You are on page 1of 21

Vertical Integration and Risk Reduction

University of California at Davis


Downloaded from at University of Westminster on October 26, 2010

University of California at Berkeley

In this paper we propose an indirect test of the "new institutional economics"
(Williamson, 1975, 1981,1985) by exploring the relationship between vertical
integration and uncertainty. We present evidence that suggests that vertical
integration, executed by merger, may reduce a firm's systematic or undiver-
sifiable risk. That is, vertical mergers reduce risk by more than the simple
portfolio effects that arise from combining business units in which returns are
not perfectly correlated, suggesting that internal organization does have dis-
tinctive properties which cannot be easily replicated by stockholders taking
separate asset positions in specialized companies operating at each stage of an
Uncertainty creates several kinds of problems for the organization of
production. One is that it complicates decisionmaking. Because of uncertainty
and bounded rationality, comprehensive contingent planning on how to

We are indebted to Richard Castanias, Pablo Spiller, an anonymous referee, and the editor for
their many useful suggestions, and to Amy Abramson for her research assistance. We wish to
thank Henry Armour and Garth Saloner for extensive help on an earlier version which was widely
ciruclated in 1980. The earlier version (Teece et al., 1980) outlined the methodology employed
here but contained several technical errors. This paper refines that methodology and reports new
results computed on a different and more satisfactory sample. The technical errors brought to our
attention have been corrected. John Cox, Jeffrey Pfeffer, Steven Ross, and Robert Wilson also
provided useful comments on the earlier draft.

Journal of Law, Economics, and Organization vol. 3, no. 1 Spring 1987

© 1987 by Yale University. All rights reserved. ISSN 8756-6222


deploy resources in the future is impossible. Not only are there too many
contingencies, but many contingencies are simply unknown—the "event set"
simply cannot be fully specified.' Decisionmakers accordingly find advantage
in being able to adapt to unanticipated contingencies as they are revealed over
time. In fact, afirmthat is able to do so quickly is likely to be considered well
managed. Putting it differently, "uncertainty appears as the fundamental
problem for complex organization and coping with uncertainty is the essence
of the administrative process" (Thompson: 159).
Several sources of uncertainty can be recognized. One approach adopted

Downloaded from at University of Westminster on October 26, 2010

by Koopmans involves separating primary from secondary uncertainty (Koop-
mans: 162). Primary uncertainty is of the state contingent kind and results
from future natural events, discoveries, and changes in preferences. Second-
ary uncertainty arises "from the lack of communication, that is from one
decisionmaker having no way of finding out the concurrent decisions and
plans made by others" (163). According to Koopmans, this kind of uncertainty
is "quantitatively at least as important as the primary uncertainty arising from
random acts of nature and unpredictable changes in consumers' preferences"
The secondary uncertainty which Koopmans has in mind appears to be of a
rather passive kind. But as Williamson (1975, 1979, 1981) has frequently
pointed out, economic agents may sometimes fail to disclose information and
may in fact disguise and distort it. They may also adopt business strategies
designed to create additional business uncertainty for their rivals. In addition,
therefore, to the problems of "nonconvergent expectations" to which Koop-
mans (and later Malmgren) referred, it is necessary to make provision also for
what has subsequently been referred to as "behavioral uncertainty" (William-
son, 1985: 58-59). 2
Both kinds of uncertainty are relevant to vertical supplier—buyer relation-
ships. Suppose a downstream firm requires components or raw materials from
an upstream source. Suppose further that the twofirmsbear a bilateral depen-
dency relation (by reason of asset specificity) to one another. Both secondary
and behavioral uncertainties thereby result. Thus whereas vertical integra-
tion has no impact on primary uncertainty, it is hypothesized here to reduce
both secondary and behavioral uncertainties as compared to the unintegrated
The reasoning is quite straightforward. Internal organization facilitates
information flows between separable stages since there are no proprietary
boundaries encountered, and furthermore, communication codes and rou-

1. See, for example, Hadley (16-17).

2. Subsequent (o our earlier discussion (Teece et al., 1980) of secondary uncertainty, Wil-
liamson has coined the term behavioral uncertainty to describe the phenomenon we identified.
The label is most helpful, and we adopt it hereafter.

tines commonly emerge within organizations, which minimize the cost of

identifying and disclosing information to the relevant parties (Armour and
Teece, 1978, 1980; Arrow; Williamson, 1975; Nelson and Winter; Monte-
verde and Teece). More important for our purposes here, incentives for
strategic distortion and nondisclosure are attenuated, since such behavior has
a zero-sum impact on profits at the corporate level. Agents can place greater
reliance on information communicated between vertically related divisions of
the firm than on that communicated between vertically related firms.
If vertical integration can reduce a firm's exposure to uncertainty, and the

Downloaded from at University of Westminster on October 26, 2010

risks investors face in holding its securities, then there are theoretical and
empirical reasons for believing that its cost of capital and its costs of production
will be lower than otherwise. In a competitive market, these savings will tend
to be translated into lower product prices and will also render entry by firms
that are not vertically integrated difficult because their capital costs will be
higher. Lower risk also implies lower expected rates of return to investors in
vertically integrated firms if capital markets are efficient. However, lower
returns need not leave investors worse offsince there is an offsetting reduction
in the riskiness of the investor's portfolio. Thus, if risk is reduced by vertical
integration, and lower risks mean lower capital costs and rates of return,
vertical integration will benefit the consumers of the firm's output while
leaving investors no worse off.


