Knowledge that Transforms

Existing research finds little evidence of overinvestment by successfully acquired targets. This paper shows how samples drawn from completed takeovers are biased against finding overinvestment and documents evidence of overinvestment in targets that use a highly lever? aged transaction to avoid a takeover. The evidence also suggests that these restructurings create value by mitigating the targets' overinvestment problems. I. Introduction Jensen's (1986) free cash flow theory implies that some firms become takeover targets because their managers inefficiently allocate free cash flow to unprofitable investments. Empirical studies of completed takeovers by Morck, Shleifer, and Vishny (1988), Bhagat, Shleifer, and Vishny (1990), and Servaes (1994), among others, however, do not support this prediction. Nonetheless, these studies do not mean that free cash flow is unimportant in the market for corporate control. Both Jensen (1986) and Stulz (1990) suggest the threat of a disciplinary takeover can prompt firms to curtail overinvestment of free cash flow. Therefore, the absence of overinvestment in successfully acquired firms does not rule out the possibility that this problem characterizes many takeover targets. It is plausible that the threat of takeover systematically leads overinvesting firms to reduce investment. In this paper, I examine firms that use leveraged restructurings to thwart takeover attempts. Jensen (1986), (1989) argues that increased leverage bonds managers to pay out their excess cash flow instead of overinvesting. I begin with a simple model to show how takeover bids can lead to leveraged restructurings. This model suggests that successful acquisitions will be associated with bidder, but not target, overinvestment. The intuition is simple: a leveraged restructuring commits a firm to paying out its excess cash flow, eliminating the need for a disciplinary takeover. To the extent that these restructurings defeat takeover attempts, studies *Leavey School of Business, Santa Clara University, Santa Clara, CA 95053. An earlier version of this paper was titled, What Role Does Overinvestment Play in the Market for Corporate Control? I am grateful to Rene Stulz, David Mayers, John Persons, and Ralph Walkling for their helpful guidance. Thanks are also due to Jonathan Karpoff (the editor), Henri Servaes (the referee), Yaron Brook, Patric

This study examines the wealth effects of convertible bond call announcements on stockholders, straight bondholders, and called and non-called convertible debtholders. We document that forced conversions are associated with a significant loss in firm value. The results suggest that convertible call announcements can trigger both negative signal and wealth transfer effects. We show that at least part of the negative effect on stock prices results from wealth transfer to straight bondholders. Our analysis also lends empirical validity to the common contention that called convertible bondholders suffer wealth expropriation due to the elimination of the premium. The wealth effect on non-called convertible debtholders is insignificant. Cross-sectional analysis reveals that the negative signal effect is important in explaining bond, stock, and firm excess returns. Finally, we present evidence that refutes the notion that bonds are called to relieve the firm from restrictive debt covenants.

This paper investigates the hypothesis that tough antitrust enforcement in the 1960s led firms to engage in diversification programs by preventing them from growing within their own industries. If true, diversification should have occurred more often when large firms merged than when small firms merged because small mergers were less likely to have received antitrust attention. Such a pattern is not observed in a sample of 549 acquisitions from 1968?diversification was equally common in large and small mergers. Survey evidence shows that diversification movements occurred in other industrialized nations where there was a loose antitrust environment. Both pieces of evidence suggest that antitrust played a minor role in the diversification movement.

Douglas O. Cook, Lewis J. Spellman, Firm and Guarantor Risk, Risk Contagion, and the Interfirm Spread among Insured Deposits, The Journal of Financial and Quantitative Analysis, Vol. 31, No. 2 (Jun., 1996), pp. 265-281

This paper examines trading volume on the Tokyo Stock Exchange. Traditional theory suggests that taxes create strong incentives to delay realization of capital gains and accelerate realization of losses. Contrary to the theory, we find strong evidence that turnover is higher for stocks with gains (winners) than for stocks with losses (losers). In particular, the winner stocks of keiretsu firms tend to have high end-of-fiscal-year turnover. This is true even when realizing gains could result in higher tax liabilities. We conclude that capital gains taxes have only a small impact on turnover in Japan. Other non-tax-related motives, especially window dressing, appear to dominate investor behavior. We find strong evidence that this window dressing is concentrated in the stock of keiretsu firms.

This paper develops an intertemporal model of international capital market segmentation. Within the model, under various forms of segmentation/integration, the equilibrium asset prices and allocations, the risk-free interest rate, and the intertemporal consumption behavior and welfares of two countries are derived and compared. It is shown that the equilibrium interest rate is increased on integration, and that integrating markets may be significantly welfare decreasing for one of the countries. Conditions that may lead to a decrease in welfare are investigated. The conclusions as to the effects of segmentation on asset prices in the mean-variance model of the existing finance segmentation literature are also shown to break down in an intertemporal model.

Paul D. Childs, Steven H. Ott, Timothy J. Riddiough, The Pricing of Multiclass Commercial Mortgage-Backed Securities, The Journal of Financial and Quantitative Analysis, Vol. 31, No. 4 (Dec., 1996), pp. 581-603

Previous tests of stock index arbitrage models have rejected the no-arbitrage constraint imposed by these models. This paper provides a detailed analysis of actual S&P 500 arbitrage trades and directly relates these trades to the predictions of index arbitrage models. An analysis of arbitrage trades suggests that i) short-sale rules are unlikely to affect the cashfutures mispricing, ii) the opportunity cost of arbitrage funds exceeds the Treasury bill rate, and iii) the average price discrepancy captured by arbitrage trades is small. Tests of the models provide some support for a version ofthe arbitrage model that incorporates an early liquidation option. The ability of these models to explain arbitrage trades, however, is surprisingly low.

Stijn Claessens, George Pennacchi, Estimating the Likelihood of Mexican Default from the Market Prices of Brady Bonds, The Journal of Financial and Quantitative Analysis, Vol. 31, No. 1 (Mar., 1996), pp. 109-126

This paper investigates the relation between the form of compensation and the manager's decision horizon. It finds that while all-cash contracts induce managers to underinvest in the long term, all-stock contracts induce overinvestment in the long term. It shows that compensation contracts consisting of both cash and restricted stock can produce efficient investment, thereby providing a rationale for the existence of both cash and stock incentive schemes in executive compensation packages. This explains why the adoption of either type of incentive scheme results in a positive stock price reaction. In addition, the paper derives the following testable hypotheses: i) the proportion of the stock compensation is decreasing in the precision of the manager's ability and increasing in the precision of the firm's cash flows; ii) firms compensate their managers with proportionately more stock in profitable years and proportionately more cash in leaner years; and iii) the greater the growth opportunities, the higher the proportion of stock compensation.