Journal of Business Research 109 (2020) 271–287

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Journal of Business Research

journal homepage: www.elsevier.com/locate/jbusres

Unbalanced data, type II error, and nonlinearity in predicting M&A failure T

a,⁎ b c a d
Kangbok Lee , Sunghoon Joo , Hyeoncheol Baik , Sumin Han , Joonhwan In
a
Auburn University, Harbert College of Business, 415 W. Magnolia Ave, Auburn, AL 36849, United States
b
California State University Dominguez Hills, College of Business Administration and Public Policy, 1000 E. Victoria Street, Carson, CA 90747, United States
c
Stockton University, School of Business, 101 Vera King Farris Drive, Galloway, NJ 08205, United States
d
Ulsan National Institute of Science and Technology, Graduate School of Technology and Innovation Management/School of Business Administration, Ulsan 44919, South
Korea

ARTICLE INFO ABSTRACT

Keywords: The traditional forecasting methods in the M&A data have three limitations: first, the outcome of M&A deal is an
Nonlinearity prediction event with a small probability of failure, second, the consequences of misclassifying failure as success are much
Unbalanced data more severe than those of misclassifying success as failure, and third, the nonlinear and complex nature of the
Logit and Probit model relationship between predictors and M&A outcome could limit the advantage of logistic regression. To overcome
Generalized logit model
these limitations, we develop a forecasting model that combines two complementary approaches: a generalized
Neural network
logit model framework and a context-specific cost-sensitive function. Our empirical results demonstrate that the
Merger and acquisition
Machine learning proposed approach provides excellent forecasts when compared with traditional forecasting methods.

1. Introduction
Despite decades-long scrutiny from academics and practitioners in
the disciplines of finance and management (Krishnan & Masulis, 2013;
Wang & Branch, 2009), the accurate forecast of merger and acquisition
(M&A) outcomes has been a challenging task for organizations that
need to make strategic business decisions (Lin, Lan, & Chuang, 2013).
Given that the choice of the right forecasting model is a multi-faceted
decision that must consider both the pros and cons of forecasting
models of interest and data characteristics, we claim that the use of
traditional forecasting methods (e.g., logit and probit) in the M&A
forecast context could have three critical limitations.
From a probabilistic model standpoint, the failure of M&A deals can
be characterized as rare events, with a small probability of failure (i.e.,
unbalanced data); in general, successful instances of M&A outnumber
the failures (e.g., about 10% of the sample) (Wang & Branch, 2009).
Under such conditions, the estimation or training of a model using such
unbalanced data can introduce bias towards the success-category due to
the larger number of data points under the success category. This could
lead an organization to make a wrong business decision and ultimately
endanger itself in the market.
From a managerial standpoint, it is not uncommon in the business
environment that the consequences of a type II error (i.e., false nega-
tive; misclassifying failure as success) render more detrimental impacts
on organizations than those of a type I error (i.e., false positive; mis-
classifying success as failure). Barnes (1999) noted that in takeover
predictions, the penalty of misclassifying a non-target firm as a target
(type II error) is significantly higher than misclassifying a target as a
non-target (type I error), while Hansen, McDonald, Messier, and Bell
(1996) explained that in fraud detections, the failure to detect fraud
when it occurs (type II error) is significantly costlier to Certified Public
Accountant firms than predicting fraud when it does not occur (type I
error), since type II errors lead to litigation, while type I errors lead to
over-auditing. Similarly, misclassifying M&A failures as successes (type
II error) may incur the opportunity cost caused as a result of not
searching for alternative targets, and this opportunity cost may be high
when compared to the cost related to preparing for alternative deals as
a result of misclassification of M&A success as failure (type I error).
High levels of misclassification are of a vital concern in takeover pre-
dictions—especially when costly type II errors occur (Rodrigues &
Stevenson, 2013), that is, when M&A failures are predicted to be suc-
cesses.
From a model selection standpoint, the nonlinear and complex
nature of the relationship between predictors and M&A outcome data
could limit the advantages of logit and probit classification methods
over linear models. Research addressing the prediction of M&A success
or failure has largely used the logit and probit models in finance lit-
erature over the last three decades (see Table 2). This may be because

Corresponding author.
⁎

E-mail addresses: kbl0009@auburn.edu (K. Lee), sjoo@csudh.edu (S. Joo), hyeoncheol.baik@stockton.edu (H. Baik), szh0117@auburn.edu (S. Han),
junani12@gmail.com (J. In).

https://doi.org/10.1016/j.jbusres.2019.11.083
Received 19 March 2019; Received in revised form 27 November 2019; Accepted 28 November 2019
0148-2963/ © 2019 Elsevier Inc. All rights reserved.
K. Lee, et al.
such models are well-established and are, thus, considered to be pow-
erful approaches in the classification of binary response in literature
(Audrino, Kostrov, & Ortega, 2019). The logit and probit classification
methods could overcome the shortcomings of linear regression models.1
However, the logit and probit models cannot solve non-linear classi-
fication problems because their decision surface is linear, as illustrated in
Fig. 1 (see note in Fig. 1). These approaches separate the predictors into
two regions using a linear boundary (i.e., M&A success and failure). As
depicted in the left panel of Fig. 1, the logit and probit models assume a
linear decision boundary between the two classes and, thus, their pre-
diction power could be lower than that of the neural network model using
nonlinear decision boundaries. As an example, Giordani, Jacobson, Von
Schedvin, and Villani (2014) were able to improve forecasting power by
using nonlinearity specification2 between firm failure and leverage,
earnings, and liquidity. Therefore, it can be argued that forecasting the
success or failure of M&A deals requires prediction models that (i) can
mitigate potential problems arising from unbalanced data, (ii) incorporate
a misclassification error, and (iii) assume possible nonlinear structures of
association between predictors and response variables.
This research combines two complementary approaches: a gen-
eralized logit model framework (i.e., the general form of sigmoid-type
functions) and a context-specific cost-sensitive function (the penalty
term in an objective function) to account for unbalanced data and type
II errors, respectively. To identify the possible nonlinear relationship
between predictors and M&A outcomes, we focus and develop a neural
network-based M&A forecasting model as the models gain flexibility in
the choice of the nonlinear form of threshold classification, which does
not require the same functional form for all data, as with data points in
the right panel of Fig. 1. Neural network models have been proven to
have good predictive power in the literature (Hatzakis, Nair, & Pinedo,
2010). The nonparametric nature of neural models makes them parti-
cularly well-suited for observational data in social science where as-
sumptions of linearity and normality cannot be assured3; neural net-
work models have demonstrated the ability to accurately approximate
almost any non-linear arbitrary function.
Our research differs from existing studies in two respects. Our
proposed model employs the general form of sigmoid-type functions
that could add more parameters in order to increase the limits of the
output range and control the steepness of its graph. This approach al-
lows the proposed model to flexibly address bias in the dominant class
model (i.e., the class with more observations).
Second, in the conventional setting of a model that allows a linear model
to be related to the response variable via a sigmoid-type link function, the
model’s classification accuracy is typically evaluated by estimating its error
rate on the sample based on the assumption that all classification errors
have equal costs. As previously mentioned, this assumption does not hold in
our context as the error costs drastically differ between types (e.g., type I
errors vs. type II errors). Hence, our research incorporates cost-sensitive
modifications into the estimation procedures following the works of Kukar
and Kononenko (1998) and Breiman, Friedman, Olshen, and Stone (1984)
(We discuss more of this in detail in Section 3.3).
This paper is organized as follows. In the following section, we
describe the pilot study to explain how the logit function can suffer
from unbalanced data and why increasing the limits of the output range
and controlling the steepness of its graph can help mitigate potential
problems from unbalanced data. After reviewing various forecasting
1
In the linear model, the dependent variable is assumed to be continuous and
unbounded. By introducing the sigmoid function, the logit and probit can work
well with M&A outcome data, especially if we believe in a non-monotone re-
lationship between predictors and the probability of M&A outcome.
2
Giordani et al. (2014) implemented spline functions in a logit model to
account for a highly nonlinear structure.
3
Lippmann (1987) showed that neural models are robust and are not easily
confounded by the misspecification of underlying data distributions.
272
Journal of Business Research 109 (2020) 271–287
models in the finance and management literature, we develop a neural
network-based M&A forecasting model and assess the predictive power
of the proposed model using a number of competing models. We con-
clude the paper with the discussion on the contributions and sugges-
tions for future research. The implementation of our approach is
available using the R software (see Appendix A).
2. Experiments using logit functions with unbalanced data
In this section, we highlight the limitations of logit functions in
forecasting unbalanced data and succinctly explain our overall mod-
eling approach.
2.1. Unequal contribution of ones (failures) and zeros (success) to the
learning process in the unbalanced data
Let us define a single output y as the posterior probability of a
failure class. Then, the posterior probability of a success class will be
given by 1 y . Let t denote the target variable where t = 1 if the input
vector belongs to the withdrawn class with probability y and t = 0 if it
belongs to the complete class with probability 1 y ; equivalently,
Pr(t = 1) = y . Suppose we are interested in estimating the logit model
that maximizes the log likelihood function, Li , which describes the
likelihood of observing the dyadic outcome ti for an acquiring firm i
considering the total asset difference ( x i ) between the acquiring firm i
and its target firm, given the parameter . For our model, we get:
logit 1( xi )for ti = 1
Li = .
1 logit 1 ( xi )for ti = 0 (1)
We can summarize this piecewise function as
Li = [logit 1 ( x i )]ti [1 logit 1 ( x i )]1 ti . Maximum-likelihood logit
analysis then works by finding the value of that provides the max-
imum value of the log likelihood function ln i Li , and we label this
N
estimator . The asymptotic variance matrix, V ( ) , is also estimated to
calculate the standard errors. When observations are selected randomly
and there is no perfect discrimination between zeros and ones, is
consistent and asymptotically efficient. However, as previously men-
tioned, very small parts of data sets contain most of the important in-
formation, which can be seen by examining the variance matrix,
N 1
V ( ) = [ i yi (1 yi ) x i' x i ] . The part of this variance matrix affected
by the unbalanced data is the component yi (1 yi ). In this setting,
additional ones will significantly decrease the variance (i.e., un-
certainty; inverse of yi (1 yi ) ) because yi (1 yi ) will be larger with
additional ones than with additional zeros in the unbalanced data
(Imbens, 1992; Lancaster & Imbens, 1996). Thus, additional ones (small
part; rare events) of data sets contain more information than additional
zeros.
2.2. Skewness refers to a lack of symmetry and causes overestimation
The problem with the logit model introduced by unbalanced data is
illustrated by Fig. 2, which shows the logit curves for unbalanced data
and balanced data (by using random under-sampling). For these data
sets, Pr(M&A = failure) is shown as a function of the differences in total
assets between the acquiring and target firms. The developmental
sample for the curves consists of 803 M&A cases (107 failures; 13%)
between 2006 and 2015 (more details about this data set will be given
in the Section 4).
To achieve the balanced data, we randomly remove the majority of
examples from the original data set. For a clearer presentation, we here
establish some of the notations used in this section. Considering a given
data set N with m observations, we define subsets Nmajority N and
Nminority N , where Nmajority is the set of majority-class examples in N ,
and Nminority is the set of minority-class examples in N . Thus,
Nmajority Nminority = { } and Nmajority Nminority = N . To create the set of
K. Lee, et al. Journal of Business Research 109 (2020) 271–287

