Merger Motives and Target Valuation: A Survey of Evidence from CFOs

Tarun K. Mukherjee, Halil Kiymaz, and H. Kent Baker

This study provides insights about the motives for mergers and acquisitions (M&As) as well as divestitures and the practices used to value targets during 1990-2001. The survey evidence shows that the primary motivation for M&As is to achieve operating synergies while the top-ranked reason for divestitures is to increase focus. The results also show that most firms believe diversification is a justifiable motivefor acquisitions most notably as a means of reducing losses during economic downturns. Discounted cashflow methods dominate market multiples as the preferred approach for valuing both publicly-held and closely-held companies. Perhaps the most surprising finding is that although firms often define merger cash flows as the equity cash flows from the target, the discount rate used by acquiring firms is their own WACC rather than the targets 'cost of equity. This finding reflects one of the most persistent bad practices in valuing M&As and might lead to overpayment to targets. [G34]

The determinants of merger and acquisition (M&A) behavior have long been a topic of interest to researchers. Stewart, Harris, and Carleton (1984) observe that empirical studies on M&A behavior have typically followed one of two general strategies. Some researchers have examined the differences between the pre-merger and post-merger performance of merged firms. Others have focused on identifying differences in the characteristics of firms involved versus those not involved in M&As. Despite each having its flaws, both strategies have produced some valuable insights into M&A behavior. Although voluminous research exists on M&As over the past two decades, the observation made by Stewart et al. (1984) is still valid today. In this study, we follow a less well-traveled path to understanding M&A behavior by asking the decision makers. Unlike most research on M&As, we survey chief financial officers (CFOs) of US firms to obtain direct evidence of managerial perspectives about M&As. As with other approaches used to investigate M&A behavior, survey research has its strengths and

weaknesses.' Surveys of managers do not replace the two general approaches previously mentioned to examine M&A behavior, but they complement them and yield additional insights. As Bruner (2002, p. 50) notes, "The task must be to look for patterns of confirmation across approaches and studies much like one sees an image in a mosaic of stones." Several reasons underlie the importance of taking a fresh look at M&As by conducting a new survey. First, more than a decade has passed since the publication of the last academic survey on the topics addressed in our study.^ Hence, this survey of executives provides a means of benchmarking how academics see the world. Second, the largest merger wave in history occurred during 1992-2000. However, the characteristics of the takeovers in the 1990s differ greatly from those of earlier periods.* Third, the
'Bruner (2002) compares the strengths and weaknesses of four research approaches (event studies, accounting studies, survey of managers, and case studies) used to examine the profitability of M&As. ^To our knowledge, Ingham, Kran, and Lovestam (1992) published the most recent academic study on M&As. As Bruner (2002) notes, practitioners have also conducted surveys to assess the profitability of M&As and he sumniarizes the results of 13 surveys.

Tarun K. Mukherjee is the James Moffett Chair in Financial Economies at the University of New Orleans in New Orleans, LA 70148. Halil Kiymaz is an Associate Professor of Finance 'During the 1990s, the number of hostile takeovers and leveraged al Rollins College in Winter Park. FL 32789-4499. H. Kent buyouts declined substantially, while the number of cross-border Baker is University Professor of Finance at American Universitymergers increased. See, for example, Andrade, Mitchell, and Stafford (2001) and Holmstrom and Kaplan (2001). in Washington. DC 20016-8044.

JOURNAL OF APPLIED FINANCE FALL/WINTER 2004

importance attached to factors motivating M&As changes over time. As Sorenson (2000) notes, a generally accepted tenet is that different factors motivated the 1990s merger movement compared with earlier ones in the 1960s or the 1970s-1980s. For example, Grinblatt and Titman (2002) characterize the 1960s and 1970s as a period of conglomerate acquisitions primarily motivated by fmancial synergies, taxes, and incentives; the 1980s as one of financial acquisitions motivated by taxes and incentive improvements; and the 1990s as a period in which strategic acquisitions motivated by operating synergies became increasingly important. The scope of our study is somewhat broader than previous academic surveys on M&As such as Baker, Miller, and Ramsperger (1981a, 1981b) and Mohan et al. (1991). In this study, we include questions on M&A motives, valuation models, and other pertinent issues. Specifically, the study's three main objectives are to: (1) identify primary motivations for engaging in M&As and divestitures during 1990-2001; (2) learn how managers view the relationship between diversification and firm value; and (3) gain insights about valuation techniques used to value target firms. In addition, we seek managers' opinions on some statements containing results of empirical studies relevant to M&As. Although this study is partially exploratory in nature, we have a priori expectations about responses from the survey participants. Regarding our first objective, a consensus appears from the merger literature that a premium to the target firm is justified if the merger produces synergistic benefits. Financial theory suggests that managers should take actions that increasefirmvalue. Empirical studies by Bradley, Desai, and Kim (1988), Mulherin and Boone (2000), and others support the notion that synergistic effects lead to value creation. Consequently, we expect managers to cite synergy as the primary motive for M&As. Similarly, we expect focus to be the primary motive for divestitures. Our results confirm these expectations. We link our second objective to the continuing academic debate about the effects of diversification on the value of the mergedfirm.The view expressed in much of the pertinent literature is that conglomerates are inefficient and diversification destroys value.'' Yet, some recent research by Campa and Kedia (2002) and Villalonga (2004) challenges the notion of a
"See Wernerfelt and Montgomery (1988), Lang and Stulz (1994), Berger and Ofek (1995), Rajan, Servaes, and Zingales (2000), Whited (2001), Lamont and Polk (2001, 2002), among others.

diversification discount and suggests potential value creation from diversification. Our intention here is to see where financial managers stand on this debate. Our evidence shows that an overwhelming majority of the respondents cast their votes in favor of diversification as a sound motive for M&As. The basis of our third objective is a growing body of evidence (for example, Trahan and Gitman, 1995, Bruner, Eades, Harris, and Higgins, 1998, and Graham and Harvey, 2001) showing that managers rely on discounted cash flow (DCF) based valuation in general corporate finance settings. In particular, our interest lies infindingout the extent to which an acquiring firm relies on the DCF model (in preference to a market multiple model) when evaluating a target. We anticipate heavy reliance on DCF methods. Our results on this particular aspect of the survey, to quote Graham and Harvey (2001, p. 189), "are both reassuring and surprising." A reassuringfindingis that most acquiring firms use present value techniques to evaluate targets. Surprisingly, despite defining cash fiows as the equity cash fiows from the target, firms generally use their own cost of capital rather than the target's cost of equity as the discount rate. Academics often view the use of this discount rate as an inappropriate practice.

