20.12Summary and Conclusions

This chapter illustrates how the tools developed through-out this text can be used to analyze mergers and acquisi-tions. Acquisitions require the valuation of an existingbusiness, which can be performed with the tools devel-oped in Chapters 9 through 13. In addition, acquisitionsneed to be financed, so our analysis of the capital struc-ture decisions in Chapters 14 to 19 also is applicable. Themanagement incentive issues discussed in Chapter 18 areespecially important for understanding the takeover mar-ket. Some acquisitions are motivated by value improve-ments created by correcting incentive problems. How-ever, many bad acquisitions were motivated by badincentives.

In summary, we suggest that managers consider thefollowing checklist for evaluating a merger or acquisitionproposal:

•Evaluate and quantify the real operating synergies of

the acquisition. Is a merger the best way of

achieving these synergies?

•Evaluate and quantify the tax benefits of the merger.

Is a merger required to achieve these tax benefits?

•Evaluate how management incentives are affected

by the merger. Will the acquisition correct an

incentive problem, or will it create new incentive

problems?

Based on an analysis of the empirical evidence, wecannot say whether mergers, on average, create value. Cer-tainly, some mergers have created value while others wereeither mistakes or bad decisions. Of course, many of themistakes were due to unforeseen circumstances and wereunavoidable. However, we believe that other mergers andacquisitions were due to misguided notions about thevalue of diversification, misaligned incentives of theacquiring firm’s management, and poor judgment. Fortu-nately, past experience has taught us a great deal abouthow mergers can create value, and we believe firms canapply this knowledge to make sound acquisition decisions.

Grinblatt1472Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1472Hill
Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

730Part VIncentives, Information, and Corporate Control

Key Concepts

Result	20.1:	The main sources of takeover gains include:	•Managers may find it difficult to cut
			back optimally on losing divisions
		•Taxes.
			when they can subsidize the losers
		•Operating synergies.
			out of the profits from their winners.
		•Target incentive problems.
			Result 20.5:Stock price reactions to takeover bids can
		•Financial synergies.
			be described as follows:
Result	20.2:	Before the implementation of the Tax
			•The stock prices of target firms
		Reform Act of 1986, the U.S. Tax Code
			almost always react favorably to
		encouraged corporations to acquire other
			merger and tender offer bids.
		corporations. Taxes currently play a much
			•The bidder’s stock price sometimes
		less important role in motivating U.S.
			goes up and sometimes goes down,
		acquisitions. In some cases, however,
			depending on the circumstances.
		mergers increase the combined capacity
		of merged firms to utilize tax-favored	•The combined market values of the
		debt.	shares of the target and bidder go up,
Result	20.3:	Conglomerates can provide funding for	on average, around the time of the
		investment projects that independent	announced bids.
		(smaller) firms would not have been able
			Result 20.6:The bidder’s stock price reacts more
		to fund using outside capital markets. To
			favorably, on average, when the bidder
		the extent that positive NPVprojects
			makes a cash offer rather than an offer to
		receive funding they would not have
			exchange stock. This may reflect the
		otherwise received, conglomerates create
			relatively negative information about the
		value.
			bidder’s existing business signaled by the
Result	20.4:	The advantages of diversification can be	offer to exchange stock.
		described as follows:
			Result 20.7:On average, cash flows of firms improve
		•Diversification enhances the	following leveraged buyouts. Three
		flexibility of the organization.	possible explanations for these
			improvements are:
		•The internal capital market avoids
		some of the information problems	•Productivity gains.
		inherent in an external capital
			•Initiation of LBOs by firms with
		market.
			improving prospects.
		•Diversification reduces the
			•The incentives of leveraged firms to
		probability of bankruptcy for any
			accelerate cash flows, sometimes at
		given level of debt and increases the
			the expense of long-run cash flows.
		firm’s debt capacity.
			While we expect all three factors to
		•Competitors find it more difficult to
			contribute to the observed increase in cash
		uncover proprietary information from
			flows, existing empirical evidence suggests
		diversified firms.
			that a major part of the increase is due to
		•Diversification is advantageous if it
			productivity gains.
		allows the firm to utilize its
			Result 20.8:Small shareholders will not tender their
		organization more effectively.
			shares if they are offered less than the post-
		The disadvantages of diversification can	takeover value of the shares. As a result,
		be described as follows:	takeovers that could potentially lead to
			substantial value improvements may fail.
		•Diversification can eliminate a
		valuable source of information which
		may, among other things, make it
		difficult to compensate the division
		heads of large diversified firms
		efficiently.

