2008-59
Cross-sectional Stock Returns on Fundamental value
vs. Market Value in Mergers and Acquisitions:
Evidence from Japan
Tadanori Yosano Yoshinori Shimada

Cross-sectional Stock Returns on Fundamental Value vs. Market Value in Mergers andAcquisitions: Evidence from Japan

Tadanori Yosano[1]Graduate School of Business Administration of Kobe University, 2-1, Rokko-dai cho, Nada-ku, Kobe,
657-8501, Japan

Yoshinori Shimada
Graduate School of Business Administration of Kobe University, 2-1, Rokko-dai cho, Nada-ku, Kobe,
657-8501, Japan
Abstract
This study looks at the difference between the fundamental value and the market value of firms during themerger and acquisition process, and investigates the role of that difference on the method of payments (cashvs. stock) and on the subsequent stock performance around the merger and acquisition (M&A)
announcement date. The number of M&A transactions has dramatically increased since the stock swap andstock transfer schemes were introduced in 1999. We investigate the scenario that managers who specialize inanalyzing the corporate value of the firms possibly shorten the value correction time and partially reduce
misvaluation in the capital market. The Means of Payment hypothesis suggests that the managers
should choose stock payment over cash payment when the acquiror is over-valued in the market. However,
we found that Japanese managers more positively use cash payment when the firm has sufficient financial
slack (is cash rich). The Misvaluation hypothesis suggests that positive excess returns of the acquiror could
be detected around the announcement day of M&A transactions, when the acquiror and/or the target
is/are under-valued in the market. We found strong evidence which supports the Misvaluation hypothesis. In
calculating the fundamental value of the firms, we employed the Residual Income Model, using financial
analysts forecast value of future profits, after controlling the book-to-market ratio. We found strong evidence
which supports the Misvaluation hypothesis. In particular, the hedging portfolio strategy supports the longposition of the acquiring firms (M&A transactions are categorized as high acquiror’s valuation–high target’s
valuation group) and simultaneously holds the short position of the acquiring firms (M&A transactions areconversely categorized as low acquiror’s valuation–low target’s valuation group). This combination shows
more persistent and more positive abnormal returns than the long position strategy of simply holding
acquired stock after all M&A transactions. However, the simple long position strategy in Japan is still
positive, when compared to the US.
Keywords
Merger and acquisitions, Means of Payment hypothesis, Misvaluation hypothesis, Fundamental value,
Residual income model[1] Corresponding author. Tel,: +81-78-803-6989.
E-mail address: yosano@kobe-u.ac.jp (T. Yosano)11. Introduction(1) Purpose
This study investigates the difference between the fundamental value and the market
value of firms (Misvaluation) when mergers and acquisitions (M&A) have occurred andexamines the subsequent effects on cross-sectional stock returns. The number of M&Atransactions in Japan has dramatically increased since the revision of corporate law, such as
the introduction of the pure holding company (corporate law revision 1997), the stock swap
and stock transfer schemes, and the corporate divestiture scheme (corporate law revision
1999; 2000). The stock swap and stock transfer schemes were introduced to achieve thesmooth shift to the holding company and to establish the relationship between the 100%parent and subsidiary company. These schemes resulted in the number of M&A transactions
nearly doubling--going from 669 in 1998 to 1,251 in 20011 [Source: Marr M&A data CD-ROM
by Recof Ltd.] In the late 1990s, Japanese firms greatly relied on funding from banks, but
after the stock swap schemes, many firms shifted from bank funding to stock issuance.
The corporate situation and resulting legal climate stimulated activity in the M&A
market. A shift in financing from lending (especially main banking lending) to direct funding
from a capital market was much needed. Large shareholders require corporate managers tomaximize the firms’ value, unlike conventional creditors. Firms have to ‘select and focus’ on
their business and carefully allocate resources in order to be more efficient and maximize
value. In these cases, M&A and spin-off transactions are utilized as enhancement methods toshorten the ‘select and focus’ process, as opposed to restructuring the business internally.
Within an active M&A market, larger shareholders, especially investment fund holders,increase their managerial participation. For instance, the number of buy-outs by investment
funds was 31 (total transaction value was 2,292 billion yen) in 2001; 76 (total value was 9,225
billion yen) in 2006; and 86 (total value was 655.9 billion yen) in 2007. The cumulative total
number stood at 395 (total value was 40,939 billion yen) since the first occurrence of a buy-out
fund in1998 [Source: Japanese Buy-out Research Institute Ltd.]The increase in activity in such an M&A market increases the possibility of shortening
the value correction time and reducing misvaluation. It is commonly believed that investment
funds analysts have priveleged access to information. Their influential position gives them anadvantage over individual investors because analysts directly meet with managers and obtaina better and more insightful understanding of management decisions. Therefore investment
funds analysts are believed to play a significant role in correcting misvaluation.
Our study investigates the difference between the fundamental value and the market
value of firms (Misvaluation) when M&As have occurred and their subsequent effects oncross-sectional stock returns. We examined the following two aspects:
1

The Business Accounting Council issued a new Accounting Standards for Business Combination on October 31, 2003,
which has been executed since the business fiscal year that begins after April 1, 2006. The number of the transactions ofmerger and acquisition reached a new high of 1,897 (total value was 1,174 billion yen) in 2006.

2

Our first hypothesis concerns the manager's decision of payment method (cash vs. stock).
We hypothesize that managers focus on misvaluation (the difference between thefundamental value and the market value of the firm).

We predict that if managers take thefundamental value of their own and the target firms into consideration, and their own stock isovervalued or the target firm’s stock is undervalued, then stocks will be positively used as
payment.
Our second hypothesis is whether the investors are able to profit after an M&A. If theinvestors buy the stock of the acquiring firms when the acquirors and targets are bothundervalued, and simultaneously sell the stock of acquiring firms when the acquirors andtargets are both overvalued, then we predict this will be a profitable investment strategy.
In this paper, both hypotheses were investigated by focusing on short-term abnormal
returns. The fundamental value was calculated according to the Residual Income Model(RIM), using stock holders’ equity value and the expected future net income of the firm's
value.
(2) Composition
The composition of this paper is as follows:
Section 2 reviews the previous research on short-term stock performance of M&Atransactions. We especially examined the differences of post-M&A stock performance between
the U.S. and Japan. We also compare the post-M&A stock performance between payment
methods (cash vs. stock).
Section 3 describes the Means of Payment hypothesis and the Misvaluation hypothesis.
Section 4 gives a general view of our data sample, data characteristics, and our method of
estimating the fundamental value of the firm.
Section 5 presents the results of our investigation of the payment method (cash vs. stock)and the subsequent cross-sectional stock returns using univariate and multivariate tests.
Section 6 reports additional results of subsequent cross-sectional stock returns constructedwith a hedging portfolio strategy utilizing the V/P ratio (Fundamental value to Market value
ratio).
Section 7 provides our main conclusions and future research goals.
2. Short-term Stock Performance of M&A Transactions(1) Previous Research of Short-term Stock Performance of M&A Transactions
In the US, the measurement of the economic effect of M&A information has beenthoroughly investigated with event study methodology for more than thirty years. Jensen andRuback (1983) surveyed previous research of successful sample M&A transactions in sample
periods from 1962 to 1979. They reported the following short-term excess returns occurred
around M&A announcements. For target firms, the announcement effect for two days around3

the announcement day was 7.72% on average, whereas the announcement effect for one
month is 15.90% on average. For the acquiring firms, the announcement effect for two daysaround the announcement day was -0.05% on average, and the announcement effect for one
month was 1.37% on average.
Regarding acquiring firms, a significant excess return has not been reported prior to 1983,
except for Asquish, Bruner, and Mullins (1983), who reported an average excess return of
3.48% for a one month period, during the sample period from 1963 to 1979. If we expand thesample periods to the 1990s, we find that Andrade, Mitchell, and Stafford (2001), using thesample period from 1973 to 1998, reported a significantly positive average excess return of
16.0% around the announcement day (-1, +1) for the target firms. However, there was an
insignificantly average negative excess return of -0.7% around the announcement day (-1, +1)
for acquiring firms. Andrade, Mitchell, and Stafford reported that acquiring firms paid a highM&A premium (the median was 37.9%) from 1973 to 1998 in the U.S. Also, taking into
consideration the high M&A premium in the U.S., we may conclude that the shareholders of
the target firms receive exclusive benefits of the short-term stock appreciation that occurs
around M&A transactions.
In Japan, the number of M&A transactions was far lower than in the U.S., until the early
1990s. Pettway and Yamada (1986), examined sixty-six M&A transactions in the period 1977
to 1984 and reported an insignificantly negative excess return (-0.07% on average) around theannouncement day (-1, +1) for the target firms.

There was also an insignificantly positive

excess return (0.82% on average) around the announcement day (-1, +1) for acquiring firms.
Usui (2001) examined the period of 1989 to 1999 and reported an average positive excess
return of 4.08% (10% significant level)around the announcement day (-1, +1) for the target

firms, as well as an average positive excess return of 1.62% (10% significant level) around theannouncement day (-1, +1) for acquiring firms. His sample period included a much larger
number of M&A transactions than Pettway and Yamada (1986). Similarly, Inoue (2002),
examining the period 1990 to 2002, also reported an average positive excess return of 4.37%(10% significant level) around the announcement day (-1, +1) for the target firms, as well as
an average positive excess return of 1.51% (10% significant level) around the announcementday (-1, +1) for acquiring firms.
(2) Measurement of the Economic Significance of M&A Transactions
In this paper, we adopted standard event study methodology to measure the economic
effect of an M&A announcement on the acquiring firms, the target firms, and on the total
economic wealth of the acquiror and target firms. Table 1 shows Cumulative Abnormal
Return (CAR, equal-weighted) for various periods around the announcement day, given as (0),of the M&A, including 372 M&A transactionsin the period January, 1996 to October, 2007