I. Literature Review
In this section, we discuss the relevant literature about the motives for M&As and divestitures, the relationship between diversification and firm value, and valuation techniques used to analyze the target firm. A. Motives for M&As There are probably almost as many motives for M&As as there are bidders and targets. Yet, grouping the motives of M&A transactions into various categories is often useful. Trautwein (1990) offers several theories of merger motives including efficiency, monopoly, raider valuation, empire-building, process, and disturbance theory. Berkovitch and Narayanan (1993) suggest three major motives for takeovers: synergy, agency, and hubris. Other motives include diversification, tax considerations, management incentives, purchase of assets below their replacement cost, and breakup value. Although the rationale may differ from one merger or acquisition to another, a common measure of success of a merger is the increased value of the combined firm.' Based on this measure, synergy stands out as perhaps
'Bruner (2002) eonsiders a merger suecessful as long as it does not destroy value.

MUKHERJEE, KIYMAZ, & BAKER MERGER MOTIVES AND TARGET VALUATION

the most justifiable motive in M&As. Sirower (1997) defines synergy as increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently.* Eccies, Lanes, and Wilson (1999) outline the source of synergies as eost savings, revenue enhancements, process involvements, financial engineering, and tax benefits. Goold and Campbell (1998) report six forms of synergy including shared know-how, shared tangible resources, pooled negotiation power, coordinated strategies, vertical integration, and combined business creation.' Several empirical studies lend support to the importance of synergy as a merger motive. For example, Bradley, Desai, and Kim (1988) document that a successful tender offer increases the combined value of the target and acquiring firms by an average of 7.4%. Berkovitch and Narayanan (1993) show that synergy is the primary motive in takeovers with positive total gains. Maquieira, Megginson, and Nail (1998) examine 260 pure stock-for-stock mergers from 1963 to 1996. They document significant net synergistic gains in non-conglomerate mergers and generally insignificant net gains in conglomerate mergers. Mulherin and Boone (2000) study the acquisition and divestiture activity of a sample of 1305 firms from 59 industries during 19901999. The symmetric, positive wealth effects for acquisitions and divestitures are consistent with a synergistic explanation for both forms of restructuring. Houston and Ryngaert (1996) discuss cost cutting, revenue enhancement, and risk reduction as possible factors explaining successful acquisitions, with costcutting being the most important for banks. They argue that most bank acquisitions have not added value to the acquiring bank's shareholders. This finding suggests that some of the reasons for undertaking an acquisition do not warrant the size of the premiums offered. Based on nine case studies of bank mergers, Rhoades (1998) finds that all of the cases involve significant cost cutting in line with pre-merger projections and four of the nine mergers show clear efficiency gains relative to peers. Eun, Kolodny, and Scheraga (1996) test the synergy hypothesis for cross-border acquisitions using a sample of foreign acquisitions of US firms during 19791990. Their findings indicate that cross-border takeovers are generally synergy-creating activities. Kiymaz and Mukherjee (2000) point to the synergistic benefit resulting from country diversification. Seth,
'Sirower (1997) further argues that to obtain any synergy acquiring firms must limit competitors' ability to contest their or the targets' current input markets, process, or output markets, and must open new markets where these competitors cannot respond. 'See Fluck and Lynch (1999) for a theory of financial synergy.

Song, and Pettit (2000) also find that the synergy hypothesis is the predominant explanation for their sample of foreign acquisitions of US firms.

B. Motives for Divestitures

Several research studies report that companies often subsequently divest previous acquisitions. For example, Kaplan and Weisbach (1992), who study a sample of large acquisitions completed between 1971 and 1982, find that these acquirers divested almost 44 % of the target companies by the end of 1989. They characterize the ex post success of the divested acquisitions and consider 34 to 50% of classified divestitures as unsuccessful. Although diversifying acquisitions are almost four times more likely to be divested than related acquisitions, they do not find strong evidence that diversifying acquisitions are less successful than related ones. Firms have a wide variety of reasons for divestitures. For example, a common reason is to increase a firm's focus. Comment and Jarrell (1995) document a trend toward corporate focus. John and Ofek (1995) find that asset sales lead to an improvement in the subsequent operating performance of the seller's remaining assets. They find that the improvement in performance occurs primarily in firms that increase their focus. Borde, Madura, and Akhigbe (1998) find evidence that valuation effects are more favorable when foreign divestitures are for strategic reorganization purposes. Another reason for divestitures is to eliminate a lowperforming division or business. By divesting the business, especially one in an unrelated area resulting from a previous conglomerate merger, a company may be able to recreate the value destroyed at the time of the earlier acquisition. Allen et al. (1995) examine the correction-of-a-mistake hypothesis with a sample of 94 spin-offs that occurred during the 1962-1991 period. Their results suggest that managers who undertake poor acquisitions can redeem themselves, at least partially, by subsequently divesting the unwise acquisition. A third reason for divestitures is to increase managerial efficiency. By spinning-off parts of the business, managers may be able to operate more efficiently alone in the spun-off firm than together in the parent firm. Johnson, Klein, and Thibodeaux (1996) find evidence consistent with the notion that spinoffs create value by improving investment incentives and economic performance. A fourth reason is to achieve a specific organization form such as through a spin-off or carve-out. By splitting the firm into its component businesses, the market may be able to value the components more accurately than when they are combined. According to Nanda and Narayanan (1999), when firms are

