2010-52
Testing the Pecking Order, Method-of-Payment,
Financial Slack, and Misvaluation Hypotheses
for Tender Offers: Evidence from Japan
Tadanori Yosano Yoshinori ShimadaTesting the Pecking Order, Method-of-Payment, Financial Slack, and Misvaluation
Hypotheses for Tender Offers: Evidence from Japan

Tadanori Yosano
Graduate School of Business Administration of Kobe University, 2-1, Rokko-dai cho, Nada-ku,
Kobe, 657-8501, Japan
Tel: +81-78-803-6989
Fax: +81-78-803-6989
Email: yosano@kobe-u.ac.jp
Yoshinori Shimada
Graduate School of Business Administration of Kobe University, 2-1, Rokko-dai cho, Nada-ku,
Kobe, 657-8501, Japan

Abstract:
In this paper, we investigated the affect of tender offer transactions in Japan from four
perspectives. The first one is in regards to the Pecking Order Theory, and the second one
concerns the Method-of-Payment Hypothesis. Both of these first two perspectives are related
to manager payment method decisions, such as cash versus stocks. The third perspective istaken from the Financial Slack Hypothesis, which is very similar to the Free Cash Flow
Hypothesis, and the last perspective takes into account the Misvaluation Hypothesis. Theselatter two perspectives are similarly related to the subsequent responses from investors that
follow the announcements of tender offers.
We found strong evidence supporting the Pecking Order Theory, because managers
are deeply motivated to select cash payments when they have an extensive amount offinancial slack, free cash flow, representative of cash or cash equivalent. Unfortunately, on
the other hand, we could not find any empirical data to fully support the Method-of-Payment
hypothesis which was originally introduced and supported empirically in the U.S.
Evidence from our research for the Financial Slack or Free Cash Flow andMisvaluation hypotheses proved that investor reactions in Japan are similar to those in the
U.S. A Japanese market with an increase in tender offer transactions contributes to the wealthof both acquiring and target firms, despite the stock market responding negatively toinvestments from acquiring firms with an extensive amount of financial slack or free cash
flow. Furthermore, our B/P ratio conclusions reaffirm the propositions of Shleifer and
Vishny (2003), while the V/P ratios support Dong, et al. (2006) who used the Residual
Income Model.

[JEL Classification] G34, M41[Key Words] Tender Offers, Pecking Order, Method-of-Payment, Financial Slack,
Misvaluation Hypothesis

11. Introduction(1) Purpose
The following study investigates the affect of tender offer transactions in Japan from four
perspectives. The first one regards the Pecking Order Theory, and the second one concerns
the Method-of-Payment Hypothesis. Both of these first two perspectives are related to
manager decisions about payment methods, such as cash versus stocks. The third perspective
is in regards to the Financial Slack Hypothesis, which is very similar to the Free Cash Flow
Hypothesis, and the last perspective takes into account the Misvaluation Hypothesis. Theselatter two perspectives are similarly related to the subsequent responses from investors that
follow the announcements of tender offers.
In Japan, the new corporate situation and resulting legal climate further stimulated
activity within the tender offer market, and created a much needed shift in financing fromlending, especially main banking lending, towards direct funding from the capital market.
Shareholders often require corporate managers to maximize the firms’ value, unlike
conventional creditors, and therefore, inadvertently promote the stock swap scheme of 1999.
Firms have to focus on their business, and allocate resources carefully in order to be more
efficient maximizing their value. In these cases, tender offer transactions are used as anenhancement to shorten the ‘focus’ process without having to restructure the businessinternally.
Firstly, we investigated whether an acquiring firm with a great amount of financial
slack or abundant cash or cash equivalents is more inclined to choose cash payment, as
proposed by the Pecking Order Theory. We also investigated if firms with a high debt ratio
are more inclined to choose the stock payment option.
Secondly, we investigated whether managers are motivated to increase thestockholder value by acquiring relatively under-valued companies using their own stocks as
payment when their stocks are over-valued, outlined by the Method-of-Payment hypothesis
introduced by Shleifer and Vishny (2003).
2

Thirdly, we investigated whether managers who have an extensive amount offinancial slack have a tendency to over-invest in poor opportunities originally suggested byMyers and Majluf (1984) and Lang et al. (1991). We also investigated whether managers
with an expendable cash stock or cash equivalent also have a tendency to over-invest in poor
opportunities, which is more commonly known as the Free Cash Flow hypothesis (Jensen,
1986).
Lastly, we assessed the difference between the fundamental value and the market
value of firms (Misvaluation). Investors will buy the acquiring firm’s stock when theacquirers and/or targets are undervalued, and furthermore, consistently sell the stock ofacquiring firms when the acquirers and/or targets are overvalued. The fundamental value wascalculated according to the Residual Income Model (RIM) using the 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 previous research published on the short-term stock performance oftender offer transactions. We especially highlight the differences in the post-tender offer
stock performance between the U.S. and Japan.
Section 3 describes hypotheses related to manager decisions on payment methods,
such as cash versus stocks. The first and second hypotheses are the Pecking Order hypothesis,
and the Method-of-Payment hypothesis.
Section 4 describes hypotheses, such as the Financial Slack or Free Cash Flow, andMisvaluation hypothesis, related to investor subsequent responses following theannouncement of tender offers.
Section 5 provides a general overview of our data sample, sample characteristics, andthe method used to estimate the fundamental value of a firm, which is qualified to test the
Method-of-Payment and Misvaluation hypothesis.
3Section 6 presents our investigation results with respect to the payment method (cashvs. stock) and the subsequent cross-sectional stock returns performing univariable tests.
Section 7 presents our investigation results with respect to the payment method (cashvs. stock) and the subsequent cross-sectional stock returns performing multivariable tests.
Section 8 provides our main conclusions and future research goals.

2. Short-term Stock Performance of Tender Offer Transactions(1) Previous Research on the Short-term Stock Performance of Tender Offer
Transactions
In the U.S., the economic effect of tender offer transactions has been thoroughly investigatedwith event study methodology for more than thirty years. Bhagat et al. (2005) reported anaverage positive 0.18% on five-day Cumulative Abnormal Returns (CARs, equal-weighted)
for the acquiring firms (not significant), an average positive 30.01% on five-day CARs forthe target firms (1% significant level), and an average positive 5.27% on five-day CARs forthe combined acquiring and target firms (1% significant level) calculated using thevalue-weighted average of acquirer and target CARs.
In Japan, the number of tender offer transactions has been far less than in the U.S., up
until the early 1990s. Usui (2001) examined the period from 1989 to 1999 and reported anaverage positive 0.24% on three-day CARs for Japanese acquiring firms (not significant), andan average positive 5.81% on three-day CARs for Japanese target firms (1% significant
level).

