) (5) INTERCEPT SIZE MTOB DIVIDEND ROA DIVERSE DISPERSION ERROR NUMBER Chi square of the likelihood ratio test p-value of Chi-square 63.75 <0.01 72.86 <0.01 76.06 <0.01 29.30***
(3.04)

(6) 21.84***
(3.47)

5.23
(102.4)

21.65*** 24.90***
(3.43) (3.01)

8.91
(1713)

0.059
(0.15)

0.53***
(0.18)

0.45***
(0.17)

0.34**
(0.17)

0.78***
(0.22)

0.63***
(0.19)

0.027
(0.080)

-0.050
(0.11)

-0.11
(0.10)

-0.15
(0.10)

-0.054
(0.11)

-0.13
(0.10)

-1.08**
(0.55)

-1.16*
(0.67)

-1.25**
(0.63)

-0.93*
(0.56)

-1.00
(0.070)

-1.09*
(0.62)

-8.70***
(2.17)

-7.86***
(2.75)

7.34***
(2.64)

-7.03***
(2.12)

-6.66**
(2.83)

-5.54**
(2.79)

0.46
(0.47)

0.57
(0.67)

0.49
(0.57)

18.42***
(4.87)

16.10***
(5.21)

92.38*** (28.06) -0.084*


(0.044)

63.97** (30.41) -0.077*


(0.044)

94.81*** (27.48) -0.083*


(0.043)

54.18 <0.01

82.49 <0.01

82.11 <0.01

Table 7: Logistic Regressions on the Likelihood of Offering CVRs Rather Than Only Cash in Acquisitions: This table presents results from logistic regressions of firms' choice between offering CVRs and offering only cash and no CVRs in acquisitions. The sample in regressions include firms offering CVRs (offerors, 23 observations) and the matching samples of offerors (426 observations). The exact number of observations in each regression may vary due to unavailability of information. The dependent variable is one for firms offering CVRs and zero for firms not offering CVRs. The independent variables include NUMBER, measured as the number of analysts following the firm; DISPERSION, measured as the standard deviation of all analysts' earnings forecasts scaled by the mean forecast; ERROR, measured as the absolute difference between the forecast earnings and the actual earnings per share, scaled by price; and DIVERSE, dummy for diversification, which is equal to 1 if a firm diversifies in its acquisition and zero otherwise. We also control for SIZE, measured as the log of the market value of firm; MTOB, calculated as the ratio between market value and book value of firm; BUS, the business cycle factor, measured as In[SP(1)/SP(-12)], where -1 and -12 refer to the month relative to the announcement month and SP refers to the Standard and Poor's 500 Index; DIVIDEND, equal to 1 if a firm pays dividend and zero otherwise; LEVERAGE, the ratio between book value of debt and market value of equity; TAXLOSS, a dummy equal to 1 if a firm has positive taxloss carryforward, and 0 otherwise; ROA, measured as EBITDA divided by book value of assets; TARGET, equal to 1 if a firm is a target in the acquisition, and 0 if it is an acquirer; and SOURCE, equal to 1 if a firm is involved in a takeover where the acquirer takes over more than 50% of the target's shares and 0 if it is involved in a partial acquisition where less than 50% of the target's shares are acquired. Coefficients of TARGET and SOURCE are not reported. Neither are coefficients of SP, DIVERSE and LEVERAGE, since they are insignificant for all regressions. Standard deviations are provided under the coefficient estimates. *, **, and *** indicate significance at the 1%, 5%, and 10% levels, respectively, in Chi-square tests. Dependent Variable Is Equal to 1 for Firms Offering CVRs in Acquisitions Explanatory Variables (1) (2) (3) (4) INTERCEPT SIZE MTOB TAXLOSS DIVIDEND ROA DISPERSION ERROR NUMBER Chi square of the likelihood ratio test p-value of Chi-square 59.68 <0.01 55.55 <0.01 -7.54*
(4.21)

(5) -6.54
(3.99)

-3.91
(3.83)

-2.49
(3.34)

-11.23
(4.44)

0.21
(0.20)

0.052
(0.18)