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undervalued due to unobservability of divisional cash flows, they may resort to divestiture to raise capital. C. Diversification and Firm Value According to Grinblatt and Titman (2002), purely diversifying takeovers offer both potential advantages and disadvantages. A common argument in support of diversification is that lowering the risk of a firm's stock increases its attractiveness to investors and thereby reduces the firm's cost of capital. Diversification may also enhance a firm's flexibility, allow it to use its organization more effectively, reduce the probability of bankruptcy, avoid information problems inherent in an external capital market by way of internal allocation of resources, and increase the difficulty of competitors uncovering proprietary information. On the other hand, combining two firms can destroy value if managers misallocate capital by subsidizing unprofitable business lines. Another disadvantage is that mergers can reduce the information contained in stock prices. Whether gains are associated with diversificationrelated M&As depends partly on whether diversification helps or hurts firm values. Much empirical work focuses on how corporate diversification affects shareholder value.* Servaes (1996) reports that the market's attitude toward diversification depends on the period studied. He finds diversification discounts or penalties in the 1960s and 1980s, but not during the 1970s. The prevailing wisdom among fmancial economists since the 1990s has been that diversified firms sell at a discount relative to the sum of the imputed values of their business segments. A stream of literature suggests that the discount on diversifiedfirmsimplies a destruction of value resulting from diversification. For example, empirical research by Morck, Shieifer, and Vishny (1990), Lang and Stulz (1994), Berger and Ofek (1995), Walker (2000), and Lamont and Polk (2002) suggests that diversification related acquisitions may be value reducing. Financial economists offer many explanations for the diversification discount. A leading hypothesis consistent with the notion that diversification destroys value is the inefficient-internal-capital-market hypothesis. That is, conglomerates tend to misallocate their investment funds by cross-subsidizing investments in divisions with poor growth opportunities. Alternative explanations also exist for the diversification discount. For example, managers may have pursued a diversification strategy even when it hurts shareholders in order to reduce their
*See Martin and Sayrak (2003) for a survey of recent developments in the literature on corporate diversification and shareholder value.

human capital risk (Amihud and Lev, 1981), entrench themselves (Shieifer and Vishny, 1989), or pursue size as an end (Ravenscraft and Scherer, 1987). Whited (2001) contends that the diversification discount stems from measurement error. Graham, Lemmon, and Wolf (2002) attribute the diversification discount to the performance of recent acquisitions. They show that much of value reduction occurs because firms acquire already discounted business units, and not because diversifying destroys value. Mansi and Reeb (2002) argue that this documented discount stems from the risk-reducing effect of corporate diversification. On the other hand, a recent stream of empirical studies argues that diversification does not destroy value. Campa and Kedia (2002) and Villalonga (2004), for example, use different statistical techniques to reduce selectivity bias. These studies demonstrate that the documented discount on diversified firms disappears after correcting for the selection bias. For example, Villalonga uses the Business Information Tracking Series (BITS), a new census database that covers the whole US economy at the establishment level, and reports the existence of a diversification premium.' D. Valuation Analysis Although numerous valuation approaches exist to estimate the value of the target company, the DCF model is most sound on theoretical grounds.'" This approach also provides the most intuitive and rational framework." Marren (1993, p. 195) considers DCF analysis as "... the most important valuation technique for estimating the worth of a business to an individual bidder." Researchers over the years have found increasing use of DCF models in various decisionmaking settings of a corporation. More recent
'Villalonga (2004) uses a common sample of firms and a common method to compare the value estimates obtained on BITS against those obtained on COMPUSTAT. The results show the existence of a diversification discount when firms' activities are broken down into COMPUSTAT segments, consistent with existing studies. When the same firms' activities are broken down by using BITS segments, the diversified firms trade at a significant average premium relative to comparable portfolios of single-business firms. The author offers two explanations for these findings: 1) COMPUSTAT yields a conglomerate discount that is different but consistent with the premium found in BITS for related diversification; and 2) the discount found in COMPUSTAT results from strategic accounting practices in managerial segment reporting. '"See Marren (1993) for a description of the various valuation approaches used to estimate the value of a company. "Several complexities exist in using the DCF method. For example, DCF models are highly sensitive to assumptions made for growth, profit margin, and terminal value. In addition, a target company's future cash flows depend on the method of acquisition and the purchase price.

MUKHERJEE, KIYMAZ, & BAKER MERGER MOTIVES AND TARGET VALUATION

11

testimony of this trend is provided by Trahan and Gitman (1995), Bruner et al. (1998), and Graham and Harvey (2001). For example, in a telephone survey of leading practitioners, Bmner et al. (1998) find that DCF is the dominant investment-evaluation technique. Graham and Harvey (2001) conduct a comprehensive survey analyzing the current practice of corporate finance and report that most companies follow academic theory and use DCF techniques to evaluate capital budgeting projects. Applying the DCF method requires forecasting postmerger cash flow and estimating a discount rate to apply to these projected cash flows. Some controversy exists about the proper discount rate to use in the analysis. There is, however, some consensus that when the cash flows from the target are estimated as equity cash flows, the appropriate discount rate is the target's cost of equity.'^ Two popular models for calculating the cost of equity capital are the capital asset pricing model (CAPM) and arbitrage pricing theory (APT). Once analysts determine the target company's beta, they can adjust the beta to the new expected capital structure for the target company. Several surveys provide evidence about techniques used to value target firms. For example. Baker, Miller, and Ramsperger (1981a) report that firms primarily use DCF analysis to determine the value of takeover targets. Mohan et al. (1991) find that managers place high importance on DCF and market value approaches compared to alternative techniques, especially liquidation and book value. A well-known method employed by practitioners to value a target company is market multiple analysis. This involves applying a market-determined multiple to net income, EBITDA, earnings per share, sales, book value, or other measures. This approach helps to identify a value range for the target and is useful when there are no acceptable comparable transactions or comparable public companies. This simple method does not have a sound theoretical footing. In keeping with the trend observed by other researchers involving the increasing popularity of the DCF technique, we should see less importance attributed to market multiple models.

survey instrument, sample, and limitations of this study.

