Showing papers in "Review of Financial Studies in 2009"

Estimating Standard Errors in Finance Panel Data Sets: Comparing Approaches

Abstract: In both corporate finance and asset pricing empirical work, researchers are often confronted with panel data. In these data sets, the residuals may be correlated across firms and across time, and OLS standard errors can be biased. Historically, the two literatures have used different solutions to this problem. Corporate finance has relied on clustered standard errors, while asset pricing has used the Fama-MacBeth procedure to estimate standard errors. This paper examines the different methods used in the literature and explains when the different methods yield the same (and correct) standard errors and when they diverge. The intent is to provide intuition as to why the different approaches sometimes give different answers and give researchers guidance for their use.

Market Liquidity and Funding Liquidity

Abstract: We provide a model that links a security’s market liquidity — i.e., the ease of trading it — and traders’ funding liquidity — i.e., their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding, that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model explains the empirically documented features that market liquidity (i) can suddenly dry up (i.e. is fragile), (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences “flight to liquidity” events, and (v) comoves with the market. Finally, the model shows how the Fed can improve current market liquidity by committing to improve funding in a potential future crisis.

Optimal Versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy?

Abstract: We evaluate the out-of-sample performance of the sample-based mean-variance model, and its extensions designed to reduce estimation error, relative to the naive 1-N portfolio. Of the 14 models we evaluate across seven empirical datasets, none is consistently better than the 1-N rule in terms of Sharpe ratio, certainty-equivalent return, or turnover, which indicates that, out of sample, the gain from optimal diversification is more than offset by estimation error. Based on parameters calibrated to the US equity market, our analytical results and simulations show that the estimation window needed for the sample-based mean-variance strategy and its extensions to outperform the 1-N benchmark is around 3000 months for a portfolio with 25 assets and about 6000 months for a portfolio with 50 assets. This suggests that there are still many "miles to go" before the gains promised by optimal portfolio choice can actually be realized out of sample. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Variance Risk Premiums

Abstract: We propose a direct and robust method for quantifying the variance risk premium on financial assets. We show that the risk-neutral expected value of return variance, also known as the variance swap rate, is well approximated by the value of a particular portfolio of options. We propose to use the difference between the realized variance and this synthetic variance swap rate to quantify the variance risk premium. Using a large options data set, we synthesize variance swap rates and investigate the historical behavior of variance risk premiums on five stock indexes and 35 individual stocks. (JEL G10, G12, G13) It has been well documented that return variance is stochastic. When investing in a security, an investor faces at least two sources of uncertainty, namely the uncertainty about the return as captured by the return variance, and the uncertainty about the return variance itself. It is important to know how investors deal with the uncertainty in return variance to effectively manage risk and allocate assets, to accurately price and hedge derivative securities, and to understand the behavior of financial asset prices in general. We develop a direct and robust method for quantifying the return variance risk premium on an asset using the market prices of options written on this asset. Our method uses the notion of a variance swap, which is an over-thecounter contract that pays the difference between a standard estimate of the realized variance and the fixed variance swap rate. Since variance swaps cost zero to enter, the variance swap rate represents the risk-neutral expected value of the realized variance. We show that the variance swap rate can be synthesized accurately by a particular linear combination of option prices. We propose to

Macro Factors in Bond Risk Premia

Abstract: Are there important cyclical fluctuations in bond market premiums and, if so, with what macroeconomic aggregates do these premiums vary? We use the methodology of dynamic factor analysis for large datasets to investigate possible empirical linkages between forecastable variation in excess bond returns and macroeconomic fundamentals. We find that “real” and “inflation” factors have important forecasting power for future excess returns on U.S. government bonds, above and beyond the predictive power contained in forward rates and yield spreads. This behavior is ruled out by commonly employed affine term structure models where theforecastability ofbondreturns andbondyields is completely summarized by the cross-section of yields or forward rates. An important implication of these findings is that the cyclical behavior of estimated risk premia in both returns and long-term yields depends importantly on whether the information in macroeconomic factors is included in forecasts of excess bond returns. Without the macro factors, risk premia appear virtually acyclical, whereas with the estimated factors risk premia have a marked countercyclical component, consistent with theories that imply investors must be compensated for risks associated with macroeconomic activity. (JEL E0, E4, G10, G12)