0.056
(0.197)

0.51**
(0.23)

0.30
(0.21)

0.45**
(0.21)

0.51***
(0.18)

0.35**
(0.16)

0.51**
(0.21)

0.50***
(0.17)

0.840
(0.70)

0.60
(0.60)

0.96*
(0.53)

0.70
(0.75)

0.55
(0.60)

-0.65
(0.73)

0.70
(0.66)

-0.69
(0.60)

-0.45
(0.78)

-0.67
(0.65)

-10.94***
(3.94)

-11.97***
(3.80)

-11.24***
(3.37)

-11.40***
(3.98)

-11.54***
(3.82)

20.09***
(5.62)

16.84***
(6.45)

86.73***
(24.31)

-0.055
(0.049)

56.81* (31.24) -0.080*


(0.047)

97.29*** (26.93) -0.086*


(0.046)

39.91 <0.01

66.72 <0.01

59.34 <0.01

Table 8: Logistic Regressions on the Likelihood of Offering CVRs Rather Than Cash as Part of Payments in Acquisitions: This table presents results from logistic regressions of firms' choice between offering CVRs and offering cash as part of payments and no CVRs in their acquisitions. The sample in regressions include firms offering CVRs (offerors, 23 observations) and the matching samples of offerors (667 observations). The exact number of observations in each regression may vary due to unavailability of information. The dependent variable is one for firms offering CVRs and zero for firms not offering CVRs. The independent variables include NUMBER, measured as the number of analysts following the firm; DISPERSION, measured as the standard deviation of all analysts' earnings forecasts scaled by the mean forecast; ERROR, measured as the absolute difference between the forecast earnings and the actual earnings per share, scaled by price; and DIVERSE, dummy for diversification, which is equal to 1 if a firm diversifies in its acquisition and zero otherwise. We also control for SIZE, measured as the log of the market value of firm; MTOB, calculated as the ratio between market value and book value of firm; BUS, the business cycle factor, measured as In[SP(-1)/SP(-12)], where -1 and -12 refer to the month relative to the announcement month and SP refers to the Standard and Poor's 500 Index; DIVIDEND, equal to 1 if a firm pays dividend and zero otherwise; LEVERAGE, the ratio between book value of debt and market value of equity; TAXLOSS, a dummy equal to 1 if a firm has positive taxloss carryforward, and 0 otherwise; ROA, measured as EBITDA divided by book value of assets; TARGET, equal to 1 if a firm is a target in the acquisition, and 0 if it is an acquirer; and SOURCE, equal to 1 if a firm is involved in a takeover where the acquirer takes over more than 50% of the target's shares and 0 if it is involved in a partial acquisition where less than 50% of the target's shares are acquired. Coefficients of TARGET and SOURCE are not reported. Neither are coefficients of SP, DIVERSE and LEVERAGE, since they are insignificant for all regressions. Standard deviations are provided under the coefficient estimates. *, **, and *** indicate significance at the 1%, 5%, and 10% levels, respectively, in Chi-square tests. Dependent Variable Is Equal to 1 for Firms Offering CVRs in Acquisitions Explanatory Variables (1) (2) (3) (4) INTERCEPT SIZE MTOB TAXLOSS DIVIDEND ROA DISPERSION ERROR NUMBER -8.59**
(4.29)

(5) -7.68**
(3.74)

-5.05
(3.55)

3.14
(3.19)

-12.13***
(4.32)

0.28
(0.19)

0.082
(0.17)

0.10
(0.20)

0.58***
(0.22)

0.34*
(0.20)

0.41**
(0.19)

0.48***
(0.17)

0.28*
(0.16)

0.49**
(0.20)

0.45***
(0.17)

0.64
(0.66)

0.60
(0.58)

0.96*
(0.52)

0.45
(0.72)

0.47
(0.59)

-0.81
(0.70)

-0.79
(0.64)

-0.74
(0.58)

-0.53
(0.74)

-0.71
(0.63)

-9.95***
(3.68)

-10.04***
(3.02)

-9.97***
(2.77)

-10.95***
(3.65)

-9.65***
(3.12)