Grinblatt1474Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1474Hill
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Strategy, Second Edition

Chapter 20

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731

Key Terms

acquiring firm692	operating synergies695
acquisition691	poison pills727
conditional tender offer723	pooling of interests accounting	720
conglomerate (diversifying) acquisition695	purchase of assets720
disciplinary takeover695	raider701
fair price amendments727	staggered board terms727
financial acquisition695	stepping up the basis698
financial synergies695	strategic acquisition695
flipover rights plan728	supermajority rules727
follow-up merger726	takeover premium692
friendly takeover694	target firm692
greenmail727	tender offer694
horizontal merger700	Tobin’s q711
hostile takeover694	two-tiered offer726
management buyout (MBO)701	unconditional (any-or-all) offer	724
merger691	vertical merger700

Exercises

20.1.Jacobs Industries is currently selling for $25 a share20.5.Leveraged buyouts are observed mainly in industries

and pays a dividend of $2 a share per year. Analystswith relatively stable cash flows and products that are

expect the earnings and dividends to grow 4 percentnot highly specialized. Explain why.

per year into the foreseeable future. The company20.6.When a firm with an extremely high price/earnings

has 1 million shares outstanding. John Jacobs, theratio purchases a firm with a very low price/

CEO, would like to take the firm private in aearnings ratio in an exchange of stock, its earnings

leveraged buyout. Following the buyout, the firm isper share will increase. Do you think firms are

expected to cut operating costs, which will result inmore likely to acquire other firms when it results in

a 10 percent improvement in earnings. In addition,an increase in their earnings per share? Is it

the firm will cut administrative fixed costs bybeneficial to shareholders to initiate a takeover for

$200,000 per year and save $500,000 per year onthese reasons?

taxes for the next 10 years. Assuming that the risk-

20.7.Tobacco companies have a large potential liability.

free interest rate is 5 percent, and that Jacobs

In the future, they may be subject to extremely

Industries’cost of capital is 12 percent per year,

large product liability lawsuits. Discuss how this

what value would you put on Jacobs Industries

affects the incentives of tobacco companies to

following the LBO?

merge with food companies.

20.2.Refer to exercise 20.1. Explain why John Jacobs is

20.8.One of the stated benefits of a management buyout

likely to make these changes following an LBO, but

is the improvement in management incentives. In

would not make the changes in the absence of an

many cases, however, the top managers do not

LBO.

change after the buyout. Explain why.20.3.What type of firm would you prefer to work for: a

20.9.Why do think AT&Twas willing to spend $500

diversified firm or a very focused firm? What does

million to get pooling of interest accounting

your answer to the above question tell you about one

treatment in its acquisition of NCR?

of the advantages or disadvantages of diversification?

20.4.Diversified Industries has made a bid to purchase

Cigmatics Inc., offering to exchange two

Diversified shares for 1 share of Cigmatics. When

this bid is announced, Diversified Industries’shares

drop 5 percent. Henry Clavett, the CEO, has asked

you to interpret what this decline in stock prices

means. Does it imply that Cigmatics is a bad

acquisition?

Grinblatt1476Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1476Hill
Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

732Part VIncentives, Information, and Corporate Control

References and Additional Readings

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pp.103–120.

Asquith, Paul. “Merger Bids, Uncertainty, and

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Berger, Philip, and Eli Ofek. “Diversification’s Effect on

Firm Value.” Journal of Financial Economics37

(1995), pp. 39–65.

Bhagat, Sanjay; Andrei Shleifer; and Robert Vishny.

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(1990), pp. 1–72.

Bhide, Amar. “Reversing Corporate Diversification.”

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pp. 70–81.

Bradley, Michael. “Interfirm Tender Offers and the

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Bradley, Michael; Anand Desai; and E. Han Kim. “The

Rationale Behind Interfirm Tender Offers.” Journal

of Financial Economics11, no. 1 (1983),

pp. 183–206.