A. Survey Instrument
We developed our original set of questions based on an extensive review of books, journal articles, and previous surveys on the motives for acquisitions and divestitures as well as practices used to value acquisitions. During March-April 2002, we pre-tested a preliminary version of our survey by sending it to seven chief financial officers (CFOs) in the Houston area. Based on the feedback from five CFOs, we eliminated several questions to shorten the survey and changed the wording on some questions to improve clarity. Based on the recommendation of these CFOs, we also omitted the detailed DCF models for evaluating a target that are described in popular textbooks such as Brigham and Ehrhardt (2002). The CFOs suggested that including these models would unnecessarily complicate the survey. The final version of the fourpage survey consists of 23 questions (hereafter referred to by Q#). We focused on asking closed-end questions to lessen the subjectivity involved with classifying responses to open-ended questions. The Appendix contains a copy of the survey. The survey includes five areas of inquiry. The first area involves background data on the number and average size of the acquisitions (Ql - Q2). The next group of questions concerns motives for making M&A decisions including questions on synergy-related and diversification-related M&As (Q3 - Q8). The third area of inquiry concerns methods used to value publiclyheld and closely-held targets (Q9 - Q l l ) . The fourth area examines divestitures (Q12 - Q14). The final part of our survey asks respondents to indicate their level of agreement or disagreement with nine statements involving M&As (Q15 - Q23). The respondents use a five-point, equal-interval scale where +2 = strongly agree, +1 = agree, 0 = neither agree nor disagree (no opinion), -1 = disagree, and -2 = strongly disagree. For these nine questions, we use one-sample t-tests to determine whether the level of agreement or disagreement differs significantly from zero, which represents a "no opinion" response. In reporting the survey results, we address three major research questions and relate empirical predictions to the responses received. First, what are the primary motives behind corporate M&As and divestitures? We expect that the primary motivation for M&As is synergy. This finding would be consistent with empirical research involving the increasing importance of synergy as a merger motive since the 1990s. Although we expect diversification to be an important motive to some firms, we do not expect it to be the top-ranked motive. Evidence suggests a much

II. Research Design

The research design consists of three elements: the
''Some debate exists over the appropriate diseount rate to use. Aecording to Rappaport (1986), using the aequirer's eost of eapital to diseount the target's cash-flow stream is only appropriate when the target's risk is identical to the acquirer's risk. Marren (1993) recommends using the weighted average cost of capital (WACC) of the target, assuming a given capital structure for the target company. Others such as Brigham and Ehrhardt (2002) indicate the most appropriate discount rate is the target's eost of equity, not that of either the acquiring firm or the consolidated post-merger firm.

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more negative view of diversifying takeovers since the 1980s. We expect that the two major motives for divestitures are to increase focus and to divest a lowperforming division. Comment and Jarrell (1995) document a trend toward corporate focus and away from conglomeration (diversification). Allen et al. (1995) show thatfirmsoften unwind unsuccessful prior acquisitions. Second, what views do managers have about the relationship between diversification and firm value? Much debate exists about the effects of diversification on value. One interpretation of empirical work on firm diversification supports the view that conglomerates are inefficient and diversification destroys value.'^ Matsusaka (1993) notes a dramatic reversal in sentiment toward diversification - positive in the 1960s, neutral in the 1970s, and negative in the 1980s. Some more recent research by Campa and Kedia (2002) and Villalonga (2004) shows the documented discount on diversified firms is not evidence per se that diversification destroys value. Because diversification is a deliberate choice, managers are unlikely to diversify unless they believe that the benefits of diversification outweigh the costs. Our questions on diversification explore where managers stand on this issue. Third, what methods do managers use to value the target firm? We expect that the DCF method is the most common approach used to value both publiclyheld and closely-held targetfirms.Such afindingwould be consistent with the growing body of evidence that managers rely on DCF valuation in general corporate fmance settings. For example, survey results by Bruner et al. (1998) show that DCF is the dominant investmentevaluation technique used by the most financially sophisticated companies and financial advisers.''' Graham and Harvey (2001) report similarfindings.The use of DCF methods to value targets would also be consistent with evidence from past practitioner surveys on M&As by Baker, Miller, and Ramsperger (198 la) and Mohan etal. (1991). B. Sample Our initial sample contains the largest 100 M&As reported by Mergers and Acquisitions in each year during the period of 1990-2001, yielding 1200 acquisitions. We adjusted the sample for multiple acquisitions by the same firms and firms acquired by other firms in subsequent years. The final sample consists of 721 firms that engaged in acquisitions
"See, for example, Weraerfelt and Montgomery (1988), Lang and Stulz (1994), Berger and Ofek (1995), Rajan, Servaes, and Zingales (2000), Whited (2001), and Lamont and Polk (2001, 2002). '"Other examples include Trahan and Gitman (1995) and Graham and Harvey (2001).

during 1990-2001. We obtained the names and mailing addresses of CFOs from FIS and Hoover's Online. To increase the response rate, we included a selfaddressed, postage-paid envelope along with a personally addressed cover letter with each survey. Of the 721 surveys, 85 were returned undelivered. In addition, about 30firmseither returned the survey blank or contacted us to express their unwillingness to participate, mostly for the reason of insufficient time. Our final sample consists of 75 usable responses, which represents 11.8% of the 636 delivered surveys. This response rate is similar to that reported in other academic studies offinancialexecutives." The length, difficulty, and confidential nature of the subject matter may help explain the participation rate. C. Limitations Our study has several potential limitations. One limitation is the possibility of non-response bias. This is true despite taking the normal precautions to avoid such bias including ensuring confidentiality. To test for non-response bias, we compared characteristics of the responding (sample) firms with those of the population. Having similar characteristics between these groups would lessen the concern about potential non-response bias and the ability to generalize the results. Based on t-tests, our sample closely conforms to asset sizes of the population as well as their industrial affiliations." Another limitation is that our study addresses only some of the interesting hypotheses prevalent in the field at present. We limit the scope and hence the length of our survey to increase the response rate. This decision to focus on several key areas involving M&As entails a tradeoff between comprehensiveness and the response rate. As the length and complexity of practitioner surveys increase, the response rate generally declines, which increases the potential for non-response bias. We believe, however, that the tradeoff is justified in this situation.

III. Survey Results

We present our results in six parts: characteristics of responding firms, motives for M&As, divestiture types and motives, diversification and firm value, valuation analysis, and other views of M&As.
"For example, Graham and Harvey (2001) achieve a response rate of nearly 9% from CFOs in a survey about the cost of capital, capital budgeting, and capital structure. Trahan and Gitman (1995) obtain a 12% response rate in a survey mailed to 700 CFOs. "These tests are available from the authors upon request.