Logit model decision boundary Neural network decision boundary

The overall percentage of correctly classified cases for The overall percentage of correctly classified cases
the logit model for the neural network
51% 97.5%
Fig. 1. The linear and nonlinear decision boundaries, logit model and neural network, respectively, are displayed, dividing M&A success and failure classes.

Unbalanced (original) data Balanced (resampling) data

Fig. 2. The logit curves for unbalanced (original) and balanced (resampling) data illustrate the problem with the logit model introduced by unbalanced data.

balanced data, we randomly select majority examples and remove them
from the set, Nmajority . In this way, the number of total examples in
Nmajority is decreased by D = Nmajority Nminority , where Nminority indicates
minority examples. In particular, we randomly select a set of majority
examples in Nmajority and remove these samples from N so that
Nbalanced = Nminority + Nmajority D. In this way, undersampling readily
gives us a simple method for adjusting the balance of the original data
set N.
We then fit the logit model to the data and compute the slope
coefficient ( 1) and location parameters ( 0 ). The probability of M&A
failure can be expressed as Pr(M&A = failure x ) =
1 x )) . The logit curve has the properties
p (t = 1 x ) = (1 + exp( 0 1
that the value of x at which Pr(M&A = failure) is 50% is given by
0 1, and the parameter 1 is such that the distance between the 95%
point and the 50% point is approximately 3 1 . Thus, the slope and
spread parameters can be defined by | 1| and |3 1|, respectively.
Therefore, the logit curve is completely determined by the two para-
meters, where the 50% value locates the midpoint of the curve and the
spread provides the shape of the curve.
A model provides a good fit to the data if it results in a high value of
L4 (as discussed in the previous section)—in other words, a high
4
If we assume independence across the dyadic relationships between ac-
quiring and target firms, the likelihood of observing success versus failure in
our sample is simply the product of the individual likelihood L = i Li . A
model provides a good fit to the data if it results in a high value of L .

273
K. Lee, et al. Journal of Business Research 109 (2020) 271–287

likelihood of observing the success or failure M&A combinations in the

sample given the parameter values of 0 and 1. Since maximum like-
lihood allows us to choose the optimal values of 0 and 1, the estimated

80 (True negative; 75% minority class

27 (False negative, type II error; 25%
Actual: M&A failure (Nminority = 107 )
values ( 0 and 1) that provide the best fit to the unbalanced data may
sharply underestimate the probability of rare events (in this case, M&A
failure). With the estimated parameters, we can predict the probability

Condition negative = 107

of a failed M&A: . Fig. 2 illustrates a logit model that includes the dif-

minority class miss rate)

ference in total assets as a single explanatory variable. By plugging the
explanatory variable into the logit transformation in both panels, we
map from the predictor to a probability. The dashed line shows a pre-
diction for 0 = 1 and 1 = 1. It is important to note that not only do the

detection)
50% values of the curves differ, but so do the slopes and spreads. The
logit curve for unbalanced data is flatter ( 0 1= 2.21; 0 = 1.04 ,
p -value = 4.87 × 10 11; 1 = .47, p -value = 5.8 × 10 8 ) than the

64 (True positive, power; 60% majority class

curve for balanced data ( 0 1 = 1.85; 0 =1.28, p -value = 1.2 × 10 ;
6

1= .69, p -value = 5.7 × 10 8 ). Therefore, the spread of the curve for

= 107 )

43 (False positive, type I error; 40%

unbalanced data (|3 1| = 6.38) is greater than that for balanced data
(|3 1| = 4.34 ). Obviously, if the difference in total assets between the

balanced
Actual: M&A success (Nmajority
acquiring and target firms is transformed into a deviation from the 50%

Balanced (resampling) data

Condition negative = 107

majority class miss rate)
values, then a given deviation would not give the same
Pr(M&A = failure) with balanced and unbalanced data. For example,
when a total asset difference is close to 1, the predicted probability is
about a 70% chance of failure in the balanced data but only a 20%

detection)
chance of failure in the unbalanced data.
We also report the confusion matrix in Table 1 and find that the
errors are not uniformly distributed in the unbalanced data, with 100%
false negatives and 0% false positives. Surprisingly, the slope and

Predicted: M&A Success

Predicted: M&A Failure

constant parameters are statistically significant at the even 0.01% level
despite the 100% prediction failure of withdrawn M&As. However, the Nbalanced = 214
confusion matrix for the balanced data shows more uniform errors than
that of the unbalanced data (25% false negatives and 40% false posi-
tives), probably because the slope is steeper and therefore the logit
model is more flexible; the predicted ranges of the probability of failure
for balanced and unbalanced data are approximately 0.26
0 (True negative; 0% minority class detection)

1 1
(= 1 + exp(1.04 + . 47 × . 018) 0 ) and 0.78 (= 1 + exp( 1.28 + . 69 × . 018) 0 ), re-
107 (False negative, type II error; 100%

spectively, where 0.018 is the minimum value of the difference in total

Actual: M&A failure (Nminority = 107 )

assets between the acquiring and target firms. It can be argued that the
steepness of a slope in the logit model reflects the difference in the
balance between M&A failures and successes. In other words, this il-
lustrates that it is possible to considerably mitigate the problem of
Condition negative = 107
minority class miss rate)

unbalanced data by adding more parameters that can increase the limits
of the output range or control the steepness of its graph. Thus, in this
study, we propose using the general form of the sigmoid function. We
consider this approach in more detail in the next section on modeling
approach.
0 (False positive, type I error; 0% majority
696 (True positive, power; 100% majority

3. A modeling framework for M&A forecasting

Actual: M&A success (Nmajority = 696 )

M&A forecasting models have been used in both management and

finance literatures. Examples include the logit model (Chakrabarti &
Mitchell, 2016; Cudd & Duggal, 2000;, Jeon & Ligon, 2011; Lin et al.,
Unbalanced (original) data

Condition positive = 696

2013; Renneboog & Zhao, 2014; Walkling, 1985), probit model (Baker,
Pan, & Wurgler, 2012; Lin et al., 2013; Officer, 2003), weighted logit
model (Wang & Branch, 2009), and neural network (Branch, Wang, &
class detection)

class miss rate)

Yang, 2008; Zhang, Johnson, & Wang, 2012) (see Table 2 for more
details). Among these approaches, neural network classifiers have
proven to have good predictive power in forecasting future behavior
(Hatzakis et al., 2010) and have been well recognized as a promising
method in both academia and practice. Although the regression-type
Predicted: M&A failure

models that comprised linear combinations of fixed functions have

Confusion matrix.

useful analytical and computational properties, their practical applic-

Predicted: M&A

Column total

ability is limited by the curse of dimensionality (Bishop, 2006). How-

success
Nraw = 803

ever, neural network approach that comprises multiple layers of logistic

Table 1

regression models is to fix the number of basis functions in advance but

allow them to be adaptive; to use parametric forms for the basis

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 K. Lee, et al.

Table 2
M&A success/failure prediction literature.
Study Journal DV (Binary) In-sample (S/ Out-of-sample Sample period Sample (S/ Proportion of Methodology
F/O) (S/F/O) F) failure

de Bodt, Cousin, and Roll (2018) Journal of Financial and Yes – – 1994–2014 5318/462 0.20 Probit
Quantitative Analysis
Chakrabarti and Mitchell (2016) Strategic Management Journal Yes – – 1980–2004 1326/277 0.17 Logit
Betton, Eckbo, Thompson, and The Journal of Finance Yes – – 1980–2008 5035/1068 0.18 Logit
Thorburn (2014)
Renneboog and Zhao (2014) Journal of Corporate Finance Yes – – 1995–2012 609/134 0.18 Logit
Krishnan and Masulis (2013) The Journal of Law and Yes (Failure = 1) – – 1990–2008 8474/1086 0.11 Logit
Economics
Lin et al. (2013) Journal of Forecasting Yes (95.4/29.0/ – 2000–2007 66/38 0.36 Option-based approach; Logit; Probit
71.2)
Baker et al. (2012) Journal of Financial Economics Yes – – 1984–2007 4853/1609 0.24 Probit
Zhang et al. (2012) Journal of Business and Yes – (97.1/50.4/ 1991–2004 1050/146 0.12 Logit; Neural network; SVM – Linear Kernel; REPTree;
Economic Research 91.0) Decision tree; Random forest; AdaBoost
Jeon and Ligon (2011) Journal of Corporate Finance Yes – – 2001–2007 1489/213 0.12 Logit
Wang and Branch (2009) Journal of Business and Yes (Failure = 1) – – 1995–2005 1170/143 0.11 Logit; Weighted logit
Economic Studies
Branch et al. (2008) International Review of Yes – (98.2/58.0/-) 1991–2004 1050/146 0.12 Neural network; Logit
Financial Analysis