[Source: Recof Ltd. MARR M&A data CD-ROM]. The sample includes merger bids and tender
offers in which both acquiror and target were listed on the Japanese Stock Market in order to4eliminate small cases. We excluded cases where either acquiror or target was a financial
institution, or cases with a bailout takeover where the transaction was a result of the target
being in financial distress, etc.
According to Fuller, Netter, and Stegemoller (2002), the abnormal returns of the acquiror
and target were calculated by the market adjustment model based on NYSE index data; inour study, we used the Topix indicator as a market portfolio. Regarding acquirors, we found on
average short-term positive abnormal returns for the following time periods: 1.49% (1%significant level) around the announcement day (-1, +1); 1.20% (5% significant level) aroundthe announcement day (-3, +3); and 1.35% (1% significant level) on around the announcementday (-5, +5). If we extend the announcement period from (-1, +1) to (-1, +3) or (-1, +5), theshort-term positive abnormal returns worsened to 1.00% and 0.95% respectively. This meansthat investors over-reacted immediately after the M&A announcement.
Focusing specifically on tender offers, we found the following positive abnormal returns:
1.40% (1% significant level) around the announcement day (-1, +1); 1.57% (5% significant
level) around the announcement day (-3, +3); and 0.79% (1% significant level) around theannouncement day (-5, +5). Unlike M&As, we found that the announcement effect persisted
for tender offers. The abnormal return of around the announcement day (-1, +1) does notdiminish. If we extended the period from (-1, +1) to (-1, +5), the positive abnormal return wasmaintained at the level of 1.50% (5% significant level).
Regarding targets, we found a short-term positive abnormal return of 7.16% (1%significant level) around the announcement day (-1, +1), 7.82% (1% significant level) aroundthe announcement day (-3, +3), and 8.10% (1% significant level) around the announcementday (-5, +5). These returns are considerably larger than those of acquiring firms. These
results show that stock holders of the target firms substantially benefit more than those of
the acquiring firms. However, the combined

wealth of the stock holders of the acquiring

and target firms is far less than than their counterparts in the U.S. We emphasize that inJapan the stock holders of the acquiring firms also benefit from M&A transactions, which iscontrary to the U.S.
We also found that in tender offer cases, the announcement effect persisted for targets.
The abnormal return 7.16% around the announcement day (-1, +1) does not diminish even if
we extend the period to (-1, +5). The positive abnormal returns were 6.82% (1% significant
level) (-1, +3) and 6.52% (1% significant level) (-1, +5). We found the positive abnormal returnsof targets are found mainly in the tender offer cases. In the more friendly merger bids, wefound a positive significant abnormal return 2.09% (10% significant level) only at (-1, +1). On
the other hand, in tender offers, which can be friendly or hostile, we found considerably larger
positive abnormal returns (over 10%) over various periods. These results support theprevailing economic intuition that acquiring firms, especially in hostile tender offers, have to
pay a larger portion of premiums to the stock holders of the target firms.
In Japan, the number of M&A transactions has dramatically increased since the late5

1990s. So, we have included early data from the 1990s in our sample period, as Usui (2001)
and Inoue (2002) did. Our extended time period (late 1990s to 2007) revealed similar results:
the short-term increase of stockholders’ equity value in Japan is shared between acquirors
and targets, contrary to findings in the U.S. However, we also found that the increase of thestockholders’ value of the target firm is reduced. The lower appreciation is due to lower
premiums: median values are 2.43% in M&A and 5.13% in tender offers.
(3) Payment method of M&A (cash vs. stock) and the measurement of economic significanceRegarding the discretionary use of payment (cash vs. stock), we believe that managers are
well-advised to positively use their stocks as payment in M&A transactions, especially when
their stocks are priced higher than the fundamental value. In this case, for acquiring firms wepredict that the short-term stock performance following stock payment transactions will be
negative around the announcement day. On the other hand, the managers should positively
use cash as a payment in M&A transactions, when their stocks are priced reasonably or lower
than the fundamental value. In this case, for acquiring firms we predict that the short-term
stock performance would be positive around the announcement day.
This suggested discretionary use of payment was first examined by Travlos (1987) in the
U.S. For the period 1972 to 1981, Travlos reported a significant excess return of -3.94%
following stock payment M&A transactions, and an non-significant positive excess return of
0.25% following cash payment M&A transactions around the announcement day (-1, +1) for
the acquiring firms. Louis (2004) examined a later period (1992 to 2000) and also reported an
excess return of -2.28% (1% significant level) following stock payment M&A transactions, anda positive excess return of 0.44% (10% significant level) following cash payment M&A
transactions around the announcement day (-1, +1) for the acquiring firms, which is similar to
Travlos' (1987) results.
On the other hand, the results of previous research in Japan are inconsistent with thediscretionary use of payment described above. For the period 1990 to 2002, Inoue (2002)
reported a positive excess return of 1.8% (10% significant level) following stock payment M&A
transactions, and an insignificant positive excess return of 0.1% following cash payment M&A
transactions around the announcement day (-1, +1) for the acquiring firms.
In our study, we compared the performance of payment methods (cash vs. stock) on
short-term stock performance following M&A transactions in Japan for the period 1996 to2007 for only tender offer cases, see Table 1. We focused on tender offers when analyzing
payment methods because all merger bids in our sample were stock payments (see footnote inTable 2). We excluded transactions in which the acquiror and/or target were financial
institutions, or the transaction involved a bailout takeover as a result of the target being in
financial distress. Table 1 also presents the short term stock performance of all cases, merger
bids cases, and tender offers cases.
Unlike Inoue (2002), we could not detect the suggested discretionary use of cash/stock in6

our sample period. Regarding the acquiror CARs, we found that the positive abnormal
returns of tender offers occurred only in stock payment cases, not in cash payment cases.
Examining stock payment cases alone, we found that the positive abnormal returns leapt
from 1.40% to 2.47% (1% significant level) around the announcement day (-1, +1); from 1.57%
to 3.41% (1% significant level) around the announcement day (-3, +3); and from 0.79% to3.25% (1% significant level) around the announcement day (-5, +5), respectively. Cashpayment tender offers, however, were all positive but non-significant: 0.33%

around theannouncement day (-1, +1); 0.36% around the announcement day (-3, +3); and 1.12% aroundthe announcement day (-5, +5) for the acquiror.
Finally, turning our attention to target CARs, we found substantial positive significant
abnormal returns (over 10%) both in stock payment cases and cash payment cases. This is in
striking contrast to the acquirors, where the positive abnormal returns of tender offers wereobtained only in stock payment cases.
3. Means of Payment Hypothesis and Misvaluation Hypothesis
According to previous researchers, the positive effect of disciplined management and thenegative effect of the agency problem significantly impact M&As as well as the subsequent
stock performance of the acquiring firms. Disciplined management, which entails adhering to
the shareholders directives, involves the effective channeling of funds into (1) new businesses
which have a synergistic effect with the core business, or (2) businesses which have economies
of scale, economies of scope, and involve the acquisition of new technologies.
Other negative effects have been reported in the literature. Two negative effects are free
cash flow problems (Jensen, 1986) and manager entrenchment behavior (Shleifer and Vishny,1986). They each pointed out that undisciplined managers make use of M&A transactions as ameans of pursuing personal private profit. In such cases, managers tend to invest free cash
flows into inefficient business opportunities (overinvestment) in an attempt to exaggerate
their management skill and overstate their business ideas as a means of retaining theircurrent position and strengthening their managerial powers. The positive short-term excess
return overviewed in Section 2 might be explained to some degree by the primacy of positiveeffects over negative ones. However, since the early 2000s, much research in the U.S. hasreported evidence that M&A transactions were driven by the perceived difference between thefundamental value and the market value of the firms.
(1) Means of Payment Hypothesis
Shleifer and Vishny (2003) reported that managers have the incentive to increase thestockholder value by acquiring relatively under-valued companies through the payment of
their own stock when their stocks are over-valued. In these cases, the subsequent stock
performance of the acquiring firm would be negative. On the other hand, managers have the
incentive to use cash payments when their own stocks are reasonably-valued or under-valued.
7

In these cases, the subsequent stock performance of the acquiring firm would be positive.
They concluded that managers attempt to increase their stockholders’ value in two ways: (1)by positively acquiring relatively under-valued target firms and using stock payment when
their own stocks are relatively over-valued, and (2) by positively using the cash payment
when their own stocks are relatively under-valued. They call this “stock market driven
acquisitions,” and their assertion is widely known as the Means of Payment hypothesis.

In the means of payment hypothesis, managers positively use stock payment when theirown stocks are relatively over-valued in the capital market and they positively use cash
payment when their own stocks are reasonable or relatively under-valued in the capital
market.
The fundamental value of firms has been variously determined in the past. Shleifer and
Vishny (2003) used book value in place of fundamental value, whereas Dong, Hirshleifer,
Richardson, and Teoh (2006) used the Residual Income Model (RIM, detailed methodology isshown in Section 4 (2)). Dong et.al. reported that managers executed M&A transactions byfocusing on the difference between fundamental and market value. In particular, they
concluded that for cases where both the acquiror and the target were under-valued in themarket, this dual undervaluation actually initiated M&A transactions and reduced
Misvaluation in the capital market. This is widely known as the Misvaluation Hypothesis.
(2) Misvaluation Hypothesis
Frankel and Lee (1998) pioneered research in capital market misvaluation. They
examined the investment strategy of hedging portfolios using RIM2 in U.S. M&A transactions
from 1975 to 1993, and they reported a positive long-term excess return. They estimated thefundamental value of the firm by using the value of future profit and the long term growthrate forecast by financial analysts in the I/B/E/S data base for RIM. They constructed quintile
portfolios sorted by the V/P ratio. They estimated that the fifth quintile (the highest V/P ratio)
represents the most under-valued firms whose subsequent stock performance would be thehighest. The first quintile (the lowest V/P ratio) represents the most over-valued firms whose
subsequent stock performance would be the lowest.
They defined a cumulative performance of hedging portfolios (long-short portfolios) that
promotes the long position for the fifth portfolio (the highest V/P ratio) and simultaneously
promotes the short position for the first portfolio (the lowest V/P ratio). They reported that
this strategy outperforms a hedging portfolio strategy which merely utilizes the B/P ratio orsize (market value).
In Japan, previous research (Okumura and Yoshida, 2000; Suda and Takehara, 2005;

2

Dechow, Hutton, and Sloan (1999) and Lee, Myers, and Swaminathan (1999), etc also reported the results of investment
strategy following this V/P anomaly.

8Muramiya, 2008) also reported positive long-term excess returns for hedging portfolios using
RIM, similar to Frankel and Lee (1998).