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13

A. Characteristics of Responding Firms

the types of divestitures consist of sale of an operating unit to another firm (50.0%), outright liquidation of Exhibit 1 shows the results involving the number and assets (43.5%), and spin-offs (6.5%). Because individual average asset size of acquisitions (Ql and Q2), divestitures may not necessarily fit neatly into any one respectively. The findings show the involvement of most motive, we asked respondents to check all motives that of the responding firms in multiple acquisitions during apply to their company's divestitures. Panel B provides 1990-2001. For example, 46.7% of the responding firms the main reasons the responding firms engaged in engaged in more than 10 acquisitions during this period. divestitures. The evidence shows that the top-ranked Exhibit 1 also shows that 66.7% of the acquired firms reasons are to increase focus (35.9%) and divest a loware less than $500 million in asset size. We computed performing division (35.9%). These findings are the Spearman rank correlation (r^) between the asset consistent with our expectations. sizes of acquiring firms and the average size of the acquired firms. The results show that large firms become D. Diversification and Firm Vaiue larger through repeated acquisitions of relatively large firms (r^ = 0.320 significant at the 0.05 level). Exhibit 5 provides the responses to three questions (Q4 - Q6) involving diversification and firm value. As shown in Panel A, when asked if they agree with the B. Motives for M&As statement (Q4) "Some say that diversification is not a justifiable motive for merger," only 22.7% of the Exhibit 2 reports the results involving the top-ranked reasons for acquiring another firm (Q3). We gave respondents agree with this statement. Panel B shows respondents seven choices plus an "other" option. that their rationale for this belief centers on three Consistent with our expectations, the most important reasons (Q5): shareholders can diversify on their own motive is synergy, which received 37.3% of the top- (35.7%), the parent company can lose its focus by ranked responses. The second highest-ranked motive diversifying (21.0%), and a firm should stay in the is diversification, chosen by 29.3% of the respondents. business it knows best (26.2%). The overwhelming Although synergy and diversification represent almost majority (77.3%) of the respondents believe that two thirds of our responses, companies engage in diversification can be a good reason to merge (Q6). The importance attributed by respondents to the benefits mergers for other reasons. of diversification is consistent with the new stream of Anticipating the importance of synergy as a motive, research by Campa and Kedia (2002) and Villalonga (2004). we asked two other questions about synergy-related As Panel C shows, half of these respondents agree that mergers. One question (Q7) asked respondents to diversification provides protection during economic indicate whether their firms were directly or indirectly downturns because such downturns do not affect all of involved in synergy-related mergers. Of the 75 the firm's segments equally. respondents, 69 (92.0 %) answered "yes." The other question (Q8) instructed these respondents to indicate the most important source of the merger-ielated E. Vaiuation Anaiysis synergy among four choices (operating economies, financial economies, differential efficiency, and Exhibit 6 provides responses to three questions (Q9 increased market power) plus an "other" option. Only - Q l l ) involving valuation techniques. Panel A shows 62 of the 69 respondents provided an answer. As that 37 of the 75 responding firms (49.3%) primarily Exhibit 3 shows, the overwhelming source of synergy use a DCF model and another 25 firms (33.3%) use this is operating economics, chosen by 89.9% of the model along with the market multiple method to value respondents. Although we did not investigate the a publicly-held target firm. Thus, almost 83% of specific type of operating economy that served as the acquiring firms apply DCF models to determine the source of synergy, it could result from various sources value of target firms. This practice is consistent with such as economies of scale in management, market, our expectations as well as past surveys on the reliance on DCF methods in both general corporate finance production, or distribution. settings and an M&A setting. In asking the question about the use of the DCF C. Divestiture Types and Motives model, we explained the DCF model in the following manner: we determine the expected post-merger cash Of the 75 responding firms involved in M&As during flows that will accrue to my firm's shareholders and 1990-2001,46 of them (61.3 %) also report divestitures then discount such cash flows at an appropriate (Q12). Panels A and B of Exhibit 4 present the results of discount rate. In other words, we were clear about the two other questions (Q13 and Q14). As Panel A shows. specific nature of cash fiows (i.e., equity cash fiows).

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Exhibit 1. Characteristics of Responding Firms: Number and Average Size of M&As

This exhibit shows the number of M&As undertaken by the responding firms during 1990-2001 and the average asset size of the target firms acquired during this period. n 1-3 4-7 8-10 Above 10 Totals = Panel A. Number of Acquisitions ^ 14 17 9 35 75 50 15 5 5 75 % 18.7 22.7 12.0 46.7 100.1 66.7 20.0 6.7 6J 100.1

Panel B. Average Asset Size ofAcquired Firms Less than $500 million $500 million - $ 1.5 billion $1.6 billion-$5 billion Over $5 billion Totals Note: Percentages do not equal 100 due to rounding. Exhibit 2. iVIotives for iVI&As This exhibit shows the most important reasons that responding firms gave for their M&As during 1990-2001. Respondents could indicate more than one reason but this exhibit reports only the top-ranked motive. Motives Take advantage of synergy Diversify Achieve a specific organizational form as part of an ongoing restructuring program Acquire a company below its replacement cost Use excess free cash Reduce tax on the combined company due to tax losses of the acquired company Realize gains from breakup value of the acquired firm Other Totals n %

28 22 8 6 4

37.3 29.3 10.7 80 . 53 .

2
0 5 75

1.1
00 . 67 / 100.0

Exhibit 3. Sources of Synergy

This exhibit presents the source of synergy for those firms directly or indirectly involved in synergy-related mergers. Of the 75 total respondents, 69 stated that they were involved in such activities. Although respondents could indicate more than one source, this exhibit reports only the top-ranked source. Source of Synergy Operating economies (resulting from greater economies of scale that improve productivity or cut costs) Financial economies (resulting from lower transaction costs and tax gains) Increased market power (due to reduced competition) Differential efficiency (due to the acquiring firm's management being more efficient) Totals n %

62 4 3 0 69

89.9 58 . 43 . 00 . 100.0

Therefore, the use of acquiring firm's WACC as opposed to the target's cost of equity is inappropriate. As Panel B shows, 38 of 62 firms (61.3%) using DCF models employ their own WACC

as the discount rate. Few companies use either the target's WACC (8.1%) or cost of equity (1.6%) as the discount rate. Mohan et al. (1991) report similar findings in their survey. These results may indicate

MUKHERJEE, KIYMAZ, & BAKER MERGER MOTIVES AND TARGET VALUATION

15

Exhibit 4. Divestiture Types and Motives

This exhibit presents the responses of the 46 firms involved in divestitures during 1990-2001. The number of responses in Panel B exceeds the number of firms engaging in divestitures because respondents could indicate more than a single response.

n
Panel A. Types ofDivestitures Sale of an operating unit to another firm Outright liquidation of assets Spin oflf Equity carve-out Other Totals _ _ _ ^ 23 20 3 0 0 46 33 33 9 7 10 9?.

