Deal Performance Evaluation

Learning Objectives
In this lesson, you are expected to:

 Understand the concept of shareholder value creation in mergers and

acquisitions
 Measure short-term gains from the deal using event study
 Presenter Notes
2022-09-14 [Link]
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The economic and strategy
Different Perspectives of M&As perspectives suggest that mergers
may be driven by economic and
strategic logic that seeks to establish
 Economic and strategic perspective – establish competitive advantage competitive advantage, leading to
value creation for shareholders.

which should then lead to value creation for shareholders The finance perspective proposes
shareholder wealth maximization as
the pre-eminent objective of merger
decisions, although contextual
factors such as principal–agent
 Finance perspective – the main objective is value creation for shareholders.
problems, weak corporate
governance structure and an
imperfect market for corporate
Obstacles include principal-agent problems, weak corporate governance and market
control may cause deviation from
this objective.
imperfections The organizational perspective calls
into question the assumption that
acquisition decision process is a
coldly logical process driven by
considerations of economic
 Organisational perspective – acquisitions are driven by intended rationality and shareholder value
imperative. It also raises the

organizational changes. However, these may not be always achieved possibility that the outcome of any
merger may not deliver the ex ante
merger objectives because of the
difficulties in achieving the
organizational change that is a
 Managerial perspective – M&As are the result of managerial incentives precondition for their achievement.
The managerial perspective, again
drawing upon the agency model of
whose interests though may not be aligned with those of shareholders the firm, points to managerial
objectives that may conflict with
shareholder objectives. Managerial
incentives, designed to alleviate the
agency conflicts, may also have
perverse effects by encouraging
managers to take more risk. The
collapse of the stock markets and of
the M & A waves in 2000–2001
have been attributed to such skewed
incentives. These various
 Presenter Notes
2022-09-14 [Link]
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Nevertheless, mergers and
Company Stakeholders acquisitions are of considerable
interest to all the stakeholders in the
merging firms. These include
shareholders, managers, employees,
consumers and the wider
community. Thus assessment of the

Government ‘success’ of mergers depends on the

particular stakeholder perspective
adopted. The interests of these
groups do not always coincide. One
group can win at the expense of the
others. For example, a takeover can
lead to high shareholder returns, but

Managers Shareholders loss of managerial jobs. The

antitrust authorities are the
custodians of the interests of the
consumers and the community at
large, and regulate mergers and
acquisitions. These competition
authorities generally follow the rule
that mergers that lead to substantial
FIRM lessening of competition (SLC)
should be prohibited.

Consumers
Employees

Community
 Testing the Impact of M&As on Firm Value: Event Study
 Event studies are used to examine the impact of several corporate events such
as M&As , IPOs, CEO turnover, earnings announcements, changes in capital
structure, etc.

 They help address the fundamental question of how the flow of information to
the market about an event affects share returns and assess the wealth
impact of corporate changes

 For the above reasons, it is determined whether there is an abnormal return

following an (unanticipated) corporate event

 Non-zero abnormal returns that persist after an event are inconsistent with the
efficient market hypothesis (EMH). The EMH argues that prices adjust quickly
to fully reflect new information
 Measuring Post-Acquisition Performance: The Benchmark Problem
 The merged entity is not the same firm as the two firms preceding the
acquisition

 Post-deal performance may not be directly comparable to pre-deal

performance

 How would the merged firm perform if the acquisition had not taken
place?

 The expected shareholder value improvements from the merger should be

incorporated in the benchmark
 The Benchmark Problem: Illustration
Acquirer’s hypothetical
Stock Price stock-price performance

Acquirer’s actual
stock-price performance

Acquirer’s hypothetical
stock-price performance
T
i
m
 Presenter Notes
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CAPM: A firm that has the same
The Benchmark Problem: Possible Solutions systematic risk as the merging firms
then provides a good control for
estimating the post-merger
 Performance forecast – allows for expected changes in market conditions or performance. However, this
procedure assumes that the

competitive reaction but sensitive to the quality and reliability of analysts’ forecast
systematic risk of the merged firm
will continue to be the same as that
of the control firm. This raises the
question of whether the merger has
altered the systematic risk profile of
 Control sample – match the acquiring firm to a non-acquiring control firm or a set
the merging firms. Strategic
reconfiguration of firms often alters
their risk profile. For example, a
of control firms based on a number of characteristics. Example: horizontal or vertical merger may
change the cost structure, market
share and volatility of earnings,
thereby changing the risk profile. In

(a) CAPM (based on systematic risk)

this event the control may no longer
be a valid benchmark if it does not
undergo similar transformation

(b) Additional variables such as industry, size and growth prospects (market-
to-book ratio)

(c) Propensity-score matching (PSM) – matching the acquiring firm to a non-

acquiring firm with a similar propensity to acquire (a probit regression model
is usually required)
 Presenter Notes
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A security’s price performance can

Calculating Abnormal Returns: CAPM be considered abnormal only with

reference to some benchmark, and
therefore it is necessary to specify a

 According to Capital Asset Pricing Model (CAPM), the expected return on stock
return-generating model before
abnormal returns can be measured.
If the actual return at the time of a
i depends on its systematic (non-diversifiable) risk: merger exceeds the expected return,
the excess or abnormal return ARit
in time t for the stock of merging
company i is a measure of the
merger impact on the value of the