(2) Measuring the Economic Significance of Tender Offer Transactions
In this paper, we adopted a standard event study methodology to measure the tender offer
announcement’s economic effect on the acquiring firms, the target firms, and the total
economic wealth of the acquirer and target firms calculated with the value-weighted averageof acquirer and target CARs. Table 1 shows the CARs for various periods around the4announcement day of tender offers, signified by a (0),, including 217 tender offer transactions
from January 1996 to December 2007 [Source: Recof Ltd. MARR M&A data CD-ROM]. In
order to eliminate small cases, the sample is compromised of tender offers where both theacquirer and target firm are listed on the Japanese Stock Market. We excluded cases where
either the acquirer or target is a financial institution, and cases where a bailout takeover is a
result of the target being in financial distress. The term financial distress can be defined bytargets who fall into bankruptcy and firms that are saved at a below-market price.
According to Fuller et al. (2002), the abnormal returns of the acquirer and target arecalculated with the market adjustment model based on NYSE index data, and, in our study,
we used the Topix indicator as a market portfolio. In concern to acquirers, we found average
short-term positive abnormal returns for the following time periods: 1.4025% (1% significant
level) around the announcement day (-1, +1); 1.5751% (5% significant level) around theannouncement day (-3, +3); and 0.7905% (1% significant level) 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 are likely to be 1.5013% and 1.4950% respectively. Thismeans the announcement effect persists for tender offers, and investors incorporated thetender offer effect immediately following the tender offer announcement.
In considering targets, we found a short-term positive abnormal return of 10.7814%(1% significant level) around the announcement day (-1, +1), 12.6155% (1% significant
level) around the announcement day (-3, +3), and 12.9358% (1% significant level) around theannouncement day (-5, +5). These returns are considerably larger than those of acquiringfirms. These results show that stockholders of target firms benefit substantially more thanacquiring firm stockholders. The announcement effect also persists for target firms. The
abnormal return 10.7817% around the announcement day (-1, +1) does not diminish even if
we extend the announcement period to (-1, +5). The positive abnormal returns continued at
11.6946% for (-1, +3) and 11.3508% for (-1, +5).

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When considering the combined wealth of stockholders of the acquiring and target
firms, we found a short-term positive abnormal return of 1.8097% (1% significant level)around the announcement day (-1, +1), 1.9806% (1% significant level) around theannouncement day (-3, +3), and 2.3846% (1% significant level) around the announcementday (-5, +5).
In Japan, the combined wealth of stockholders in both the acquiring and target firms is
far less than their counterparts in the U.S. In Japan, acquiring firm stockholders obtainbenefits from tender offers, which is contrary to the U.S. findings. The stockholders of target
firms, on the other hand, obtain smaller benefits in comparison to their U.S. counterparts,
despite the irony that Japanese target firm stockholders still receive much greater benefits
than Japanese stockholders of acquiring firms.

3. Hypotheses Regarding the Means of Payment
According to previous researchers, the positive effect of a regulated management
counterbalanced by the negative effects of agency problems have a significant impact ontender offer transactions and the subsequent stock performance of the acquiring firms.
Regulated management, which requires an adherence to shareholder directives, involves theeffective appropriation of funds into (1) new businesses with a potential synergistic effectwith the acquiring firm’s core business, and/or (2) businesses characterized by economies ofscale, economies of scope, and involvement in acquisition of new technologies.

(1) The Pecking Order Hypothesis
Brealey et al. (2007) introduced the pecking order theory. The pecking order theory illustrates
the effects of asymmetric information between internal firms and external investors uponchoices between in-house finances, such as cash or cash equivalents, new issues of debt, andequity securities. The choices available for funding consequently lead to a preference
amongst firm managers to initially finance a new investment with internal funds, followed by6

new issues of debt, and finally with new issues of equity. Therefore, new issues of equity area last resort used only when the company reaches the maximum debt ratio.
Brealey et al. (2007) introduced the optimal debt ratio using the tax shield concept,
which indicates the benefit of the debt in accounting terms when a firm is able to deduct theinterest rate on the debt from the taxable income of the firm. Brealey et al. (2007)
demonstrated that the tax shield has a positive effect for high debt ratios up until the debt
ratio reaches the optimal debt ratio level. Beyond the optimal debt ratio level, however, thenegative debt effect from bankruptcy costs outweighs the positive tax benefits for the firm.
Therefore, we can hypothesize that an acquiring firm who has a great amount offinancial slack or abundant cash or cash equivalents is more inclined to choose cash payment.
However, if a firm has a high debt ratio, acquiring firms are inclined to choose stock payment.
Hence, we propose the following two consequential hypotheses:

Hypothesis 1: The more financial slack or cash ratio within the acquiring firm,
the higher the cash payment ratio.

Hypothesis 2: The higher the debt ratio for an acquiring firm, the higher thestock payment ratio.

(2) The Method-of-Payment Hypothesis
Shleifer and Vishny (2003) reported that managers are motivated to increase the stockholder
value by acquiring relatively under-valued companies using their own stocks as payment
when their stocks are over-valued. Under these circumstances, the subsequent stock
performance of the acquiring firm is negative. Managers are also motivated to use cash
payments when their own stocks are reasonably-valued or under-valued, in which case, thesubsequent stock performance of the acquiring firm is positive. Shleifer and Vishny (2003)
concluded that managers will attempt to increase stockholder values by positively acquiring
7

relatively under-valued target firms in two ways: (1) using stock payments with their own
relatively over-valued stocks, or (2) using cash payments when their own stocks are relatively
under-valued. These two transactions are considered to be “stock market driven acquisitions,”
and is widely known as the Method-of- Payment hypothesis.

Hypothesis 3: The Method-of-Payment hypothesis predicts that managers use
stock payments positively when their own stocks are relatively over-valued in
the capital market, and, furthermore, they use cash payments positively when
their own stocks are reasonable or relatively under-valued in the capital market.

4. Hypotheses Regarding the Subsequent Stock Performance(1) The Financial Slack or Free Cash Flow Hypothesis
According to the findings of Myers and Majluf (1984) and Lang et al. (1999), firms’
managers who have an extensive financial slack, defined as the operating income plus
depreciation after any interest, taxes, and dividends, have a tendency to over-invest in poor
opportunities. Jensen (1986) also introduces the opportunistic behaviors of firm managers
within investment decisions given that their firm has an abundant amount of cash or cash
equivalents, known as the free cash flow hypothesis, or is also referred to as the manager’s
entrenchment behavior (Shleifer and Vishny, 1986). Jensen (1986), Shleifer and Vishny(1986) pointed out that the managers make use of M&A transactions as a means for pursuitsof personal profits, and managers tend to invest free cash flow in inefficient assets(over-investment) or target firms that will strengthen their managerial powers.
Therefore, we hypothesize that firms with a large amount of financial slack or cash
and cash equivalents are also more inclined to obtain a non-suitable target firm due todecisions made by goal-driven managers. The entrenchment behavior of managers leads tothe proposal of the following hypothesis:8Hypothesis 4: The more financial slack or cash ratio of the acquiring firm, thelower the subsequent stock performance of the acquiring firm.

(2) The Misvaluation Hypothesis
Frankel and Lee (1998) pioneered research in capital market misvaluations. They examined
the investment strategies of hedging portfolios using RIM 1 in U.S. M&A transactions
between 1975 to 1993, which reported a positive long-term excess return. The fundamental
value of the firm was estimated from the future earning value and the long term growth rate
forecast given by financial analysts in the I/B/E/S data base for RIMs. Quintile portfolios
were constructed and sorted according to the V/P ratio. The organization facilitated Frankel
and Lee’s estimation that the fifth quintile (the highest V/P ratio) consisted of the mostunder-valued firms whose subsequent stock performance would ironically be the highest. The
first quintile (the lowest V/P ratio), on the other hand, represents the most over-valued firms
whose subsequent stock performance is lowest.
The cumulative performance of hedging portfolios (long-short portfolios) is definedby the encouragement for long-term acquisition of firms in the fifth portfolio (the highest V/Pratio) and the simultaneous short-term possession of first portfolio firms (the lowest V/Pratio). This strategy outperforms the conventional hedging portfolio strategy that merely
relies on the B/P ratio or size (market value).

Hypothesis 5: The difference between the firms’ fundamental value and market
price has an impact on the subsequent stock performance of acquiring firms. The
more under-valued the acquirer and the target firms are, the higher the stock
performance of both firms around the tender offer announcement date.