———. “Synergistic Gains from Corporate Acquisitions

and Their Division Between the Stockholders of

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Comment, Robert, and Gregg A. Jarrell. “Corporate Focus

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37 (1995), pp. 67–87.

Comment, Robert, and G. William Schwert. “Poison or

Placebo? Evidence on the Deterrence and Wealth

Effects of Modern Antitakeover Measures.” Journal

of Financial Economics39 (1995), pp. 3–44.Denis, David J.; Diane K. Denis; and Atulya Sarin.

“Agency Problems, Equity Ownership and Corporate

Diversifications.” Journal of Finance52 (1997),

pp.135–160.

Dodd, Peter. “Merger Proposals, Management Discretion

and Stockholder Wealth.” Journal of Financial

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Eckbo, B. Espen; Ronald M. Giammarino; and Robert L.

Heinkel. “Asymmetric Information and the Medium

of Exchange in Takeovers: Theory and Tests.”

Review of Financial Studies3, no. 4 (1990),

pp.651–75.

Franks, Julian R.; Robert S. Harris; and Colin Mayer.

“Means of Payment in Takeovers: Results for the

U.K. and U.S.” InCorporate Takeovers: Causes and

Consequences,A. J. Auerbach, ed. Chicago:

University of Chicago Press, 1988.

Grossman, Sanford J., and Oliver D. Hart. “Takeover

Bids, the Free-Rider Problem and the Theory of the

Corporation.” Bell Journal of Economics11 (Spring

1980), pp. 42–64.

———. “The Costs and Benefits of Ownership: ATheory

of Vertical and Lateral Integration.” Journal of

Political Economy94 (1986), pp. 691–719.

Hasbrouck, Joel. “The Characteristics of Takeover

Targets.” Journal of Banking and Finance9, no. 3

(1985), pp. 351–62.

Healy, Paul; Krishna Palepu; and Richard Ruback. “Does

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Journal of Financial Economics31 (1992),

pp.135–76.

Hirshleifer, David. “Mergers and Acquisitions: Strategic

and Informational Issues.” Chapter 26 in Handbooks

in Operations Research and Management Science:

Volume 9, Finance,Robert Jarrow, V. Maksimovic,

and W. Ziemba, eds. Amsterdam, The Netherlands:

Elsevier Science, B.V., 1995, pp. 839–85.

Holmstrom, Bengt, and Steven Kaplan. “Corporate

Governance and Merger Activity in the United States:

Making Sense of the 1980s and 1990s.” Journal of

Economic Perspectives15 (2001), pp.121–44.Huang, Yen-Sheng, and Ralph A. Walkling. “Target

Abnormal Returns Associated with Acquisition

Announcements: Payment, Acquisition Form, and

Managerial Resistance.” Journal of Financial

Economics19, no. 2 (1987), pp. 329–50.

Jarrell, Gregg, and Annette Poulsen. “Shark Repellents

and Stock Prices: The Effects of Antitakeover

Amendments since 1980.” Journal of Financial

Economics19 (1987), pp. 127–68.

———. “Returns to Acquiring Firms in Tender Offers:

Evidence from Three Decades.” Financial

Management18 (1989), pp. 12–19.

Jarrell, Gregg A.; James Brickley; and Jeffrey Netter.

“The Market for Corporate Control: The Empirical

Evidence since 1980.” Journal of Economic

Perspectives2, no. 1 (1988), pp. 49–68.

Jensen, Michael C., “Agency Costs of Free Cash Flow,

Corporate Finance, and Takeovers.” American

Economic Review76 (1986), pp. 323–29.

———. “Selections from the Senate and House Hearings

on LBOs and Corporate Debt.” Journal of Applied

Corporate Finance2, no. 1 (1989), pp. 35–44.

Grinblatt1478Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1478Hill
Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

Chapter 20

Mergers and Acquisitions

733

Jensen, Michael C., and Richard Ruback. “The Market for

Corporate Control: The Scientific Evidence.”

Journal of Financial Economics11 (1983), pp. 5–50.Kaplan, Steven. “The Effects of Management Buyouts on

Operating Performance and Value.” Journal of

Financial Economics24 (1989), pp. 217–54.Kaplan, Steven, and Jeremy Stein. “The Evolution of

Buyout Pricing and Financial Structure in the

1980s.” Quarterly Journal of Economics108 (1993),

pp. 313–57.