^
50.0 43.5 6.5 0.0 0.0 100.0 35.9 35.9 9.8 7.6 10.9 100.1

^ Panel B. Motivesfor Divestitures

Increase focus Divest a low-performing division Increase managerial efficiency Achieve a specific organizational form Others (e.g., increase cash position, take advantage of high market value, reallocate capital, and antitrust considerations) Totals Note: Percentages do not equal 100 due to roimding.

Exhibit 5.

Diversification and Firm Vaiue

This exhibit presents the responses on whether or not diversification is a justifiable merger motive and the reasons underlying these views. The total responses in Panels B and C exceed the number of "yes" and "no" responses in Panel A because respondents could indicate more than a single response.

n
Panel A. Diversification as a Merger Motive Some say that diversification is not a justifiable motive for a merger? Do you agree? Yes No Totals Panel B. Diversification: Not Justified as a Merger Motive Diversification through mergers does not create value because: Shareholders can diversify on their own The parent loses its focus A firm should stay in the business it knows best Other (e.g., does not contribute to the firm by itself) Totals Panel C. Diversification: Justified as a Merger Motive Diversification can be a good reason to merge because it: Results in much less devastating effects on the firm during economic downturns Takes advantage of the seasonality of the production cycle Affords internal capital allocation Other (e.g., expands the customer and product base and acquires expertise) Totals 17 58 75

22.7 77.3 100.0

15 13 11 3 42

35.7 31.0 26.2 7.1 100.0

36 10 9 17 72

50.0 13.9 12.5 23.6 100.0

the inability to derive a discount rate for the target or reports the results about the valuation models used a lack of sophistication in valuation analysis. If the by the 64 responding firms that report acquiring cash flows used are cash flows to equity, a cost of closely-heldfirms.Almost half (48.4%) of these firms equity is an appropriate discount rate. Panel C indicate that they use DCF models, while 37.6 % use

16

JOURNAL OF APPLIED FINANCE FALL/WINTER 2004

Exhibit 6. Valuation Techniques Used for Target Firms

This exhibit presents responses on the valuation techniques used to value publicly-held and closely-held target firms.
n
%

Panel A. Valuation of a Publicly-Held Target Firm Discounted cash flow approach Discounted cash flow approach plus market multiple analysis Market multiple analysis only Other Totals Panel B. Discount Rate Used to Value a Target Pirm Acquiring firm's weighted average Acquiring firm's cost of equity Target's weighted average cost of capital Other (e.g., target's cost of equity) Totals Panel C. Valuation of a Closely-Held Target Firm Discounted cash flow approach Apply industry price-to-eamings multiple to the target Apply industry price-to-book value multiple to the target Other (e.g., cash flow multiple, comparable firms, EBITDA multiple, price-to-revenue multiple, internal projections, customer base, and long-term contracts) Totals
Note: Percentages do not equal 100 due to rounding.

37 25 9
j4

75

49.3 33.3 12.0 5.3 99.9 61.3 11.3 8.1 19.4 100.0 48.4 31.3 6.3 14.1 100.1

38 7 5
VL 62

31 20 4 _9 64

an industry multiple approach. Thus, the percentage of firms that primarily use a DCF model to value publicly-held (49.3%) and closely-held (48.4%) firms is similar."

F. Other Views on M&As

Exhibit 7 shows the extent to which the respondents agree or disagree with nine statements about M&As (Ql 5 - Q23). We rank the responses from the highest to lowest mean response based on a five-point scale. The literature generally provides support for all nine statements.'*The respondents, on average, agree with most of the statements, except Q15 and Q19. Only four of the nine statements (Q17, Q18, Q20, and Q22) show a positive mean value statistically different from zero (no opinion) at the 0.05 level or above using a one-sample t-test. At least 75% of the respondents agree with two statements. The first statement (Q17) is "a hostile takeover often results in higher payment to the acquired company than a friendly merger." Agreement with this statement is consistent with the results reported in several previous studies such as Asquith (1983) and
"In Qll of our survey, we did not give respondents the option of indicating that they could combine the DCF model with the following model as we did in Q9. "See, for example, Jensen and Ruback (1983), Copeland and Weston (1988), Weston, Chung, and Hoag (1990), and Grinblatt and Titman (2002) for summaries of empirical evidence on the effects of mergers on value.

Dennis and McConnell (1986). Chen and Comu (2002) also find that merger premiums in tender offers are significantly higher than the premiums in friendly mergers, which is consistent with numerous studies. The second statement (Q18) is "an acquisition in a related industry is worth more than an acquisition in a non-related industry." Maquieira, Megginson, and Nail (1998) report net synergistic gains in non-conglomerate mergers and generally insignificant net gains in conglomerate mergers. A majority of the respondents agree with the statement (Q22): "most of the gains from M&As usually accrue to shareholders of the acquired firm." Researchers typically agree that takeovers increase the wealth of the shareholders of target firms as reflected by the favorable stock price reactions to takeover bids. Debate exists, however, as to whether mergers benefit the acquiring firm's shareholders. For example, Roll (1986) and Bradley, Desai, and Kim (1988) report that average returns to bidding shareholders from making acquisitions are at best slightly positive, and significantly negative in some cases. The combined market value of the shares of the target and bidder, on average, go up around the time of the announced bids."
"Based on the evidence from 14 informal studies and 100 scientific studies from 1971 to 2001, Bruner (2002, p. 48) concludes "the mass of research suggests that target shareholders earn sizable positive market-returns, that bidders (with interesting exceptions) earn zero adjusted returns, and that bidders and target combined earned positive adjusted returns."