275
Heron and Lie (2006) Journal of Business Yes – – 1985–1998 111/415a 0.21 Logit
Bhagat et al. (2005) Journal of Financial Economics Yes – – 1962–2001 690/328 0.32 Logit
Bange and Mazzeo (2004) The Review of Financial Studies Yes – – 1979–1990 297/139 0.31 Logit
Branch and Yang (2003) Quarterly Journal of Business Yes – (91.2/62.5/ 1991–2001 86/13 0.13 Logit
and Economics 88.9)
Officer (2003) Journal of Financial Economics Yes – – 1988–2000 2084/427 0.17 Probit
Baker and Savasoglu (2002) Journal of Financial Economics Yes – – 1981–1996 1470/431 0.23 Probit
Cudd and Duggal (2000) The Financial Review Yes – (7.7/78.0/76.1) 1987–1991 13/460 0.03 Logit
Duggal and Millar (1994) Quarterly Review of Economics Yes – – 1984–1987 51/29 0.36 Logit
and Finance
Kaplan and Weisbach (1992) The Journal of Finance Yes – – 1971–1982 179/92 0.34 Linear Probability Model
Walkling (1985) Journal of Financial and Yes (100/9.1/ (87.1/33.3/ 1972–1977 72/36 0.33 Logit
Quantitative Analysis 83.9) 82.4)b
(85.7/80.0/ (14.3/100/
82.6) 62.5)c