Kaplan, Steven, and Michael Weisbach. “The Success of

Acquisitions: Evidence from Divestitures.” Journal

of Finance47 (1992), pp. 107–38.

Klein, April. “The Timing and Substance of Divestiture

Announcements: Individual, Simultaneous and

Cumulative Effects.” Journal of Finance41 (1986),

pp. 685–97.

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and Economics21 (1978), pp. 297–326.

Lang, Larry, and Rene M. Stulz. “Tobin’s q,Corporate

Diversification and Firm Performance.” Journal of

Political Economy102 (1994), pp. 1248–80.Lang, Larry; Rene Stulz; and Ralph Walkling. “ATest of

the Free Cash Flow Hypothesis: The Case of Bidder

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pp. 315–36.

Lehn, Kenneth, and Annette Poulsen. “Free Cash Flow

and Stockholder Gains in Going Private Transactions.”

Journal of Finance44 (1989), pp.771–88.

Lichtenberg, Frank R., and Donald Siegel. “The Effects of

Leveraged Buyouts on Productivity and Related

Aspects of Firm Behavior.” Journal of Financial

Economics27, no. 1 (1990), pp. 165–94.

Lowenstein, Louis. “Management Buyouts.” Columbia

Law Review85 (1985), pp. 730–84.

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of Financial Economics39 (1995), pp. 353–78.

Matsusaka, John. “Takeover Motives During the

Conglomerate Merger Wave.” Rand Journal of

Economics24 (1993), pp. 357–79.

———. “Did Tough Antitrust Enforcement Cause the

Diversification of American Corporations?” Journal

of Financial and Quantitative Analysis31, no. 2

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Mitchell, Mark L., and Kenneth Lehn. “Do Bad Bidders

Make Good Targets?” Journal of Applied Corporate

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Journal of Finance45 (1990), pp. 31–48.

Muscarella, Chris, and Michael Vetsuypens. “Efficiency

and Organizational Change: AStudy of Reverse

LBOs.” Journal of Finance45 (1990), pp. 1389–1414.Opler, Tim C. “Operating Performance in Leveraged

Buyouts: Evidence from 1985–1989.” Financial

Management21, no. 1 (1993), pp. 27–34.

Ravenscraft, David J., and F. M. Scherer. Mergers,

Selloffs, and Economic Efficiency. Washington, DC:

Brookings Institution, 1987.

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Case 9-285-053.

Safieddine, Assem, and Sheridan Titman. “Debt and

Corporate Performance: Evidence from Successful

Takeovers,” Journal of Finance54 (1999),

pp.547–80.

Sampson, Anthony. The Sovereign State of ITT. New

York: Stein and Day, 1973.

Servaes, Henri. “The Value of Diversification during

Conglomerate Merger Waves.” Journal of Finance

51 (1996), pp. 1201–25.

Shleifer, Andrei, and Lawrence Summers. “Breach of

Trust in Hostile Takeovers.” Chapter 2 in Corporate

Takeovers: Causes and Consequences. A. J. Auerbach,

ed. Chicago: University of Chicago Press, 1988.Smith, Abbie J. “Corporate Ownership Structure and

Performance: The Case of Management Buyouts.”

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pp.143–64.

Travlos, Nickolaos G. “Corporate Takeover Bids,

Methods of Payment, and Bidding Firms’Stock

Returns.” Journal of Finance42, no. 4 (1987),

pp. 943–63.

Weston J. Fred; Kwang S. Chung; and Susan E. Hoag.

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Englewood Cliffs, NJ: Prentice Hall, 1990.

Grinblatt1480Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1480Hill
Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

734Part VIncentives, Information, and Corporate Control

PRACTICALINSIGHTSFORPARTV

Allocating Capital forReal Investment

•Managers, acting in their own interests, often invest

more than shareholders would like. (Section 18.3)•Managers and large shareholders sometimes prefer

diversifying investments that reduce the probability of

the firm going bankrupt over higher NPVinvestments

that provide less diversification. (Section 18.3)

•Managers may choose investment projects that pay off

quickly over projects with higher NPVs that take longer

to pay off if increasing the firm’s current share price is

an important consideration for them. (Section 19.3)•Managers who wish to temporarily boost their stock

prices may underinvest in positive NPVprojects that

cannot be readily observed by shareholders and instead

use the cash savings to pay a dividend or repurchase

shares. (Section 19.4)