The difference between the fundamental value and the market price has an impact on thesubsequent stock performance of both the acquiror and the target. The more under-priced
both the acquiror and the target are, the higher the stock performance of both firms aroundthe M&A announcement day.
Regarding short term returns, Dong, Hirshleifer, Richardson, and Teoh (2006) examined
U.S. M&A transactions from 1998 to 2000 and obtained evidence which supports theMisvaluation Hypothesis. They calculated the fundamental value of the firm by using RIM
and showed that the V/P ratio (fundamental value to market value) has explanatory power
even after controlling for the B/P ratio (book value to market value). The V/P ratio, which
represents the degree that the market has mispriced the stock, is not equivalent to the B/P
ratio; it has additional explanatory power in predicting future stock performance following
M&A transactions.
4. Characteristics of Sample Data and Methodology(1) Characteristics of Sample Data
Our study focuses on the payment method (cash vs. stock) and the short-term stock
returns of both the acquiror and the target around the announcement day of M&Atransactions, and tests the hypotheses addressed in Section 3. Our sample includes M&A
transactions from January 1996 to October 2007, available in the database of RECOF MARR
CD-ROM, that satisfy the following criteria:(a) Acquiror and/or target firms were not financial institutions, nor involved in a bailout
takeover where the transaction was a result of the target being in financial distress, etc.
(b) Both acquiror and target firms were listed in the stock exchange in order to exclude
small cases.
(c) The payment method of the M&A transaction (cash vs. stock) was identified by Nikkei
Telecom 21, Nikkei Newspaper digital Ltd., or MARR M&A data CD-ROM by Recof Ltd.
(d) Stock price and financial data were available from the Nikkei NEEDS-Financial
QUEST by Nikkei Media Marketing, Inc., in order to calculate the B/P ratio.
(e) Financial analyst forecast value of future profit was available from the I/B/E/S orTokyo Keizai data base, in order to calculate the V/P ratio.
(f) Monthly returns were available for at least twenty-four months in order to calculate
the cost of the equity capital.
Table 2 shows our sample characteristics for both tender offers and merger bids bycalendar year. For tender offers, the number of listings of targets and acquirors dramatically9increased from single digits to double digits, after stock swap and stock transfer schemes wereintroduced in 1999. The level exceeded thirty in 2005 and 2006.
For merger bids cases only, all of the Japanese firms in our sample used the stock
payment method. This is very different from the U.S. payment method, which typically uses
half stock payment, half cash payment in merger bids transactions. For tender offers cases,
Japanese firms in our sample used a mix of cash and stock payment. Since 1999, the numberof firms which used the stock payment method exceeded the number of firms that used cash
payments. However, the cash payment method also increased in 2005 - 2007.
We presented the following financial attributes of our sample: market equity (which
represents firm size), book-to-market ratio, leverage, and ROE. We calculated these figures
based on the data that was available on the M&A announcement dates.
The median market equity value of the acquiring firms (¥128,507 million) is 12.36 times
greater than the medium market value of the target firms (¥9,245 million). The acquirors inour sample have a considerably higher median stock value than the median firm value listedon the stock exchange (¥128,507 million vs. ¥15,342 million).
Regarding the book-to-market ratio, the medium of the acquiror is 0.7207, and that of thetarget is 1.0515. Regarding financial leverage, the medium of the acquiror is 0.6468, and thatof the target is 0.6038. Regarding ROE, the medium of the acquiror is 4.84%, and that of thetarget is 2.91%. The book-to-market is widely interpreted as the proxy variable of the firm’s
growth. The medium 0.7207 of the acquiror is much less than the medium book-to-market
ratio 1.119 of all the listed firms, and the medium ROE 4.84% of the acquiror is much higher
than the medium ROE 3.93% of all listed firms. Therefore, the acquirors in our sample arecomposed of firms that are highly profitable and have the characteristics of growth stocks (i.e.,
low book-to-market stocks), in other words, possessing high qualified growth opportunities.
Table 2 shows our sample characteristics by year and Table 3 shows them by industry.
M&As in Japan are concentrated because only four sectors account for 45% of all M&As in our
sample. These four sectors are: service (15.79%), retail trade (10.88%), electric & electric
devices (9.82%), and wholesale trade (9.47%). Construction (5.96%) and foods (5.61%) were
the fifth and sixth ranked sectors. In the service, retail trade, and food sectors, M&As were allwithin the same sectors (non-diverisifed) as opposed to across sectors (diversified).

On theother hand, in electric & electric devices, wholesale trade, and construction industries,
diversified and non-diversified M&As were found in equal proportions.
(2) The Residual-Income Valuation Model
Dividends are defined as the net distribution of value to the common stockholders(payment of dividends to shareholders minus buy-backs of their treasury stocks). Therefore, astock’s intrinsic value is typically defined using the dividend discount model (DDM), which
expresses the present value of future dividends based on the current available information set.
Denoting the stock’s intrinsic value at date t as Vt, this means that
10

1
where

= the expected future net dividends paid for the period ending at date t+i,re = the cost of equity capital
Ohlson (1995) and Feltham and Ohlson (1995) demonstrated that if the accounting system
satisfies the ‘clean surplus relation,’
,τ

1,

where

Bt = the book value of common equity at date t,
NIt+i = the net income attributable to common equity for the period ending at datet+i,
= the net dividends paid for the period ending at date t,then the DDM can be rewritten as the current book value plus an infinite total of discounted
residual income, which describes the residual income model (RIM), as follows:
1
1

,

where

Bt = the book value of common equity at date t,· = the expectation operator at date t,

NIt+i = the net income attributable to common equity for the period ending at date t+i,re = the cost of equity capital,
ROEt+i = the after-tax return on common equity for the period ending at date t+i.
The equation expresses the firm’s intrinsic value in terms of infinite series, but we mustspecify an explicit forecast period to apply RIM in practice. It is necessary to estimate a‘terminal value’ – an estimate of the firm’s value based on the residual income earned after
the explicit forecasting period. Lee et al. (1999) reported the predictive power of Vt estimatesusing three different forecast horizons beyond three years, and Vt estimates were notsensitive to the number of the forecast periods or the cost of equity capital. Thus we used
three period forecast horizons following Dong et al. (2006),
1

1

where

Bt = the book value of common equity at date t,· = the expectation operator at date t,
11

1

,

re = the cost of equity capital,
ROEt+i = the after-tax return on common equity for the period ending at date t+i,
and the last term discounts the period t+3 residual income in perpetuity.
Forecast ROEs are calculated as
⁄

,

where

EPSt+i = the forecasted earnings per share (EPS) for the period ending at date t+i,/2,
If we assume that the firm’s book value increases with a sustainable growth rate, thenthe future book values of common equity at date t+i are calculated as
1,

To estimate the sustainable growth rate k, RIM calls for an estimate of the expected
proportion of earnings to be paid out in dividends. We estimated this ratio by dividing actual
dividends from the current fiscal year by the same time period;
EPS.

We excluded stock repurchases due to the practical problems associated with determining
the likelihood of their occurrence in future periods, following Lee et al. (1999). For firms withnegative earnings for period t, we assumed their payout ratio was 0.06 times the stockholders'equities because historically the long term return-on-equities (ROE) in Japan isapproximately 6%3.
(3) Estimation of the Cost of Equity Capital
The cost of equity capital re for each firm (annual rate) was estimated using the Capital
Asset Pricing Model (CAPM). β at the time of t was estimated monthly using the estimation
window from minus 60 months to minus 1 month of the announcement day. We required
minimal return data of at least 24 months preceeding the announcement date. We estimatedthe cost of equity capital for each firm as 4.4%, assuming that the risk premium of the market
portfolio equaled the average annual rate of Topix4.
5. Results of Our Univariate and Multivariate Tests(1) Equity Valuation and Univariate Test
Our study estimated the fundamental value of firms by using the forecast value of the
future profit and the long term growth rate by financial analysts in the I/B/E/S data base (or3The long-run return-on-equities (ROE) in Japan is approximately 6%. Therefore we use 6% of ROE as a proxy for normal
earnings levels when current earnings are negative. Lee et al. (1999) and Dong et al. (2006) use 6% of return-on-total-assets,
which is approximately the same as the long-run performance of the United States, as a proxy for normal earnings levels
when current earnings are negative.
4
Average TOPIX risk premium for 30 years, from January 1976 to December 2005, was 4.4% [Source: Stocks Risk
Premium Report of Japan (version in fiscal year 2006) by Ibottoson Associates Japan Ltd.]

12

Tokyo Keizai data base if the forecast value was not available in the I/B/E/S data base) for
RIM5. Table 4 shows the V/P ratio (fundamental value to market value ratio) and B/P ratio(book-to-market ratio) of both acquirors and targets. This includes comparisons between
various financial attributes and CARs by the modes of offers (merger bids and tender offers)
and was obtained by consulting Nikkei Telecom 21 by Nikkei Newspaper Digital Ltd. or
MARR M&A data CD-ROM by Recof Ltd. It includes comparisons between various financial
attributes and CARs by the modes of offers (merger bids and tender offers). We identified thepayment methods (cash vs. stock) of 351 transactions within our sample from the same
sources. We calculated V/P ratios for 372 cases by using the financial analyst forecast value ofthe future profit and estimating the cost of equity capital by CAPM. Our sample required thatboth acquiror and target were listed in the stock exchange in order to eliminate small cases.
All of the merger bid cases in our sample used the stock payment method.
Using univariate tests, we investigated the statistical differences of various financial
attributes and CARs between the low V/P rank group and the high V/P rank group of bothacquirors and targets. Table 4 summarizes the results of the differential test of mean values.
We reported t values assuming independent samples.
(2) Univariate Test of V/P Ratio Rank of Acquirors
First, we focused on the difference of the acquiror’s financial attributes between the low
V/P ratio rank group and the high V/P ratio rank group. We treated tender offer cases
separately. Our main concern was to see if the V/P Ratio was significant after controlling for
the B/P Ratio. We found that if the acquiror’s V/P ratio is high, then the B/P ratio is also high(10% significant level), although the correlation (14.26%) between these ratios is not very high.
We concluded that V/P and B/P are only marginally correlated.
The mean ROE of high V/P groups (14.07%) is considerably higher than the mean
ROE of low V/P groups (-3.37%) at only the 10% significant level. Economic intuition suggeststhat if the current ROE is high, then the expected ROE may be high too, leaving some firms
undervalued.
The mean liquidity of high V/P groups (12.29%) was also considerably higher than themean liquidity of low V/P groups (7.54%), which is significant at the 1% level. High ROE wasstrongly correlated with high liquidity. We defined liquidity as operating income plus
depreciation minus interest, taxes, and all dividends. This is expressed as a ratio to total
assets; this definition is typical of the accounting area and emphasizing the cash flow
viewpoint. We also found that the undervalued firm (high V/P ratio) is inclined to have some5

The I/B/E/S updates the fiscal year-end of all their forecasts (that is, FY1, FY2, and FY3) in the month that actual annual
earnings are announced. If EPS forecast for any horizon is not available, it is calculated by multiplying the long-term growthrate (provided by the I/B/E/S) by EPS forecast for the previous period. If the long-term growth rate is not available in the
I/B/E/S, it is substituted by the first preceding available EPS forecast, following a constant forecast model (see Dong et al.
(2006)). Contrary to the United States, the book value of the equity for the most recent fiscal year end is also available in
Earnings announcement by firms in Japan, where the Tokyo Stock Exchange requires listed firms to report the financial resultin their Earnings announcements within 45 days of a fiscal year-end, and which are the highlight of annual report, together
with the summary of financial statements.