MUKHERJEE, KIYMAZ, & BAKER MERGER MOTIVES AND TARGET VALUATION

17

Exhibit 7. Level of Agreement or Disagreement with Statements Involving M&As This exhibit reports the level of agreement or disagreement of the respondents to nine statements involving M&As based on a five point scale: +2 = strongly agree, +1 = agree, 0 = no opinion, -1 = disagree, and -2 = strongly disagree. The one-sample t-value indicates whether the mean is statistically different from zero (no opinion).

Agree Statement 17 A hostile takeover often results in higher payment to the acquired company than a friendly merger. 18 An acquisition in a related industry is worth more than an acquisition in a non-related industry. 22 Most ofthe gains from M&As usually accrue to shareholders ofthe acquired firm. 20 An all-cash offer is more effective in a hostile merger than in a friendly merger. 21 Poison pills usually represent nonwealth-maximizing behavior. 23 M&As may increase shareholders' wealth at the expense of bondholders, especially in leveragedbiiyout situations. 16 Cash (or cash combined with stock exchange) requires a higher premium because of tax consequences to the shareholders ofthe acquired firm. 19 Suppose A and B are two target companies in two different countries. The economy of A's country has a much lower correlation (than B's country) with the economy of the United States. All else the same, a higher premium is justified for A . 15 Cash (or cash combined with stock exchange) payment requires a higher premium in M&As than a straight stock-exchange transaction. n +2 +1

Disagree -1 -2

t-Value Mean

74

25.7%

50.0%

18.9%

5.4%

0.0% 0.959

10.087*

74

23.0

52.7

18.9

2.7

2.7

0.905

8.866*

75

6.7

49.3

21.3

20.0

2.7

0.373

3.335***

72

5.6

40.3

31.0

20.8

1.4

0.278

2.598*

74

9.5

29.7

31.1

28.4

1.4 0.176

1.514

73

2.7

26.0

52.1

16.4

2.7

0:096

1.021

74

5.4

32.4

31.1

23.0

8.1 0.041

0.331

72

1.4

13.9

55.6

26.4

2.8

-0.153

-2.024**

74

10.8

18.9

17.6

37.8 14.9

-0.270

-1.872*

Note: The percentages for each question may not add to 100 due to rounding. ***,**, *, indicates statistical significance at the 0.01, 0.05 , and 0.10 levels, respectively.

The fitial statetnent (Q20) oti which substantial agreement exists among the respondents is that: "an all-cash offer is more effective in a hostile merger than in a friendly merger." Several studies such as Travlos (1987) and Franks, Harris, and Mayer (1988) find that

annouticement returns to bidding firms tnaking cash offers are higher than when making stock offers. This result may reflect the relatively negative information about the bidder's existing business signaled by the offer to exchange stock. Based on a sample of takeover

18

JOURNAL OF APPLIED FINANCE FALLWINTER 2004

offers during 1981-1986, Brown and Ryngaert (1991) find that the returns for cash offers are significantly higher than the returns for all stock or mixed offers. The only statement (Q15) about which a majority of respondents disagree is "cash (or cash combined with stock exchange) payment requires a higher premium in M&As than a straight stock-exchange transaction." This finding is inconsistent with results reported in several empirical studies. For example, Huang and Walkling (1987) show that valuation effects are larger for cash offers than stock exchange offers. Sullivan, Jensen, and Hudson (1994) subsequently confirmed this finding.

IV. Conclusions
We survey CFOs of US firms engaged in M&As and divestitures to learn their views about these activities and how they value the target firm. Based on the survey evidence, we find that the primary motivation for M&As is to achieve operating synergies while the top-ranked reason for divestitures is to increase focus. Both results are consistent with other empirical evidence that strategic acquisitions are the dominant form of acquisitions during the 1990s. Strategic mergers are typically horizontal mergers that achieve operating synergies by combining firms that were former competitors or whose products or talents fit well together. Our results also show that most firms believe diversification is a justifiable motive for acquisitions, most notably as a means of reducing losses during economic downturns. We find that discounted cash flow is the dominant method for valuing both publicly-held and closelyheld companies, while market multiple analysis is a distant second. Perhaps the most surprising finding is that although a large percentage of firms define merger cash flows as the equity cash flows from the target, the discount rate used by acquiring firms is their own WACC rather than the targets' cost of equity. This evidence documents one of the most persistent bad practices in M&As - using the buyer's WACC to value a target's cash flows. On average, managers generally agree with statements involving research evidence and issues about M&As. Only four of the nine statements, however, show a level of agreement that is statistically different from "no opinion." Although managers may not have direct knowledge of the specific research

studies serving as the basis for these statements, they apparently understand, perhaps by experience, the nature of such evidence. Our findings suggest several important implications for practitioners, teachers, and researchers. First, the mismatch of cash flows and discount rates found in our survey implies overvaluation of target firms. Goold and Campbell (1998) note that even synergy-producing mergers are not free from overpayments to targets. They trace the source of overpayment to four biases that distort the thinking of executives. One bias is to overestimate the benefits and to underestimate the costs of synergy. Sirower (1997) reaches a similar conclusion and argues that executives mostly focus on the total price of acquisition rather than the premium paid. Executives need to be clear about how acquisition prices are derived and what exactly they present and focus on post acquisition strategy of the acquiring firm. Even in the presence of unbiased estimates of costs and benefits, the use of a wrong (lower than justified) discount rate would result in overpayment. Alternatively, buyers may be underestimating the risk of target cash flows because they are overconfident about their investment. This warrants further study, possibly along the lines of some ofthe hypotheses in behavioral finance about investor overconfidence reported by Shefrin (2002). In any case, the persistence of the bad practice in M&As of using the buyer's WACC to value the target's equity cash flows should prompt teachers and practitioners to redouble their efforts to promote "best practice" or at least better practice in M&As. Second, the allure of synergies as a motive for M&As invites further exploration of the nature, size, and uncertainty of synergy values. Future surveys could break down synergistic effects into various subgroups and investigate the relative importance of the various types of synergies. For example, operational synergies could be divided into cost savings and revenue enhancements. A reassuring finding is that the survey evidence seems to reject the popular belief that managers pursue mergers for noneconomic (managerial) reasons. Finally, our findings add fuel to the debate between the pro- and anti-diversification advocates. Some recent research by Campa and Kedia (2002) and Villalonga (2004) challenges the notion of a diversification discount. The importance attributed by our survey respondents to the benefits of diversification is consistent with this new stream of research.