In-sample and out-of-sample prediction accuracy rates are reported in terms of percentage (%). When there is multiple methodology used in a study, we italicize and bold the methodology that generates the highest
prediction accuracy rates and report corresponding in-sample and out-of-sample prediction accuracy rates. Note that S, F, and O indicate in-sample and our-of-sample prediction accuracy for success, failure, overall,
respectively.
a
This paper uses the sample of 526 hostile takeover attempts.
b
Uncontested sample.
c
Contested sample.
Journal of Business Research 109 (2020) 271–287
K. Lee, et al.
functions in which the parameter values are adapted during estimation
stage. There is an immense literature supporting this approach in en-
gineering, computer science, statistics, psychology, neuroscience,
medicine, finance, and other disciplines.
As mentioned before, one problem with the empirical im-
plementation of the logit function is the underestimation of the prob-
ability of rare events. For example, about 7–25% of M&A withdrawals
are reported in previous studies such as those of Brar, Giamouridis, and
Liodakis (2009), Wang and Branch (2009), and Baker et al. (2012). This
necessitates developing a model that can deal with unbalanced data to
accurately predict the ultimate success of takeover attempts. Most ex-
isting studies rely on the logit model and thus assume balanced data.
However, these studies conclude that there is significant empirical
evidence of M&A predictability without an examination of model fit.
Standard neural network classifiers, such as standard classifier learning
algorithms, also assume a balanced class distribution because of the
logit activation function (He & Garcia, 2009; Kwak & Choi, 2002), in
that the model is often estimated from a pair-matched sample (Barnes,
1999; Wang & Branch, 2009). Put more simply, a standard neural
network classifier is designed to avoid rare events (i.e., a balanced class
assumption) and instead prefer a balanced frequency. This method is
more appropriate for a controlled or experimental setting rather than
uncontrollable environments such as those of observational studies; as
the class imbalance increases, a standard neural network classifier is
less likely to capture true data characteristics because most standard
learning algorithms assume a balanced distribution (He & Garcia,
2009). Therefore, a standard neural network classifier may not effec-
tively forecast the outcome of M&As, given that events labeled “rare”
are prevalent in reality (Denrell & Fang, 2010).
3.1. Linkage between logit model and neural network
Since the success and failure classes are mutually exclusive and
exhaustive, a Bernoulli distribution fully describes this variable. Thus,
the probability of observing either target value is
Pr(t x ) = y t (1 y )1 t , (2)
which is a case of the binomial distribution. Let a vector of a constant
term with k inputs be denoted x = {1, x1, x2, , xk } . Then the relation-
ship between y and x can be specified by a linear function, which is
known as the linear probability model:
t ~ Bernoulli(y ),
y=x = 0 + 1 x1 + + k xk , (3)
where x is a matrix expression for the linear association between y and
x (i.e., x = linear(x ) ), and there are k coefficients on each of the k
inputs. However, it would not make sense to fit the continuous linear
regression model x + error to the binary variable t that takes on the
values 0 and 1. In other words, since it can generate values of t that are
either negative or greater than one, even the predicted values within
the correct range near the limits are questionable. Instead, we model
the probability that t = 1:
t ~ Bernoulli(y ),
ex
Pr(t = 1) = y = logit 1(x ) = ,
1 + ex (4)
under the assumption that the outcome t is independent given these
probabilities. The function logit 1 (x ) transforms continuous values into
a range between 0 and 1, which is crucial because probabilities must be
between 0 and 1. Since we still refer to x as the linear predictor and
the underlying probability of failure, y , as a logit function of a linear
function of x , the function becomes y = logit 1(linear(x )) . In other
words, within the generalized linear modeling framework, the logit
model predicts Pr(t = 1) for binary data from a linear predictor with an
inversed logit transformation.5
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Journal of Business Research 109 (2020) 271–287
However, a common unrealistic assumption when using the logistic
distribution at small scales is that it has 1 as an upper asymptote con-
version and an inflection point at x = 0 . When an inflection point is
expected in an isolate curve, the model provides a poor fit to the data.
This inherent inflexibility of the parametric nature of the logit model
largely stems from the linear terms that are used for continuous and
bounded output structure (e.g., the lower asymptote is 0 and the higher
asymptote is 1) of the model. An effective way to mitigate this major
downside is to create an unbounded growth rate in the sigmoid function
by adding more logit functions.
Hence, we can also approach the modeling framework of the neural
network in a similar fashion to that of the generalized linear modeling
by adding an additional link function. The neural network model allows
more than one logit curve to be used simultaneously to approximate the
relationship between the predictors and the target variable. To ap-
proximate the relationship between y and x with a set of L logit curves
(this is also known as the number of hidden neurons), the neural net-
work model can be expressed in terms of the logit and linear predictors:
t ~ Bernoulli(y ),
Pr(t = 1) = y
= logit 1 ( 0 + 1 logit
1 ( x 1) + 2 logit
1 (x 2) + + L logit 1(x L )).
(5)
This neural network model differs from the logit model in the shape
of the sigmoid curve. Since a direct sum of logit transformations is
projective, the model’s inflexibility increases. When L = 1, the neural
network model becomes a logit transformation of a linear function of a
logit transformation of a linear function:
y = logit 1 (linear(logit 1 (linear(x )))) . The larger the number of hidden
neurons of L , the more the logit functions are used in the generalized
model, and thus the larger the variety of shapes the overall fit can
approximate. The neural network models provide more flexibility in the
functional form of the model, which can approximate any hypothetical
association between y and x based on the large number of choices for
the number of logit functions (see Table 3). Thus, this form of neural
network allows to handle problems for which relationships are non-
linear, complex, and less known compared with highly structured
equation-based approaches such as logistic regression.
Again, it is important to note that the neural network model still
uses the inverse logit function as an activation function and thus suffers
from unbalanced data. The majority of practical applications of neural
network classifiers are facilitated by using the back propagation algo-
rithm and the delta (i.e., gradient descent) rule (Haykin, 2009). More
concretely, the model assumes that an error function is defined as:
E ( ) = 2 (ti yi ) 2, where is a set of weights that requires a training
1
set, and ti and yi are the observation of the ith target value and network
output value from a given neuron, respectively. In a conventional ma-
chine learning or data mining setting, the classifiers usually try to re-
duce (or minimize) the classification error; the gradient descent rule
aims to find the steepest descent to modify the following weights at
each iteration: n = E ( n) , where is the specified neural net-
work learning rate parameter and represents the gradient operator
with respect to weights . A probabilistic estimate for the output is
usually defined by normalizing the output values of all output neurons.
Such a setting is valid only when the costs of the different errors are
equal (i.e., with balanced class data). Statistically, this implies that the
performance of classification algorithm can be biased due to un-
balanced class data in which one class outnumbers the other by a large
proportion (He & Garcia, 2009). This may also cause a deep neural
network or other conventional statistical model to perform poorly. In
other words, standard classification algorithms may generate
5
The probit model is the same as logit model but with the inverse-logit
function replaced by the normal cumulative distribution.
K. Lee, et al.
Table 3
Link function, response range, and conditional variance function.
Logit model Probit model
Link function y = (1 + e linear(x ) ) 1 y= (linear(x ))
A linear predictor logit 1(linear(x )) (linear(x ))
Range of y (0, 1) (0, 1)
inaccurate predictions regarding M&A failures, which are typically rare
events. Accurate predictions on such important corporate events, de-
spite rare, can determine organizational success or failure (He & Garcia,
2009; Sun, Wong, & Kamel, 2009).
3.2. Proposed M&A forecasting model
For the purpose of this study, unbalanced class data means that one
class (e.g., ti = 0 ) outnumbers the other (e.g., ti = 1) in the target
variable by a large proportion. There are two evident ways we can try
to circumvent the problem introduced by unbalanced class data (Daqi &
Genxing, 2003). First, the crux of most existing methods balances the
dataset through data sampling (illustrated in Section 2.2), the technique
of which involves over-sampling or under-sampling the underweighted
class6; second, the strength and gain parameters of a sigmoid-type ac-
tivation function can be modified to accelerate the learning speed and
improve classification rates, an approach we refer it as a generalized
activation function approach. In this study, we focus on the generalized
activation function approach because the over-sampling method re-
quires removing instances from the majority groups, and this may not
be appropriate in the social sciences, in which situations typically have
a larger number of variables and relatively smaller data sets.
In neural networks, the strength and gain parameters of a sigmoid-
type activation function determine the learning capabilities (intrinsic
data characteristics; unbalanced class) of multilayer neural networks
with a linear function. Daqi and Genxing (2003) show that the char-
acteristics of a sigmoid-type activation function influence the con-
vergence rate, classification ability, and nonlinear fitting accuracy of
multilayer networks and thus, the characteristics ultimately influence
forecast accuracy. The change in the activation function will be very
limited after the input information, x , moves beyond a certain range.
This is because the first-order derivative of the activation function ap-
proaches zero. In that range, the sum of squared errors, E ( ) , hardly
changes, and the weights and model fall to a local minimum point
(Menon, Mehrotra, Mohan, & Ranka, 1996). Thus, the learning cap-
abilities highly depend on the shape of the activation function, which is
described by the strength and gain parameters. Furthermore, the type
(or shape) of the activation function has a critical effect not only on the
network’s learning speeds but also on its classification rates and non-
linear mapping precision (Daqi & Genxing, 2003; Menon et al., 1996).
This problem becomes more severe in the case of unbalanced class data.
Despite the importance of the shape of the sigmoid activation function,
the standard logit model (i.e., 1 (1 + exp( x ) ; 0 = 0 and 1 = 1) is the
default setting; as we illustrated in Section 2.2, the slope and spread
parameters of the standard logit models are fixed to 1 (i.e., | 1| = 1) and
3 (i.e., |3 1| = 3), respectively.
To address this problem, the following methods are proposed: (i) the
use of the general form of the sigmoid-type activation function (Chen &
Chang, 1996) in which the equation (Thimm, Moerland, & Fiesler,
1996) is written as f (x ) = (1 + exp( x )) 1 , where is the strength
parameter, which limits the output range from 0 to , and is the gain
6
Over-sampling and under-sampling refer to removing instances (or ex-
amples) of the majority class and adding instances to the minority class, re-
spectively.
Journal of Business Research 109 (2020) 271–287
Standard NN when L = 1 NN with generalized logit model when L = 1
y = logit 1(y )= (1 + e linear(y )) 1 , y = glogit 1(y )= (1 + e linear(y ) ) 1 ,
where y = logit 1(linear(x )) where y = glogit 1(linear(x ))
logit 1(linear(logit 1(linear(x )))) glogit 1(linear(glogit 1(linear(x ))))
(0, 1) (0, )
parameter, which controls the steepness of the activation function7;
and are both self-adapted; (ii) reinitiating the weights linked with a
node that is in a cutoff (i.e., saturated) state (Stäger & Agarwal, 1997);
and (iii) the use of locally linearized activation functions (Rubanov,
2000). However, one of the main defects of these methods is their ex-
cessive calculating workload (Daqi & Genxing, 2003), which rapidly
increases with an increase in the size of the networks. Taylor expansion
may improve the learning speed and forecasting precision of small
networks in this case, but it may yield poor performance for large
networks (Buntine & Weigend, 1994).
Therefore, we propose a sampling-based optimization method to
overcome the calculating workload while escaping a local minimum
point. The sampling-based optimization methods are less dependent on
asymptotic theory, and are thus able to produce reliable empirical re-
sults even with small data sets. The posterior distributions of and
can be estimated by using a large number of observations drawn from
the posterior distribution of the unknown parameters through Markov
Chain Monte Carlo (MCMC) methods. The basic idea is to partition the
set of unknown parameters ( and ) and then estimate them one at a
time with each parameter estimated conditional on the other. This
approach (like Gibbs sampling) is considered effective for a wide range
of problems because estimating separate parts of a model is relatively
easy, even when it is hard to know how to estimate all the parameters
simultaneously (Gelman & Hill, 2007). Thus, we argue that our ap-
proach can overcome the excessive calculating workload stemming
from the conventional approach. We propose a sampling-based opti-
mization approach to estimate the strength and gain parameters using
Metropolis-Hastings algorithm.
3.3. Cost-sensitive modifications and sampling-based optimization
In the usual setting of the logit model, classification accuracy is
typically evaluated by estimating its error rate on the sample. As we
discussed earlier, it is assumed that all classification errors have equal
costs. However, this assumption usually fails in the M&A data because
the error costs drastically differ across types (e.g., type I error vs. type II
error). To mitigate this concern about the misclassification costs, in this
section, we follow the work of Kukar and Kononenko (1998) and
Breiman et al. (1984) and present four approaches to making cost-
sensitive modifications to the estimation procedure. A misclassification
cost is defined as a function of the actual and predicted dichotomous
(class) responses (i.e., st [actualresponse, predictedresponse]). This func-
tion is used to reduce misclassification costs and is considered an ad-
ditional input to the parameter estimation. The cost function is defined
as: cost [i, j]= cost of misclassifying an observation from “response i” as
“response j”, cost [i, i] = 0 , where i = 1, 2 , and j = 1, 2 . In other words,
cost [i, j] is equal to a predefined cost value when the actual response (i )
and the output response ( j ) are different, and cost [i, j] is equal to zero
7
In this study, we consider a network with a single output y = f (x ), the value
of which is to be interpreted as a probability, and the general logistic activation
function: f (x ) = (1 + exp( x )) 1 , which has the property
f ' (x ) = f (x )[ f (x )]. Then, we have the derivative of the error with respect
E yi yi ti f (xi )
to x that takes the following form: i E
= = . yi = f (x i )
yi ti yi ti
xi yi xi yi (1 yi ) xi
= yi (1 yi )
f (x i )[ f (x i )] = y[
yi (1 yi ) i
yi ].
277
K. Lee, et al.
when the actual response (i ) and the output response ( j ) are the same.
This cost matrix has been widely implemented in the cost-sensitive
learning algorithm (Lu, Liu, Lu, & Wang, 2012). Furthermore, the cost
[i , j ] (i.e., misclassification cost) can be either a fixed value or a func-
tion and can be associated with either a class or a sample. The fixed cost
associated with a class, which is utilized in this study, has been widely
employed due to its lower risk of encountering an over-fitting problem
than that of the cost associated with a sample (Ma, Song, Hung, Su, &
Huang, 2012).
To include the misclassification costs, we must define a cost vector
to evaluate the classifiers’ performance based on cost [i, j]. The cost
vector indicates the expected cost of misclassifying a training sample
1
that belongs to the ith class: costvect [i] = 1 p (i ) j i p (j ) cost [i , j ], where
cost [i, j] indicates the cost of misclassifying a sample from class i as
class j8 and p (i) indicates an estimate of the prior probability that a
sample belongs to the ith class (i.e., i class : p (i ) = i t ).9 Thus, the
t Specifically, we use the SDC database to gather M&A data and
j j
performance criterion becomes not the error rate (i.e.,
# of incorrectly classified samples
), but the average cost per sample:
number of training samples
1 N
avgcost = N i = 1 cost [i , j], where N is the number of testing samples.
We denote M&A success and failure as responses 1 and 2, respec-
tively. Then, the 2 × 2 cost matrix is represented by
cost [1, 1] cost [1, 2] 0.0 cost [1, 2]
cost = = . costvect [1],
cost [2, 1] cost [2, 2] cost [2, 1] 0.0
which is the expected cost of misclassifying success as failure, is equal
to cost [1, 2]. Similarly, costvect [2], which is the expected cost of mis-
classifying failure as success, is equal to cost [2, 1]. We may then handle
the cost asymmetry in the two types of misclassification errors by as-
suming that cost [1, 1] = cost [2, 2] = 0.0 , cost [1, 2] = 1.0 , and
cost [2, 1] = 1.1 1.5. Thus, it is clear that the cost of misclassifying the
observation of “response 2” as “response 1” (i.e., false negative; mis-
classifying failure as success; 1.1 cost [2, 1] 1.5) is always higher
than the cost of misclassifying the observation of “response 1” as “re-
sponse 2” (i.e., false positive; misclassifying success as failure;
cost [1, 2] = 1.0 ).
Cost-sensitive classification (CS1): To reduce the misclassification
costs, we modify the probability estimates of the network in the clas-
sification of the testing sample period. Thus, the probability p (i) that a
sample belongs to class i is replaced with the altered probability, which
costvect [i] p (i)
considers the expected costs of misclassification: p' (i ) = costvect [i] p (i) .
j
This approach increases the probability p (i) for highly expected mis-
classification cost samples.
Adaptive output (CS2): To correct the output of the error function in
the ordinary network that gives the classes with higher expected mis-
classification costs, we change and scale the actual output of the net-
work instead of the estimated probabilities in the following way:
costvect [j] t j
t 'j = . This function differs from the above approaches in that
maxcostvect [i]
i
the observed outputs of the network are modified and appropriately
scaled.
Adaptive learning rate (CS3): In this approach, we compensate for the
samples that belong to classes with high expected misclassification costs
by increasing their prevalence in the classification of the testing sample
period. The altered prior can be simulated by giving the high-cost
costvect [class (p)]
samples higher weights: (p) = maxcostvect [i] .
i Some of continuous and all of categorical variables capture M&A deal
Minimization of misclassification costs (CS4): Instead of minimizing
the squared error, in this method, the learning algorithm minimizes the
misclassification costs. The error function is corrected by embedding
the factor m [i , j], where i is the desired class and j is the actual class:
E = p examples 2 i output ((yi oi ) m [class(p), i]) 2 . The factor m [i , j] is
1
8
The cost [i , i] = 0 ; zero cost for correct classification.
9
The normalized output can be viewed as an estimation of the probability
p (i) that a sample belongs to the ith class.
278
Journal of Business Research 109 (2020) 271–287
costvect [i], i = j
defined as follows: m [i , j] = (for more detail, see
cost [i , j], i j
Kukar and Kononenko (1998); a ready-to-use pseudo code can be found
in Appendix A).
In order to compute the estimates of the parameters of and given
the cost functions in this study. Since Gibbs sampling is not possible in
this case because of the lack of conjugate priors for logistic models
(Hoff, 2009), we use the random walk Metropolis-Hasting approach
(Gelman & Hill, 2007) to simulate values from the posterior distribution
(for more detail see Appendix A).
4. Application
We compile data from two sources: The Securities Data Company’s
(SDC) U.S. Mergers and Acquisitions database and Compustat.
Compustat for the bidder and target characteristics.
4.1. Sample data
We use the SDC database to identify proposed takeovers that
eventually succeed or are withdrawn. We start with all deals announced
between January 1, 2006 and December 31, 2015.
We applied several screens during our sample period to obtain the
final sample of takeover offers. Some acquisitions are recorded twice in
the SDC database. We deleted 525 repeat acquisitions, keeping only one
unique takeover announcement. In addition, the SDC database records
a share repurchase as a deal in which the acquirer is identical to the
target firm. We removed 8170 such share repurchase deals. We re-
stricted our samples to U.S. public firms since we measured predictors
in our takeover withdrawn prediction model using Compustat, which
provides financial and accounting data for most publicly held compa-
nies in the U.S. and Canada. In this process, a total of 95,051 ob-
servations (e.g., from government firms, joint ventures, private firms,
and subsidiaries) were eliminated. An additional 1099 acquiring and
target firms were not listed on Compustat and were therefore omitted
from our sample. Among the acquiring and target firms matched with
Compustat, 867 observations had incomplete coverage in the SDC da-
tabase (e.g., the database listed the deal status as unknown, rumored, or
pending) or Compustat (e.g., Compustat had missing values for items
that are used to construct predictors). These were therefore eliminated
from our sample.
This sample selection process yields a total of 803 successful or
withdrawn takeover offers in our final sample. Among the 803 deals,
696 are successful (about 87%), and 107 (about 13%) are announced
but not completed. As we noted, the frequency of failed mergers in our
final sample follows an unbalanced class distribution, indicating that
our final sample is appropriate, typical, and fits our purpose.
Table 4 provides summary attributes of the final sample that are
used in our withdrawn takeover prediction model. We separate vari-
ables into continuous and categorical variables. For continuous vari-
ables that capture acquirers’ and targets’ firm characteristics, we take
the absolute difference to capture the similarity or dissimilarity be-
tween the acquiring and target firms (more details about why we take
the absolute difference for these variables are given in Section 4.2.).
characteristics.
4.2. Variables
Dependent variable. In this paper, we develop a withdrawn takeover
prediction model. The target variable, therefore, is binary, equaling one
when the announced offer ultimately lead to the withdrawn takeover of
a target firm and zero otherwise. Our sample shows that one class of the
target variable (the number of complete takeovers, tk = 0 ) outnumbers
the other (the number of withdrawn takeovers, tk = 1) by a large
 K. Lee, et al.