We have hypothesized that vertical integration may enable afirmto produce a
de facto reduction in the uncertainty of its environment. In order to translate
this hypothesis into a form that will enable it to be tested, we first trace the
implications of the hypothesis through to its impact on the riskiness to
investors holding the firm's securities.
Various measures of investor risk have been proposed. One is the variance
of a security's total return, and another is the coefficient of variation, which is
the standard deviation divided by the mean or expected return. But neither of
these measures takes into account that investors hold assets not in isolation
but jointly with other assets, so that the riskiness of an asset can be influenced
by the interaction of the pattern of its return with the patterns of returns of the
other assets with which it is combined in an investor's portfolio. Thus the
riskiness of assets held in portfolios can be measured by their contribution to
portfolio risk. The relationship can be measured by the covariance of the
assets' return with the return on the market as a whole, commonly known as
beta (P). The Capital Asset Pricing Model (CAPM) of Sharpe (1964), Lintner,
and Mossin sets forth a theory of the relationship between the risk of an asset
and the required risk adjustment factor. The relationship is expressed in the

security market line (Sharpe, 1964). In short, the total risk involved in holding
an asset can be decomposed into two parts:

total risk = systematic risk + unsystematic risk,

(nondiversifiable) (diversifiable)

Unsystematic risk, such as wildcat strikes or a technological breakthrough that

makes obsolete a firm's products but has minimal repercusions elsewhere, is
unique to the particular company. Systematic risk such as a congressional tax

Downloaded from at University of Westminster on October 26, 2010

initiative or an oil shock, on the other hand, affects securities overall. It cannot
be diversified away. If one assumes that investors as a whole are efficiently
diversified, unsystematic risk becomes quantitatively unimportant and sys-
tematic risk emerges as the relevant measure of a firm's risk.3


While systematic risk cannot be reduced through the use of capital market
instruments, the arguments in section 1 above suggest that internal organiza-
tion, and in particular vertical integration, can be an instrument for reducing
systematic risk. To understand why, we must explore beneath the surface of
the CAPM market model.4
In the CAPM, it is not the expected market return (in excess of the risk-free
rate) which generates the expected asset return. Rather, anticipated eco-
nomic events are the causal factors behind both Rm and Rp. If one looks

3. Roll specifically criticized beta as a risk measure on two grounds:first,that it will always be
(significantly) positively related to observed average individual returns if the market index is on
(not significantly off) the positive sloped section of the ex-post efficient frontier, regardless of
investors' attitudes toward risk; and second, that it depends, nonmonotonically, on the particular
market proxy used. These criticisms are theoretically valid and imply, as suggested above, that
estimated betas may be unreliable measures of diversifiable risk.
4. We wish to warn that the test presented, since it assumes the validity of the CAPM, is
exposed to some of the criticims of this particular theoretical construct, the most serious of which
questions the empirical usefulness of the model. Roll has pointed out that while the underlying
theory of the CAPM suggests a relationship between an asset's returns and the covariability of
these returns with the returns of all other assets (including human capital), empirical application
of the market model, by necessity, restricts examination and estimation of covariability to a much
smaller population of assets, typically publicly traded securities. Thus an estimate of the system-
atic risk (covariability) associated with an asset may differ from the "true" theoretical risk.
Further, two individual investors holding different efficient portfolios, neither containing a
complete representation of all assets, may obtain different systematicriskestimates for the same
asset due to differing covariability with the returns associated with the other assets in their
portfolios. Ross has questioned the empirical appeal of two alternative assumptions required to
derive the basic model, that of quadratic preferences or, alternatively, that asset returns are
multivariate normally distributed. The implication of these limitations to the present study lie in
making the results conditionally applicable to the population of assets utilized. That is, the
comparison of pre- and post-merger systematic risk estimates is strictly relevant only to those
investors holding the portfolio used to generate the risk estimates.

forward in time one can see that the market will be significantly affected by
changes in the expected rate of inflation, interest rates, regulation, the growth
rate of real GNP, and many other factors. There are also a number of less
general events, related to these, that deserve greater attention: movements
in crude oil and other raw material prices, developments in alternative domes-
tic energy supplies, changes in public attitudes toward regulation, and possible
changes in the tax law, among others. Each of these events is important in
contributing to the uncertainty of future market returns; and for each, one can
anticipate the effect upon any particular security.

Downloaded from at University of Westminster on October 26, 2010

Consider, for example, a domestic oil stock. Oil shocks will have a propor-
tionally greater effect upon such a stock, and inflation-related events probably
a proportionally smaller effect, than for the market as a whole. As a result, if
one foresees that the major source of uncertainty in future returns is from
developments in energy markets, one will anticipate an unusually high beta,
but if one foresees that the major source of uncertainty lies in inflation-related
events, one will anticipate an unusually low beta (Rosenberg and Guy: 3).
Notice from the example that two types of parameters determine the level of
systematic risk (beta): the degree of uncertainty associated with potential
economic events, and the responses of security returns to those events. If
vertical integration enables the firm to adapt to uncertainty/complexity in a
fashion which cannot be replicated as efficiently by long-term contracts and
spot trading, then vertical integration should reduce the response of the
security relative to the market response to an event. If vertical integration
reduces the relative response of security returns to economic events outside of
the firm, it will reduce beta.


We wish to establish a quasi-controlled experiment to examine the effects of
vertical integration on a firm's beta. Hypothesis testing using vertically inte-
grated firms that have become vertically integrated via internal expansion is
rendered difficult by the fact that the firms in this category have maintained a
fairly constant level of vertical integration over the time period for which data
is available. Accordingly, it is extremely difficult, if not impossible, to execute
a controlled experiment by analyzing firms that have become vertically inte-
grated by internal growth.
By focusing on vertical mergers, we are able to observe the effects of
vertical integration on beta over a much more compressed timespan. This
reduces the data and statistical problems to manageable proportions. How-
ever, to the extent that vertical integration by merger renders vertical com-
munication and administrative control more difficult than it is when the
vertical integration is achieved by internal growth, a statistical design based
on vertical mergers will bias the results against our hypothesis. Spiller, using a

different approach to that employed here, has also used vertical mergers in his
examination of the gains to merger and risk reduction.5
The general design employed here involves forming an "experimental"
group of U.S. firms that have participated in vertical mergers. Each pair of
experimental firms is then matched against a pair of control firms similar in
most important respects save that of merger activity. There is sometimes a
presumption, based on studies such as Blume (1971), that betas do not change
greatly over time. Other studies have showed, however, that individual firm
betas may be nonstationary and do tend to regress to the grand mean of all