•Managers sometimes have information that indicates

that their debt and equity is not fairly priced, which

implies that their financing alternatives may not have

zero NPVs. Managers may, therefore, pass up positive

NPVinvestments if they must be financed by negative

NPVinstruments. (Section 19.5)

•Corporate takeovers can create value through tax

savings, operating synergies, financial synergies, and by

correcting incentive problems. (Section 20.4)

•Because of various capital market imperfections,

conglomerates sometimes do better than the capital

markets in allocating investment capital. However,

markets better allocate capital when market prices

contain useful information that managers do not have

and when there exist conflicts between managers’and

shareholders’interests. (Section 20.4)

Financing the Firm

•In most major corporations, the debt-equity choice is

made by the board of directors but investment choices

are made by management. If the board understands the

tendency of management to overinvest, they might want

to offset this tendency by increasing the firm’s debt to

equity ratio. (Sections 18.3 and 18.4)

•Managers should not use stock price reactions to

corporate actions, like dividend and leverage changes,

to evaluate how the market views the decision. The

market may be reacting to the information conveyed by

the decision rather than to whether the decision is

value-enhancing. For example, the market may react

positively to the announcement of a cash financed

acquisition if investors are surprised by the firm’s

ability to raise the cash for the acquisition. This may be

the case even when the acquisition itself is a negative

NPVinvestment. (Section 19.1)

•If the firm’s board of directors and its management

believe that the firm is undervalued, they might choose

to increase the firm’s debt ratio to convince investors

that its value is higher. Increasing leverage provides a

favorable signal for two reasons: First, it demonstrates

that managers (who personally find financial distress

costly) are confident that they can generate the cash

needed to meet the higher debt obligation. Second, the

firm sends the signal that its shares are a “good

investment” when it increases its leverage by

repurchasing shares. (Section 19.5)

•When a firm is doing poorly, there is generally a lot of

uncertainty about its true value. Afirm’s stock price

would be likely to react very negatively in this situation

if the firm issued equity. Amanager might also consider

debt financing very unattractive in this situation

because of the threat of bankruptcy and perhaps less

need for the tax benefits of debt. For these reasons, we

often observe firms issuing preferred stock in these

situations. (Section 19.5)

•Firms often use their stock to finance major

acquisitions. One previous advantage of this was that it

allowed the firm to use pooling of interest accounting,

which is no longer permitted. This financing option also

is less attractive when the acquirer believes its own

stock is undervalued. (Section 20.9)

Allocating Funds forFinancial Investments

•Decisions that lead to higher leverage ratios generally

result in higher stock prices. Decisions that lead to

lower leverage ratios generally result in lower stock

prices. (Section 19.6)

•Increased dividends and share repurchases generally

result in higher stock prices. Dividend cuts and equity

issues generally result in lower stock prices. (Section

19.6)

•Empirical evidence suggests that stock prices

underreact to some corporate announcements, like

dividend and capital structure changes. Investors may

be able to profit by buying stocks following

announcements that convey positive information and

selling stocks following announcements that convey

negative information. (Section 19.6)

Grinblatt1482Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1482Hill
Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

Chapter 20

Mergers and Acquisitions

735

EXECUTIVEPERSPECTIVE

Lisa Price

In my experience as a banker, I frequently encounter trans-action and valuation issues that reinforce many principlesaddressed in Part Vof this book. Understanding howtaxes, management incentives, accounting considerations,and operating synergies motivate acquisitions is critical toidentifying potential business combinations, valuingacquisition targets, and structuring transactions. Part Vofthe text discusses these and related issues clearly and com-prehensively, combining academic principles with actualexperience to provide relevant guidelines for today’sfinancial managers.