1

Dechow, et al. (1999) and Lee, et al. (1999), etc also reported the results of investment
strategy following this V/P anomaly.
95. 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
the acquiring firms around the announcement day of tender offer transactions, and tests the
hypotheses addressed in Section 3 and 4. Our sample includes tender offer transactions fromJanuary 1996 to October 2007, available in the database of RECOF MARR CD-ROM, thatsatisfy the following criteria:(a) Acquirer 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 acquiring and target firms were listed in the stock exchange in order to exclude
small cases.
(c) The payment method of the tender offer 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 or
Toyo 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 thecost of the equity capital.
Table 2 shows our sample characteristics for tender offers by calendar year. The
number of tender offer transactions in Japan has increased dramatically since the revision of
corporate law introduced the stock swap scheme in 1999. This scheme has led to an increasein tender offer transactions, because more listed acquiring firms bid on the listed targetingfirms with the option of stock swapping as payment. Therefore, the number of listed firm
tender offer cases has overall increased dramatically, jumping from the single digits into the10double digits simply due to the change in policy implemented by the stock swap scheme in
1999. The level exceeded thirty in 2005 and 2006.
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 tender offer announcement dates.
The median market equity value of the acquiring firms (¥204,336 million) is
25.39times greater than the medium market value of the target firms (¥8,049 million). The
acquirers in our sample have a considerably higher median stock value than the median firm
value listed on the stock exchange (¥204,336 million vs. ¥15,342 million).
Regarding the book-to-market ratio, the medium of the acquirer is 0.6497, and that of
the target is 1.0693. Regarding financial leverage, the medium of the acquirer is 0.6509, andthat of the target is 0.5872. Regarding ROE, the medium of the acquirer is 5.44%, and that of
the target is 2.87%. The book-to-market is widely interpreted as the proxy variable of thefirm’s growth. The medium 0.6497 of the acquirer is much less than the medium
book-to-market ratio 1.119 of all the listed firms, and the medium ROE 5.44% of the acquirer
is much higher than the medium ROE 3.93% of all listed firms. Therefore, the acquirers inour sample are composed of firms that are highly profitable and have the characteristics ofgrowth 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.
Tender offers in Japan are concentrated because only four sectors account for 43% of alltender offers in our sample. These four sectors are: retail trade (11.52%), electric & electric
devices (11.06%), service (11.06%), and wholesale trade (9.68%). Construction (5.99%) andchemicals (5. 99%) were the fifth and sixth ranked sectors. In the service, retail trade, andfood sectors, tender offers were within the across sectors (diversified) as opposed to same
sectors (non-diversified). On the other hand, in electric & electric devices, wholesale trade,11and construction industries, diversified and non-diversified tender offers were found in equal
proportions.

(2) The Residual-Income Valuation Model
We estimate 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 estimates using threedifferent forecast horizons beyond three years, and Vt estimates were not sensitive to thenumber of the forecast periods or the cost of equity capital. Thus we used three period
forecast horizons following Dong et al. (2006),

1

1

1

,

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

,

12

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;.
We excluded stock repurchases due to the practical problems associated withdetermining the likelihood of their occurrence in future periods, following Lee et al. (1999).
For firms with negative 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 is approximately 6%2.

(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 preceding the announcement date. We estimated thecost of equity capital for each firm as 4.4%, assuming that the risk premium of the market
portfolio equaled the average annual rate of Topix3.

(4) Estimation of the Fundamental Value
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 (or Tokyo2

The 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 thesame as the long-run performance of the United States, as a proxy for normal earnings levels
when current earnings are negative.
3
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.]
13

Keizai data base if the forecast value was not available in the I/B/E/S data base) for RIM4.
From Table 4 to Table 6 show the V/P ratio (fundamental value to market value ratio) andB/P ratio (book-to-market ratio) of both acquirers and targets. We identified the payment
methods (cash vs. stock) of 217 transactions within our sample from Nikkei Telecom 21 by
Nikkei Newspaper Digital Ltd. or MARR M&A data CD-ROM by Recof Ltd. We calculated
V/P ratios for 217 cases by using the financial analyst forecast value of the future profit andestimating the cost of equity capital by CAPM. Our sample required that both acquirer andtarget were listed in the stock exchange in order to eliminate small cases.

6. Results of our Univariable Tests
Using univariable tests, we investigated the statistical differences amongst payment methods
and CARs between low financial attributes, such as the financial slack, the cash ratio,
leverage, comparing them against high financial attributes. We also investigated the statisticaldifferences amongst payment methods and CARs between low and high ranking V/P groups,
and low and high ranking B/P groups. Table 4 summarizes the results of this differential test
on mean values, and the z value for the differential ratio test and t value for the differential
number test are reported given the assumption of independent samples.

(1) The Univariable Test for the Pecking Order Hypothesis within Acquiring Firms
First, we focused on the cash payment ratio differences between acquiring firms categorized
as having low financial slack and cash ratios, and acquiring firms who have a high amount of

4

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 notavailable, it is calculated by multiplying the long-term growth rate (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 constantforecast model (see Dong et al. (2006)). Contrary to the United States, the book value of theequity 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 thehighlight of annual report, together with the summary of financial statements.
14

financial slack and cash ratios. The pecking order hypothesis insists that firms with a highamount of financial slack and/or cash ratio have the tendency of using cash payments when
acquiring target firms.
The first and second rows of Panel (A) show the results of the univariable testcomparing firms with a low amount of financial slack and/or cash ratio (the first tertile)
against firms with a high amount of financial slack and/or cash ratio (the third tertile). Our
results are consistent with the aforementioned hypotheses 1 and 2.
The low financial slack firms (the average financial slack = 0.60%) have a cash
payment ratio at 48.78%, which is significantly lower than the cash payment ratio of highfinancial slack firms (the average financial slack = 17.57%) who are at a calculated 66.67%(5% level, one-tailed). However, Martin (1996) showed contradictory empirical results in the
U.S. (4.85% financial slack cash payment measures versus 3.23% financial slack stock
payment measures with a 1% significance level).
Low cash ratio firms (the average cash ratio = 4.57%) also have a significantly lower
cash payment ratio of 44.19% compared to the 57.58% cash payment ratio found in high cash
ratio firms (the average cash ratio = 32.57%, 10% level, one-tailed). This finding, on theother hand, is consistent with Martin’s (1996) empirical findings in the U.S. (2.86% cash
ratio cash payment measures versus 3.23% cash ratio stock payment measures, and thedifference has a 5% significant level).
Secondly, we focused on the cash payment ratio differences between acquiring firms
categorized as having a low debt ratio and acquiring firms with high debt ratios. The Pecking
Order hypothesis insists that firms who exceed an optimal debt ratio have the tendency of
issuing new stocks when acquiring target firms. Therefore, we expect a low cash payment
ratio for firms with high debt ratios.
The third row of Panel (A) shows the results of the univariable test that compares low
leverage acquiring firms (the first tertile) with high leverage acquiring firms(the third tertile).
We could not find any significant differences between low and high leverage acquiring firms,
15even though Harford et al. (2009) did find empirical differences consistent with our
hypothesis 2. They found a negative association between the deviation from the optimal
leverage and the use of cash payment by estimating the optimal leverage according to thetobit model shown in Kayhan and Titman (2007).