E ri   rf  i E rM   rf 

stock to investors.

where
𝐸(𝑟𝑖) = Expected return on share i
𝑟𝑓 = Risk-free rate
𝛽 = Beta of share i
𝐸(𝑟𝑀) = Expected return on the market portfolio
 Calculating Abnormal Return: CAPM
 The abnormal return is difference between the actual (realised) return and the
expected return

ARi  ri  E ri 

where
𝐴𝑅𝑖 = abnormal return on share i
𝑟𝑖 = actual (realized) return on share i
 Presenter Notes
2022-09-14 [Link]
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The plot shows the average monthly
Excess Returns on Size Portfolios 1926 - 2011 excess return (the return minus the
one-month risk-free rate) for ten
portfolios formed in each year (by
Fama and French) based on firms’
market capitalizations, plotted as a
function of the portfolio’s estimated
beta. The black line is the security
market line. If the market portfolio
is efficient and there is no
measurement error, all portfolios
would plot along this line. The
error bars mark the 95% confidence
bands of the beta and expected
excess return estimates.
 Presenter Notes
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The plot shows the same data with
Excess Returns on Book-to-Market Portfolios 1926 - 2011 portfolios formed based on stocks’
book-to-market ratios rather than
size. Note the tendency of value
stocks (high book-to-market) to be
above the security market line, and
growth stocks (low-book-to-market)
to be near or below the line.
 Presenter Notes
2022-09-14 [Link]
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This application of the Fama–
Abnormal Returns Extended CAPM (Fama and French 3-Factor Model) French three factor (FFTF) model
assumes that three factors are
adequate to explain the observed
 Incorporating the size and growth factors in the CAPM, the model take the returns. But Carhart found that
there was another missing factor!

following form: This is the momentum in stock

returns: that is, firms experiencing
high returns in the past continue to
earn high returns. But the last word
has perhaps not been said on this
matter, since finance researchers

E ri   rf  i E rM   rf   hi HML  si SMB

have been engaged in a search for
what are quaintly described as
‘anomalies’. Other researchers have
tried to explain asset prices by
including, in addition to beta, size
and book-to-market, other proxies
where for more obscure factors such as

𝑟𝑓 = risk-free rate 𝐻𝑀𝐿 = difference in returns between high and low

dividend yield, past performance or
bankruptcy risk. Thus the
enthusiastic search for the Holy
market-to-book value portfolios Grail of the asset pricing model
continues Both the FFTF and

𝑆𝑀𝐵 = difference in returns between small and big firm

Carhart four-factor models are
𝛽𝑖 = beta of share i generally used to measure long term
performance and are estimated using
portfolios monthly returns.
 Presenter Notes
2022-09-14 [Link]
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The market model and the CAPM
Abnormal Returns: Market Model are related, and alpha can be related
to the risk-free return and beta.
Many early studies of stock market
 The expected return on share i is given by the following equation: efficiency and the impact of
numerous corporate events, such as
acquisitions, dividend policy
changes, accounting policy changes,
ri   0   1 rM new share issues and seasoned
share issues, were conducted using
the CAPM, the market model, or
slight variations of these.

where

𝑟𝑀 = Actual return on the market

𝛾𝛾0 and 𝛾𝛾1 = Estimate obtained by regressing the actual security return on the
actual market returns over the estimation period

 The estimation period is usually 140 trading days (-200, -60) preceding the
acquisition announcement date or a similar period
 Abnormal Returns: Market-Adjusted Model
 The market-adjusted model is a variation of the market model assuming that  0
is equal to zero.

 By definition, the beta of the market portfolio is equal to 1

 Therefore, the model implies that the individual share i earns the same normal
(expected) return as the market, that is, share i is the same as the average share in the
market

 The model is also consistent with CAPM under the assumption that  = 1 for all
i

securities
 Short-Term Deal Performance: Cumulative Abnormal Returns (CARs)
 The market reaction to a M&A announcement is measured by the Cumulative
Abnormal Returns (CARs) to shareholders over a short event window of a few
days around the event:
T
CARi,t   ARi,t
t 1

where ARi,t is the abnormal return on share i on day t

 Short-Term Deal Performance: Cumulative Abnormal Returns (CARs)
 Therefore, using a 3-day event window:
3
CARi,3   AR
t
i,t  ARi,1  ARi,2  ARi,3
1
 Usually, for a 3-day CAR we use the symbol CAR(-1, +1) where -1 is the date
preceding the acquisition announcement, 0 is the acquisition announcement date and
+1 is the next day following the acquisition announcement
 So, What Have We Learnt?
 To determine whether the performance of short- and long-term performance of the
acquisition, the event study is used
 Event study can be used to calculate abnormal return and cumulative
abnormal return
 Abnormal return (AR) is excess return over and above return adjusted for risk
(CAPM)
 Cumulative abnormal return (CAR) is the sum of daily return across a time
period