This Week In Finance

Great Unsolved Mysteries in Finance (GUMFs):

Mystery no. 17: The Shareholder Wealth Effects of Mergers and Acquisitions

One of the things that keeps the field of Finance interesting is that there exist a number of fundamental issues that remain unresolved, despite substantial amounts of theoretical and empirical research. Even students in the introductory course can find themselves fascinated by these "great unsolved mysteries in Finance." (A digression: when intro- ducing GUMFs, I always point out the fact that the roots of modern Finance go back less than 4 decades -- to M&M (1958); while those of disci- plines such as economics are counted in centuries. Alternatively, GUMFs help to illustrate the fact that the world is a complicated place, and the role of theoretical and empirical research is to help us sorth things out. The latter is my response to those students inclined to shrug at frequent intervals while muttering those famous words: "Ah, it's only a theory.")

Consider the shareholder wealth effects of a merger announcement. Numerous empirical studies document that target firm share values increase upon merger announcements, while the value of the acquiring firm's shares fall or, at best, do not change significantly.

A rough-and-ready example of this well-documented phenomenon comes from The Wall Street Journal of Friday, August 15. Sealed Air Corp. announced the purchase of the packaging business of W.R. Grace & Co. in a $4.9 billion cash and stock transaction. On a day when the Dow-Jones Industrial remained nearly unchanged (+.17%), the value of the Grace shares rose $3.00 (4.5%), while those of Sealed Air fell 2.2%.

It is an interesting classroom exercise to ask students what might explain the valuation effects observed. Chances are, their efforts will mirror those of finance researchers: target share value changes are likely attributable (generally) to higher expected cash flows, decreased risk, or both; but what causes acquirer values to fall? And, perhaps more importantly, if the above result is typical (as the results of numerous event studies of the past two decades suggest), why do rational acquirers engage in such activity?

Don't look for the answer here -- this is a Great Unsolved Mystery! However, the example does provides you the opportunity to bring up many topics and issues of Finance such as agency costs, perverse incentives associated with some types of compensation schemes, managerial hubris, NPVs and the market for corporate control, and the complexities inherent in the interpretation of empirical research.

In short, I have found that GUMF-based discussions can generate a great deal of student thought, and give the students a chance to exercise their reasoning skills. At the same time, they have the opportunity to utilizing the financial tools they have developed over the semester.

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