(2) The Univariable Test for the Method-of-Payment Hypothesis within Acquiring Firms
In this step, we focused on the cash payment percentage differences between the low V/Pratio ranking group and the high V/P ratio ranking group. Furthermore, we investigated the
cash payment percentage differences between the low B/P ratio ranking group and the highB/P ratio ranking group, because the B/P ratio is commonly used as a conductive corporate
valuation proxy for the V/P ratio.
The fourth and fifth rows of Panel (A) show the results of the univariable test thatcompares acquiring firms with a low valuation ratio (relatively expensive: the first tertile)
with acquiring firms with a high valuation ratio (relatively cheap: the third tertile). We foundthat if the acquirer’s V/P ratio is high, then the B/P ratio is also high (10% significant level)5
The low V/P ratio firms (the average V/P ratio = 0.5251) have a 55.22% cash
payment ratio which is higher than (not significantly) the high V/P ratio firms (the average
V/P ratio = 1.8985) who have a 47.46% cash payment ratio. While these results do notsupport our hypothesis 3, it also does not completely disprove our theory. The proxyvaluation measure, the B/P ratio, also showed a contradictory result with hypothesis 3(54.76% cash payment for low B/P ratio groups versus 35.71% cash payment for high B/Pratio groups at a 5% significance level, one-tailed).

(3) The Univariable Test for the Financial Slack and Free Cash Flow Hypothesis within
Acquiring Firms

5

The covariance (14.26%) between these two ratios is not high. Therefore, the V/P and B/Pratios can be considered only marginally correlated.
16

In this following step, we focused on the CAR (-3, +3) differences between acquiring firms
categorized as having low financial slack and cash ratios, and acquiring firms with a highamount of financial slack and cash ratios independently. The Financial Slack and/or Free
Cash Flow hypotheses insist that firms with a high amount of financial slack and/or cash ratio
have the tendency of investing in poor opportunities, including non-suitable target firms.
The first and second rows of Panel (B) show the results of the univariable testcomparing low financial slack and/or cash ratio firms (the first tertile) withhigh amountfinancial slack and/or cash ratio firms (the third tertile). Our results are consistent withhypotheses 4.
Low financial slack firms (the average financial slack = 0.71%) have a 4.09% CAR(-3, +3) which is significantly higher than the high financial slack firms (the average financial
slack = 17.76%) with a 0.80% CAR (-3, +3) (10% level, one-tailed) also supporting
hypothesis 4. Low cash ratio firms (the average cash ratio = 4.60%) also have a significantly
higher CAR (-3, +3) at 2.31% compared to the high cash ratio firms' (the average cash ratio =31.93%) who have a CAR (-3, +3) at -1.54% (10% level, one-tailed), which is further
consistent with hypothesis 4.

(4) The Univariable Test for the Misvaluation Hypothesis within Acquiring Firms
In this perspective, we focused on the CAR (-3, +3) differences between the low V/P ratio
ranking group and the high V/P ratio ranking group for both acquiring and target firms. We
also investigated the CAR (-3, +3) differences between the low B/P ratio ranking group andthe high B/P ratio ranking group for both acquiring and target firms. We executed theunivariable test with consideration to CAR (-3, +3) differences by using CARs that were
estimated through the market model. The fourth and fifth rows of Panel (B) show the resultsof the univariable test that compares acquiring firms with a low valuation ratio (relatively
expensive: the first tertile) against acquiring firms with a high valuation ratio (relatively
cheap: the third tertile). The sixth and seventh rows of Panel (B) show the results of the17univariable test that compares acquiring firms with low target firms valuation ratios against
acquiring firms with a high target firms valuation.
Low acquiring firmV/P ratio groups (the average V/P ratio = 0.5174) have a -0.74%
CAR (-3, +3), which is significantly lower than the high acquiring firm V/P ratio groups (theaverage V/P ratio = 1.8672) 3.65% CAR (-3, +3) (1% level, one-tailed). These results support
hypothesis 5. The proxy valuation measure, B/P ratio, also showed a consistent result
supporting hypothesis 5 with a -0.87% CAR (-3, +3) for low acquiring B/P ratio groups
versus a 5.50% CAR (-3, +3) for high B/P ratio groups at a 1% significance level, one-tailed.
We also found consistent results with hypothesis 5 in regards to target firm valuations.
The low target firms’ V/P ratio groups (the average V/P ratio = 1.0821) have a significantly
lower CAR (-3, +3) at 0.60% compared to the high target firms’ V/P ratio groups (theaverage V/P ratio = 1.1911) CAR (-3, +3) at 3.81% (1% level, one-tailed). Similarly, lowtarget firms’ B/P ratio groups (the average B/P ratio = 0.4045) 1.02% CAR (-3, +3) is alsosignificantly lower than the high target firms’ B/P ratio groups (the average B/P ratio =2.6349) CAR (-3, +3) at 4.27% (5% level, one-tailed).
For both univariable tests for the Financial Slack/Free Cash Flow and Misvaluation
hypothesis, CAR (-3, +3) differences were taken into account by using CARs that were
estimated through the market model as a robustness check.

We present these results inAppendix 1, and they are shown to be consistent with Panel (B) of Table 4.

7. Results of our Multivariable Tests
Table 5 shows the results of the logit multivariable regression. The Pecking Order hypothesis
is tested by examining the relationship between the financial attributes, such as financial
slack, cash ratio, and leverage, and payment methods, either cash or stocks, after controllingother variables. The Means of Payment hypothesis is tested by examining the relationshipbetween the V/P ratio and payment methods given the control of all other variables.

18

Table 6 displays the results from the ordinary multivariate regression. The Financial
Slack or Free Cash Flow hypotheses can be tested by examining the relationship between thefinancial slack or the cash ratio and the subsequent stock performance of the acquirer giventhat all other variables are controlled. The Misvaluation hypothesis can be tested byexamining the relationship between the V/P ratio and the subsequent stock performance of
the acquirer while controlling all other variables. We regressed the cumulative abnormal
returns of the acquirer (-3, +3) with respect to the financial slack, the cash ratio, andacquiring firm V/P ratios.
In tables 5 and 6, we included the following control variables: the diversification
Dummy, the logarithm of relative equities, the acquirer’s logarithm of equities, and thetarget’s logarithm of equity.
The control variables in our study are defined as follows:
The diversification dummy = 1, if the target is outside the acquirer's industry; diversification
dummy = 0, if they are both in the same industry.
Relative equity is the ratio of the acquirer’s market equity to the target’s market equity.
Equity is the market value of common stockholders.
The second column in the tables gives the expected coefficient signs in accordance with our
hypotheses. The first row gives the coefficient, and the second row gives the p-value inparentheses (The coefficient is followed by the p-value in parentheses).

(1) The Multivariable Test for the Pecking Order Hypothesis within Acquiring Firms
The Pecking Order hypothesis suggests that managers will choose a cash payment if theirfirm has a great amount of financial slack, abundant cash, or cash equivalents. However, thePecking Order hypothesis also suggests that, if a firm has a high amount of leverage,
managers will be more inclined to choose stock payments. In the 6th column of Table 5, thecoefficient of the acquiring firms’ financial slack is 7.1783 (5% significant level), and thecoefficient of the acquiring firms’ cash ratio is 3.2986 (10% significant level), which are both19

consistent with hypothesis 1. However, the coefficient of the acquiring firm’s leverage at
0.5024 is not significantly positive. This result is contradictory with our expectations inhypothesis 2.

(2) The Multivariable Test for the Method-of-Payment Hypothesis within Acquiring
Firms
The Method-of-Payment hypothesis predicts that managers will select stock payments when
the acquiring firm is overvalued in the market. In the last column of Table 5, the coefficientof acquirers’ V/Ps at -0.3291 is not significantly negative. This result is also contradictorywith our expectations outlined in hypothesis 3. The coefficient for the acquirers’ B/Ps, whichis the alternative corporate valuation variable, is also not significantly negative at-0.4692.
Similarly, this result also contradicts our predictions presented in hypothesis 3.

