A Financial Perspective on Mergers and Acquisitions and the Economy

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The Free Cash Flow Theory of Takeovers: A Financial Perspective on Mergers and Acquisitions and the Economy

Michael C. Jensen
Harvard Business School MJensen@hbs.edu

© Michael C. Jensen, 1987

“The Merger Boom”, Proceedings of a Conference sponsored by Federal Reserve Bank of Boston, Oct. 1987, pp.102-143

This document is available on the Social Science Research Network (SSRN) Electronic Library at: http://papers.ssrn.com/ABSTRACT=350422

The Free Cash Flow Theory of Takeovers: A Financial Perspective on Mergers and Acquisitions and the Economy Michael C. Jensen*
Harvard Business School MJensen@hbs.edu From, “The Merger Boom”, Proceedings of a Conference sponsored by Federal Reserve Bank of Boston, Oct. 1987, pp.102-143

Economic analysis and evidence indicate the market for corporate control is benefiting shareholders, society, and the corporate form of organization. The value of transactions in this market ran at a record rate of about $180 billion per year in 1985 and 1986—47 percent above the 1981 record of $122 billion. The number of transactions with purchase prices exceeding one billion dollars was 27 of 3300 deals in 1986 and 36 of 3000 deals in 1985 (Grimm, 1985). There were only seven billion-dollar plus deals in total, prior to 1980. In addition to these takeovers, mergers, and leveraged buyouts, there were numerous corporate restructurings involving divestitures, spinoffs, and large stock repurchases for cash and debt. The gains to shareholders from these transactions have been huge. The gains to selling-firm shareholders from mergers and acquisition activity in the period 1977-86 total $346 billion (in 1986 dollars).1 The gains to buying-firm shareholders are harder

Estimated from data in Grimm (1986). Grimm provides total dollar values for all merger and acquisition deals for which there are publicly announced prices amounting to at least $500,000 or 10 percent of the firm and in which at least one of the firms was a U.S. company. Grimm also counts in its numerical totals deals with no publicly announced prices that it believes satisfy these criteria. I have assumed that the deals with no announced prices were on average equal to 20 percent of the size of the announced transactions and carried the same average premium. *Professor of Business Administration, Harvard Business School, and Professor of Finance and Business Administration, University of Rochester. The author is grateful for the research assistance of Michael Stevenson and the helpful comments by Sidney Davidson, Harry DeAngelo, Jay Light, Robert Kaplan, Nancy Macmillan, Kevin Murphy, Susan Rose-Ackerman, Richard Ruback, Wolf Weinhold, Toni Wolcott, and especially Armen Alchian. This research is supported in part by the Division of Research, Harvard Business School, and the Managerial Economics Research Center, University of Rochester. The analysis here draws heavily on that in Jensen (forthcoming 1988).

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M. C. Jensen

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1987

to estimate, and to my knowledge no one has done so yet, but I estimate that they would add at least another $50 billion to the total. These gains, to put them in perspective, equal 31 percent of the total cash dividends (valued in 1986 dollars) paid to investors by the entire corporate sector in the past decade.2 Corporate control transactions and the restructurings that often accompany them can be wrenching events in the lives of those linked to the involved organizations: the managers, employees, suppliers, customers and residents of surrounding communities. Restructurings usually involve major organizational change (such as shifts in corporate strategy) to meet new competition or market conditions, increased use of debt, and a flurry of recontracting with managers, employees, suppliers and customers. This activity sometimes results in expansion of resources devoted to certain areas and at other times in contractions involving plant closings, layoffs of top-level and middle managers and...
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