Downloaded from at University of Westminster on October 26, 2010

betas, equal to 1.00 (Blume, 1977).6 Over time, the betas that are less than
1.00 tend to rise, and vice versa. In addition, changes in the economic
environment and other variables may also affect post-merger betas. There-
fore, a straightforward calculation of pre- and post-merger betas might not
permit the effect of vertical integration on risk to be effectively isolated.
In their study of the microeconomic consequences of all types of mergers,
Lev and Mandelker use a paired sample technique similar to the one em-
ployed here. They note that merging firms may differ systematically from
nonmerging firms and suggest that a pairing system that accounts for the
major sources of differences between the two groups may reduce some of this
systematic bias. Lev and Mandelker controlled for industry, firm size, and
chronological time period. There is some evidence that industry betas vary
over time; for example, in the oil industry, firm betas exhibited similar
patterns of change throughout the 1970s.7 Additionally, if factors other than
covariance with the market return affect individual stock returns (as suggested
by King), pairing may control for some of these factors. In order to net out such
influences we use a procedure described below to select twofirmsas compara-
ble as possible to the merging firms; using the same estimation procedures
and chronological periods, we calculate the pre- and post-merger betas.
U.S. firms involved in vertical mergers between 1948 and 1979 inclusive,
as reported by the Federal Trade Commission,8 formed the sample from
which the companies in this study were chosen. The analysis was performed
using monthly security returns from the Center for Research in Security
Prices (CRSP) tapes. Companies were included in the monthly sample pro-
vided that:

5. In an excellent recent study, Pablo Spiller explored market power versus efficiency
explanations of the risk reduction associated with vertical mergers and found that latter more
compelling. In particular, he found that vertical mergers amongst firms with geographically
proximate vertically related facilities (his proxy for specialized assets) showed largest gains from
merging as well as a larger reduction in their systematic risk.
6. Estimated beta coefficients tend to regress toward the grand mean of all betas over time.
According to Blume (1977), part of this observed regression tendency represents real nonstation-
arities in the betas of individual securities. In other words, companies of extreme risk—either
high or low—tend to have less extreme risk characteristics over time. See Blume (1977:31) for
possible explanations.
7. This information is based on unpublished work by Richard Castanias.
8. In its 1981 Statistical Report on Mergers and Acquisitions.

1. their shares were publicly traded for at leastfiftymonths before the

end of the seventh month prior to the announcement of the merger;9
2. the merged firm was publicly traded for at leastfiftymonths follow-
ing the merger;10
3. market data was contained on the CRSP tapes of monthly New York
Stock Exchange security returns;
4. firms involved in other nonvertical mergers, with either the acquir-
ing or acquired company (as reported by the FTC),11 were also listed

Downloaded from at University of Westminster on October 26, 2010

on the monthly CRSP tapes during the time periods described in 1 and
2 above.
Because other nonvertical mergers may change the value of the merged firm's
stock market beta, the nonvertically acquired companies must be included in
the analysis.12
Of the companies involved in vertical mergers listed by the FTC, over forty
pairs of firms were listed on the CRSP tapes. The other criteria, however,
caused numerous firms in the original sample to be excluded from our
analysis. The firms involved in the fourteen mergers using monthly data that
satisfy these criteria are listed in table I. 13 The vertical nature of each of
these mergers was double-checked using the type of business descriptions in
Moody's Industrial Manual.
Pre-merger betas were estimated using OLS and fifty months of data for
the monthly sample. Betas were estimated in the standard way from the

Rjt = a, + (5, RMt + Sjt (1)

9. Studies have shown that the stock market anticipates mergers well before their announce-
ment dates. We rely on Halpern's results showing abnormal returns as early as the end of the
seventh month prior to the announcement date. The announcement date is the first public
announcement of possible intentions to merger appearing in the Wall Street Journal or in the
New York Times where Wall Street journal information is not readily available.
10. The merger date is taken as the last month when the acquired company's stock was traded
or a return recorded on CRSP.
11. Many firms were involved in smaller mergers of less than $10 million not listed by the
FTC. We expect that mergers involving relatively small firms will not greatly affect the com-
puted values of the betas.
12. In his work on vertical mergers, Spiller uses similar criteria to select a sample of firms
using monthly CRSP data, with the omission of criterion number 4. Because we incorporate the
impact of other nonvertical mergers on the estimates of beta, our sample of vertical mergers is
smaller than Spiller's.
13. This sample provides a strong test of our hypothesis in that we do not attempt to screen
out those vertical mergers for which transactional considerations are unimportant, or for which
transactional economies were not realized because of managerial ineptitude or failure to imple-
ment the organizational linkages necessary to improve scheduling and coordination advantages
and the like. To the extent that firms with these characteristics are in our sample, the data will be
biased against our hypothesis.
Table 1. Sample Firms Involved in Vertical Mergers, 1948-79 Monthly Return
Data (Acquired firms listed first)
Market value ($MM)*
Case no. Firm name (equity and debt) Merger date**

1 Hinde & Dauche 27.4 Nov. 1953

W. Va. Pulp & Paper 109.9
2 Lion Oil 252.0 Nov. 1955
Monsanto 862.1

Downloaded from at University of Westminster on October 26, 2010

3 National Container 156.2 Nov. 1956
Owens Illinois 447.3
4 Visiting 109.2° Jan. 1957
Union Carbide 3,902.7
5 Superior Steel" 8.1 Dec. 1958
Copperweld Steel* 29.9
6 Phileo 154.8 Dec. 1961
Ford Motor Co. 6,571.6
7 Columbian Carbon1* 91.4 Feb. 1962
(Miami Copper)b 36.9 June 1960
(Tennessee Corp.)b 163.4 June 1963
Cities Service1" 1,087.5
8 Haveg* 57.4 Aug. 1964
Hercules Powder0 813.2
9 Sealrite Oswego 42.0 Oct. 1964
Phillips Petroleum 2,006.3
10 American Potash 146.4 Jan. 1968
Kerr-McGee 1,015.3
11 Amerada Petroleum 1,582.5 June 1969
Hess Oil 644.1
12 Kelsey Hayes 151.3 Nov. 1973
Fruehauf 367.4
13 Latrobe Steel 28.1 Apr. 1975
Timken 342.1
14 Sprague Electricd 134.9 Dec. 1976
(Automation Inds.)d 110.3 May 1978
General Cable Corp.d 411.4