13

financial slack.
On the other hand, the mean cash ratio of high V/P groups (10.38%) is lower than themean cash ratio of low V/P groups (14.79%), significant at the 1% level. The cash ratio isdefined as cash equivalent plus short-term investments and is expressed as a ratio to assets.
In general, the B/P ratio is regarded as the best predictor of the firm’s growth potential. We
predict that a firm with high growth potential (low B/P ratio) has an advantage in future
investment opportunities because they are cash rich and have fewer financial contraints.
Secondly, we examined general financial attributes as a function of target V/P rank (low vs.
high). Despite the varying financial attributes of acquirors, the targets' financial attributes do
not vary significantly between the low and high groups.
Thirdly, we examined the likelihood of cash vs. stock payment as a function of V/P ratio(low vs. high) of the acquirors. In our sample, payment methods of merger bids were all stock
payments; therefore, we limited our analysis to tender offer cases. The probability of cash
payment by the low V/P group (48.19%) is lower than the probability of cash payment by thehigh V/P group (54.41%), but this difference is not significant. The Means of Payment
hypothesis suggests that the managers will select stock payment when their own stock isover-valued in the market. Our results did not support this hypothesis. We address theresults of the multivariate test of the Means of Payment hypothesis (after controlling for
explanatory variables) in the next section.
Finally, we examined the various CARs as a function of V/P ratio (high vs. low) of theacquirors. For example, the mean acquiror CAR (-3,+3) -0.38% and the mean acquiror CAR(-5,+5) -0.09% of the low group are significantly lower than the corresponding values for thehigh group (2.47% and 2.37%) and are significant at the 5% and 10% levels, respectively. For
nearly all of the various periods, our sample showed that the stockholders of the acquirors
typically benefit from M&A transactions when acquirors are undervalued, which is consistent
with the Misvaluation hypothesis.
(3) Univariate Test of V/P Ratio Rank of Targets
First, we focused on the difference of the acquirors’ V/P ratio between the low targets’ V/Pratio group and the high targets’ V/P ratio group. The mean acquirors’ V/P ratio of low targets’
V/P ratio group (1.0476) is significantly lower than of high targets’ V/P ratio group (1.2512),
which is only significant at the 10% level. The mean target V/P ratio of the low acquiror V/Pratio group (0.9958) is lower than the high targets’ V/P ratio group (1.1378), but notsignificantly so. We predict that, in general, relatively under-valued acquirors positively
search for relatively under-valued targets in Japan, which is similar to the conclusion pointed
out by Shleifer and Vishny (2003) that misevaluation drives mergers and acquisitions in the
U.S.
Secondly, we focused on the difference of the acquiror’s financial attributes between the
low V/P ratio rank group and the high V/P ratio rank group of the targets. The mean liquidity14

of the low group (9.76%) is considerably higher than the mean liquidity of the high group(7.75%), which is significant at the 10% level. This result suggests that, on average, firms
with low accounting cash flow positively search for under-valued target firms (high V/P ratio
firms).
Thirdly, we focused on the difference of the targets’ financial attributes between the low
V/P ratio rank group and the high V/P ratio rank group of the targets. Regarding the B/P ratio,
the higher the V/P ratio of the target, the higher the B/P ratio of the target (5% significant
level), although the covariance (18.90%) between these ratios is not so high. Moreover, ROE of
all groups are negative. This means that firms with low profitability could be targets of an
acquisition. The mean liquidity of the low group (4.24%) is considerably lower than the meanliquidity of the high group (9.05%), significant at the 1% level. Additionally, the mean E/P of
low groups (-0.1116) is considerably lower than the mean E/P of high group (0.0123) which issignificant at the 10% level. The under-valued firms’ financial attributes are inclined toinclude a sufficient financial liquidity and a comparably high E/P.
Finally, we focused on the difference of the various CARs between the low V/P ratio rank
group and the high V/P ratio rank group of the targets. In our sample, all period CARs of theacquirors and the targets, both separately and together, are significantly higher in the highgroup than the low group, which is consistent with Misvaluation hypothesis. For example, themean acquiror CAR (-3, +3) 2.87%, the mean target CAR (-3, +3) 10.44%, and both the meanacquiror and target CAR (-3, +3) 13.36% of the high group are significantly higher than therespective values of the low group (-0.29%, 5.54%, and 5.21%) at the 1%, 5%, and 10%
significance level, respectively. Regarding total wealth from M&A transactions, existing stock
holders of acquirors and targets of the under-valued target group amazingly obtained 8.14%
more than the of the over-valued group. In our univariate test, the explanatory power of theMisvaluation hypothesis is much stronger for the target V/P ratio than for the acquiror V/Pratio. The reason could be partially attributed to the size of the target firms. In our sample,
the target firms’ size is less than one tenth of the acquiror’s size (Table 2). Investors who
specialize in analyzing corporate valuation might not cover all the firms, and may pay lessattention to smaller firms; therefore the smaller firms are more likely to be under-valued.
Following M&A transactions, investors carefully monitor the stock values and consequently,
misevaluation in the capital market diminishes.
(2) Equity Valuation and Multivariate Regression(2-1) Payment Methods and the Means of Payment Hypothesis
Table 5 shows the results of logit multivariate regression. The Means of Payment
hypothesis may be tested by examining the relationship between the V/P ratio and payment
methods (cash vs. stock) after controlling for other variables. The independent variable waspayment method and the dependent variable was B/P ratio. In table 5, we included the15following control variables: B/P ratios of both the acquiror and the target, acquiror’s liquidity,acquiror’s cash ratio, diversification Dummy, log of relative equity, acquiror’s log of equity,
target’s log of equity, and acquiror’s financial leverage. The other possible variables (such as
ROE and E/P) which are given in Table 4, are omitted because they do not have any additional
explanatory power in our sample.
The control variables in our study are defined as follows:

Liquidity is operating income plus depreciation minus interest, taxes, and all dividends,
and is expressed as a ratio to total assets.
The cash ratio is cash equivalent plus short-term investments, expressed as a ratio toassets.
The diversification dummy=1 if the target is outside the acquiror's industry;

diversification dummy=0 if they are both in the same industry.
Relative equity is the ratio of the acquiror’s market equity to the target’s market equity.
Equity is the market value of the common stock holders.
Leverage is the ratio of total debt to total assets.
In our sample, the payment method of merger bids are all stock payments; therefore, wereport only on tender offer cases. In table 5, the second column gives the expected signs of thecoefficient of the Means of Payment hypothesis. The coefficient is followed by the p-value inparentheses.
The Means of Payment hypothesis predicts that managers will select stock payment when
the acquiror is overvalued in the market. In the logit multivariate regression (which includes
only targets’ V/Ps, acquirors’ V/Ps, targets’ B/Ps, and acquirors’ B/Ps), all coefficients of thefour independent variables are not significant. However, in the regressions which featureseveral control variables by their order, the coefficient of the acquiror V/P is statisticallysignificant, but in the opposite of the predicted direction. We found counterevidence of
discretionary use of payment (cash vs. stock) by Japanese managers in our multivariate test,
which is inconsistent with our univariate test. (The direction of the sign of the payment
method in our univariate analysis was opposite from our prediction, but was not significant.)
We also found that Japanese managers positively use cash payment when their firm has
sufficient financial slack, which is consistent with economic intuition. However, why Japanesemanagers positively use cash payment even when the firm’s stock is over-valued is still an
open question.
(2-2) Cumulative Abnormal Returns of the Acquirer and the Misvaluation Hypothesis
Table 6 gives the results of ordinary multivariate regression. The Misvaluation hypothesis
can be tested by examining the relationship between the V/P ratio and the subsequent stock
performance of the acquiror, after controlling for other variables. We regressed cumulative
abnormal returns of the acquiror for (-3, +3) on the V/P ratios of both the acquiror and thetargets. In table 6, we present the control variables which were given in Table 5 and defined16

in the previous section. The left side presents the results of merger bids/tender offers. The
right side presents the results of tender offers alone. The second column gives the expected
signs of the coefficient of the Misvaluation hypothesis. The first row gives the coefficient andthe second row gives the p-value in parentheses.
The Misvaluation hypothesis suggests that positive excess returns of the acquiror will be
detected around the announcement day of M&A transactions, when the acquiror and/or target
is/are undervalued in the market. In the ordinary multivariate regression (which includes
several control variables), the coefficients of the acquirors and targets V/P are almost
significant consistent with our Hypothesis. For example, in the eighth column of merger bids
and tender offers, both coefficients of the acquirors’ and targets’ V/P are significant at the 5%
level. Likewise, in the fourteenth column of tender offers, both coefficients of acquirors andtargets V/P are significant at the 5% level and 10% level, respectively. However, theexplanatory power of the targets V/P is slightly weaker than in the univariate test.

Also, thecoefficient of CAR is slightly weaker for the target V/P (0.007943) than the acquiror V/P(0.012476, see column eight).

The coefficient of the target V/P is still significant, after

controlling for B/P, liquidity and cash ratio, which have had strong explanatory power inprevious research.
We conclude that M&A transactions result in shortening the value correction time andpartially reduce Misvaluation in the capital market within a short time. We also conclude thatJapanese investors regard M&A investment as a means of managerial opportunism, or inother words, risk of over-investment in poor business opportunities when the firms havefinancial slack and/or cash equivalent. This is consistent with the findings of Myers and
Majluf (1984), Smith and Kim (1994), Lung, Stulz, and Walkling (1999), and Bowers, Moore,and Majrice Tse (2000). Finally, we found that these results are similar for various periods ofdependent variable CARs of the acquirors, including (-10, +10), (-5, +5), (-3, +3), (-1, +1), (-1,+3), and (-1, +5), which were not included in our original analyses.
6. Hedging Portfolio Strategy Following V/P ratio and Misvaluation Hypothesis
In order to confirm the findings of the Misvaluation hypothesis, we executed a robustness
check by constructing the hedging portfolio strategy given in Table 7. We constructed four
partition cells with breakpoints based on the median valuation ratios (V/P and B/P ratio) of alllisted firms. All M&A transactions were assigned to one of four groups. We specifically wereinterested in the cases where the acquirors and targets were both undervalued compared tothose cases where the acquirors and targets were both overvalued. If the Misvaluation
hypothesis accurately predicts economic performance, the stock performance of the former
cases will outperform the latter.
According to Fuller, Netter, and Stegemoller (2002), an abnormal return is calculated witha market adjustment model. In our study, we used TOPIX as a market indicator, thebenchmark for estimating the daily returns with the market adjusted model. First, we17