(3) The Multivariable Test for the Financial Slack and Free Cash Flow Hypotheses
within Acquiring Firms
The Financial Slack hypothesis predicts that the stock market will respond negatively toinvestments from acquiring firms which have an extensive amount of financial slack. The
Free Cash Flow hypothesis similarly suggests that the stock market will respond negatively toinvestments from acquiring firms which have an expendable stock of cash or cash equivalents.
In the 6th column of Table 6, the coefficient for the acquiring firms’ financial slack is -0.1883(5% significant level), while the coefficient of the acquiring firms’ cash ratio is -0.2944 (10%significant level), and both of which are consistent with the hypothesis 4.

(4) The Multivariable Test for the Misvaluation Hypothesis within Acquiring Firms
The Misvaluation hypothesis suggests that positive excess returns for the acquiring firms will
be detected around the announcement day of tender offer transactions if the acquirer and/or
target are undervalued in the market. In the farthest right column in Table 6, the coefficients20

of the acquiring firms V/P and target firms V/P are significant at a 5% and 10% level
respectively, supporting our fifth hypothesis. The target firm’s V/P coefficient, 0.0105, on
average, is one-third of the acquiring firm’s V/P coefficient, 0.0334.
Furthermore, we continued to consider the alternative valuation measure, B/P, in theordinary multivariate regressions. In the farthest right column in Table 6, the coefficient of
the acquiring firm’s B/P is not significantly positive, while the coefficient of the target firm’s
B/P is contrastingly significantly positive at a 1% level. Both of these findings are consistent
with hypothesis 5.
We found that these results are surprisingly similar over various periods for the
dependent variable, CARs, of the acquirers, including (-10, +10), (-5, +5), (-3, +3), (-1, +1),(-1, +3), and (-1, +5), which were not included in our original analyses.
Similar to the univariable tests in section 6, we also considered the CAR (-3, +3)
estimated by the market model in the multivariable tests for the Financial Slack/Free Cash
Flow and Misvaluation Hypotheses as a robustness check. These results are also consistent
with Table 4, and are displayed in Appendix 2.

8. Concluding remarks
In this paper, we investigated the effects of tender offer transactions in Japan from four
perspectives during the sample period from 1996 to 2007. The first perspective is in regards
to management payment decisions, such as cash versus stocks. We found strong evidence
supporting the Pecking Order Theory as managers are deeply motivated to select cash
payments when they have an extensive amount of financial slack or free cash flow,
representative of cash or cash equivalent. Unfortunately, we could not find any empirical data
to fully support the Method-of-Payment hypothesis that was originally introduced and later
repeatedly supported empirically in the U.S.
The second angle we investigated was the investor’s subsequent response following
tender offer announcements. Evidence in this step of our research proved that reactions in
21

Japan are similar to those in the U.S., and predicted by the Financial Slack, the Free Cash
Flow Ratio Hypothesis, and the Misvaluation Hypothesis. The first piece of evidence wefound that supports this conclusion is within the Japanese market where an increase in tender
offer transactions contribute to the wealth of both acquiring and target firms, even though thestock market responds negatively to investments from acquiring firms with an extensive
amount of financial slack. In conclusion, our results are consistent with the findings of Myersand Majluf (1984), Smith and Kim (1994), Lang et al. (1999), and Bowers et al. (2000), andempirical data from the U.S., Furthermore, our B/P ratio conclusions reaffirm the
propositions of Shleifer and Vishny (2003), while the V/P ratios support Dong et al. (2006)
who used the Residual Income Model.
[2010.10.5 1002]

22

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Lang, L. H. P., R. M. Stulz and R. A. Walking (1991) "A Test of the Free Cash Flow
Hypothesis: The Case of Bidder Returns,” Journal of Financial Economics, Vol.29
No.2 (October), pp. 315-335.
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Investment for the Value Management (CyuOh Keizai sha), pp. 71-111 (in Japanese)24

Table 1 Acquirer and target announcement period cumulative abnormal returns (CAR)(1) Acquirer Announcement Period CAR
Tender Offers(stock payment)

Tender Offers(cash payment)

PeriodALL
Tender Offers

CAR (-10, +10)

1.5589%*0.4935%**0.8498%

CAR (-5, +5)0.7905%***3.2544%***

1.1174%

CAR (-3, +3)

1.5751%**

3.4075%***0.3636%

CAR (-1, +1)

1.4025%***2.4667%***

0.3321%

CAR (-1, +3)

1.5013%**2.9998%***0.3288%

CAR (-1, +5)

1.4950%**2.3604%***0.9141%

CAR (-1, +10)N

1.2082%217

2.1815%**0.4043%100

93

Tender Offers(stock payment)

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

CAR (-10, +10)

13.2873%***

13.0501%***

16.6361%***

CAR (-5, +5)

12.9358%***

12.3522%***16.0449%***

CAR (-3, +3)

12.6155%***

12.0437%***

15.5219%***

CAR (-1, +1)

10.7814%***10.7501%***

13.1573%***

CAR (-1, +3)

11.6946%***

11.0506%***

14.6614%***

CAR (-1, +5)

11.3508%***

10.6905%***

14.6033%***

CAR (-1, +10)N

11.1181%217***

10.3334%***

14.7260%

***

100

93

(3) Acquirer and Target Announcement Period CAR
Tender Offers
PeriodTender Offers(stock payment)

Tender Offers(cash payment)

CAR (-10, +10)

2.1189%**3.6714%***

1.2169%

CAR (-5, +5)2.3846%***3.7735%***

1.6681%

CAR (-3, +3)

1.9806%***

3.6682%***

1.0213%

CAR (-1, +1)

1.8097%***2.6203%***

1.1280%CAR (-1, +3)

1.8641%***3.3665%***0.8942%

CAR (-1, +5)

1.8040%***2.8540%***1.3146%

CAR (-1, +10)N

1.5239%217**2.9117%***0.5976%100

93

Table 1 shows Cumulative Abnormal Returns for various periods around the announcement (day 0) of theacquisition. Our sample includes tender offer transactions from January 1996 to December 2007, taken from the
RECOF MARR CD-ROM database, that satisfy the following criteria:(a) Acquirer and/or target firms were not financial institutions, nor involved in a bailout takeover that wasa result of the target being in financial distress.
(b) Both acquiring and target firms were listed in the stock exchange, in order to exclude small cases.
(c) The payment method of the tender offer transaction (cash vs. stock) is identifiable by the Nikkei
Telecom 21, Nikkei Newspaper digital Ltd., or MARR M&A data CD-ROM by Recof Ltd.
(d) The financial analyst forecast for the future profit value is available from the I/B/E/S or Toyo Keizaidata base, in order to calculate the V/P ratio to test the Method-of-Payment and Misvaluation hypotheses(e) Monthly return amounts are available for at least twenty-four months prior to the announcement month,in order to calculate the cost of the equity capital.
***, **, * 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.