20.11***
(5.37)

17.40***
(5.80)

89.36***
(23.25)

-0.068
(0.050)

64.98** (29.85) -0.090*


(0.048)

98.31*** (25.49) -0.091*


(0.047)

Table 9: Probit Regressions on the Likelihood of Offering CVRs in Acquisitions: This table presents results from the probit regressions on firms' choice between offering CVRs and offering no CVRs in acquisitions. Columns (1) - (4) study the choice between CVR offers and pure stock offers, while columns (5) - (8) study the choice between CVR offers and pure cash offers. The independent variables are the proxies of information asymmetry including NUMBER, measured as the number of analysts following the firm; DISPERSION, measured as the standard deviation of all analysts' earnings forecasts scaled by the mean forecasts; ERROR, measured as the absolute difference between the forecast earnings and the actual earnings per share, scaled by price; and DIVERSE, dummy for diversification, equal to 1 if the firm diversifies in its acquisition and zero otherwise. The control variables include SIZE, measured as the log of the market value of firm; MTOB, calculated as the ratio between market value and book value of firm; BUS, the business cycle factor, measured as In[SP(-1)/SP(-12)], where -1 and -12 refer to the month relative to the announcement month, and SP refers to the Standard and Poor's 500 Index; DIVIDEND, which equals to 1 if the firm pays dividend and zero otherwise; LEVERAGE, the ratio between book value of debt and market value of equity; TAXLOSS, a dummy equal to 1 if a firm has positive taxloss carryforward, and 0 otherwise; ROA, measured as EBITDA divided by book value of assets; TARGET, equal to 1 if the firm is a target in the acquisition, and 0 if it is an acquirer; and SOURCE, equal to 1 if the firm is involved in a takeover where the acquirer takes over the more than 50% of the target's shares and 0 if it is involved in a partial acquisition where less than 50% of the target's shares is acquired. Results on SP, LEVERAGE, and DIVERSE are not reported, since they are insignificant for all regressions. Standard deviations are provided under the coefficient estimates. *,**,*** indicate significance at the 10%, 5%, and 1% levels, respectively, in Chisquare tests. Dependent variable: 1 for offering CVRs Dependent variable: 1 for offering CVRs and 0 for offering pure stock and 0 for offering pure cash (1) (2) (3) (4) (5) (6) (7) (8) 4.97
(17368)

Explanatory Variables INTERCEPT SIZE MTOB TAXLOSS DIVIDEND ROA DISPERSION ERROR NUMBER

4.68
(17368)

6.73
(17386)

3.44
(17386)

-3.89**
(1.92)

-2.33
(1.71)

-1.42
(1.54)

-5.05**
(2.09)

0.17**
(0.077)

0.17**
(0.072)

0.13*
(0.077)

0.32***
(0.10)

0.10
(0.091)

0.047
(0.08)

0.021
(0.088)

0.22*
(0.11)

-0.014
(0.053)

-0.034
(0.050)

-0.067
(0.049)

-0.019
(0.056)

0.20**
(0.092)

0.22***
(0.083)

0.15*
(0.078)

0.23**
(0.10)

0.042
(0.29)

0.067
(0.27)

0.31
(0.24)

-0.046
(0.31)

0.36
(0.32)

0.28
(0.28)

0.50**
(0.25)

0.30
(0.33)

-0.31
(0.28) (1.20)

-0.42
(0.26) (1.24)

-0.33
(0.24) (0.96)

-0.26
(0.30)

-0.26
(0.34) (1.67)

-0.28
(0.30) (1.64)

-0.32
(0.27) (1.36)

-0.19
(0.36) (1.80)

-3.08*** -3.18*** -3.09*** 7.91***


(2.15)

-2.35*
(1.37)

-4.81*** -5.31*** 4.58*** -4.77*** 9.68***


(2.69)

7.10***
(2.40)

8.37***
(3.01)

48.15***
(13.48)

32.50**
(14.84)

45.16***
(12.81)

25.44*
(15.66)

-0.034*
(0.019)

-0.037*
(0.020)

-0.018
(0.020)

-0.031
(0.022)