How Active Is Your Fund Manager? A New Measure That Predicts Performance

Abstract: the share of portfolio holdings that differ from the benchmark index holdings. We compute Active Share for domestic equity mutual funds from 1980 to 2003. We relate Active Share to fund characteristics such as size, expenses, and turnover in the cross-section, and we also examine its evolution over time. Active Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Nonindex funds with the lowest Active Share underperform their benchmarks. (JEL G10, G14, G20, G23)

Bank Liquidity Creation

Abstract: Although the modern theory of financial intermediation portrays liquidity creation as an essential role of banks, comprehensive measures of bank liquidity creation do not exist. We construct four measures and apply them to data on virtually all U.S. banks from 1993 to 2003. We find that bank liquidity creation increased every year and exceeded $2.8 trillion in 2003. Large banks, multibank holding company members, retail banks, and recently merged banks created the most liquidity. Bank liquidity creation is positively correlated with bank value. Testing recent theories of the relationship between capital and liquidity creation, we find that the relationship is positive for large banks and negative for small banks. (JEL G21, G28, G32)

Do Politically Connected Boards Affect Firm Value

Abstract: This article explores whether political connections are important in the United States. The article uses an original hand-collected data set on the political connections of board members of S&P 500 companies to sort companies into those connected to the Republican Party and those connected to the Democratic Party. The analysis shows a positive abnormal stock return following the announcement of the nomination of a politically connected individual to the board. This article also analyzes the stock-price response to the Republican win of the 2000 presidential election and finds that companies connected to the Republican Party increase in value, and companies connected to the Democratic Party decrease in value. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Do Retail Trades Move Markets

Abstract: We study the trading of individual investors using transaction data and identifying buyer- or seller-initiated trades. We document four results: (1) Small trade order imbalance correlates well with order imbalance based on trades from retail brokers. (2) Individual investors herd. (3) When measured annually, small trade order imbalance forecasts future returns; stocks heavily bought underperform stocks heavily sold by 4.4 percentage points the following year. (4) Over a weekly horizon, small trade order imbalance reliably predicts returns, but in the opposite direction; stocks heavily bought one week earn strong returns the subsequent week, while stocks heavily sold earn poor returns.

Short-Sale Strategies and Return Predictability

Abstract: We examine short selling in US stocks based on new SEC-mandated data for 2005. There is atremendousamountofshortsellinginoursample: shortsales represent24%ofNYSE and 31% of Nasdaq share volume. Short sellers increase their trading following positive returns and they correctly predict future negative abnormal returns. These patterns are robust to controlling for voluntary liquidity provision and for opportunistic risk-bearing by short sellers. The results are consistent with short sellers trading on short-term overreaction of stock prices. A trading strategy based on daily short-selling activity generates significant positive returns during the sample period. (JEL G12, G14)

The "Wall Street Walk" and Shareholder Activism: Exit as a Form of Voice

Abstract: We examine whether a large shareholder can alleviate conflicts of interest between managers and shareholders through the credible threat of exit on the basis of private information. In our model, the threat of exit often reduces agency costs, but additional private information need not enhance the effectiveness of the mechanism. Moreover, the threat of exit can produce quite different effects depending on whether the agency problem involves desirable or undesirable actions from shareholders’ perspective. Our results are consistent with empirical findings on the interaction between managers and minority large shareholders and have further empirical implications. (JEL D53, D82, G10, G30, G34) The role of active large shareholders in improving corporate performance has been discussed extensively in the last two decades. Although large shareholders (including pension funds, mutual funds, hedge funds, and other investors) hold a substantial and increasing fraction of shares in public companies in the United States, most large shareholders play a limited role in overt forms of shareholder activism such as takeovers, proxy fights, strategic voting, shareholders’ proposals, etc. One likely reason for this is that active shareholders only realize a relatively small fraction of the benefits from their monitoring while bearing the full cost, which can be substantial. In other words, we have a classic “free rider” problem. In addition, legal barriers, agency problems affecting the incentives of the large shareholder, and the fact that many large shareholders are committed to being passive and not investing resources to monitor their portfolio firms