Chapters 18 through 20 describe the economic andstrategic rationale for mergers and acquisitions.Historically, events such as economic shifts in demand orsupply and the maturation of industries have createdopportunities to realize operating synergies through thecombination of companies, frequently driving a wave ofindustry consolidation. For example, the defense sectorhas recently witnessed this effect on an unprecedentedscale due to budgetary pressures in Washington and thereduced role of the U.S. military forces in the post–ColdWar era. Bear Stearns has recently represented severalmajor defense companies in acquisitions as they sought tobuild critical mass and scale to allow them to maintainlong-term market position and cost competitiveness. Suchtransactions occur as the defense sector attempts to “right-size.” Similarly, transactions that we completed in thetechnology and telecommunications sectors weremotivated by strategic considerations resulting fromtechnological acceleration and uncertainty, a changingregulatory environment, and an increasingly globalmarketplace. Mergers and acquisitions have allowedcompanies to build scale and scope, fill in gaps intechnologies, share research and development and otheroverlapping costs, and access greater capital to supporttop-line growth opportunities.

Grinblatt and Titman point out how important it is notonly to identify operating synergies when evaluating anacquisition target but also to quantify their impact onvalue and, consequently, the premium that a buyerwould pay. In practice, the value created is shared by thebuyer and seller. The amount of synergies received bythe selling shareholders generally depends on the type ofsynergy, whether the buyer or seller is primarily respon-sible for its creation, the competitive dynamics in theselling process, and the mix of acquisition considerationreceived.

In a low-premium, stock-for-stock transaction, syner-gies are primarily realized through the seller’s ongoingparticipation in the acquirer’s stock. In a cash transaction,synergies are realized explicitly through the premium.

When Bear Stearns advised Martin Marietta in its stock-for-stock merger with Lockheed in 1994, Martin Mariettashareholders initially received a 20 percent premium andalso had continuing upside participation in the combinedLockheed Martin’s stock. By contrast, Raytheon, in its1995 cash acquisition of E-Systems, paid an approximate40 percent premium and E-Systems’shareholders receivedno continuing interest in the combination.

Consistent with issues raised in Chapter 20, I havealso found tax considerations to be very important instructuring transactions. In 1997, Bear Stearns advisedRaytheon in its $9.5 billion acquisition of HughesElectronics’defense unit from General Motors.Persuading GM to sell its defense operations requiredconsiderable effort to create a structure to permit thedisposition on a tax-free basis.

Part Vindicates that an acquirer’s choice of cash orstock as acquisition currency depends on a number offactors, including the acquirer’s financial flexibility,accounting-related issues, tax considerations, and the pro-posed governance provisions of the transaction. Often,companies pursue stock transactions to achieve tax-freetreatment for shareholders or to qualify for pooling-of-interests accounting to avoid ongoing goodwill amortiza-tion charges that reduce reported earnings. These were theconcerns of Bell Atlantic and NYNEX when they agreedto a stock-for-stock merger in 1997.

The ability of the combined company to service addi-tional debt is also critical in determining the acquisitioncurrency. For example, a high-growth technology com-pany may prefer to use stock rather than cash to minimizeits ongoing fixed charges and maintain future financialflexibility.

Additionally, the choice of cash or stock reflects theproposed governance of the combined company. In stock-for-stock mergers, the shareholders and management ofthe acquired company frequently have significant ongoinginfluence in the combined entity through board representa-tion or management roles. Cash acquisitions, on the otherhand, are more commonly associated with “change-of-control” transactions in which the acquired managementhas no meaningful influence after combination. In 1996,for example, Bear Stearns represented Lockheed Martin inits $9.4 billion acquisition of Loral’s defense operations.Initial discussions contemplated a stock-for-stock transac-tion with “merger-of-equals” governance. When discus-sions evolved to consider a reduced role for Loralmanagement in the combined company as well as the spin-off to Loral shareholders of one of its operating units,Loral Space, the transaction was restructured as a cashacquisition.

Grinblatt1484Titman: Financial	V. Incentives, Information,	20. Mergers and	© The McGraw1484Hill
Markets and Corporate	and Corporate Control	Acquisitions	Companies, 2002
Strategy, Second Edition

736Part VIncentives, Information, and Corporate Control

The issues that I have addressed here highlight just amergers and acquisitions and should be useful to anyonefew of the principles that Grinblatt and Titman discuss inpursuing a career in this field.

Part V. The theoretical discussion, supported by practical

Ms. Price is currently managing director of Chase Manhattan, specializingexamples offered in the book, I believe, will provide a good

in strategic and tactical mergers and acquisitions. Previously, Ms. Pricefoundation for understanding the issues and intricacies ofwas with Bear Stearns, Nestlé U.S.A., and Dean Witter Reynolds.