Table 4
Summary of attributes of final sample of takeover deals.
Continuous variables Mean Std. Dev. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Firm characteristics
1. ROA 0.16 0.38 1.00
2. DPS 0.58 1.36 −0.04 1.00
3. Invntr/TA 0.05 0.07 −0.01 0.06 1.00
4. M/B ratio 0.84 1.16 0.54 −0.03 −0.01 1.00
5. P/E ratio 51.9 202 −0.02 −0.04 −0.06 0.12 1.00
6. Grwth in sales 0.42 2.37 0.15 −0.03 −0.02 0.04 −0.01 1.00
7. CapExp/OprtRev 1.41 36.7 0.17 −0.02 0.04 −0.01 0.00 0.01 1.00
8. Inv cap trnovr 1.33 4.14 0.10 −0.01 0.12 0.03 −0.01 −0.01 −0.01 1.00
9. Div pyt ratio 0.52 2.66 −0.03 0.17 −0.02 −0.03 0.04 −0.01 −0.00 0.02 1.00
10. Div yld 0.02 0.11 0.01 0.37 0.09 −0.02 −0.02 −0.01 −0.01 0.00 0.15 1.00
11. Log (TA) 2.21 1.83 0.27 0.12 0.18 0.26 −0.00 0.01 0.04 0.08 −0.05 −0.01 1.00

Deal characteristics
12. Rel deal size 1.84 26.4 −0.00 0.01 0.14 0.00 0.00 −0.01 −0.00 0.01 0.02 0.00 0.08 1.00
13. TaPrc 1d prior 22.9 24.4 −0.20 0.10 −0.06 −0.02 −0.01 −0.07 −0.03 −0.05 −0.02 −0.03 −0.12 0.05 1.00

279
14. TaPrc 1w prior 22.7 24.2 −0.20 0.10 −0.06 −0.02 −0.02 −0.07 −0.03 −0.05 −0.02 −0.03 −0.12 0.05 0.99 1.00
15. TaPrc 4w prior 22.1 23.7 −0.20 0.11 −0.06 −0.02 −0.02 −0.07 −0.03 −0.05 −0.02 −0.03 −0.12 0.05 0.99 0.99 1.00
16. AcTrm fee 0.74 0.44 −0.04 0.01 0.00 −0.03 −0.01 −0.02 −0.01 −0.01 −0.01 −0.01 −0.10 0.16 0.12 0.12 0.13 1.00
17. TaTrm fee 45.4 255 −0.09 0.07 −0.01 −0.03 0.00 −0.04 −0.01 −0.04 0.01 −0.01 −0.08 0.28 0.35 0.34 0.34 0.60 1.00
18. Toehold 57.6 145 −0.03 0.04 −0.02 −0.01 −0.03 −0.01 −0.01 0.01 0.01 0.02 −0.07 0.00 −0.02 −0.02 −0.02 −0.03 −0.06

Categorical variables Mean Std. Dev.

19. Trm fee clause 0.74 0.44
20. Hostile 0.03 0.16
21. Tender offer 0.23 0.42
22. All-cash deal 0.51 0.50
23. Competing bid 0.07 0.26