MUKHERJEE, KIYMAZ, & BAKER MERGER MOTIVES AND TARGET VALUATION

19

Appendix. Survey on Mergers and Acquisitions (M&As)

Note: This survey applies only to firms that acquired other firms. 1. a a a a 2. a a Q 3. My company was involved in (Please check only one.) 1-3 4-7 8-10 above 10 M&As during the period January 1, 1990 - December 31,2001.

The following choice most closely describes the average asset size ofthe companies we acquired during the last 12 years. {Please check only one.) Less than $500 million $500 million-$1.5 billion $1.6 billion-$5 billion Over $5 billion Provided below are some ofthe reasons that are offered for acquiring another company. Which of these motives best explain your firm's acquisitions in the last 12 years? {If you check more than one choice, please rank them, with 1 being the most important reason.) In making M&A decisions, our primary motive(s) was (were) to: acquire a company below its replacement cost. reduce tax of the combined company due to tax losses of the acquired company. use excess free cash. diversify. take advantage of synergy. realize gains from breakup value ofthe acquired firm. achieve a specific organizational form as part of an ongoing restructuring program. Other (Please fill in.) Some say that diversification is not a justifiable motive for merger. Do you agree? Yes No If the answer to question #4 is "No," please s/c/p to question #6. If the answer is "Yes," please answer #5 and sl<ip #6.

Q Q a a a a Q 4. Q Q

5. Q a Q 6. Q a

(Please check all that apply). Mergers through diversification do not create value because: a firm does not need to diversify as its shareholders can diversify on their own. diversification results in the parent company losing its focus. a firm should stay in the business it knows best. Other (Please fill in.) (Please check all that apply.) Diversification can be a good reason to merge because it: reduces/avoids the need for external capital by transferring capital internally. results in much less devastating effects on the firm during economic downturns as not all sectors of a firm are expected to perform equally poorly during such downturns. takes advantage of the seasonality of the production cycle, Other (Please fill in.)

7. My firm was directly or indirectly involved in synergy-related mergers. Yes a No

20

JOURNAL OF APPLIED FINANCE FALL/WINTER 2004

If the answer to #7 is no, please skip to question #9. 8. Merger-related synergy is said to derive basically from the following sources: A. Operating economies (resulting from economies of scale). B. Financial economies (lower transaction costs/ more coverage by security analysts). C Differential efficiency (acquiring firm's management is more efficient). D. Increased market power (lower degree of competition). The following source(s) most closely describes my firm's M&As during the period January 1,1990 - December 31,2001. (If more than one source was relevant, please rank the sources, 1 being the most important.) Operating economies Q Financial economies Differential efficiency Increased market power Other (Please fill in.) 9. My firm determines the share price of a publiclv-held target firm in the following manner. We primarily use a discounted cash flow model (i.e., we determine the expected post-merger cash fiows that will accrue to my firm's shareholders and then discount such cash fiows at an appropriate discount rate). We combine the discounted cash fiow model with the following model(s). {Please fill in.)

We use market multiple analysis. (Please fill in.)

We use the following model(s) (Please ftll in.)

If your firm does not use a discounted cash fiow model in evaluating mergers, please skip question #10. 10. a Q Q a When employing the discounted cash fiow model, we determine the discount rate in the following manner: We use my firm's average cost of capital as the discount rate. We use the target firm's average cost of capital as the discount rate. We use my firm's cost of equity capital as the discount rate. We use the target firm's cost of equity capital as the discount rate. We determine the discount rate by the following method. (Please fill in.)

11. When the target happens to be a closely-held (private) company, we determine the offer price in the following manner. This question does not apply to my firm because we did not acquire any private company. Applying industry price-to-eaming multiple to the earnings ofthe company to be acquired. Q Applying industry price-to-book value multiple to the earnings of the company to be acquired. a Discounted cash fiow approach. Q We use the following method to determine the offer price for a closely-held company. (Pleasefitllin.)

12. During January 1,1990 - December 31,2001, my company Q Was Q Was not

involved in divestitures.

If the answer to #12 is "was not," please skip to question #15. If the answer is "was," please continue. 13. My firm was involved in the following type(s) of divestitures. (Please check all that apply.) a Outright liquidation of assets Q Sale of an operating unit to another firm

MUKHERJEE, KIYMAZ, & BAKER MERGER MOTIVES AND TARGET VALUATION

21

a a a 14. a a Q a O

Spin-off Equity carve-out Other (Please fill in.) (Please check all that apply.) The main motive(s) for my company's divestittires was (were) to: inerease focus. divest low-performing division. increase managerial efficiency. lower the cost of external financing. achieve a specific organizational form. reward the manager ofthe division that is being spun off. Other motive (Please fill in.)

MISCELLANEOUS. Please indicate the extent of your agreement or disagreement by checking the appropriate column. (SA = Strongly Agree, A = Agree, NAND = Neither Agree nor Disagree, D = Disagree, and SD = Strongly Disagree.) STATEMENT 15. Cash (or cash combined with stock exchange) payment requires a higher premium in M&As than a straight stock-exchange transaction. 16. Cash (or eash combined with stock exchange) requires a higher premium because of tax consequences to the shareholders of the acquired firm. 17. A hostile takeover often results in higher payment to the acquired company than a fnendly merger. 18. An acquisition in a related industry is worth more than an acquisition in a non-related industry. 19. Suppose A and B are two target companies in two different countries. The economy of A's country has a much lower correlation (than B's country) with the economy ofthe United States. All else the same, a higher premium is justified for A. 20. An all-cash offer is more effective in a hostile merger than in a fnendly merger. 21. Poison pills usually represent non-wealthmaximizing behavior. 22. Most ofthe gains from M&As usually accrue to shareholders ofthe acquired firm. 23. M&As may increase shareholders' wealth at the expense of bondholders, especially in leveraged-buyout situations. SA A NAND SD

THANK YOU FOR YOUR KIND PARTICIPATION (PLEASE ATTACH YOUR BUSINESS CARD IF YOU WISH TO RECEIVE THE FINAL REPORT)

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JOURNAL OF APPLIED FINANCE FALL/WINTER 2004

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