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Managerial optimism and market misvaluation: The effects on mergers and acquisitions

Todd Alan Brown, University of Nebraska - Lincoln


This study examines the role that both managerial and investor optimism can have on mergers. A simple model is constructed to show the effects that belief differences can have on merger activities. The model combines the acquirer and target manager's possible optimism in their abilities with the potential misvaluations that may exist in the stock market. Several testable hypotheses are implied from the model including the desired method of payment, the amount of the premium paid to the target, and the market's reaction a merger. Empirical tests are then implemented to assess the predictions of the model. ^ The model demonstrates the effects of optimism on the method and amount of payment in mergers along with the market's reaction to the merger announcement. We find that optimistic acquiring managers will prefer cash mergers because of they believe that their stock is undervalued. Their optimism will also bias them to pay a larger premium in cash mergers than an unbiased manager resulting in a negative stock market reaction to the merger announcement. Optimistic target managers will instead prefer stock mergers and demand a larger premium in cash mergers, compared to an unbiased manager. This increased premium leads to the target's share price experiencing a positive stock market reaction to the acquisition announcement. ^ To test the model, investor misvaluations are proxied by both price-to-book and price to residual-income ratios. Managerial optimism is measured as positive bias in their ability to manage their company. Managers are classified as optimistic if they fail to exercise significantly in-the-money vested options or purchase their own companies stock. ^ Empirical tests show that market overvaluation leads to stock mergers and undervaluation leads to cash mergers, which agrees with the predictions of the acquiring manager and not the target manager. Optimistic managers, both acquiring and target, are associated with larger premiums. The market reacts negatively to the news of a merger announcement when either the acquirer or target shares are overvalued. No market response is documented for an optimistic acquiring manager purchasing another firm. A positive market reaction is found, however, if an optimistic target manager is being acquired. ^

Subject Area

Economics, Finance

Recommended Citation

Brown, Todd Alan, "Managerial optimism and market misvaluation: The effects on mergers and acquisitions" (2006). ETD collection for University of Nebraska - Lincoln. AAI3225889.