'Debt includes long-term debt plus preferred stock. Stock market equity is valued as of the last trade
date on CRSP of the acquired company. Debt is valued at year-end prior to the merger.
••Merger date is that of last CRSP record for the acquired company.
a. The post-merger sample has only 40 observations.
b. Cities Service acquired Tennessee Corp. in a nonvertical merger. Tennessee Corp. had previously
acquired Miami Copper in a nonvertical merger.
c. The pre-merger sample has only 42 observations due to lack of CRSP data for another nonvertical
merger at the beginning of the pre-merger period.
d. General Cable acquired Automation Inds. in a nonvertical merger. The post-merger sample has only
35 observation because Genera! Cable (then called CK Technologies) was acquired by another firm and


Rjt = the ex-post return for security j for month t14

RMt = the ex-post return of the value-weighted market index,


E(eJt) = 0, E(eitejt) = 0, t * j .

Downloaded from at University of Westminster on October 26, 2010

These estimated betas reflect the systematic risk associated with the firm's
stock market equity, rather than with the entire value of the firm. Therefore,
firm asset betas are derived from the estimated stock market betas as follows:

debt \ „ / equity
\debt + equity/ \debt + equity


PA = estimated asset systematic risk

Pdebt = estimated debt systematic risk, assumed to equal zero15
Pequity =estimated beta from (1) above
equity = CRSP stock market value of common stock
debt = par or liquidating value of preferred stock plus book value of
debt at year-end.16
For the pre-merger asset betas, the debt and equity values are those as of the
last date in the pre-merger sample. A predicted post-merger beta for the
merged firms which reflects diversification effects was then computed as
PP = W, p, + W 2 p 2 (3)

14. More specifically, RJt = (PJt + DIVJ( - Pj,-l)IPJ,,-l where Pjt is the price of security,;
in period t, and DIVjr is the dividend associated with security j in period /.
15. See Brealey and Myers (chap. 9). Although the beta for debt may not in fact be zero, this
approximation is often used.
16. Due to the difficulty of estimating the market values of firm debt, we have used book
values, a common procedure in computing firm asset betas. This may introduce some bias in the
net risk reduction calculations. For hypothetically perfect controls, which have the same relation
of market to book values of debt and the same pre-merger betas as do the merging firms, the use of
a book value greater than the true market value yields a lower absolute net risk reduction than is
actually the case. The reverse occurs if book value is less than the true market value of debt.
17. See Sharpe (1970: chap. 7) for the derivation of this algorithm.


3 P = the predicted post-merger systematic risk

P( = the estimated pre-merger systematic risk offirm»
W( = the market value (debt + stock market equity) of firm i as
a proportion of the total value of the surviving firm (W^ +
W2 = I).18

In cases where one of the firms had other nonvertical mergers during the

Downloaded from at University of Westminster on October 26, 2010

pre-merger period, the asset betas for the acquired firms were estimated;
each was weighted by its market value as a share of the market value of the
surviving firm (computed subsequent to all mergers) and included in the
predicted post-merger beta.
The actual post-merger beta, |3 a , for each of the merged firms was then
estimated with the same regression model using the fifty monthly return ob-
servations subsequent to the merger date. The betas from the OLS regression
were transformed into asset pa's using debt and equity values just subsequent
to the merger. These asset betas adjust for the possible impact on stock market
betas of an increase in debt to finance the merger. In the absence of risk
reduction and confounding effects, one would expect 0 p — (3a = 0 on aver-
age. If, however, risk reduction effects are present and confounding effects
are absent, then P p - p\, > 0.
To handle confounding effects, a control group was chosen by searching the
CRSP and COMPUSTAT tapes and Moody's Industrial Manual in each case
to find firms which matched the merging firms as closely as possible on the
criteria of industry group, market value, and listing on the CRSP tapes for the
pre- and post-merger sample periods. In order to control for effects of regres-
sion toward the mean, firms qualifying on the above criteria were selected on
the basis of closeness of pre-merger estimated beta to that of the matched
merging firms. More specifically, the industry group occupied by each of the
merging firms was first identified. This was followed by a search for firms of
approximately the same asset size who were not involved in vertical mergers
during the period in which they would serve as controls. For the sixfirms(or
fewer, depending on the availability of firms on CRSP in the same industry
group in the sample period) closest in market value (including debt), asset
betas were calculated and the firm selected which had the closest value of
beta.19 The resulting betas were reasonably close. To be precise, the average
absolute difference in pre-merger betas between the monthly sample and

18. The market value is computed as of the merger date.

19. Debt/equity ratios for the control firms were assumed to stay the same during both the
pre- and post-merger sample periods; the ratios used to compute asset betas for the controls are
those at the start of the post-merger period. We do not attempt to adjust for changes in these ratios
for reasons other than merger.

control firms was . 124 for the acquiring firms and .236 for the acquired firms.
The selected control firms for the monthly sample are listed in table 2, and
the asset betas for the original and control companies are displayed in tables 3
and 4. 2 0
The risk effect of vertical integration can be isolated by the following

D = (pp - p j - (pcp - P J (4)

Downloaded from at University of Westminster on October 26, 2010


Pcp = the predicted post-merger weighted asset beta for the control
Pc.a = the actual post-merger weighted asset beta for this group.21

D thus measures the additional reduction in systematic risk in the vertically

merging firms over that in the control group and is therefore the effect that can
be attributed to vertical integration. Under the null hypothesis D is not
significantly different from zero. If the null hypothesis can be rejected on a
one-dimensional test, this will confirm that vertical integration is associated
with risk-reduction.