calculated the daily abnormal returns (AR) around the announcement day of the sample firms,
defined as the difference between the raw return and TOPIX. Second, we calculated theaverage abnormal returns (AR) of each cell. Cumulative abnormal returns (CAR) is
accumulated from daily abnormal returns for the testing periods. The significance of AR andCAR was obtained by a cross-sectional t test.
Figure 1 plots the CARs for twenty-one days, (-10, +10), given by V/P and B/P based
hedging portfolio strategies around the announcement day (0) of the M&A transactions. We
confirmed that the stock performance of the acquiring firms where the acquirors and targets
were both undervalued is definitely higher than acquiring firms where the acquirors andtargets were both overvalued around the announcement day. V/P performance peaks on the
fourth day and consistently exceeds B/P performance for ten days following theannouncement day.
Table 8 shows the ARs and CARs for twenty-one days, (-10, +10), given by V/P and B/P
based hedging portfolio strategies around the announcement day (0). In particular, we foundsignificant CAR values one day after the announcement day for the V/P based strategy: AR
was 1.28% (10% significant level), and CAR was 3.93% (10% significant level). CAR values of
the V/P based strategy were considerably higher than that of the B/P based strategy (2.8%).
Table 9 shows CARs for various periods, given by V/P and B/P based hedging portfolio
strategies around the announcement day (0) of M&A transactions. The results of CAR for (-1,+1), (-1, +3) and (-1, +5) are 1.60%, 3.57%, and 4.30%, respectively. The result of the V/P based
strategy for twenty-one days (-10, +10) is 3.4% higher than the B/P based strategy. These
results support the findings of the multivariate analysis in Section 5 (2-2).
7. Concluding remarks
In this paper, we found evidence that the increase of M&A transactions (in both number
and magnitude) shortens the value correction time and reduces misvaluation in the capital
market. We believe that investment funds analysts, whose main business focuses on corporate
value, play an important role in this process. They are sometimes able to obtain direct
information from managers. We supposed that they had played a primary role in our testing
period. However, with a valuation model using data which is generally available, we showed
how to construct the most profitable strategy. Therefore, we believe that value corrections are
driven by ordinary investors not necessarily investment funds analysts.
The Misvaluation hypothesis predicts that positive excess returns of the acquiror will be
detected around the announcement day of the M&A transaction, especially when the acquiror
and/or target is/are undervalued. Our data provide new evidence from Japan which supports
the Misvaluation hypothesis, as was initially reported by Dong, Hirshleifer, Richardson, andTeoh (2006) in the U.S.
In our multivariate analysis, we found that the positive post-M&A stock performance offirms with high V/P ratios (undervalued) was consistent with the Misvaluation hypothesis,
18

after controlling for the B/P ratio. Consequently, we confirmed that the Residual Income
Model (RIM) adequately estimates the fundamental value of the firm.
On the other hand, we did not find evidence which supports the Means of Payment
hypothesis, as reported in the U. S. The Means of Payment hypothesis suggests thatmanagers select the stock payment option when the acquiror is overvalued in the market. But
we found that regardless of overvaluation, Japanese managers most likely positively use cash
payment when the firm has a sufficient financial slack. However, the question of why
Japanese managers positively use cash payment even if the firm’s stock is over-valued is still
an open question.
Our results confirm the existence of V/P and B/P anomalies in the relatively highly
efficient capital market, suggesting that the market possibly overlooks the mispricing of somestocks for a long time.
Observing the managers and investment fund analysts (who have far more information
than the market) and understanding the base information that they utilize in evaluating thefundamental value is an extremely interesting research topic in the future. This may help
explain why Japanese managers persist in using cash payments in M&A transactions evenwhen the firm’s stock is overvalued.

[2008.12.2 904]

19

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22

Table 1 Acquiror and target announcement period cumulative abnormal returns (CAR)(1) Acquiror Announcement Period CAR
PeriodAll

CAR (-10, +10)

1.1076%*

CAR (-5, +5)

1.3548%***

CAR (-3, +3)

1.1968%

CAR (-1, +1)

Tender Offers(stock payment)

Merger Bids

Tender Offers

0.4758%1.5589%*0.5021%**0.6671%1.4889%***1.6099%

CAR (-1, +3)0.9991%**

CAR (-1, +5)0.9504%**

CAR (-1, +10)N0.7014%372

Tender Offers(cash payment)

0.4935%**0.8498%0.7905%***3.2544%***

1.1174%

1.5751%**

3.4075%***0.3636%1.4025%***2.4667%***

0.3321%0.2959%1.5013%**2.9998%***0.3288%0.1880%1.4950%**2.3604%***0.9141%-0.0083%155

1.2082%217

2.1815%**0.4043%Merger Bids

Tender Offers

***

100

93

Tender Offers(stock payment)

Tender Offers(cash payment)(2) Target Announcement Period CAR
PeriodAll

CAR (-10, +10)8.6169%***1.9766%13.2873%***

13.0501%***

16.6361%***

CAR (-5, +5)

8.0986%***

1.4081%12.9358%***

12.3522%***16.0449%***

CAR (-3, +3)

7.8196%***

1.1551%

12.6155%***

12.0437%***

15.5219%***

CAR (-1, +1)

7.1614%***2.0934%10.7814%***10.7501%***

13.1573%***

CAR (-1, +3)

6.8173%***0.0398%

11.6946%***

11.0506%***

14.6614%***

CAR (-1, +5)

6.5217%***-0.1576%

11.3508%***

10.6905%***

14.6033%***

CAR (-1, +10)N

6.1779%372***-0.8460%
155

11.1181%217***

10.3334%***

14.7260%

***

*

100

93

Tender Offers(stock payment)

Tender Offers(cash payment)(3) Acquiror and Target Announcement Period CAR
PeriodAll

Merger Bids

Tender Offers

CAR (-10, +10)9.9810%***2.8981%14.9628%***

16.1219%***17.4860%***

CAR (-5, +5)

9.4959%***1.9246%14.9700%***

15.8163%***

17.1623%***

CAR (-3, +3)

9.0188%***1.8434%14.1824%***

15.4896%***

15.8855%***

CAR (-1, +1)8.6503%***3.7033%12.1839%***

13.2168%***

13.4894%***

CAR (-1, +3)

7.8199%***0.3418%13.2014%***14.1089%***

14.9902%***

CAR (-1, +5)

7.5062%***0.0418%12.9030%***

13.2140%***

15.5174%***

CAR (-1, +10)N

7.1134%372***-0.4941%155

12.4641%217***

12.9127%***

15.1303%

***

***

100

93

Table 1 shows Cumulative Abnormal Return for various periods around the announcement day, given as (0), of
the M&A, including 372 M&A transactions in the period January, 1996 to October, 2007. The sample includes
merger bids and tender offers in which both acquiror and target were listed on the Japanese Stock Market inorder to eliminate small cases. We excluded cases where either acquiror or target was a financial institution,or cases with a bailout takeover where the transaction was a result of the target being in financial distress,etc.
***, **, * denote that the difference in mean values is significant at the 1%, 5%, and 10% level (one-tailed), respectively,
based on the two-sample t-test.

23

Table 2 Descriptive statistics of M&A transactions by calendar year
（median）
AcquirorTargetmarketbook-toequity
market leverage ROE(¥ mln)ratio

marketbook-toequity
market leverage ROE(¥ mln)
ratio

Total

N of
tenderoffersN ofmerger
bids

1996

0

4

177,5470.61420.7572 1.60%

120,938

0.3568 0.8180 3.86%

143,999

162,040

100% -7.73%

3

1

0

4

1997

1

8

165,0280.77150.7224 6.21%

18,062

1.0474 0.6050 3.98%

8,786

45,188

100% -4.65%

6

3

0

9

1998

3

16

155,705

1.08340.7501 3.67%

11,0171.3261 0.7808 2.74%

8,858

15,273

100%

2.51%

13

6

3

16

1999

13

21

102,3510.77430.6609 2.22%

8,793

0.8106 0.5844 1.29%

8,954

70,744

100% -3.69%

24

10

4

29

2000

29

11

156,0200.59860.6600 1.20%

9,283

1.3939 0.5699 0.86%

9,930

18,25095.45%

0.59%

13

9

3

17

2001

17

14

74,4480.92080.5411 4.00%

5,901

1.3457 0.6008 1.49%

7,439

29,82493.55% -0.06%

17

14

4

27

2002

24

13

105,577

1.0222

0.6648 3.07%

4,597

1.7529 0.6688 0.65%

3,397

8,299

97.30%

3.66%

21

16

3

33

2003

28

14

124,333

0.91140.7250 1.90%

6,715

1.1632 0.6666 3.92%

3,800

20,99892.86%

1.89%

25

17

11

36

2004

29

14

175,702

0.66510.5601 6.21%

8,841

1.0693 0.5465 3.98%

9,285

37,23097.67%

2.15%

18

25

10

29

2005

31

19

69,4850.53890.6406 6.47%

10,2890.7921 0.5806 3.76%

6,441

47,32696.00%

3.36%

27

23

19

28

2006

36

11

186,472

0.59740.5614 7.68%

14,854

0 .8471 0.5106 4.38%

12,30036,11787.23%

8.21%

30

17

19

21

2007

24

10

378,1410.60210.6361 7.52%

12,4620.9335 0.6292 4.98%

5,911

46,17094.12% 13.04%

22

12

17

15

Total

217

155

128,5070.72070.6468 4.84%

9,245

1.0515 0.6038 2.91%

19,092

36,59895.16%

153

153

93

264

year

%

Non

M&A

-cationtransaction transaction
PremiuStockDiversifi Cashcompleted
Diversifi
value-cation payment paymentvaluem(¥ mln)3.39%

Market equity, book-to-market ratio, leverage, and ROE of both acquiror and target, transaction value, % completed M&A, Non Diversification, Diversification, cash payment, and stock
payment are reported as medium values, by calendar year. The sample includes merger bids and tender offers in which both acquiror and target were listed on the Japanese
Stock Market in order to eliminate small cases. We excluded cases where either acquiror or target was a financial institution, or cases with a bailout takeover where thetransaction was a result of the target being in financial distress, etc. In our sample, payment methods of merger bids are all stock payments.