25

Table 2 Descriptive statistics of tender offer transactions by calendar year
（median）
Acquireryear

N oftenderoffers

1997

1

1998

3

563,479

1999

13

2000

Marketbook-toequity
market ratio(¥mln)
211,7590.4341(%)(%)

TargetMarketbook-toequity
market ratio(¥mln)
109,7250.3804leverageROE

0.7972

5.75%

Total
% of
transaction completed
value(¥ mln) Acquisitions
2,420
2,420
100%

1.07230.5294

5.92%

8,858

49,2584,962

0.54800.4590-4.31%

8,130

2.73%

8,049

1.54080.52670.76%

0.5349

4.69%

5,434

1.34570.60081.00840.6890

3.36%

2,411

3.0378150,3210.90490.7467

0.76%

5,720

29

175,7020.67260.5802

5.65%

2005

31

164,6410.46870.7167

2006

36

550,383

0.58582007

24

680,180

0.6021-81.42%

Non
Diversification
1

100%

30.69%

1

2

3

0

190,723100%-2.75%

6

7

4

8

2,900

48,898

100%

4.25%

4

7

3

6

1.28%

4,993

198,509100%

12.77%

7

10

4

13

0.6564-9.28%

1,723

111,774

100%

11.57%

13

11

3

20

1.21080.6334

4.43%

2,919

333,79696.43%

17.46%

15

13

11

12

8,024

1.21390.5872

2.53%

4,771

314,896

100%

7.47%

18

11

10

16

7.04%

7,311

0.73430.6158

3.21%

5,045

327,282

96.77%

2.97%

18

13

19

9

0.5774

7.68%

16,1890.8722

0.4812

4.71%

11,8371,305,087

86.11%

14.91%

12

24

19

10

0.6584

8.55%

12,462

1.07610.5717

4.30%

5,537

751,33895.83%

13.97%

10

14

17

5

leverageROE

0.8801-0.21%

0.6146

0.6643

3.67%

13,050219,9370.75530.48762.17%

29

223,8170.57440.74782001

17

98,7700.8063

2002

24

153,253

2003

28

2004

transaction
value

Premium(%)

Diversification

Cashpayment

Stockpayment

0

0

1

Total
217
204,3360.64970.65095.44%
8,049
1.0693 0.5872
2.87%
4,908
3,633,981
96.31%
9.83%
105
112
93
100
Market equity, book-to-market ratio, leverage, and ROE of both acquirer and target, transaction value, % of completed M&A, Non Diversification, Diversification, cash payment, and stock payment are reported as
medium values, by calendar year. Our sample includes tender offer transactions from January 1996 to December 2007, taken from the RECOF MARR CD-ROM database, that satisfy the following criteria:(a) Acquirer and/or target firms were not financial institutions, nor involved in a bailout takeover that was a result of the target being in financial distress.
(b) Both acquiring and target firms were listed in the stock exchange, in order to exclude small cases.
(c) The payment method of the tender offer transaction (cash vs. stock) is identifiable by the Nikkei Telecom 21, Nikkei Newspaper digital Ltd., or MARR M&A data CD-ROM by Recof Ltd.
(d) The financial analyst forecast for the future profit value is available from the I/B/E/S or Toyo Keizai data base, in order to calculate the V/P ratio to test the Method-of-Payment and Misvaluation hypotheses(e) Monthly return amounts are available for at least twenty-four months prior to the announcement month, in order to calculate the cost of the equity capital.

26

Table 3 Descriptive statistics of tender offer transactions by industry(median)Acquirer
N of tender Market equity
offers(￥mln)

Acquirer's industry

book-tomarket ratio

Targetleverage

ROE

Marketequity(￥mln)

book-tomarket ratio

leverage

ROE

Foods
Textile Products
Pulp & Paper
Chemicals
Drugs
Petroleum
Rubber Products
Stone, Clay & Glass Products
Iron & SteelNon ferrous Metal & Metal Products
Machinery
Electric & Electronic Equipment
Shipbuilding & Repairing
Motor Vehicles & Auto Parts
Precision Equipment
Other Manufacturing
Fish & Marine Products
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

610,275
116,775
571,455
155,705
63,244555,930
18,083
94,340114,931
258,822313,288856,200
164,087
8,340,398
314,762
77,00071,372
29,520693,322200,620
109,849
443,191
351,11474,448575,944572,909150,632
34,123
1,422,822
75,2900.64211.18750.80940.64970.67751.1806
0.43371.21951.33570.84360.49200.64591.02220.89450.53330.80580.47810.57440.75900.66510.57590.22490.43492.95630.47530.27800.92880.53280.99760.3096

0.4416
0.76330.73820.7141
0.32210.74810.79530.6111
0.63200.48760.64300.51840.86220.60370.54500.45890.8451
0.94380.56140.74780.6526
0.76850.88520.49010.7781
0.91320.40050.71290.7526
0.5338

5.62%-6.67%
2.93%
4.79%
11.80%
1.48%
8.20%
3.86%
0.48%
1.34%
6.85%
4.75%
3.75%
8.14%
13.75%
4.89%
13.14%
21.05%
6.27%
6.50%
6.66%
9.01%
0.26%
1.38%
18.88%-55.64%
3.42%-87.67%
8.13%
6.45%

23,655
1,320
7,302
8,503
46,53160,258
1,071
3,040
2,470
4,951
9,848
7,869
10,55547,67937,144
4,697
30,904
6,208
8,130
6,250
7,523
11,497
17,684
5,617
7,270
26,481
6,940
14,758
5,281
10,9800.9072
1.09401.12041.0723
1.21390.54801.78071.82174.9413
1.0626
1.17781.02571.7053
1.18350.62951.42860.5421
1.78481.1456
1.12401.24230.41171.26233.4742
0.78330.39561.41091.01881.4696
0.54690.41950.85130.74010.51250.34020.82290.75660.65200.67500.5101
0.52680.5481
0.52810.64030.66320.3766
0.8474
0.52600.7286
0.61950.56750.63400.76030.20920.77850.68900.55260.72070.63060.5344

6.82%
6.70%-3.72%
3.06%
8.76%-33.21%
3.98%-18.22%-2.05%
1.55%
3.88%
0.72%
1.10%
6.45%
7.05%
4.16%
12.64%-2.72%
3.59%
4.71%
4.15%
-8.32%-2.65%
2.19%
18.91%
10.36%
6.98%-2.53%-20.14%
0.74%

Total

217

204336.1

0.64970.6509

5.44%

8,049

1.06930.58722.87%

Market equity, book-to-market ratio, leverage, and ROE of both acquirer and target, transaction value, % of completed M&A, Non Diversification, Diversification,
cash payment, and stock payment are reported as medium values, by calendar year. Our sample includes tender offer transactions from January 1996 to December
2007, taken from the RECOF MARR CD-ROM database, that satisfy the following criteria:(a) Acquirer and/or target firms were not financial institutions, nor involved in a bailout takeover that was a result of the target being in financial distress.
(b) Both acquiring and target firms were listed in the stock exchange, in order to exclude small cases.