Formally, the null hypothesis is

Ho:D = 0 (5)

while the alternative hypothesis is

HA. D > 0.
Rather than resorting to distributional assumptions about D, we use the
Wilcoxon Matched Pairs Signed Ranks Test to test the null hypothesis.22 This
test ranks D according to the magnitude of the difference in the pre- and
post-merger risk reduction of the merging firms and that of the firms in the
control group. The highest number is assigned to the D with the highest
absolute value. The ranks are then signed so that where the merging firms had

20. Note thatfirmsin the original sample could also serve as control companies for other firms
providing the original firms had no vertical mergers during the time period for which they serve as
a control.
21. The weights used to compute fjc,, and p cn are those that existed at the start of the
post-merger period.
22. The power-efficiency of the Wilcoxon test for small samples is near 95 percent. Its
asymptotic efficiency compared with the parametric f-test is 3/ir = 95.5 percent (Mood). This
means that 3/n is the limiting ratio of sample sizes necessary for Wilcoxon test and f-test to attain
the same power.

Table 2. Control Group—Monthly Sample (Firm-matched, with acquired firm

listed first)
Market value ($MM)*
Case no. Firm name (equity and debt)

1 Chesapeake Corp. 14.6

KVP Paper 31.5
2 Champlin Oil 144.3
Koppers 111.7

Downloaded from at University of Westminster on October 26, 2010

3 United Board & Carton 6.7
Corning Class 436.1
4 National Vulcanized Fibre 7.7
Diamond Alkali 180.0
5 Lukens 64.2
Revere Copper & Brass 89.3
6 Magnavox 300.7
General Motors 16,704.2
7 Atlas Chemical 75.3
(Granby Mining) 9.5
(Olin Corp.) 847.6
Shell Oil 2,903.0
8 Dayco 45.4
Reichhold Chemicals 82.0
9 Chesapeake Corp. 68.1
Shell Oil 4,072.4
10 Publicker 46.5
Quaker State Oil 87.2
11 General American Oil Co., Texas 278.9
Apco Oil 123.9
12 Smith (A.O.) Co. 129.2
Chrysler Corp. 1,771.2
13 Florida Steel 40.5
Federal Mogul Corp. 173.9
14 International Rectifier 26.1
(Simmonds Precision Products) 49.9
Asarco 780.0
•Long-term debt plus preferred stock plus market value of common stock as of the first month following
the merger.

a greater risk-reduction than the control firms, the rank receives a positive
sign. If the null hypothesis is correct the summation of the positively signed
ranks and that of the negatively signed ranks summed separately should be
approximately equal. The smaller sum of the like-signed ranks, T, is approxi-
mately normally distributed for large sample sizes, while for smaller sample
sizes approximations exist.23

23 Critical values were obtained from Biometrika Tables for Statisticians, volume 2 (1976).

The methodology described above is, in many ways, biased against a finding
that vertical mergers reduce risk. The generally small sizes of the acquired
companies compared to that of the acquiring companies makes it more diffi-
cult to discern an impact of a given merger on the estimated post-merger
betas. This is due to the lower weights which smaller firms have in the
weighted beta calculations. In addition, the merger sample size is small.
Table 3 shows the calculations of the measured risk reduction in the

Downloaded from at University of Westminster on October 26, 2010

merging firms. Because the impact of vertical mergers on risk in the absence
of controls may be of interest, the extreme right-hand column displays the
results of a Wilcoxon test for the merging firms only. The sum of the negative
ranks (the less frequent sign) is 18; the null hypothesis of no change in risk can
be rejected in favor of a positive risk reduction (without controls) at the 98.5
percent level of significance.24
Table 4 displays the calculation of the measured risk reduction for the
control groups. In table 5, the risk reduction figures for both the merging and
the control firms are displayed and the result of the Wilcoxon test for the two
groups is shown in the extreme righthand column. The sum of the negative
signed ranks (the less frequent sign) is 14; we are able to reject the null
hypothesis that D = 0 in favor of the alternate hypothesis that D > 0 at the
99.3 percent level of significance.
This very high level of significance is encouraging; however, it does occur
in part because some of the control firms experienced risk increases. These
risk increases are not anomalous. In two of the cases, numbers 8 and 14,
virtually all of the possible control companies for the acquiring (and larger)
firm had an increase in risk. For case 4, betas increased for two-thirds of the
possible controls for both the acquired and the acquiring companies. The risk
increase to the acquiring firm's control in case 5 accounts for almost all of the
rise in the weighted beta; here again, two-thirds of the possible controls had
increased risk. The rise in the betas for both control companies in case 11 most
likely occurs for a different reason—regression toward the mean. The merging
companies in case 11 also had estimated pre-merger betas well below 1.00,
but their risk decreased following the merger. In summary, for those controls
whose risk increased, much of the rise appears to be explained by industry
effects or regression toward the mean, factors which the controls were de-
signed to capture.
The results of the Wilcoxon test for the risk changes in the samples with and
without controls are also highly robust. To test robustness, we progressively
drop the observation with the highest rank from the sample and recompute

24. Since it is possible that the assumption that P^-i,, = 0 may be incorrect, we also
performed this test under the extreme assumption that P<i,.|,, = P,.,,,,^- Under this assump-
tion, the null hypothesis of no risk change for the merging firms can be rejected at the 91.4
percent level of significance.
Table 3. Risk Reduction in Merging Firms

(1) (2) (3) (4) (5) (6) (7)

Weighted average Rank of absolute
Pre-merger B Pre-merger p of pre-merger Post-merger (3 of Risk reduction magnitude of
Case no. of acquired co.. of acquiring co. P's integrated firm (4)-(5) column 6 T