The Stock Market and Corporate Investment: A Test of Catering Theory

Abstract: We test a catering theory describing how stock market mispricing might influence individual firms’ investment decisions. We use discretionary accruals as our proxy for mispricing. We find a positive relation between abnormal investment and discretionary accruals; that abnormal investment is more sensitive to discretionary accruals for firms with higher RD that firms with high abnormal investment subsequently have low stock returns; and that the larger the relative price premium, the stronger the abnormal return predictability. We show that patterns in abnormal returns are stronger for firms with higher R&D intensity or share turnover. (JEL G14, G31) In this paper, we study whether mispricing in the stock market has consequences for firm investment policy. We test a “catering” channel, through which deviations from fundamentals may affect investment decisions directly. If the market misprices firms according to their level of investment, managers may try to boost short-run share prices by catering to current sentiment. Firms with ample cash or debt capacity may have an incentive to waste resources in negative NPV projects when their stock price is overpriced and to forgo positive investment opportunities when their stock price is undervalued. Managers with shorter shareholder horizons, and those whose assets are more difficult to value, should cater more.

Just How Much Do Individual Investors Lose by Trading

Abstract: Just How Much Do Individual Investors Lose by Trading? Brad M. Barber Graduate School of Management University of California, Davis Davis, CA 95616 bmbarber@ucdavis.edu www.gsm.ucdavis.edu/~bmbarber Yi-Tsung Lee Department of Accounting National Chengchi University Taipei, Taiwan actytl@nccu.edu.tw Yu-Jane Liu Department of Finance National Chengchi University Taipei, Taiwan finyjl@nccu.edu.tw Terrance Odean 1 Haas School of Business University of California, Berkeley Berkeley, CA 94720 odean@haas.berkeley.edu faculty.haas.berkeley.edu/odean October 2006 We are grateful to the Taiwan Stock Exchange for providing the data used in this study. Michael Bowers provided excellent computing support. Barber appreciates the National Science Council of Taiwan for underwriting a visit to Taipei, where Timothy Lin (Yuanta Core Pacific Securities) and Keh Hsiao Lin (Taiwan Securities) organized excellent overviews of their trading operations. We appreciate the comments of Ken French, Charles Jones, Owen Lamont, Mark Kritzberg, and seminar participants at UC-Davis, University of Illinois, the Indian School of Business, National Chengchi University, University of North Carolina, University of Texas, Yale University, the Wharton 2004 Household Finance Conference, American Finance Association 2006 Boston Meetings , and the 12 th Conference on the Theory and Practice of Securities and Financial Markets (Taiwan).

Idiosyncratic Return Volatility, Cash Flows, and Product Market Competition

Abstract: Over the past 40 years, the volatility of the average stock return has drastically outpaced total market volatility. Thus, idiosyncratic return volatility has dramatically increased. We estimate this increase to be 6% per year. Consistent with an efficient market, this result is mirrored by an increase in the idiosyncratic volatility of fundamental cash flows. We argue that these findings are attributable to the more intense economy-wide competition. Various cross-sectional and time-series tests support this idea. Economic competitiveness facilitates reinterpretation of the results from the cross-country R2 literature, as well as the US idiosyncratic risk literature. (JEL G12, G14).

Bank Lines of Credit in Corporate Finance: An Empirical Analysis

Abstract: I empirically examine the factors that determine whether firms use bank lines of credit or cash in corporate liquidity management. I find that bank lines of credit, also known as revolving credit facilities, are a viable liquidity substitute only for firms that maintain high cash flow. In contrast, firms with low cash flow are less likely to obtain a line of credit, and they rely more heavily on cash in their corporate liquidity management. An important channel for this correlation is the use of cash flow-based financial covenants by banks that supply credit lines. I find that firms must maintain high cash flow to remain compliant with covenants, and banks restrict firm access to credit facilities in response to covenant violations. Using the cash-flow sensitivity of cash as a measure of financial constraints, I provide evidence that lack of access to a line of credit is a more statistically powerful measure of financial constraints than traditional measures used in the literature. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium

Abstract: This paper presents a unified theory of both the level and sensitivity of pay in competitive market equilibrium, by embedding a moral hazard problem into a talent assignment model. By considering multiplicative specifications for the CEO’s utility and production functions, we generate a number of different results from traditional additive models. First, both the CEO’s low fractional ownership (the Jensen–Murphy incentives measure) and its negative relationship with firm size can be quantitatively reconciled with optimal contracting, and thus need not reflect rent extraction. Second, the dollar change in wealth for a percentage change in firm value, divided by annual pay, is independent of firm size, and therefore a desirable empirical measure of incentives. Third, incentive pay is effective at solving agency problems with multiplicative impacts on firm value, such as strategy choice. However, additive issues such as perk consumption are best addressed through direct monitoring. (JEL D2, D3, G34, J3)

Institutional Investors and Equity Returns: Are Short-term Institutions Better Informed?

Abstract: We show that the positive relation between institutional ownership and future stock returns documented in Gompers and Metrick (2001) is driven by shortterm institutions. Furthermore, short-term institutions’ trading forecasts future stock returns. This predictability does not reverse in the long run and is stronger for small and growth stocks. Short-term institutions’ trading is also positively related to future earnings surprises. By contrast, long-term institutions’ trading does not forecast future returns, nor is it related to future earnings news. Our results are consistent with the view that short-term institutions are better informed and they trade actively to exploit their informational advantage. (JEL G12, G14, G20) This article examines the relation between institutions’ investment horizons and their informational roles in the stock market. Although a large body of literature has studied the behavior of institutional trading and its impact on asset prices and returns, 1 the informational role of institutional investors remains an open question. Gompers and Metrick (2001) document a positive relation between institutional ownership and future stock returns. However, they attribute this relation to temporal demand shocks rather than institutions’ informational advantage. Nofsinger and Sias (1999) find that changes in institutional ownership forecast next year’s returns, suggesting that institutional trading contains information about future returns. In contrast, Cai and Zheng (2004) find that institutional trading

Demand-Based Option Pricing

Abstract: We model the demand-pressure effect on prices when options cannot be perfectly hedged. The model shows that demand pressure in one option contract increases its price by an amount proportional to the variance of the unhedgeable part of the option. Similarly, the demand pressure increases the price of any other option by an amount proportional to the covariance of their unhedgeable parts. Empirically, we identify aggregate positions of dealers and end users using a unique dataset, and show that demand-pressure effects help explain well-known option-pricing puzzles. First, end users are net long index options, especially outof-money puts, which helps explain their apparent expensiveness and the smirk. Second, demand patterns help explain the cross section of prices and skews of single-stock options.

Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market

Abstract: Do bond investors demand credit quality or liquidity? The answer is both, but at different times and for different reasons. Using data on the Euro-area government bond market, which features a unique negative correlation between credit quality and liquidity across countries, we show that the bulk of sovereign yield spreads is explained by differences in credit quality, though liquidity plays a nontrivial role, especially for low credit risk countries and during times of heightened market uncertainty. In contrast, the destination of large flows into the bond market is determined almost exclusively by liquidity. We conclude that credit quality matters for bond valuation but that, in times of market stress, investors chase liquidity, not credit quality.

Do Foreigners Invest Less in Poorly Governed Firms

Abstract: As domestic sources of outside finance are limited in many countries around the world, it is important to understand factors that influence whether foreign investors provide capital to a country's firms. We study 4,409 firms from twenty-nine countries to assess whether and why concerns about corporate governance result in fewer foreign holdings. We find that foreigners invest less in firms that reside in countries with poor outsider protection and disclosure and have ownership structures that are conducive to governance problems. This effect is particularly pronounced when earnings are opaque, indicating that information asymmetry and monitoring costs faced by foreign investors likely drive the results. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Estimating the Effect of Hierarchies on Information Use

Abstract: Theory suggests that greater hierarchical distance between a subordinate and his boss makes it more di-cult to share abstract and subjective information in decision making. A novel data set put together from credit dossiers of large corporate loan applicants enables us to observe the information collected by loan o-cers and also how it is used by the ultimate loan approving o-cer. We flnd that greater hierarchical / geographical distance between the information collecting agent and the loan approving o-cer leads to less reliance on subjective information and more on objective information. By exploiting non-linearities in the \assignment rules" that determine an applicant's hierarchical distance, and using information collecting agent flxed efiects, we show that our result cannot be driven by endogenous assignment of applicants. We also flnd that higher frequency of interactions between the information collecting agent and loan approving o-cer, both over time and through geographical proximity, helps mitigate the efiects of hierarchical distance on information use. Our results show that hierarchical distance in∞uences information use, and highlights the importance of \human touch" in communication.