27

Table 3 (Continued)(median)transaction
value

Total
transaction
value(￥mln)% ofcompleted
Acquisitions

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

28,3881,053
16,485
4,488
18,332
26,136
105
2,843
1,209
3,865
2,821
4,717
6,599
3,800
20,5582,873
38,283
9,314
4,058
4,497
2,442
7,244
12,572
2,109
5,660
13,8291,723
11,356613,312
21,388121,059
108,577
18,332
26,136105
12,24936,53075,861
55,837431,090
6,599
60,75941,115
14,43738,283391,304
170,928
372,646
9,783
444,248
61,912
26,095
5,660
13,82920,519435,388

100%
86%
80%
100%
100%
100%
100%
100%
80%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
88%
100%
100%
100%
100%
100%
100%
100%
100%
91.67%

Total

4,908

3,633,981

96.31%

Acquirer's industry

Non
Diversification

Diversification

Cashpayment

Stockpayment

28.83%-1.76%
8.34%
12.97%
18.70%-13.25%-41.26%
4.99%-0.55%
2.74%
2.44%
4.78%
-59.48%5.48%
0.85%
20.32%
15.05%
7.35%
21.93%
17.93%-11.77%
1.10%
11.50%-0.81%
34.41%
23.75%
10.03%

1
4
1
6
1
0
0
1
2
6
4
13
1
2
1
5
0
1
9
12
5
3
8
2
2
1
1
1
4
8

9
3
4
7
0
1
1
3
3
3
4
11
0
5
1
1
1
0
4
9
20
0
1
3
2
0
0
0
0
16

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

3
5
4
7
0
0
0
3
4
5
2
14
1
3
0
0
1
0
9
8
11
0
6
5
2
0
0
0
2
5

9.83%

105

112

93

100

Premium(%)(c) The payment method of the tender offer transaction (cash vs. stock) is identifiable by the Nikkei Telecom 21, Nikkei Newspaper digital Ltd., or
MARR M&A data CD-ROM by Recof Ltd.
(d) The financial analyst forecast for the future profit value is available from the I/B/E/S or Toyo Keizai data base, in order to calculate the V/P ratio totest the Method-of-Payment and Misvaluation hypotheses(e) Monthly return amounts are available for at least twenty-four months prior to the announcement month, in order to calculate the cost of the equity
capital.

28

Table 4 Result of Univariable Test
Panal (A)z-statistics

p -value(one-tailed)**1.70950.0437*1.30890.0953-2.22%-0.12620.44981.89855947.46%-7.77%-0.8704

0.192050.87027744.16%

1.92282835.71%-19.05%-1.74570.040450.038775
49.33%

1.043857
49.12%

2.578157
43.86%-5.47%-0.62420.26625

0.399645
60.00%

1.047866
48.48%

2.646178
39.74%-20.26%-2.16770.0151

1

2

3

t-statistics

p -value(one-tailed)

Acquirer financial slack
N
Acquirer CAR [-3, +3]

0.007151
4.09%

0.0843101
0.81%

0.177665
0.80%-3.29%*-1.42930.0778Acquirer cash ratio
N
Acquirer CAR [-3, +3]0.046099
2.31%

0.114181
2.10%

0.319337-1.54%-3.85%*-1.3398

0.0937

Acquirer leverageN
Acquirer CAR [-3, +3]0.355561
2.37%

0.570951
0.52%

0.8079105
1.63%-0.75%-0.3646

0.35815

Acquirer V/PN
Acquirer CAR [-3, +3]0.517476-0.74%

1.046577
2.14%

1.8672
64
3.65%

4.39%

***

2.45220.0078Acquirer B/PN
Acquirer CAR [-3, +3]0.418898-0.87%

0.866386
2.86%

2.0574
33
5.50%

6.37%

***

2.80260.00295

Target V/PN
Acquirer CAR [-3, +3]

1.082187-0.60%

1.041264
2.23%

1.1911
66
3.81%

4.41%

***

2.65950.00435

Target B/PN
Acquirer CAR [-3, +3]0.404556
1.02%

1.030179-0.83%

2.6349
82
4.27%

3.24%

**

2.27140.01235

Rank

Difference
3-1

1

2

3

Acquirer financial slackN% of Cash Payment

0.00604148.78%

0.084988
34.09%

0.175760
66.67%

17.89%

Acquirer cash ratioN% of Cash Payment

0.045786
44.19%

0.114570
47.14%

0.325733
57.58%

13.39%

Acquirer leverageN% of Cash Payment

0.347154
50.00%

0.573245
44.44%

0.793290
47.78%

Acquirer V/PN% of Cash Payment

0.525167
55.22%

1.061963
39.68%

Acquirer B/PN% of Cash Payment

0.424884
54.76%

Target V/PN% of Cash Payment
Target B/PN% of Cash Payment****

Panel (B)
Rank

Difference
3-1

The sample includes tender offers in which 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 bailout
takeover where the transaction is as a result of the target being in financial distress, where the data is needed(1) recognize the method of payment (cash vs. stock), and (2) calculate V/P and B/P available.
Financial slack is accounting free cash flow defined as operating income plus depreciation minus, taxes, anddividends, as a ratio to total assets. Cash ratio is cash equivalent plus short-term investments, as a ratio to
Leverage = acquirer’s total debt / total assets. 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 the book-to-price ratio.
***, **, * denotes the significance level in mean values between low ranking and high ranking, at the 1%,
and 10% (one-tailed) respectively, based on the two-sample tailed t-test.

29

Table 5 Results of Logistic Regressions
Dependent Variable (=1 [cash payment], 0 [stock payment])[expected sign]
Acquirer financial slack[+]
6.6887(0.049)Acquirer cash ratio[+]
2.8602(0.055)Acquirer leverage[-]-

7.0554(0.036)3.4024(0.071)
0.4889(0.691)
-

-

-

-

-

-

-

-

-

-

-

-

-

Divesification--

Ln relative equity---0.4717(0.165)-Acquirer ln equity---0.4795(0.157)-0.1498(0.165)-

Target ln equity

-

-

-

-1.3889(0.051)189
Yes
0.1857-1.7432(0.103)
189
Yes
0.1865-0.9937(0.422)
189
Yes
0.1998Target V/P
Acquirer V/P[+]

Target B/P
Acquirer B/PIntercept
NYear Dummy
Pseudo-R

2

[+]

**
*

**
*

7.3621(0.020)3.2338(0.100)0.5312(0.660)-***7.1783(0.026)
3.2986(0.100)0.5024(0.678)--0.1182(0.298)0.2091(0.169)-3.1505(0.375)
189
Yes
0.2015

**

-

-

-

*

-

-

-

-

-

-

-0.0031(0.979)-0.3697(0.183)-0.2265(0.208)-0.2682(0.365)--0.0106(0.933)-0.3291(0.270)-0.1309(0.489)-0.4692(0.117)-0.4098(0.224)---0.0129(0.917)-0.3340(0.245)-0.1376(0.447)-0.4725(0.112)-0.4104(0.223)-0.1683(0.134)---0.2838(0.747)
189
Yes
0.16120.6953(0.395)189
Yes
0.1736--0.1639(0.160)0.1798(0.288)0.3084(0.938)189
Yes
0.2259The sample includes tender offers in which both acquirer and target were listed on the Japanese Stock Market during 1996-2007. However we exclude cases where either
acquirer or target is a financial institution, or a bailout takeover where the transaction is as a result of the target being in financial distress, where the data is needed to
calculate V/P and B/P available.
Financial slack is accounting free cash flow defined as operating income plus depreciation minus, taxes, and all dividends, as a ratio to total assets. Cash ratio is cash
equivalent plus short-term investments, as a ratio to assets. Leverage = acquirer’s total debt / total assets. 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 the book-to-price ratio. For each valuation
ratio, we require that both acquirer and target have known values. Diversification =1 if the acquirer and target are not in the same industry (There are 33 industrial sectors
on the Tokyo Stock Exchange); 0 otherwise. Relative size is the acquirer’s market value / target’s market value. Target size = target’s market value of equity.
The first row reports coefficient, and the second row in parentheses reports the p-value. ***, **, * denote significant at the 1%, 5%, and 10% level respectively.