1 1.017445 .5992289 .6826984 .8331071 -.1504087 6 6

2 .9772209 1.0036458 .9976681 .9318527 .0658154 3
3 .5718657 .9578601 .8579764 .6526582 .2053182 10
4 .7078524 .9792752 .9718876 .7968439 .1750437 9
5 1.2684521 .9606079 1.0262742 .6775343 .3487399 13
6 1.0099688 .9722603 .9731282 1.0654082 -.09228 4 4
7 1.1527121* .8042226 .8959696 .2508674 .6451022 14
8 2.5441532 1.0486786 1.1473104 1.2857318 -.1384214 5 5
9 .6596737 .814925 .8117442 .847195 -.0354508 2 2
10 .845915 .9848874 .9673769 .7955002 .1718767 8
11 .558048 .678802 .5929784 .2467771 .3462013 12
Downloaded from at University of Westminster on October 26, 2010

12 .5731739 .9215254 .819901 .4845268 .3353742 11

13 .7182735 1.124393 1.093533 1.0995292 -.0059962 1 1
14 .7872474 d .7808936 .8627669 .7053954 .1573715 7

a. (J for Columbian Carbon.

b. & for Miami Copper.
c. p for Tennessee Corp.
d. 6 for Sprague Electric.
e. B for Automation Inds.
Table 4. Risk Reduction in Control Group
(1) (2) (3) (4) (5) (6) (7) (8)
Pre-merger Pre-merger Weighted Post-merger Post-merger Weighted
$ of firm P of firm average of P of firm P of firm average of Risk
Case matched with matched with pre-merger matched with matched with post-merger reduction
no. acquired firm acquiring firm p's acquired firm acquiring firm P's (4)-(7)

1 1.296059 .7242077 .9052537 1.286096 .8504807 .9883949 .0831412

2 .918111 .9680148 .9434507 1.1037528 .82962566 .9645558 -.0211051
3 .4580774 .9650575 .9573405 .7809048 1.5090916 1.4980075 -.540667
4 .6493176 .976841 .9633996 1.2986353 1.0870248 1.0957091 -.1323095
5 1.3816054 1.0636639 1.1966767 1.7164166 1.8052947 1.768112 -.5714353
6 .1308006 1.0919257 1.0857463 1.5327794 .843351 .855541 .2402053
7 1.0171632" 1.0494717 1.0584573 .6621023" .8601623 .8995811 .1588762
(1.4917961)1' (1.912625)1'
(1.087984 )c (1.0443062)"
8 .8408465 .995641 .9405225 1.0171964 1.3728347 1.2462008 -.3056783
9 .7489922 .7016597 .702437 .347047 .6981332 .6861659 .0162711
10 .9473385 .9645965 .9585976 1.6274997 .9971185 1.216273 -.2576754
11 .546873 .7772373 .6177254 1.353818 .9955759 1.2436345 -.6259091
12 .4713638 .7019615 .6862806 .4990933 .4941231 .494461 .1918196
.4975121 .6130173 .4611883 .4898888 .0076233
Downloaded from at University of Westminster on October 26, 2010

13 .8109566 .42445
14 .8331745 ll .5773559 .6145383 1.070555d 1.2522501 1.2546624 -.6377118
(.9734299)c- (1.2930393)c

a. 3 for Atlas Chemical.

b. ^ for Cranby Mining.
c. p for Olin Corp.
d. fi International Rectifier.
e. 8 for Simmonds Precision Products.

Table 5. Wilcoxon Signed Rank Test of the Risk-Reduction Hypothesis

(1) (2) (3) (4) (5) (6)

Risk reduction Rank of
Risk reduction of firms in Net risk absolute
Case of merging firms control group reduction magnitude
no. (from table 3) (from table 4) (2)-(3) of col. (4) T

1 -.1504087 -.0831412 -.0672675 3 3

2 .0658154 -.0211051 +.0869205 4
3 .2053182 -.540667 +.7459852 11

Downloaded from at University of Westminster on October 26, 2010

4 .1750437 -.1323095 +.3073532 7
5 .3487399 -.5714353 +.9201752 13
6 -.09228 .2402053 -.3324853 8 8
7 .6451022 .1588762 +.486226 10
8 -.1384214 -.3056783 +.1672569 6
9 -.0354508 .0162711 -.0517219 2 2
10 .1718767 -.2576754 +.4295521 9
11 .3462013 -.6259091 +.9721104 14
12 .3353742 .1918196 +.1435546 5
13 -.0059962 .0076233 -.0136195 1 1
14 .1573715 -.6377118 +.7950833 12

the significance level. Table 6 shows the results of this procedure for the
samples with and without controls. Where controls are used, the deletion of
the top four net risk changes, over one quarter of the sample, still produces a
significance level of over 90 percent; similarly, for the sample without con-
trols, the deletion of the top three net risk changes produces a significance
level of approximately 90 percent.
To provide yet another check on our results, we have calculated the net risk
reductions using an alternative control group—industry indexes. Each merg-
ing firm is assigned a value-weighted industry index, composed of all firms in
the industry who were listed on CRSP during the entire pre- and post-merger
periods and were not involved in mergers during that time. The asset beta for

Table 6. Tests for Robustness

Wilcoxon test results using matched pairs
Sample size Cases deleted Significance level (%)

14 None 99.3
13 11 98.7
12 11, 15 97.4
11 11, 5, 14 94.9
10 11, 5, 14, 3 90.3
Wilcoxon test results without controls
Sample size Cases deleted Significance level (%)

14 None 98.5
13 7 97.1
12 7,5 94.5
11 7, 5, 11 89.7
Table 7. Risk Reduction in the Industry Index Control Group
(1) (2) (3) (4) (5) (6) (7) (8)
Pre-merger Pre-merger Post-merger Post-merger
(3 of industry P of industry Weighted P of industry P of industry Weighted
index matched index matched average of index matched index matched average of Risk
Case with acquired with acquiring pre-merger with acquired with acquiring post-merger reduction
no. firm firm p's firm firm (4)-(7)