Institutional Investors and the Informational Efficiency of Prices

Abstract: Using a broad panel of NYSE-listed stocks between 1983 and 2004, we study the relation between institutional shareholdings and the relative informational efficiency of prices, measured as deviations from a random walk. Stocks with greater institutional ownership are priced more efficiently, and we show that variation in liquidity does not drive this result. Onemechanismthroughwhichpricesbecomemoreefficientisinstitutionaltradingactivity, even when institutions trade passively. But efficiency is also directly related to institutional holdings, even after controlling for institutional trading, analyst coverage, short selling, variation in liquidity, and firm characteristics. (JEL G12, G14) Institutional shareholdings and trading have increased dramatically over the past several decades. In 1965, members of the Securities Industries Association held 16% of U.S. equities; in 2001, they held 61% according to the Securities Industry Association Fact Book (2002). Moreover, nonretail trading accounted for 96% of New York Stock Exchange (NYSE) trading volume in 2002 (Jones and Lipson 2004). How this broadened scope of institutional ownership and trading affects the quality of equity markets, however, is an open question. Using a broad cross-section of NYSE-listed stocks between 1983 and 2004, we link institutional ownership to the informational efficiency of transaction prices. Intraday prices of stocks with greater institutional ownership more closelytrackfundamentalvalues,inthattheymorepreciselyresemblearandom walk, than prices of stocks with less institutional ownership. Moreover, we use proprietary NYSE data to establish institutional trading activity as one source of the improved short-horizon information environment. These findings have

Differences in Governance Practices between U.S. and Foreign Firms: Measurement, Causes, and Consequences

Abstract: We construct a firm-level governance index that increases with minority shareholder protection. Compared with U.S. matching firms, only 12.68% of foreign firms have a higher index. The value of foreign firms falls as their index decreases relative to the index of matching U.S. firms. Our results suggest that lower country-level investor protection and other country characteristics make it suboptimal for foreign firms to invest as much in governance as U.S. firms do. Overall, we find that minority shareholders benefit from governance improvements and do so partly at the expense of controlling shareholders. (JEL G32, 34, 38) Using the well-known definition from Shleifer and Vishny (1997), governance consists of the mechanisms that ensure minority shareholders receive an appropriate return on their investment. Governance depends on both country-level as well as firm-level mechanisms. The country-level governance mechanisms

The Effects and Unintended Consequences of the Sarbanes-Oxley Act on the Supply and Demand for Directors

Abstract: Using eight thousand public companies, we study the impact of the Sarbanes-Oxley Act (SOX) of 2002 and other contemporary reforms on directors and boards, guided by their impact on the supply and demand for directors. SOX increased directors’ workload and risk (reducing the supply), and increased demand by mandating that firms have more outside directors. We find both broad-based changes and cross-sectional changes (by firm size). Board committees meet more often post-SOX and Director and Officer (D&O) insurance premiums have doubled. Directors post-SOX are more likely to be lawyers/consultants, financial experts, and retired executives, and less likely to be current executives. Post-SOX boards are larger and more independent. Finally, we find significant increases in director pay and overall director costs, particularly among smaller firms. (JELD23, G32, G34, G38, K22, M14)

The Myth of Diffuse Ownership in the United States

Abstract: This article offers evidence on the ownership concentration at a representative sample of U.S. public firms. Ninety-six percent of these firms have blockholders; these blockholders in aggregate own an average 39% of the common stock. The ownership of U.S. firms is similar to and by some measures more concentrated than the ownership of firms in other countries. These findings challenge current thinking on a number of issues, ranging from the nature of the agency conflict in domestic corporations to the relationship between ownership concentration and legal protections for investors around the world. (JEL G32, G34)

a dynamic model of the limit order book

Abstract: of a Markov equilibrium in which the bid and ask prices depend only on the numbers of buy and sell orders in the book, and which can be characterized in closed-form in several cases of interest. My model generates empirically verified implications for the shape of the limit-order book and the dynamics of prices and trades. In particular, I show that buy and sell orders can cluster away from the bid-ask spread, thus generating a hump-shaped limit-order book. Also, following a market buy order, both the ask and bid prices increase, with the ask increasing more than the bid—hence the spread widens.