24

Table 3

Descriptive statistics of M&A transactions by industry
Acquiror
Acquiror's industry

N oftenderoffersN ofmergerbids

Foods
TextilesPulp & Paper
Chemicals
Drugs
Petroleum
Rubber
Stone, Clay & Glass
Iron & SteelNon-ferrous Metal
Machinery
Electric & Electronic Equipment
Shipbuilding & Repairing
Motor Vehicles & Auto Parts
Precision Equipment
Other Manufacturing
Fish & Marine
MiningConstruction
Wholesale Trade
Retail Trade
Real Estate
Railroad Transportation
Trucking
Sea Transportation
Air Transportation
Warehousing & Harbor Transportation
Communication Services
Utilities - Electric
Services

10
7
5
13
1
1
1
4
5
9
8
24
1
7
2
6
1
1
13
21
25
3
9
5
4
1
1
1
4
24

Total

217

Targetmarket equity(￥mln)

book-tomarket ratio

7
3
7
7
5
1
2
4
4
7
14
8
0
5
3
3
0
0
15
21
10
2
1
0
2
2
0
1
0
21

167,673
82,263
462,671
178,522423,384
493,819
105,988
19,455
163,446
50,889141,793624,814164,087
2,082,111
284,20940,454
71,372
29,52045,89768,50787,366
218,529
304,91174,448434,692
518,828
150,632
1,520,545
1,422,822
36,8800.6686
1.15540.8376
0.6611
0.6634
1.34980.43371.15161.2741
1.0951
0.66170.64591.02220.99150.60250.54140.47810.57440.98500.80540.59240.22490.44942.95630.5966
0.27800.92880.30480.99760.47450.42130.70820.69660.7066
0.28820.75920.76300.69020.77770.4876
0.63200.54390.86220.58900.59820.41730.8451
0.94380.61300.71890.65260.75570.88510.49010.80840.91110.40050.76670.7526
0.52495.27%-2.67%
2.93%
4.79%
7.19%
1.62%
5.72%
2.83%
2.47%
1.34%
4.28%
3.78%
3.75%
7.30%
13.31%
5.67%
13.14%
21.05%
5.65%
4.94%
6.66%
18.42%
0.26%
1.38%
9.44%
-55.64%3.42%-40.15%
1.54%
6.06%

16,884
2,299
18,546
15,459
192,864
76,403
15,449
3,040
7,973
4,823
11,355
9,002
10,555
6,280
57,3585,132
30,904
6,208
6,557
7,480
8,049
47,664
14,3505,617
20,74026,481
6,940
472,350
5,281
9,120

0.96001.14211.18491.05220.68731.28441.04491.78390.93241.2633
1.17451.02571.7053
1.24270.49081.38070.5421
1.78481.1052
1.0966
1.12310.3882
1.33563.47420.56940.39561.41090.70281.46960.48070.41990.80230.77370.53410.39460.81520.75660.74190.67500.4882
0.52680.5524
0.52810.6266
0.68890.48430.8474
0.52600.79640.62910.59590.63400.77050.20920.84440.68900.55260.68400.6306
0.4611

4.15%
3.22%
0.02%
3.06%
5.56%
-26.22%
5.27%-4.49%
1.40%
1.54%
3.19%
1.10%
1.10%
4.20%
2.25%
5.42%
12.64%-2.72%
2.09%
4.60%
5.25%
3.97%
-0.14%
2.19%-0.53%
10.36%
6.98%-1.53%-20.14%2.84%

155128506.7

0.72070.6468

4.84%

9,245

1.05150.60382.91%

25

leverageROE

market equity
book-to(￥mln)
market ratio

leverageROEtransaction
value

Total
transaction
value(￥mln)%
completed
M&A

Foods
TextilesPulp & Paper
Chemicals
Drugs
Petroleum
Rubber
Stone, Clay & Glass
Iron & SteelNon-ferrous Metal
Machinery
Electric & Electronic Equipment
Shipbuilding & Repairing
Motor Vehicles & Auto Parts
Precision Equipment
Other Manufacturing
Fish & Marine
MiningConstruction
Wholesale Trade
Retail Trade
Real Estate
Railroad Transportation
Trucking
Sea Transportation
Air Transportation
Warehousing & Harbor Transportation
Communication Services
Utilities - Electric
Services

15,813
1,125
16,485
6,992
111,693
61,776
7,670
4,106
8,213
3,985
6,305
5,523
6,599
3,632
20,807
3,176
38,283
5,300
5,163
5,759
3,755
10,57012,572
10,47433,5295,660
948,597
1,723
9,308

49,623
3,868
52,19642,137355,645
61,776
11,675
18,91062,045
14,81525,195
19,164
6,599
8,093
64,22927,58238,283
19,56812,33841,39554,70745,814
12,382
11,33433,5295,660
948,597
5,130
19,591100%
80%
83.33%
95%
83.33%
100%
100%
100%
88.89%
100%
95.45%
100%
100%
100%
80%
100%
100%
100%
96.43%
97.62%
91.43%
80%
100%
100%
100%
100%
100%
100%
100%
93.33%

Total

47,40036,59895.49%

Acquiror's industry

Non
Diversification

Diversification

Cashpayment

Stockpayment

20.35%-12.45%
0.22%
8.71%
1.95%
-11.24%-2.89%
5.70%
6.33%-6.78%
1.65%
3.36%-58.48%2.84%
0.52%
20.08%
15.05%-3.24%
7.09%
5.13%
9.57%
7.36%
2.50%
-7.05%-10.84%34.41%
17.04%
16.16%
4.35%

15
5
11
11
4
2
2
7
3
6
13
16
0
7
4
2
1
0
16
22
29
1
1
3
4
1
0
1
0
32

2
5
1
9
2
0
1
1
6
10
9
16
1
5
1
7
0
1
12
20
6
4
9
2
2
2
1
1
4
13

5
1
1
5
1
1
1
1
1
1
5
10
0
4
1
5
0
1
3
9
11
3
0
0
2
0
1
1
2
17

10
8
11
14
5
1
2
7
8
12
16
22
1
8
3
3
1
0
23
28
21
1
7
5
4
2
0
1
2
26

3.39%

219

153

93

252

Premium

26

Market equity, book-to-market
ratio, leverage, and ROE of bothacquiror and target, transaction
value, % of completed M&A, Non
Diversification, Diversi- fication,
cash payment, and stock payment
are reported as medium values, bycalendar year. The sample
includes merger bids andtender offers in which bothacquiror and target werelisted on the Japanese Stock
Market in order to eliminate
small cases. We excluded
cases where either acquiror or
targetwasafinancial
institution, or cases with abailout takeover where thetransaction was a result of thetarget being in financial
distress, etc. In our sample,
payment methods of merger bids
are all stock payments.

Table 4 Univariate Test of V/P Ratio Rank of Acquirors or Targets
All
Acquiror V/P Rank
12

3

Difference
1-3

Acquiror V/P

0.44120.98972.0332-1.5920

Acquiror B/P

0.82720.99600.9876-0.1604

Target V/P

0.99580.9472

1.1378Target B/P

1.19591.4896

Diversification

43.70%

t-Statistics

p -value(two-tailed)***-16.7487

0.0000*-1.6574

0.0988-0.1420-0.8259

0.4097

1.3363-0.1404-0.9551

0.340543.90%

35.09%

8.62%

1.38410.1663Acquiror ln equity 25.3275

25.8141

25.2894

0.03810.15430.8775

Target ln equity 23.2859

23.202322.9594

0.3265

1.67840.0945*Acquiror Leverage

0.60910.61780.6233-0.0142-0.51510.6070Target Leverage

0.60510.54450.6141-0.0090-0.29100.7713Acquiror ROE-3.37%

2.82%

14.07%-17.44% *-1.7872

0.0757

Target ROE -53.54%-1.08%-7.71%-45.83%-1.2438

0.21562.92720.00380.40120.6887-3.54020.0005Acquiror Cash Ratio

14.79%

10.24%

10.38%

4.40%

Target Cash Ratio

14.22%

11.79%

13.56%

0.67%

Acquiror Liquidity

7.54%

7.59%

12.29%-4.75%

Target Liquidity

6.42%

6.48%

8.28%

-1.86%

0.00710.1560

Probability of Cash Payment

29.37%

25.00%

25.93%

3.44%

0.58550.5582

Probability of Tender Offers

56.30%

62.60%

56.14%

0.16%

0.02470.9803

Probability of Success

97.78%

94.31%

92.98%

4.80%

1.8346

0.0666

Acquiror CAR(-10,+10)-0.22%

1.87%

1.86%

-2.08%-1.34920.1786

Acquiror CAR(-5,+5)-0.09%

2.00%

2.37%

-2.46%*-1.82190.0697

Acquiror CAR(-3,+3)-0.38%

1.75%

2.47%

-2.85%**-2.3149

0.0215Acquiror CAR(-1,+1)

1.31%

1.74%

1.43%

-0.13%-0.1369

0.8913

Target CAR(-10,+10)8.11%11.50%

6.00%

2.12%

0.81430.4163

Target CAR(-5,+5)

7.86%

10.35%

5.89%

1.97%

0.80300.4229Target CAR(-3,+3)

7.67%

10.08%

5.50%

2.16%

0.87920.3803

Target CAR(-1,+1)

7.15%

8.15%

6.12%

1.03%

0.5376

0.5914

Acquiror & Target CAR(-10,+10)

8.05%

13.91%

7.85%

0.21%

0.06190.9507

Acquiror & Target CAR(-5,+5)

7.88%

12.34%

8.28%-0.40%-0.13770.8906

Acquiror & Target CAR(-3,+3)

7.26%

11.83%

8.03%-0.78%-0.27370.7846

Acquiror & Target CAR(-1,+1)

8.45%

9.88%

7.55%

0.90%

0.41000.6822

27

***

***

*

All
Target V/P Rank
12

3

Difference
1-3

t-Statistics

p -value(two-tailed)

Acquiror V/P

1.04761.06081.2512-0.2036*-1.72180.0863Acquiror B/P

0.82940.87681.1378-0.3084***-2.7479

0.0067

Target V/P

0.07301.01702.4371-2.3641***-18.3916

0.0000Target B/P

1.1662

1.43401.4932-0.3270**-2.25230.0251

Diversification

43.13%

44.23%

35.19%

7.94%

1.30180.1930Acquiror ln equity

25.5282

25.851225.0398

0.4884**2.07870.0386

Target ln equity

23.2520

23.5018

22.6883

0.5637***3.14050.0019Acquiror Leverage

0.60470.60470.6304-0.0258-0.9297

0.3534

Target Leverage

0.60000.60000.6176-0.0176-0.5755

0.5654

Acquiror ROE

8.15%

8.15%

-2.65%

10.80%

1.36270.1742

Target ROE-30.14%-30.14%-31.32%1.19%

0.0326

0.9741

Acquiror Cash Ratio

13.76%

13.76%

11.65%

2.12%

1.32450.1865

Target Cash Ratio

13.19%

13.19%

13.28%-0.10%-0.0632

0.9497

Acquiror Liquidity

9.76%

9.17%

7.75%

2.01%

*

1.80170.0727

Target Liquidity

4.24%

9.15%

9.05%

-4.81%***-4.15830.0000

Probability of Cash Payment

25.85%

29.29%

26.00%-0.15%-0.02640.9790

Probability of Tender Offers

54.38%

61.54%

61.11%-6.74%-1.09280.2745

Probability of Success

93.75%

94.23%

98.15%-4.40%*-1.70760.0877

Acquiror CAR(-10,+10)-0.74%

1.31%

3.64%

-4.38%***-2.8349

0.0050Acquiror CAR(-5,+5)-0.25%

1.53%

3.56%

-3.80%***-3.0335

0.0027

Acquiror CAR(-3,+3)-0.29%

1.75%

2.87%

-3.16%***-2.65210.0085Acquiror CAR(-1,+1)

0.34%

1.71%

2.98%

-2.65%***-3.01430.0028Target CAR(-10,+10)

6.07%

9.37%

11.66%-5.59%**-2.0687

0.0396

Target CAR(-5,+5)

5.72%

8.75%

10.99%-5.27%**-2.04220.0421

Target CAR(-3,+3)

5.54%

8.60%

10.44%-4.90%**-2.0002

0.0466

Target CAR(-1,+1)

5.02%

9.17%

8.40%

-3.38%*-1.7976

0.0734

Acquiror & Target CAR(-10,+10)