1 .7016437 1.0092889 .9478876 .6333556 .7289348 .7098586 .238029

2 1.1059951 .9504503 .9856365 1.0585817 .7269082 .8019371 .1836994
3 .9354547 1.0719177 1.0366052 .4858373 .9290353 .814349 .2222562
4 .646298 .9835204 .9743419 .8179408 .963752 .9597833 .0145586
5 1.2S8932 1.2234688 1.2374328 1.0313338 1.31907 1.2576927 -.0202599
6 1.3362581 1.0690792 1.075229 1.3224691 .8487366 .8596407 .2155883
7 .7462836 • .9974425 .9771353 1.0040381' .735879 .8082978 .1688275
(1.1217788)b (1.2580779)b
( . 9384292)' (1.0792388)°
8 .7941593 .9255073 .9168444 1.0264571 1.0284881 1.0283541 -.1115097
9 1.0509585 .6692943 .6771138 1.1481767 .7117748 .7207157 -.0436019
10 .9231105 .7036367 .7312903 .5578946 .7811225 .7529958 -.0217055
11 .9598239 .5415657 .8388346 .9663155 .6735198 .8816186 -.042784
12 .8285786 .7388191 .7650045 2.3242701 .610835 1.1106944 -.3456899
13 .666581 .42445d .4428489 .6726809 .4611883d .477259 -.0344101
Downloaded from at University of Westminster on October 26, 2010

14 1.2277426° .5051038 .7845767 1.4878796' 1.0013182 1.1431882 -.3586115

(1.285288/ (1.2509527)f

a. Industry index match for Columbian Carbon.

b. Industry index match for Miami Copper.
c. Industry index match for Tennessee Corp.
d. The industry match here consists of only one company because the company in the original sample, Timken, manufactures a very specialized product.
e. Industry index match for Sprague Electric.
f. Industry index match for Automation Inds.

each firm in the index is weighted by the share of thefirm'sasset value relative
to the industry total.25 For each merger in the sample, the predicted and
actual post-merger industry betas are computed using the weights assigned to
the merging firms themselves to weight the matched industry index for each
firm. Table 7 displays the computed risk changes for the industry index
An industry index provides a much less precise control for a merging
company than does a single matched company. Neither regression toward the
mean nor firm size differences are taken into account. One or more relatively

Downloaded from at University of Westminster on October 26, 2010

large companies within the industry may disproportionately affect the beta for
the index. Therefore, although one might expect the industry controls to show
risk changes between the pre-and post-merger periods of close to zero, in fact
the numbers on table 7 show some relatively large positive and negative risk
reductions for the industry index controls. As in the case of the matched
company controls, many of the industry controls (eight in this case) show risk
increases. Table 8 presents the results of the Wilcoxon test using the industry
index controls. The sum of the negative signed ranks (the less frequent sign) is
28; we are able to reject the null hypothesis that D = 0 in favor of the alternate
hypothesis that D > 0 at the 93.2 percent level of significance. Again, the test
rejects the null hypothesis; given the less precise nature of the industry index
controls, it is not surprising that this occurs at a somewhat lower level of

Table 8. Wilcoxon Signed Rank Test Using Industry Index Controls

(1) (2) (3) (4) (5) (6)
Risk reduction Rank of
Risk reduction of industry index Net risk absolute
Case of merging firms control group reduction magnitude
no. (from table 3) (from table 7) (2)-(3) of col. (4) T

1 -.1504087 .2262132 -.3884377 10 10

2 .0658154 .1836994 -.117884 5 5
3 .2053182 .2222562 -.016938 2 2
4 . 1750437 .0145586 .1604851 6
5 .3487399 -.0202599 .3689998 9
6 -.09228 .2155883 -.3078683 8 8
7 .6451022 .1688375 .4762647 12
8 -.1384214 -.1115097 -.0269117 3 3
9 -.0354508 -.0436019 .0081511 1
10 .1718767 -.0217055 .1935822 7
11 .3462013 -.042784 .3889853 11
12 .3353742 -.3456899 .6810641 14
13 -.0059962 -.0344101 .0284139 4
14 .1573715 -.3586115 .515983 13

25. Firm debt figures are only available on an annual basis, rather than on a monthly basis as
are the CRSP stock market returns and stock market equity values. Furthermore, the debt figures
are not available on COMPUSTAT prior to 1966 and must be obtained from Moody's. Due to
these data availability problems, the betas in the industry indexes are weighted by firm values at
the time of the merger.

The results, both with and without controls, suggest that vertical integration,
at least when executed via vertical mergers, may be associated with a reduc-
tion in systematic risk. Although further work is needed to affirm the general-
ity of these findings, the results are encouraging and appear to be robust. The
statistical findings were sustained using "matched pairs" as controls, using
industry indexes as controls, and using no controls at all. Most important,
using control firms which were similar in many important ways, we obtained

Downloaded from at University of Westminster on October 26, 2010

statistical significance of greater than 99 percent.
It is interesting to note that evidence elsewhere suggests that this pheno-
menon is not associated with horizontal or conglomerate mergers. A study
that did not differentiate between the various generic classes of mergers found
that mergers had no clear directional effect on the riskiness of acquiring firms,
as measured by beta (Lev and Mandelker). The results here suggest that verti-
cally integrated firms may have cost advantages in raising equity capital
(Bicksler), which has important implications for assessing whether vertical
integration might create "barriers" to entry (Williamson, 1975; 110-13; Bork:
148). To order vertical divestiture in circumstances where secondary and
behavioral uncertainties are believed to be important, moreover, could raise
the cost of capital for the firms involved (Mitchell). Clearly, more research is
needed before the welfare implications of this organizational model can be
accurately assessed. Nevertheless, it appears that vertical integration involves
more than a portfolio effect with respect to risk reduction. Specifically, the
results indicate that enterprise managers can reduce an investment's expo-
sure to risk in ways which portfolio managers cannot.
There appear to be important implications for both the theory of the firm
and investment theory. In particular, vertical integration appears to have a
wider set of performance ramifications than is commonly supposed.