30

Table 6 Results of OLS Regressions
Dependent Variable (=Acquirer CAR [-3,+3])
Acquirer financial slack[expected sign][-]

Target V/P[+]--0.2026(0.032)-0.2878(0.010)-0.0803(0.035)-Acquirer V/P

[+]

-

-

-

-

Target B/P

[+]

-

-

-

-

Acquirer B/P

[+]

-

-

-

-

Divesification--

Ln relative equity--

0.0041(0.786)-

Acquirer ln equity--

0.0047(0.754)-0.0030(0.484)-

Target ln equity

-

-

-

Acquirer cash ratio[-]

Acquirer leverage

Intercept
NYear Dummy
Adj-R

2

-0.1612(0.069)-0.2079(0.028)-0.1874(0.000)189
Yes
0.1199******0.2613(0.000)189
Yes
0.1402

**
**
**

***

-0.1971(0.032)-0.2929(0.011)-0.0786(0.039)-0.2617(0.000)189
Yes
0.1434

**
**
**

***

-0.1883(0.039)-0.2944(0.011)-0.0780(0.039)--0.0045(0.345)0.0003(0.953)0.3673(0.005)
189
Yes
0.1462

**

-

-

-

*

-

-

-

**

-

-

-

0.0097(0.053)0.0296(0.037)0.0134(0.015)0.0125(0.320)-*-0.0098(0.054)0.0321(0.037)0.0160(0.007)0.0072(0.585)-0.0007(0.962)-0.0055(0.273)
-

-

-

**
**

-

***

0.1618(0.000)189
Yes
0.1427***0.1667(0.000)189
Yes
0.1494

*
**
***

***

0.0105(0.042)0.0334(0.034)0.0180(0.007)0.0093(0.482)-0.0004(0.978)
-

**
**
***

-0.0037(0.464)0.0097(0.165)0.1574(0.947)
189
Yes
0.1543Acquirer 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 tender
offers in which both acquirer and target were listed on the Japanese Stock Market during 1996-2007. However we excludes cases where either acquirer or target is a financial institution, or abailout takeover where the transaction is as a result of the target being in financial distress, where the data is needed to calculate V/P and B/P available.
Financial slack is accounting free cash flow defined as operating income plus depreciation minus, taxes, and all dividends, as a ratio to total assets. Cash ratio is cash equivalent plus short-term
investments, as a ratio to assets. Leverage = acquirer’s total debt / total assets. 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 the book-to-price ratio. For each valuation ratio, we require that both acquirer and target have known values.
Diversification =1 if the acquirer and target are not in the same industry (There are 33 industrial sectors on the Tokyo Stock Exchange); 0 otherwise. Relative size is the acquirer’s market value/ target’s market value. Target size = target’s market value of equity.
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

Appendix 1 Result of Univariable Test
Rank

t-statistics

p -value(one-tailed)**-1.9030

0.0299*-1.68190.0506-0.03130.4876**2.24830.01345.98%***

2.47070.0075

1.1911
66
3.45%

4.78%

***

2.66680.00432.6349
82
4.26%

3.85%

***

2.38420.0093Difference
3-1

1

2

3

Acquirer financial slack
N
Acquirer CAR [-3, +3]

0.007151
4.24%

0.0843101
0.84%

0.177665-0.40%-4.64%

Acquirer cash ratio
N
Acquirer CAR [-3, +3]0.046099
2.56%

0.114181
1.81%

0.319337-2.89%-5.45%

Acquirer leverageN
Acquirer CAR [-3, +3]0.355561
1.92%

0.570951-0.48%

0.8079105
1.85%-0.07%

Acquirer V/PN
Acquirer CAR [-3, +3]0.517476-1.33%

1.046577
2.08%

1.8672
64
3.30%

4.63%

Acquirer B/PN
Acquirer CAR [-3, +3]0.418898-1.26%

0.866386
2.96%

2.057433
4.72%

Target V/PN
Acquirer CAR [-3, +3]

1.082187-1.33%

1.041264
2.65%

Target B/PN
Acquirer CAR [-3, +3]0.404556
0.41%

1.030179-1.11%

We considered the CAR (-3, +3) estimated by the market model in the univariable tests for the Financial Slack/Free Cash
Flow and Misvaluation Hypotheses as a robustness check. These results are also consistent with Table 4.
The sample includes tender offers in which both the acquirer and target were listed on the Japanese Stock Market from
1996-2007, but excludes cases where either the acquirer or target is a financial institution, or where a bailout takeover is a
resulting transactions from the target being in financial distress, where the data is needed to (1) recognize the method of
payment (cash vs. stock), and (2) calculate V/P and B/P available.
Financial slack is accounting free cash flow defined as operating income plus depreciation minus, taxes, and all dividends,
as a ratio to total assets. Cash ratio is cash equivalent plus short-term investments, as a ratio to assets. Leverage =acquirer’s total debt / total assets. 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 the book-to-price ratio.
***, **, * denotes the significance level in mean values between low ranking and high ranking, at the 1%, 5%, and 10%(one-tailed) respectively, based on the two-sample tailed t-test.

32Appendix 2 Results of OLS Regressions
Dependent Variable (=Acquirer CAR [-3,+3])
Acquirer financial slack[expected sign][-]-0.1875(0.055)[-]-0.2311(0.021)-

Target V/P[+]--0.2275(0.028)-0.3104(0.009)-0.0808(0.051)-

Acquirer V/P

[+]

-

-

-

-

Target B/P

[+]

-

-

-

-

Acquirer B/P

[+]

-

-

-

-

Divesification--

Ln relative equity--

0.0091(0.587)-

Acquirer ln equity--

0.0100(0.545)-0.0036(0.469)-Target ln equity

-

-

-

Acquirer cash ratio
Acquirer leverage

Intercept
NYear Dummy
Adj-R

2

0.1889(0.000)189
Yes
0.1506****** 0.1848(0.000)189
Yes
0.1700**-0.2229(0.029)*** -0.3172(0.010)* -0.0781(0.059)-*** 0.2617(0.000)189
Yes
0.1757******-0.2153(0.033)-0.3181(0.009)-0.0765(0.063)--0.0049(0.391)0.0015(0.791)*** 0.3496(0.022)
189
Yes
0.1771

**

-

-

-

***

-

-

-

*

-

-

-

0.0112 ** 0.0116(0.035)(0.033)0.0310* 0.0355(0.053)(0.051)0.0157 *** 0.0196(0.007)(0.003)0.01270.0054(0.324)(0.689)0.0019(0.917)-0.0079(0.202)**-0.1601 *** 0.1668(0.000)(0.000)
189
189
Yes
Yes
0.16570.1777**0.0124(0.024)* 0.0363(0.047)*** 0.0217(0.003)0.0083(0.546)0.0033(0.854)
-

**
**
***

-0.0052(0.408)0.0131(0.107)*** -0.0388(0.821)
189
Yes
0.1838

We considered the CAR (-3, +3) estimated by the market model in the multivariable tests for the Financial Slack/Free Cash Flow and Misvaluation Hypotheses as a robustness
check. These results are also consistent with Table 6.
Acquirer 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 tender offers in which both the acquirer and target were listed on the Japanese Stock Market from 1996-2007. However we excluded cases where either theacquirer or target is a financial institution, or where a bailout takeover transaction is a result of the target being in financial distress etc., where the data is needed to calculate V/P
and B/P available.
Financial slack is accounting free cash flow defined as operating income plus depreciation minus, taxes, and all dividends, as a ratio to total assets. Cash ratio is cash equivalentplus short-term investments, as a ratio to assets. Leverage = acquirer’s total debt / total assets. V/P is the fundamental value-to-price ratio. The fundamental value V is estimatedusing 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 bothacquirer and target have known values. Diversification =1 if the acquirer and target are not in the same industry (There are 33 industrial sectors on the Tokyo Stock Exchange); 0
otherwise. Relative size is the acquirer’s market value / target’s market value. Target size = target’s market value of equity.
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.

33