5.55%

11.06%

15.52%-9.97%***-2.9494

0.0035Acquiror & Target CAR(-5,+5)

5.44%

10.42%

14.60%-9.15%***-3.02290.0028Acquiror & Target CAR(-3,+3)

5.21%

10.35%

13.36%-8.14%***-2.89400.0041

Acquiror & Target CAR(-1,+1)

5.36%

10.88%

11.38%-6.03%***-2.7591

0.006228

Tender Offers
Acquiror V/P Rank
t-Statistics

p -value(two-tailed)-20.3614

0.0000-0.0713-0.60800.5442

1.0976

0.04640.19040.84931.67411.4299-0.1183-0.5218

0.602751.32%

49.35%

43.75%

7.57%

0.89270.372025.8917

26.1734

25.9903-0.0986-0.31400.7540Target ｌn equity 23.22514

22.8289

22.76470.46051.81790.07131

2

3

Difference
1-3

Acquiror V/P

0.5174

1.046472

1.8672-1.3498

Acquiror B/P

0.7534

0.95330.8247

Target V/P

1.14401.1027

Target B/P

1.3115

Diversification
Acquiror ｌn equity****

Acquiror Leverage

0.60610.65050.6170-0.0109-0.29760.7664

Target Leverage

0.5966

0.52610.6017-0.0051-0.1299

0.8969Acquiror ROE-3.49%

3.89%

7.81%

-11.29%

-1.93

0.057

Target ROE-92.14%-4.38%-13.80%-78.33%-1.20370.2323Acquiror Cash Ratio

14.92%

10.19%

10.05%

4.86%

2.26650.0254

Target Cash Ratio

14.69%

12.68%

14.83%-0.15%-0.06200.9507

Acquiror Liquidity

7.34%

7.99%

13.57%-6.23%***-3.18810.0018Target Liquidity

6.09%

6.83%

8.87%

-2.77%*-1.74240.0837

Probability of Cash Payment

54.41%

42.42%

48.19%

6.95%

0.78190.4343

Probability of Tender Offers

100%

100%

100%

Probability of Success

97.37%

96.10%

95.31%

2.06%

0.65300.5138Acquiror CAR(-10,+10)-1.90%

3.62%

3.18%

-5.08%**-2.2126

0.0287

Acquiror CAR(-5,+5)-0.12%

2.86%

3.36%

-3.48%*-1.7849

0.0765Acquiror CAR(-3,+3)-0.74%

2.14%

3.65%

-4.39%**-2.45220.0156

Acquiror CAR(-1,+1)

0.57%

1.52%

2.25%

-1.67%-1.34240.1823

Target CAR(-10,+10)10.19%

16.78%

12.48%-2.29%-0.6175

0.5380Target CAR(-5,+5)11.77%

15.95%

10.58%

1.20%

0.33160.7408Target CAR(-3,+3)

12.00%

15.27%

10.06%

1.94%

0.55030.5830Target CAR(-1,+1)10.47%

11.90%

9.82%

0.65%

0.23180.817

Acquiror & Target CAR(-10,+10)

8.54%

20.40%

15.57%-7.03%-1.5161

0.1319Acquiror & Target CAR(-5,+5)11.84%

18.81%

13.93%-2.09%-0.5137

0.6083Acquiror & Target CAR(-3,+3)

11.20%

17.41%

13.78%-2.58%-0.66050.5101

Acquiror & Target CAR(-1,+1)

11.04%

13.42%

12.06%-1.02%-0.3340.738929***

Tender Offers
Target V/P Rank
12

3

Difference
1-3

t-Statistics

p -value(two-tailed)

Acquiror V/P

1.0821

1.0412

1.1911-0.1090-0.99910.3193Acquiror B/P

0.74940.81660.9997-0.2503*-1.8823

0.0626

Target V/P

0.05731.01472.6087-2.5514***-13.6980

0.0000Target B/P

1.36821.5706

1.5233-0.1551-0.69100.4907

Diversification

55.17%

48.44%

39.39%

15.78%*

1.93430.0531

Acquiror ｌn equity

26.1244

26.409725.50700.6174**2.08930.0384

Target ｌn equity

23.0106

23.2155

22.6084

0.4022*

1.73870.0841

Acquiror Leverage

0.60990.6372

0.6332-0.0233-0.60930.5432

Target Leverage

0.5642

0.53650.6203-0.0561-1.4589

0.1467

Acquiror ROE

5.97%

5.55%

-5.14%

11.11%

1.62710.1078Target ROE-55.43%0.04%-51.56%-3.88%-0.06140.9511

Acquiror Cash Ratio

14.37%

9.22%

10.93%

3.44%

1.55630.1217

Target Cash Ratio

14.17%

14.58%

13.26%

0.91%

0.42640.6704

Acquiror Liquidity

10.63%

9.48%

7.74%

2.89%

*

1.80000.0739Target Liquidity

4.46%

9.08%

8.91%

-4.45%***-3.29280.0013

Probability of Cash Payment

50.00%

49.15%

44.83%

5.17%

0.59390.5526

Probability of Tender Offers

100%

100%

100%

Probability of Success

95.40%

96.88%

96.97%-1.57%-0.49470.6208Acquiror CAR(-10,+10)-0.47%

1.90%

3.90%

-4.37%*-1.89020.0607

Acquiror CAR(-5,+5)

0.05%

2.14%

4.31%

-4.26%**-2.3299

0.0214

Acquiror CAR(-3,+3)-0.60%

2.23%

3.81%

-4.41%*-2.6595

0.0087

Acquiror CAR(-1,+1)

0.05%

1.78%

2.82%

-2.77%**-2.29110.0233

Target CAR(-10,+10)11.68%

14.06%

14.61%-2.93%-0.82220.4123

Target CAR(-5,+5)12.18%

13.06%

13.79%-1.61%-0.45440.6502

Target CAR(-3,+3)11.79%

12.98%

13.33%-1.54%-0.43960.6609Target CAR(-1,+1)

9.48%

14.09%

9.28%

0.19%

0.07530.9401

Acquiror & Target CAR(-10,+10)10.90%

16.61%

18.60%-7.71%-1.71610.0883Acquiror & Target CAR(-5,+5)12.18%

15.46%

18.10%-5.92%-1.46360.1454

Acquiror & Target CAR(-3,+3)

11.12%

15.22%

17.14%-6.02%-1.56560.1196

Acquiror & Target CAR(-1,+1)

9.53%

15.87%

12.11%-2.57%-0.8782

0.3813*The sample includes merger bids and tender offers in which both acquiror and target were listedon the Japanese Stock Market in order to eliminate small cases. We excluded cases where either
acquiror or target was a financial institution, or cases with a bailout takeover where thetransaction was a result of the target being in financial distress, etc., where the data is needed to (1)recognize the method of payment (cash vs. stock), and (2) calculate V/P and B/P available. V/P is thefundamental value-to-price ratio. The fundamental value V is estimated using the residual income model (RIM)
where the discount rate is based on firm-specific CAPM. B/P is the book-to-price ratio.
***, **, * denote that the difference in mean values between cash and stock offers, and acquirer and target issignificant at the 1%, 5%, and 10% level (two-tailed), respectively, based on the two-sample t-test.
30

Table 5 Logistic Regressions
Dependent Variable (=1 [cash payment], 0 [stock payment])
expectedsign
Target V/P

Tender Offers

Acquiror liquidity-0.0031(0.979)-0.3697334(0.183)-0.2264725(0.208)-0.2681805(0.365)-Acquiror cashratio-

Diversification--

0.0452235(0.733)-0.5705492 *(0.055)-0.1785526(0.292)-0.2797828(0.303)7.381381 *(0.051)2.290243(0.157)-ln relative equity

-

-

-

Acquiror ln equity

-

-

-

-

Target ln equity

-

-

-

-

-

Acquiror leverage

-

-

-

-

0.2838318(0.747)189
0.16120.0122465(0.989)189
0.2028-0.436364(0.655)189
0.2113-0.5564936(0.491)189
0.21820.0602718(0.962)0.157442(0.915)189
0.2259Acquiror V/P
Target B/P
Acquiror B/PIntercept
N
Pseudo-R

2[+]0.0241113(0.855)-0.6667436 **(0.023)-0.1992353(0.249)-0.2190803(0.444)
6.266713 **(0.040)-0.0417038(0.769)-0.5840476 **(0.049)-0.1811177(0.295)-0.2867757(0.306)
7.663318 **(0.040)2.325357(0.154)0.4673404(0.180)-0.0323778(0.818)-0.5496064 *(0.072)-0.1012916(0.570)-0.4844921(0.144)7.623909 **(0.027)2.033143(0.340)0.5226982(0.136)-0.1742426(0.180)-0.0245305(0.864)-0.570542 *(0.066)-0.1216618(0.516)-0.4940118(0.137)7.705796 **(0.023)
1.936333(0.366)
0.5295488(0.133)-0.1881682(0.167)0.1406655(0.426)
0.0532001(0.966)
1.329946(0.759)189
0.2263In our sample, payment methods of merger bids are all stock payment, therefore we excuted this logistic regression focusing ontender offers in which both acquirer and target were listed on the Japanese Stock Market during 1996-2007. However we
excludes cases where either acquiror or target is a financial institution, or a bailout takeover where the transaction is as a resultof the target being in financial distress etc., where the data is needed to calculate V/P and B/P available. V/P is the fundamental
value-to-price ratio. The fundamental value V is estimated using the residual income model (RIM) where the discount rate isbased on firm-specific CAPM. B/P is the book-to-price ratio. Liquidity is operating income plus depreciation minus interest,
taxes, and all dividends, and is expressed as a ratio to total assets. The cash ratio is cash equivalent plus short-term investments,
expressed as a ratio to assets. The diversification dummy=1 if the target is outside the acquiror's industry; diversification
dummy=0 if they are both in the same industry. Relative equity is the ratio of the acquiror’s market equity to the target’s market
equity. Equity is the market value of the common stock holders. Leverage is the ratio of total debt to total assets.
The first row reports coefficient, and the second row in parentheses reports the p-value. ***, **, * denote significant at the 1%,5%, and 10% level (two-tailed), respectively.