Financial Contracting with Optimistic Entrepreneurs

Abstract: Optimistic beliefs are a source of nonpecuniary benefits for entrepreneurs that can explain the "Private Equity Puzzle." This paper looks at the effects of entrepreneurial optimism on financial contracting. When the contract space is restricted to debt, we show the existence of a separating equilibrium in which optimists self-select into short-term debt and realists into long-term debt. Long-term debt is optimal for a realist entrepreneur as it smooths payoffs across states of nature. Short-term debt is optimal for optimists for two reasons: (i) "bridging the gap in beliefs" by letting the entrepreneur take a bet on his project's success, and (ii) letting the investor impose adaptation decisions in bad states. We test our theory on a large data set of French entrepreneurs. First, in agreement with the psychology literature, we find that biases in beliefs may be (partly) explained by individual characteristics and tend to persist over time. Second, as predicted by our model, we find that short-term debt is robustly correlated with "optimistic" expectation errors, even controlling for firm risk and other potential determinants of short-term leverage.

Measuring Abnormal Bond Performance

Abstract: We analyze the empirical power and specification of test statistics designed to detect abnormal bond returns in corporate event studies, using monthly and daily data. We find that test statistics based on frequently used methods of calculating abnormal monthly bond returns are biased. Most methods implemented in monthly data also lack power to detect abnormal returns. We also consider unique issues arising when using the newly available daily bond data, and formulate and test methods to calculate daily abnormal bond returns. Using daily bond data significantly increases the power of the tests, relative to the monthly data. Weighting individual trades by size while eliminating noninstitutional trades from the TRACE data also increases the power of the tests to detect abnormal performance, relative to using all trades or the last price of the day. Further, value-weighted portfolio-matching approaches are better specified and more powerful than equal-weighted approaches. Finally, we examine abnormal bond returns to acquirers around mergers and acquisitions to demonstrate how the abnormal return model and use of daily versus monthly data can affect inferences. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

The Nature and Persistence of Buyback Anomalies

Abstract: Using recent data, we reject the hypothesis that the buyback anomalies first reported by Lakonishok and Vermaelen (1990, Journal of Finance 45:455--77) and Ikenberry, Lakonishok, and Vermaelen (1995, Journal of Financial Economics 39:181--208) have disappeared over time. We find evidence consistent with the hypothesis that open market repurchases are a response to a market overreaction to bad news: significant analyst downgrades, combined with overly pessimistic forecasts of long-term earnings. Stock prices after tender offers are set as if all investors tender their shares, but empirically they do not. Thus, the arbitrage opportunity persists because the market sets prices as if the average, not the marginal investor, determines the stock price. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org, Oxford University Press.

How Do Mergers Create Value? A Comparison of Taxes, Market Power, and Efficiency Improvements as Explanations for Synergies

Abstract: There is little evidence in the literature on the relative importance of the underlying sources of merger gains. Prior literature suggests that synergies could arise due to taxes, market power, or efficiency improvements. Based on Value Line forecasts, we estimate the average synergy gains in a broad sample of 264 large mergers to be 10.03% of the combined equity value of the merging firms. The detailed data in Value Line projections allow for the decomposition of these gains into underlying operating and financial synergies. We estimate that tax savings contribute only 1.64% in additional value, while operating synergies account for the remaining 8.38%. Operating synergies are higher in focused mergers, while tax savings constitute a large fraction of the gains in diversifying mergers. The operating synergies are generated primarily by cutbacks in investment expenditures rather than by increased operating profits. Overall, the evidence suggests that mergers generate gains by improving resource allocation rather than by reducing tax payments or increasing the market power of the combined firm.