ROA is return on assets. DPS is dividend per share. Invntr/TA is Inventories divided by total assets. M/B ratio is market value of assets divided by book value of assets. Grwth in sales is growth in sales over the past year.
CapExp/OprtRev is capital expenditures divided by sales. Inv cap trnovr is invested capital turnover. Div pyt ratio is dividend payout ratio. Div yld is dividend yield. Log (TA) is natural log of 1 plus total assets. Rel deal size is
the ratio of deal size to acquirer size. TaPrc 1d prior is target share price 1 day prior. TaPrc 1w prior is target share price 1 week prior. TaPrc 4w prior is target share price 4 week prior. AcTrm fee is termination fee for
acquirer. TaTrm fee is termination fee for target. Toehold is the percentage of target stocks held by the acquirer prior to the announcement date. Trm fee clause is termination fee clause dummy. Hostile is a dummy variable
that equals one if a bid is recorded by the SDC database as “hostile” and zero otherwise. Tender offer is a dummy variable that equals one if a bid is a tender offer and zero otherwise. All-cash deal is a dummy variable that
equals one for purely cash-financed deals and zero otherwise. Competing bid refers to competing bidder that equals one if there multiple bidders and zero otherwise.
Journal of Business Research 109 (2020) 271–287
K. Lee, et al.
proportion. More precisely, we possess the unbalanced classification
data of 696 successful deals (about 87%) and 107 unsuccessful deals
(about 13%).
Predictors. We base our predictors on the literature that has in-
vestigated the motivations of M&A deals and the antecedents of the
outcome of a takeover offer. In essence, pertinent predictors are cate-
gorized into (i) financial predictors10 and (ii) M&A-related predictors.
Detailed descriptions of both types of predictors and their rationales for
being included as predictors in our withdrawn takeover prediction
model appear in Table 5.
Dyads and absolute difference. M&As involve two firms, acquiring
and target firms, seeking to strategically combine their resources with
those of other organizations. This inter-firm relationship requires the
acquiring and target firms to overcome potential sources of dyadic (i.e.,
combinations of target and acquiring firms taken pairwise) conflict that
inevitably arise from the M&A negotiation process. Assessing these
dyadic factors is particularly critical to understanding why two firms
involve in a takeover process either complete or withdraw from an
announced M&A. Extant research, however, has focused on the uni-
lateral perspective of the acquiring firm as opposed to assessing the
dyadic nature of M&As (Wang & Zajac, 2007). Such one-sided analysis
of the M&A process inadequately examines this clearly dyadic phe-
nomenon (Zajac & Olsen, 1993). Therefore, unlike most previous stu-
dies, we use the absolute difference between the acquirer’s and target’s
financial measures to capture the similarity or dissimilarity between the
bidding and target firms. In general, the smaller the absolute difference,
the more similar the characteristics of the two merging firms.
4.3. Benefits of accurate M&A forecasts for stakeholders
The literature on M&A can be classified into two schools of thought
based on dependent variables. One stream of research examines the
stock market performance or post-merger operating performance of
acquiring, target, or merged firms over short- or long-term periods
(Powell & Stark, 2005). In this stream of research, takeovers are
deemed successful either when the merged entity achieves positive
stock returns or when it generates operating gains from, for example,
increases in sales growth or market shares.
The other stream of research simply defines a successful takeover as
takeover attempts that are ultimately completed (Branch & Yang,
2003). The latter stream of research focuses on discussing how various
stakeholders, such as merger arbitrageurs, target shareholders/firms,
and acquiring shareholders/firms, may benefit by being able to accu-
rately determine the likelihood that a proposed takeover will ultimately
occur. Since they all play vital roles throughout the entire M&A pro-
cesses and potentially benefit the most from the successful prediction
outcomes, we discuss what these benefits are and how the costs of Type
I and Type II errors matter for each of these stakeholders.
Investors, especially merger arbitrageurs. Merger arbitrage is an in-
vestment strategy that aims to capture price differential by purchasing
the shares of target firms at lower prices immediately following the
merger announcement and by selling these shares to the acquiring firms
at higher prices upon the successful completion of the M&A. In finance,
investors who implement such an investment strategy are referred to as
“merger arbitrageurs.” Merger arbitrageurs are extremely active and
important traders in the stocks of acquirers and targets around merger
announcements (Officer, 2007). On the announcement date, target
firms’ shares will typically be trading at lower prices than the acquiring
firms’ offer prices. If a takeover offer is successful, merger arbitrageurs
lock in positive gains from this price differential. If the offer is un-
successful, however, the target share price typically falls, and merger
arbitrageurs face selling the shares in the market at lower prices than
10
A total of 22 financial predictors, 11 each for the acquiring and target firm,
are compiled at the firm level.
280
Journal of Business Research 109 (2020) 271–287
their original purchase prices, thereby suffering from large losses. Im-
portantly, positive returns from such price differential will solely be
guaranteed if the merger ultimately occurs. Therefore, the primary
objective of merger arbitrageurs is to accurately determine the like-
lihood that a proposed takeover will ultimately succeed to avoid large
arbitrage losses. As noted in Baker & Savasoglu (2002), merger arbi-
trageurs periodically suffer substantial losses, primarily due to un-
expected deal failure, which makes merger arbitrage such a risky
trading strategy. Thus, misclassifying failure as success (type II error) is
much more severely concerning for merger arbitrageurs than is mis-
classifying success as failure (type I error).
Target shareholders/firms. Target firms’ existing shareholders may
also benefit by accurately predicting whether or not a merger will
occur. Not surprisingly, when takeover attempts eventually fail because
either acquiring firms withdraw or target firms rebuff the offer, target
firms’ stock prices sharply decline, and target firms’ shareholders lose
almost all the takeover-related premium (Jandik & Makhija, 2005). 21st
Century Fox’s unrequited pursuit of Time Warner is a recent example of
destroyed value for shareholders of target firms when takeover attempts
eventually fail. In 2014, Time Warner’s shares fell by 13% the day after
21st Century Fox announced withdrawal on August 5th. From a target
shareholder’s standpoint, the consequences of a type II error may also
more detrimentally affect his/her wealth than those of a type I error
because type II errors are likely to incur unexpected losses and type I
errors often achieve unexpected gains.
Failed merger attempts often have lasting consequences beyond the
destruction of target shareholder value, and disciplining a target firm’s
inefficient management is one of those consequences (Chatterjee,
Harrison, & Bergh, 2003). Since being a target itself conveys adverse
information possessed by acquiring firms regarding a target firm’s
management, failed takeover attempts are followed by a high rate of
management turnover (Denis & Serrano, 1996). For example, Office
Depot, an American office supply retailer, announced that CEO Roland
Smith would step down from his role by the end of the first quarter of
2017 following a failed merger with Staples, another operator in
America. As such, a failed takeover deal often damages the credibility
of the target firm’s managers. From a target firm’s managerial stand-
point, it is also of great importance that M&A outcomes be accurately
predicted.
Acquiring shareholders/firms. In 2015 alone, takeover bids worth
$1.484 trillion were terminated or withdrawn in global markets for
corporate control (see, Fig. 3); in absolute terms, this number is en-
ormous. As previously noted, given that about 7% to 25% of each year’s
proposed deals typically end in failure, it also mirrors the recent surge
in M&A by emphasizing the ever-increasing importance that acquiring
companies identify likely takeover targets and predict ultimate deal
success.
From an acquiring firm’s perspective, immense, explicit, and im-
plicit costs are related to unsuccessful takeover attempts. Explicit costs
are expenses associated with accounting and due diligence, valuation,
and other legal/consulting/advisory activities, while implicit costs are
the opportunity costs of having to forego other attractive takeover deals
that may ultimately succeed. Implicit costs also arise from the fact that
a bid’s failure reveals to the market further information about bidders.
As noted in Pickering (1983), an ultimately unsuccessful bid reveals the
bidder’s inherent weakness, and many unsuccessful bidders become
targets of takeover bids themselves. Moreover, Bradley, Desai, and Kim
(1983) indicate that unsuccessful bidders display significant wealth
losses when their deals ultimately fail, and their intended targets are
subsequently acquired by a rival bidder. As such, failed takeover at-
tempts not only incur enormous explicit and implicit costs but also
damage the credibility of the acquirer’s managers and their strategic
decisions. Therefore, high levels of misclassification are of great con-
cern to the acquiring firms in takeover predictions, especially when
costly type II errors occur (Rodrigues & Stevenson, 2013)—that is,
when M&A failures are predicted to succeed.
K. Lee, et al. Journal of Business Research 109 (2020) 271–287

Table 5
Variable description.
Variables Description Rationale

Financial/accounting
predictors
Inefficient management
ROA
Dividend per share
Inventory/Total assets
Undervaluation
M/B ratio
Price-to-earnings ratio
P/E ratio
Growth-resource mismatch
Growth in sales over the past
year
Capital expenditure/
operating revenue
Invested capital turnover
Dividend payout
Dividend payout ratio
Dividend yield
Size
Log (total assets)
We take absolute difference between acquirer and target financial
predictors to capture the similarity or dissimilarity between
bidding and target firms
Income before extraordinary items (item 18)/total assets (item 6)
Dividend per share (item 26)
Inventories (item 3)/total assets (item 6)
Market value of assets (item 6 + (item 199 × item 25) – item
60)/book value of assets (item 6)
Closing price (item 199)/earnings per share (item 58)
(Sales (item 12) at the end of year t – sales at the end of year
t − 1)/sales at the end of year t − 1
Capital expenditures (item 128)/sales (item 12).
Sales (item 12)/total invested capital (item 37)
Total dividends (item DVT)/income before extraordinary items
(item 18)
Dividend per share (item 26)/closing price (item 199)
Natural log of 1 plus total assets (item 6)
In general, the smaller the absolute difference measure, the more similar
the characteristics of the two merging firms
In the market for corporate control, a market mechanism plays a crucial
role in transferring resources from inefficiently managed firms to more
efficient ones (Palepu, 1986)
The lower the market-to-book ratio, the more undervalued the target firm,
and thus the more attractive it is to bidding firms. Overvalued bidders in
particular look for undervalued entities (Rodrigues & Stevenson, 2013)
A firm with a low P/E ratio is more likely to be a target, since the earnings
of the firm will be valued at the multiple of the bidder (Rodrigues &
Stevenson, 2013)
Low-growth but resource-rich firms and high-growth but resource-poor
firms are natural acquisition targets (Palepu, 1986)
Firms that have a low dividend payout policy retain more earnings and
therefore can invest in future opportunities, leading to a higher growth
potential and an increased likelihood of becoming a target (Rodrigues &
Stevenson, 2013)
A consequent increase in wages and reputation after successful large
acquisitions would make managers to prefer larger rather than smaller
acquisitions (Barnes, 1999). Alternatively, fewer bidders with sufficient
resources to acquire a large target decrease the likelihood of acquisition
(Palepu, 1986)

M&A predictors
Relative deal size Ratio of deal size to acquirer size Larger size of a deal or target reduces takeover success (Branch & Yang,
2003)
Target share price
Target share price 1 day Target share price 1 day before merger announcement A rise in the target stock price prior to a merger announcement will deter
prior competing bids and lower the probability of bid revision (Jennings &
Target share price 1 week Target share price 1 week before merger announcement Mazzeo, 1993). In turn, the reduced competition and revision probability
prior increases the likelihood that any one offer will be successful (Walkling,
Target share price 4 weeks Target share price 4 weeks before merger announcement 1985)
prior
Termination fee
Termination fee clause Dummy variable equals one if a bid includes termination fee Termination clauses would make it costly for the fee-paying party to
dummy clause and zero otherwise withdraw from the merger deal, thus increasing the likelihood of the
Termination fee (Acquirer) Termination fees payable by the acquirer to the target if the ultimate success of a takeover attempt (Officer, 2003)
acquirer terminates the deal
Termination fee (Target) Termination fees payable by the target to the acquirer if the
target terminates the deal
Hostile and tender offer
Hostile Dummy variable equals one if a bid is recorded by the SDC Hostile and tender offer dummies measure target resistance. A hostile
database as “hostile” and zero otherwise takeover or tender offer are often perceived as a takeover deal that is far
Tender offer Dummy variable equals one if a bid is a tender offer and zero from completion and has been found to be negatively associated with
otherwise success rates of proposed mergers (Schwert, 2000)
All-cash deal Dummy variable equals one for purely cash-financed deals and A cash offer reduces information asymmetry about the value of acquiring
zero otherwise and target firms. Therefore, it may signal a greater degree of certainty to the
markets about the probability of deal success (Wang & Branch, 2009)
Toehold Percentage of target stocks held by the acquirer prior to the A toehold by an acquiring firm discourages competing bids and lowers the
announcement date probability of target managerial resistance (Betton & Eckbo, 2000)
Competing bidder Dummy variable equals one if there are multiple bidders and zero Existing bids reduce the probability of deal success by making competing
otherwise bidders recognize the increased likelihood that offer revision will occur
(Walkling, 1985)

Compustat is the source of variables referred to by item number.