31

Table 6 Least Squares Regressions
Dependent Variable (=Acquirer CAR [-3,+3])
expectedsign

Target V/P[+]

Acquirer V/P[+]

Target B/P[+]

Acquirer B/P[+]

Dependent Variable (=Acquirer CAR [-3,+3])

Tender offers & Merger bids
0.0082 **(0.042)0.0095(0.104)0.0107 **(0.035)0.0113(0.123)Acquirer liquidity

0.0080 **(0.041)0.0121 **(0.050)0.0102 **(0.042)0.0094(0.202)-0.0958(0.154)

Acquirer cash ratio

0.0075 *(0.060)0.0106 *(0.057)0.0094 *(0.067)0.0098(0.177)-0.0910(0.171)-0.0769(0.264)

Diversification

0.0075 *(0.060)0.0107 *(0.059)0.0094 *(0.069)0.0099(0.181)-0.0908(0.169)-0.0762(0.264)-0.0035(0.736)ln relative equity

Tender offers
0.0076 *(0.056)0.0117 **(0.040)0.0117 **(0.020)0.0044(0.561)-0.1078(0.113)-0.1038(0.169)-0.0051(0.645)-0.0036(0.270)Acquirer ln equity
Target ln equity
Acquirer leverage
Intercept
N
Adj - R2

-0.0168(0.467)372-0.0130(0.573)372-0.0038(0.882)372-0.0014(0.958)372-0.0272(0.317)0.0306(0.441)372

0.0926

0.09990.1084

0.10870.11520.0079 **(0.046)0.0125 **(0.032)0.0130 **(0.014)0.0064(0.418)-0.1163 *(0.099)-0.0947(0.208)-0.0048(0.670)0.0107 **(0.043)0.0239 *(0.094)0.0145 **(0.011)0.0166(0.194)0.0101 **(0.050)0.0315 **(0.041)0.0141 **(0.014)0.0135(0.267)-0.1572 *(0.074)0.0087 *(0.097)0.0257 **(0.041)0.0134 **(0.022)0.0146(0.219)-0.1681 *(0.064)-0.1374(0.115)-0.0022(0.521)0.0063(0.138)-0.024(0.383)-0.074(0.502)372

0.1298 ***(0.000)217

0.1298 ***(0.000)217

0.1371 ***(0.000)217

0.11790.14440.16480.18820.0087(0.101)0.0257 **(0.039)0.0134 **(0.022)0.0145(0.223)-0.1684 *(0.062)-0.1375(0.115)0.0014(0.923)0.0057(0.224)0.0260 **(0.037)0.0167 ***(0.005)0.0057(0.552)-0.2189 **(0.025)-0.2411 **(0.011)0.0044(0.744)-0.0080 *(0.072)0.0097 *(0.074)0.0329 **(0.021)0.0189 ***(0.004)0.0020(0.863)-0.2178 **(0.024)-0.2108 **(0.034)0.0002(0.988)0.1410 ***(0.000)217-0.0860 **(0.014)
0.1981 ***(0.000)217-0.0072(0.145)0.0123 *(0.071)-0.0682 *(0.060)0.0826(0.580)217

0.24380.21700.2202Acquiror Announcement Period Cumulative Abnormal Returns (CAR) are measured over the 7 days (-3, 3) around the announcement (day 0) of the acquisition. The sample includes
merger bids and tender offers in which both acquiror and target were listed on the Japanese Stock Market in order to eliminate small cases. We excluded cases
where either acquiror or target was a financial institution, or cases with a bailout takeover where the transaction was a result of the target being in financial
distress, etc., where the data needed to calculate V/P and B/P is available. V/P is the fundamental value-to-price ratio. The fundamental value V is estimated using the residual income
model (RIM) where the discount rate is based on firm-specific CAPM. Liquidity is operating income plus depreciation minus interest, taxes, and all dividends, and is expressed as a ratio
to total assets. The cash ratio is cash equivalent plus short-term investments, expressed as a ratio to assets. The diversification dummy=1 if the target is outside the acquiror's industry;
diversification dummy=0 if they are both in the same industry. Relative equity is the ratio of the acquiror’s market equity to the target’s market equity. Equity is the market value of thecommon stock holders. Leverage is the ratio of total debt to total assets.
The first row reports coefficient, and the second row in parentheses reports the p-value. ***, **, * denote significant at the 1%, 5%, and 10% level (two-tailed), respectively.

32

Table 7 Four independent cell matrix based on valuation ratios [V/P and B/P]
Target's V/P or B/P

Acquiror's
V/P or B/Phigh
Buy the acquiring firm's stockhigh when both acquiring firms and target firm
are relatively undervalued

lowSell the acquiring firm's stock
when both acquiring firms and target firm
are relatively overvalued

low

V/P is the fundamental value-to-price ratio. The fundamental value V is estimated using the residual
income model (RIM) where the discount rate is based on firm-specific CAPM. B/P is thebook-to-price ratio.
Based on the medium valuation ratios of all listed firms, all M&A transactions were sorted into fourgroups:The 1st Row, 1st Column in the Matrix represents cases where both the acquirers’ and the targets’ V/P
or B/P ratios fall above the medium valuation ratios (V/P or B/P) of all listed firms.
The 2nd Row, 2nd Column represents cases where both the acquirers’ and the targets’ V/P or B/P ratios
fall below the medium valuation ratios (V/P or B/P) of all listed firms.
The 1st Row, 2nd Column and 2nd Row,1st Column positions are negligible for the purposes of this study.
Table 7 shows four partition cells with breakpoints based on the median valuation ratios(V/P and B/P ratio) of all listed firms. All M&A transactions were assigned to one of fourgroups. We specifically were interested in the cases where the acquirors and targets
were both undervalued compared to those cases where the acquirors and targets wereboth overvalued.

33

Table 8 Cumulative abnormal returns for (-10 to +10) produced by V/P and B/P Trading strategies

B/P ratio

V/P ratio
date
-10
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
10
N

AR
-0.4411%0.8178%-0.4446%-0.4336%0.4908%0.1673%-0.5298%
0.5869%0.6491%
1.0425%0.7411%1.2800%0.4110%0.8192%0.5149%-0.2568%-0.3116%0.4723%-0.5941%0.0499%0.6186%
372

*

*

CAR
-0.4411%0.3767%-0.0679%
0.5016%-0.0108%
0.1565%-0.3734%
0.2135%0.8626%1.9051%2.6462%
3.9262%
4.3372%
5.1564%5.6713%5.4145%5.1029%5.5752%4.9811%5.0310%5.6496%
372

*
*
*
*
*
*
*
*
*
*

AR
-0.4384%0.3055%-0.2720%0.2958%-0.1028%-0.9485%-0.3675%0.4603%0.0563%1.5099%0.5507%
0.0665%0.8190%0.5942%-0.2126%
0.0828%0.1113%-0.5955%
0.3429%0.1156%-0.1306%
486

**

**

*

*

CAR
-0.4384%-0.1329%-0.4050%-0.1092%-0.2120%-1.1604%-1.5279%-1.0676%-1.0676%
1.0676%1.0493%
1.1158%1.9348%2.5290%2.3164%2.3992%2.5105%1.9150%2.2579%2.3735%2.2429%486

Table 8 shows abnormal returns (AR)/cumulative abnormal returns (CAR) over thetwenty one days (-10, +10) around the announcement (day 0) of the acquisition,
produced by V/P and B/P-based trading strategies. V/P is the fundamental value-to-priceratio. The fundamental value V is estimated using the residual income model (RIM)
where the discount rate is based on firm-specific CAPM. B/P is the book-to-price ratio.
For each valuation ratio, we require that both acquirer and target have known values.
The investment strategy is produced by buying acquiring firm’s stock where both theacquirer’s and the target’s V/P or B/P ratios fall above the medium valuation ratios (V/Por B/P) of all listed firms [high V/P of Acquirer - high V/P of Target] and selling
acquiring firm’s stock where both the acquirer’s and the target’s V/P or B/P ratios fall
below the medium valuation ratios (V/P or B/P) of all listed firms [low V/P of Acquirer- low V/P of Target].
The sample includes both successful and unsuccessful merger bids and tender offers inwhich both acquirer and target were listed on the Japanese Stock Market during
1996-2007, but excludes cases where either acquirer or target is a financial institution,
or a rescue takeover where the transaction is as a result of the target being in danger offinancial damage or difficulty in fulfilling commercial notes etc.
***, **, * denote that the difference in mean values is significant at the 1%, 5%, and
10% level (one-tailed), respectively, based on the two-sample t-test.

34

Table 9 Cumulative Abnormal Returns for various periods produced by V/P and B/P Trading
strategies

periodCAR(-1,+1)
CAR(-10,+10)
CAR(-1,+10)
CAR(-5,+5)
CAR(-1,+5)
CAR(-1,+3)
CAR(-3,+3)

V/P ratio t-test B/P ratio t-test
3.0636% **5.6496% *4.7870% **5.4253% **4.5519% **4.2939% **5.5298% ***2.1271%2.2429%3.2542% *2.6112%3.4105% **3.5403% **4.0569% ***Difference between
V/P and B/P strategy
0.9365%3.4067%1.5328%2.8142%
1.1414%0.7535%1.4729%

Table 9 shows cumulative abnormal returns produced by V/P and B/P based trading
strategies. V/P is the fundamental value-to-price ratio. The fundamental value V isestimated using the residual income model (RIM) where the discount rate is based on
firm-specific CAPM. B/P is the book-to-price ratio. For each valuation ratio, we requirethat both acquirer and target have known values.
The investment strategy is produced by buying acquiring firm’s stock where both theacquirer’s and the target’s V/P or B/P ratios fall above the medium valuation ratios (V/Por B/P) of all listed firms [high V/P of Acquirer - high V/P of Target] and selling
acquiring firm’s stock where both the acquirer’s and the target’s V/P or B/P ratios fall
below the medium valuation ratios (V/P or B/P) of all listed firms [low V/P of Acquirer- low V/P of Target].
The sample includes both successful and unsuccessful merger bids and tender offers inwhich both acquire and target were listed in Japanese Stock Market during 1996-2007,
but excludes cases where either acquirer or target is a financial institution, or a rescue
takeover where the transaction is as a result of the target being in danger of financial
damage or difficulty in fulfilling commercial notes etc.
***, **, * denote that the difference in mean values is significant at the 1%, 5%, and
10% level (one-tailed), respectively, based on the two-sample t-test.

35

Figure 1 Cumulative Abnormal Returns (-10 to 10) produced by V/P and B/P Trading strategies

CAR
7%
6%
5%
4%
3%
2%
1%
0%
-1%

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

-2%
('0'=announcement date of acquisition) business days
V/P based sttrategy

B/P based strategy

Figure 1 shows cumulative abnormal returns produced by V/P and B/P based trading strategies.
V/P is the fundamental value-to-price ratio. The fundamental value V is estimated using theresidual income model (RIM) where the discount rate is based on firm-specific CAPM. B/P is thebook-to-price ratio. For each valuation ratio, we require that both acquirer and target have known
values.
For each investment strategy, this graph depicts the cumulative abnormal returns produced bybuying acquiring firms where M&A transactions are in the case of [high V/P or B/P of Acquirer high V/P or B/P of Target] and selling acquiring firms where M&A transactions are in the case of[low V/P or B/P of Acquirer - low V/P or B/P of Target].
The sample includes both successful and unsuccessful merger bids and tender offers in which bothacquirer and target were listed on the Japanese Stock Market during 1996-2007, but excludes
cases where either acquirer or target is a financial institution, or a rescue takeover where thetransaction is as a result of the target being in danger of financial damage or difficulty in fulfillingcommercial notes etc.

36