Armour, Henry, and David J. Teece. 1978. "Organizational Structure and Economic
Performance: A Test of the M-Form Hypothesis," 9 Bell Journal of Economics
. 1980. "Vertical Integration and Technological Innovation," 62 Review of Eco-
nomics and Statistics. 470-74.
Arrow, Kenneth J. 1975. "Vertical Integration and Communication," 6 Bell Journal of
Economics 173-83.
Bicksler, James. 1977. "The Usefulness of Beta Risk for Estimating the Cost of
Capital," in I. Friend and J. Bicksler, eds., Risk and Return in Finance. Cam-
bridge: Ballinger.
Black, Fisher, Michael Jensen, and Myron Scholes. 1972. "The Capital Asset Pricing
Model: Some Empirical Tests," in M. Jensen, ed., Studies in the Theory of
Capital Markets. New York: Praeger.

Blume, Marshall. 1971. "On the Assessment of Risk," 26 Journal of Finance 1-10.
. 1977. "Betas and Their Regression Tendencies," in I. Friend and J. Bicksler,
eds., Risk and Return in Finance. Cambridge: Ballinger.
Bork, Robert H. 1969. "Vertical Integration and Competitive Processes," in J. F.
Weston and S. Peltzman, eds., Public Policy towards Mergers. Pacific Palisades:
Goodyear Publishing.
Brealey, Richard, and Stewart Myers. 1984. Principles of Corporate Finance. New
York: McGraw-Hill.
Carlton, Dennis W. 1978. "Market Behavior with Demand Uncertainty and Price
Inflexibility," 68 American Economic Review 571—87.

Downloaded from at University of Westminster on October 26, 2010

Federal Trade Commission. 1981. Statistical Report on Mergers and Acquisitions.
Washington, DC: Bureau of Economics.
Foster, George. 1978. Financial Statement Analysis. Englewood Cliffs: Prentice Hall.
Hadley, G. 1967. Introduction to Probability and Statistical Decision Theory. San
Francisco: Holden Day.
Halpem, Paul. 1973. "Empirical Estimates of the Amount and Distribution of Gains to
Companies in Mergers," 46 Journal of Business 554-75.
King, Benjamin. 1966. "Market and Industry Factors in Stock Price Behavior," 39
Journal of Business 139-90.
Klein, Benjamin, Robert G. Crawford, andArmenA. Alchian. 1978. "Vertical Integra-
tion, Appropriable Rents and the Competitive Contracting Process," 21 Journal
of Law and Economics 297-326.
Koopmans, TjallingC. 1957. Three Essays onthe State of Economic Science. New York:
Lev, Baruch, and Gershon Mandelker. 1972. "The Microeconomic Consequences of
Corporate Mergers," 45 Journal of Business 85—104.
Lintner, John. 1965. "Security of Prices, Risk and Maximal Gains from Diversifica-
tion," 20 Journal of Finance 587-616.
Malmgren, H.B. 1961. "Information, Expectations and the Theory of the Firm," 75
Quarterly Journal of Economics 399-421.
Mitchell, Edward. 1976. "Capital Cost Savings of Vertical Integration," in E. Mitchell,
ed., Vertical Integration in the Oil Industry. Washington, DC: American Enter-
prise Institute.
Monteverde, Kirk, and David J. Teece. 1982. "Supplier Switching Costs and Vertical
Integration in the Automobile Industry," 13 Bell Journal of Economics 206-13.
Mood, Alexander M. 1954. "On the Asymptotic Efficiency of Certain Non-Parametric
Two-Sample Tests," 25 Annals of Mathematical Statistics 514—22.
Mossin, Jan. 1966. "Equilibrium in a Capital Asset Market," 34 Econometrica 768—83.
Nelson, Richard R., and Sidney E. Winter. 1982. An Evolutionary Theory of Eco-
nomic Change. Cambridge: Harvard University Press.
Rohlf, F. James, and Robert R. Sokal. 1969. Statistical Tables. San Francisco: W.H.
Roll, Richard. 1977. "A Critique of the Asset Pricing Theory Test," 4 Journal of
Financial Economics 129—76.
Rosenberg, Barr, and James Guy. 1975. The Prediction of Systematic Risk. Working
paper no. 33. Berkeley: Institute of Business and Economic Research, University
of California.
Ross, Steven A. 1977. "Risk, Return, and Arbitrage," in I. Friend and J. Bicksler, eds.,
Risk and Return in Finance. Cambridge: Ballinger.
Sharpe, William F. 1964. "Capital Asset Prices: A Theory of Market Equilibrium
under Conditions of Risk," 19 Journal of Finance 425—42.
. 1970. Portfolio Theory and Capital Markets. New York: McGraw-Hill.
. 1978. Investments. New Jersey: Prentice-Hall.

Spiller, Pablo. 1985. "On Vertical Mergers," 1 Journal of Law, Economics, and
Organization 285-312.
Teece, David J. 1976. Vertical Integration and Vertical Divestiture in the U.S. Oil
Industry. Stanford: Institute for Energy Studies.
. 1981. "Internal Organization and Economic Performance: An Empirical
Analysis of the Profitability of Principal Firms," 30 Journal of Industrial Eco-
nomics 173-90.
-, Henry Armour, and Garth Saloner. 1980. "Vertical Integration and Risk
Reduction," Research paper no. 563, revised May 1983. Graduate School of
Business, Stanford University.

Downloaded from at University of Westminster on October 26, 2010

Thompson, James D. 1967. Organizations in Action. New York: McGraw-Hill.
Williamson, Oliver E. 1975. Markets and Hierarchies: Analysis and Antitrust Implica-
tions. New York: Free Press.
. 1979. "Transactions-Cost Economics: The Governance of Contractual Rela-
tions," 22 Journal of Law and Economics 233—61.
-. 1981. "The Modern Corporation: Origins, Evolution, Attributes," 19Journal
of Economic Literature 1537-68.
—. 1985. The Economic Institutions of Capitalism. New York: Free Press.