5. Results
5.1. In-sample and out-of-sample prediction accuracy
For the purposes of the present study, multiple accuracy rate mea-
sures are used as a score rule to quantify the classification model per-
formance. In Table 6, Correctly Classified (CC) lines indicate the ratio of
correctly classified takeovers (success/failure) to the total number of M
&A predictions, whereas Incorrectly Classified (IC) lines show the ratio
of incorrectly classified takeovers (success/failure) to the total number
of M&A predictions. Thus, it is always true that CC + IC = 1. Equiva-
lently, the performance of an unbalanced model is expressed in terms of
withdrawn takeovers given by Accuracy for Failure (AF) lines. This
demonstrates the ratio of correctly predicted withdrawn takeovers to
the number of actually withdrawn takeovers. Thus, it is always true that
AF + type II Error = 1. Moreover, CC and AF ratios are used to estimate

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K. Lee, et al.
Fig. 3. Dollar value of takeover bids (in $ billion) terminated or withdrawn in global markets for corporate control for the period, 2006–2015.
the percentage of observations that a model correctly predicts: the
higher the ratio, the better the predictive power of the model; con-
versely, the lower the number of IC lines and type II errors, the better
the predictive power of the model.
Table 6 presents both in-sample and out-of-sample prediction ac-
curacies for the logit model, the weighted logit model, the probit model,
the neural network model with standard logit activation function (NN),
the neural network model with four types of cost-sensitive (CS) mod-
ifications (NN CS types 1–4), the proposed neural network model with
generalized logit activation function (PNN), and the proposed neural
network model with generalized logit activation function and four types
of CS modifications (PNN CS types 1–4). For the purpose of comparison,
all the neural network models are estimated with one layer containing
three neurons. It is important to note that although increasing the
flexibility of a model allows for higher in-sample fit, it does not ne-
cessarily result in higher out-of-sample fit as higher complexity models
are more likely to overfit the training data set.
In neural network models and proposed models with different CS
type functions, and refer to the strength and gain parameters of the
general logistic activation function, while CV represents cost vector
which specifies the value of costvect [2]. For example, CV = 1.5 indicates
that we use 1.0 of costvect [1] and 1.5 of costvect [2]. The first two col-
umns indicating M&A Failure and M&A Success contain the number of
actually withdrawn takeovers and the number of actual successful ta-
keovers for in- and out-of-sample periods. Subsamples were only used
for the data recorded after the recent global financial crisis, as it af-
fected the takeover processes in unusual ways, driving down the vo-
lume of transactions and causing many companies to postpone or
abandon deals. Out-of-sample forecasts drawn from the two previous
five-year (2009–2013 and 2010–2014) samples were developed for the
subsequent year (2014 and 2015).11
Two conclusions emerge from the summary of model performance
displayed in Table 6. First, the proposed NN models (i.e., PNN CS types
1–4) outperform or perform as well as other models for the in-sample
prediction of CC, with minimum and maximum ratio values of 0.94
(94%) and 0.98 (98%), respectively. Furthermore, the proposed models
are found to outperform or perform as well as other models over all
subsample periods for the in-sample prediction of AF, with values
ranging from 0.63 (63%) to 0.96 (96%). The proposed models also have
a lower type II error rate for the in-sample prediction setting than all
other competing models, with values ranging from 0.04 (4%) to 0.37
(37%).
11
The results were similar when using each two-year period to estimate the
model and the subsequent one-year period to forecast.
282
Journal of Business Research 109 (2020) 271–287
In general, the proposed NN models (i.e., PNN CS types 1–4) out-
perform other models in terms of out-of-sample prediction of both CC
and AF in all out-of-sample periods. Additionally, the proposed models
have a lower type II error rate for the out-of-sample prediction setting
than all other competing models. It is thus probable that the problem of
unbalanced data can be mitigated by implementing the cost function
and adding strength ( ) and gain ( ) parameters. Therefore, the pro-
posed NN models provide a better fit than other models by demon-
strating higher overall out-of-sample prediction accuracy. Furthermore,
the forecasting capabilities of the proposed NN models can be effec-
tively enhanced by introducing the misclassification cost function (CS1-
4).
Second, the proposed NN CS type 4, which is found to be the best
performing model for out-of-sample forecasts, does not perform better
than all other models in terms of in-sample prediction. In other words, a
higher in-sample fit does not lead to better out-of-sample prediction
(e.g., NN CS type 3 and type 4). This can be attributed to the influence
of specific explanatory variables that can change over time, causing
forecasting models with high in-sample fit to suffer from overfitting due
to decreased flexibility.
5.2. Variable importance
Identifying the right set of predictor variables not only improves the
accuracy of forecasting models, but also enhance our understanding of
key drivers of M&A success or failure. Accordingly, we extend our
analysis to address this concern and calculate the variable importance
measure. The variable importance measure refers to the extent to which
a given forecasting model uses that variable to make accurate predic-
tions; the more heavily a model relies on a variable to make predictions,
the more important it is for the model.
Several measures of variable importance have been proposed in the
forecasting literature (Hastie, Tibshirani, Friedman, & Franklin, 2005).
We employ the metrics of classification error rate (CER) and relative
importance because (i) the M&A outcome is binary rather than con-
tinuous, for which the residual sum of squares is commonly used, and
(ii) we are interested in the outcomes’ accuracy rather than the variance
across the outcomes, for which either the Gini index or the entropy is
employed. The CER-based metric measures variable importance based
on the change in CER when a variable is dropped from all the variables.
The change is calculated from the out-of-bag set and represented by
d = CERid CERd , (6)
where d denotes the index of the out-of-bag set, i denotes the index of
the variable that is dropped, CERid is the CER when the ith variable is
dropped from all variables, and CERd is the CER when the 23 total
 K. Lee, et al.

Table 6
In-sample and out-of-sample prediction accuracy of forecast models.
M&A M&A Logit Weighted Probit NN NN CS Type 1 NN CS Type 2 NN CS Type 3 NN CS Type 4 PNN PNN CS Type 1 PNN CS Type 2 PNN CS Type 3 PNN CS Type 4
Failure Success Model Logit Model Model

In-sample: 48 336 CV = 1.3, CV = 1.3, CV = 1.1, CV = 1.2, CV=1, CV = 1.5, CV = 1.5, CV = 1.2, CV = 1.5,
2009–2013 (13%) (88%) γ = 1, γ = 1, γ = 1, γ = 1, β = 1.036 γ = 1, γ = 1, γ = 1.5, γ = 1.5,
β=1 β=1 β=1 β=1 β = 1.5 β = 1.5 β = 1.3 β=1
CC 0.93 0.88 0.93 0.97 0.97 0.97 0.97 0.97 0.98 0.95 0.95 0.97 0.95
IC 0.07 0.12 0.07 0.03 0.03 0.03 0.03 0.03 0.02 0.05 0.05 0.03 0.05
AF 0.63 0.42 0.58 0.77 0.77 0.77 0.79 0.83 0.85 0.75 0.75 0.79 0.96
Type II error 0.37 0.58 0.42 0.23 0.23 0.23 0.21 0.17 0.15 0.25 0.25 0.21 0.04

Out-of-sample: 2014 8 (10%) 75

(90%)
CC 0.88 0.88 0.89 0.89 0.89 0.89 0.93 0.93 0.90 0.92 0.92 0.93 0.89
IC 0.12 0.12 0.11 0.11 0.11 0.11 0.07 0.07 0.10 0.08 0.08 0.07 0.11
AF 0.38 0.38 0.25 0.38 0.38 0.38 0.63 0.50 0.50 0.63 0.63 0.63 0.75
Type II error 0.62 0.62 0.75 0.62 0.62 0.62 0.37 0.50 0.50 0.37 0.37 0.37 0.25

283
In-sample: 48 331 CV = 1.5,γ CV = 1.5,γ CV = 1.2,γ CV = 1.1,γ CV = 1.4,γ CV = 1.4,γ CV = 1.3,γ CV = 1.1,γ
2010–2014 (13%) (87%) =1, =1, =1, =1, CV=1, =1.5, β = 1 =1.5, =1, β = 1.9 =1,
β=1 β=1 β=1 β=1 β = 1.123 β=1 β = 1.9
CC 0.94 0.92 0.94 0.97 0.97 0.97 0.98 0.98 0.98 0.94 0.94 0.95 0.94
IC 0.06 0.08 0.06 0.03 0.03 0.03 0.02 0.02 0.02 0.06 0.06 0.05 0.06
AF 0.67 0.40 0.67 0.81 0.81 0.81 0.85 0.83 0.85 0.92 0.92 0.63 0.67
Type II error 0.33 0.60 0.33 0.19 0.19 0.19 0.15 0.17 0.15 0.08 0.08 0.37 0.33

Out-of-sample: 2015 12 78
(13%) (87%)
CC 0.89 0.91 0.88 0.87 0.87 0.87 0.90 0.91 0.86 0.90 0.90 0.93 0.91
IC 0.11 0.09 0.12 0.13 0.13 0.13 0.10 0.09 0.14 0.10 0.10 0.07 0.09
AF 0.50 0.33 0.42 0.50 0.50 0.50 0.50 0.50 0.58 0.58 0.58 0.58 0.58
Type II error 0.50 0.67 0.58 0.50 0.50 0.50 0.50 0.50 0.42 0.42 0.42 0.42 0.42

CC is correctly classified; IC is incorrectly classified; AF indicates accuracy for failure; CC IC; AF Type II error; M&A Failure is the number of total examples in M&A failure; M&A Success is the number of total examples in
M&A success; the proportions are in the parentheses; CV represents cost vector; and refer to two parameters from the general logistic activation function; Entries in bold indicate the best performance value of any model
within a particular data set.
Journal of Business Research 109 (2020) 271–287
K. Lee, et al. Journal of Business Research 109 (2020) 271–287

Fig. 4. Estimated in-sample coefficients in parentheses and variable importance in the bar chart in a neural network model with four neurons.

variables are used. If the change d in CER is positive, the ith variable is dummy mostly affects the likelihood that proposed takeovers will be
important for making accurate predictions. Then, the CER-based im- ultimately withdrawn. The termination fee clause dummy equals one if
portance is defined as a bid includes a termination fee clause for the acquirer or the target,
D
and zero otherwise. Given that the target termination fee’s variable
1 importance is ranked last for predicting M&A failure, we infer that the
d,
D d=1 (7) magnitude of the termination fee clause dummy’s variable importance
primarily originates from the bidder’s side. As previously discussed, the
where D is the total number of the out-of-bag sets. For the value of D, 50
estimated coefficient (−5.23) suggests that termination clauses would
seems reasonable, and more sets are required as the number of classes
make it costly for both fee-paying parties to withdraw from the merger
increases (Breiman, 1996). We use 100 for the value of D.
deal, thus decreasing the likelihood of deal failure.
Next, we calculate the relative importance metric, which ranges
Hostile. The predictor variable with the next largest variable im-
between 0 and 100 and is calculated in four steps. Firstly, we find the
portance is the hostile dummy. Hostile takeovers are defined as deals
maximum and minimum CER-based variable importance. Secondly, we
with target board opposition. Not surprisingly, the estimated in-sample
compute the range between the maximum and minimum CER-based
coefficient is positive (1.65), indicating that hostile deals markedly
variable importance. Thirdly, we compute the relative variable im-
increase the likelihood that a proposed takeover will ultimately fail.
portance by subtracting the minimum CER-based importance among all
Unlike friendly bids, hostile takeovers are not recommended by the
variables from this variable’s CER-based importance, then dividing the
target management either at the time of the bid announcement or im-
resulting value by the range. Lastly, we multiply the relative variable
mediately thereafter. In addition, the target management implements a
importance by 100. Thus, one variable always has variable importance
variety of defensive tactics during the course of the hostile bid, making
of 100. A higher variable importance value indicates that the variable is
takeover offers more likely to be withdrawn (Sudarsanam, 1995).
more important for making accurate predictions. Fig. 4 displays both
Consistent with this notion, our empirical result shows that the like-
estimated in-sample coefficients12 in parentheses and variable im-
lihood of takeover failure is positively associated with hostile bids
portance in the bar chart in a neural network model with four neurons.
(Renneboog & Zhao, 2014).
We find that the four most important variables in predicting the out-
The existence of competing bidders. We find that the existence of
comes of takeover bids are (a) termination fee clause dummy, (b) hostile,
competing bidders is the predictor variable that displays the next largest
(c) the existence of competing bidders, and (d) total assets (absolute dif-
variable importance. The estimated in-sample coefficient is positive
ference in size between two merging firms).
(2.40), implying that the more competitive the bids are, the more likely
Termination fee clause. Among others, the termination fee clause
it becomes that the takeover bids will ultimately fail. This finding is
consistent with the notion that the presence or arrival of competing
12
The coefficients (weights) in this artificial neural network are an approx- bidders increases the expected price the initial bidder would pay should
imation of multiple processes and thus refer to the strength of a connection he/she win, thus lowering takeover offers’ success rates (Bhagat, Dong,
between two neurons. Coefficients can be positive or negative. A weight’s Hirshleifer, & Noah, 2005). In other words, the initial bidder will not
magnitude reflects the notion that, if a large signal from the input neurons value the merger agreement as highly as he/she previously did when a
results in a large signal from the output neurons, then the weight between those competing bidder makes an offer for the target firm.
neurons will increase. Positive (negative) weights indicate that an increase in Total assets. Lastly and not surprisingly, the total assets (the absolute
the predictor variable would correspond with an increase (decrease) in the difference in size between two merging firms) is the factor that presents
outcome variable (i.e., withdrawn takeover).

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K. Lee, et al. Journal of Business Research 109 (2020) 271–287

the next largest variable importance. Caiazza and Pozzolo (2016) find
that the target’s size in absolute terms and relative to that of the bidder
has a critical impact on takeover offers’ success or failure rates. Simi-
larly, Lim and Lee (2016) demonstrate that an acquirer’s size positively
affects acquisition completion. We determine total assets to be the
fourth most important variable for predicting M&A failure. This finding,
combined with the negative estimated coefficient on total assets (-2.86),
indicates that a smaller difference in absolute size between the target
company and the acquiring firm results in a greater number of proposed
takeovers that will be ultimately withdrawn. In other words, takeover
attempts between two merging firms of similar size are more likely to
be withdrawn than are those between two different firms in terms of
total assets.
6. Conclusions
In this study, we proposed a forecasting model that employs a
flexible functional form while taking into consideration the cost-sensi-
tive function. Specifically, the proposed model consists of a neural
network with a robust generalized logit activation function to address
unbalanced class datasets and with estimated strength and gain para-
meters using the Gibbs sampler and the Metropolis-Hastings algorithm.
In addition, a context-specific, cost-sensitive function is employed to
minimize the misclassification of M&A failure. The design of this model
is motivated by two important characteristics of M&A data: (i) the
outcome of M&A data represents an event with a small probability of
withdrawn takeovers and (ii) the impact of misclassifying failure as
success (type II error) is more detrimental than misclassifying success as
failure (type I error).
Takeover deals completed or withdrawn during the years 2009 to
2015 are used to evaluate the proposed model. When compared to
benchmark models (e.g., logit model, weighted logit model, probit
model, and neural network with a standard logit activation function),
the proposed model generates more accurate out-of-sample prediction
results. These findings evince that the proposed approach (i.e., using a
generalized logit activation function) is both a consistent and accurate
method for class-unbalanced data. Our findings provide guidance to
organizations on the development of forecasting models for decision-
making processes.
Our study also offers managerial insights on the development of
forecasting models. Given that a large and varied number of factors, yet
a relatively small sample size of rare events are included in traditional
forecasting models, the use of standard classification algorithms de-
signed for balanced data are more likely to generate inaccurate pre-
dictions and overfit the data. Thus, when predicting the success or
failure of M&A deals, forecasting models that can effectively in-
corporate distributive characteristics of all possible outcomes, including
unbalanced class data, must be employed.
The results of the present study also suggest that business implica-
tions and consequences of inaccurate predictions of an organization’s
strategic decision should be taken into account when designing fore-
casting models, as the effect of misclassifying success as failure in
business contexts differs significantly from the effect of misclassifying
failure as success. From a statistical perspective, the loss functions of
type I and type II errors are asymmetrical. Organizations should,
therefore, determine scoring rules using different penalties for the two
misclassification cases (i.e., type I and type II errors).
Further, findings suggest that, in comparison to characteristics of
targets and acquirers, M&A-related factors (e.g., the existence of a
termination fee clause, hostile mergers, and the existence of competing
bidders) are good predictors of takeover offer outcomes. In particular,
the existence of a termination fee clause is a crucial factor in the pre-
diction of takeover deal outcomes. Regarding target and acquirer
characteristics, the absolute difference in size between two merging
firms is found to be an important factor in increasing success rates of
proposed takeover deals.

Appendix A. Pseudo code

Input:
x – Independent variable data in the training set
y – Dependent variable data in the training set
(0: class 1 (not withdrawn), 1: class 2 (withdrawn))
x.test – Independent variable data in the test set
Output:
y.test_pre – Predicted dependent variable data in the test set
1: Normalize the input data
2: 1
3: 1
4: numepochs 100
5: Initialize weight matrix w, bias matrix b, and learning rate
6: Set the cost matrix cm
7: // Train the neural network
8: For i = 1 to numepochs do
9: For j = 1 to count(y) do
10: // Forward pass
11: (w, b) forward(w, b, x, y, , )
12: oj f (w, b) // Compute the output neuron value oj for the jth data
13: // Compute the error (for CS Type 1, 2, and 3)
14: ej f (yj , oj )
15: // Compute the error (for CS Type 4)
16: ej f (yj , oj , cm)
17: // Backward pass (for CS Type 1, 2, and 4)
18: (w, b) backward(w, b, x, y, , , ej , )
19: // Backward pass (for CS Type 3)
20: (w, b, ) backward(w, b, x, y, , , ej , cm, )
21: End for
22: End for
23: // Test the neural network
24: o f ( x.test, w, b) // Compute the output neuron vector o
25: Normalize o between 0 and 1
26: // Predict dependent variables (for CS Type 1)
27: P f (o, cm) // Compute the class probability vector P
28: y.test_pre arg(max P)

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K. Lee, et al.
29: // Predict dependent variables (for CS Type 2)
30: o f (o, cm) // Update o using the current o and cm
31: y.test_pre arg(max o)
32: // Predict dependent variables (for CS Type 3 and 4)
33: y.test_pre arg(max o)
34: Return y.test_pre
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K. Lee, et al.
Kang Bok Lee, PhD, is an assistant professor of business analytics in the Raymond J.
Harbert College of Business at Auburn University. His research interests include corporate
governance and statistical modeling of organizational phenomena. He has published in
journals such as Academy of Management Journal, Production and Operations Management,
European Journal of Operational Research, International Journal of Research in Marketing,
European Journal of Marketing, Decision Sciences, Journal of Business Logistics, Public
Administration Review, Journal of Economics and Finance, and Quantitative Finance and
Economics.
Sunghoon Joo is a PhD candidate in the Department of Finance at Auburn University. His
research interests include financial markets and institutions, corporate finance, and
predictive modeling. He has published in journals such as Journal of Economics and
Finance, Journal of Regional Analysis and Policy, and Quantitative Finance and Economics. He
has taught Financial Markets and Institutions and Advanced Business Finance at Auburn
University.
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Journal of Business Research 109 (2020) 271–287
Hyeoncheol Baik is a PhD Candidate in the Department of Industrial and Systems
Engineering at Auburn University. His research interests include the optimization of
drone operation in the electric power industry and the military, and interdisciplinary
decision making in the air transportation. He has published several papers in Journal of
Intelligent & Robotic Systems.
Sumin Han, PhD, is an assistant professor of business analytics in the Raymond J. Harbert
College of Business at Auburn University. She has published in journals such as European
Journal of Marketing,
Joonhwan In (Ph.D., The University of Tennessee), is an assistant professor of supply
chain management at California State University Long Beach. His research interests in-
clude governance of supply chain information flows, Healthcare supply chains, and ve-
hicle routing. His research has been published in journals such as Production and
Operations Management, Journal of Business Logistics, International Journal of Physical
Distribution & Logistics Management, and international journal of production economics.