Grinblatt1485Titman: Financial	VI. Risk Management	Introduction	© The McGraw1485Hill
Markets and Corporate			Companies, 2002
Strategy, Second Edition

PART
VI
	Risk	Management

B efore the late 1980s, the typical textbook on corporate finance contained virtually

no mention of risk management, and, indeed, most corporations exhibited little

interest in this topic. Since the 1980s, however, risk management has become one of

the most important responsibilities of the treasurers in large corporations throughout

the world.

As an illustration of the growing emphasis on risk management, consider the lead

article in the August 17, 1993, edition of The Wall Street Journal,entitled “Managing

Risk: Corporate Treasurers Adopt Hedging Plans with Some Wariness.” The article

notes that “. . . derivatives help most corporations using them,” and then goes on to

quote a managing director from Credit Suisse who observed that “although many com-

panies use derivatives for capital raising . . . they are just beginning to use them for

broader risk-management purposes.” Today, the large firm that does not devote sub-

stantial financial expertise to risk management is a rare exception.

Risk management entails assessing and managing, through the use of financial

derivatives, insurance, and other activities, the corporation’s exposure to various sources

of risk. Hence, risk management specialists need a sound understanding of derivative

securities (see Chapters 7 and 8), tools for estimating the risk exposure of their firm

(see Chapters 4–6), and an understanding of which risks should and should not be

hedged.

Chapter 21, the first chapter in Part VI, describes the various motivations for firms

to expend funds and human resources to reduce their exposures to various sources of

risk. These hedging motivations relate closely to the issues examined in Parts IVand

V: minimization of taxes, reducing financial distress costs, matching cash flows with

investment needs, and reducing incentive problems. We argue in this chapter that the

motivation to hedge determines which risks the firms should hedge as well as how

firms should organize their hedging operations. In particular, Chapter 21 discusses the

differences among firms in their motivations for hedging. Depending on these motiva-

tions, some firms seek to hedge cash flow (or earnings) risk while others seek to hedge

against changes in firm values.

Chapters 22 and 23 focus more on the implementation of risk management, ana-

lyzing how firms can alter or eliminate their exposure to risk by acquiring various finan-

cial instruments. Chapter 22 is largely devoted to managing currency and commodity

risk while Chapter 23 focuses on interest rate risk. Interest rate risk deserves unique

treatment because interest rates, as discount factors, affect the present values of cash

flows, even when they do not affect the cash flows directly.

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Risk management requires a firm to first estimate its risk exposure. For example,

an oil firm might want to know how much its earnings will decline next year if oil

prices drop $3 a barrel. Afinancial institution is similarly interested in how changes in

interest rates affect the value of its loan portfolio. Both Chapters 22 and 23 discuss

howsuch risk exposure is measured, using some familiar tools developed in previous chap-

ters, including factor models, regression, and theoretical derivative pricing relationships.

The two chapters also introduce popular ways to measure risk, like value at risk (VAR),

and discuss various ways of measuring interest rate risk through concepts like duration,

DV01,and yield betas.

After estimating its risk exposure, the firm might want to consider various alter-

natives for eliminating the risk. If financial assets exist that exactly track the risk expo-

sure, then risk can be eliminated or at least altered with offsetting positions in these

assets. Both Chapters 22 and 23 discuss how to hedge with a variety of financial instru-

ments that track a firm’s risk.

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CHAPTER

Risk Management

21

and Corporate Strategy

Learning Objectives

After reading this chapter, you should be able to:

1.Understand the different motivations for corporate hedging.

2.Explain which firms should be the most interested in hedging.

3.Understand which risks firms should hedge.

4.Understand the different motivations for foreign currency and interest rate risk

management.

Intel Corporation incurs most of its expenses in the United States where it performs

the bulk of its R&D and most of its manufacturing, but the company generates

revenues throughout the world. Intel is subject to substantial currency risk because

of the relatively long time between its quotation of a price to a customer and the

customer’s payment for the products. Intel’s policy has been to actively hedge the

currency exposures that arise in these situations.

Corporations throughout the world devote substantial resources to risk management.

Risk management entails assessing and managing the corporation’s exposure to

various sources of risk through the use of financial derivatives, insurance, and other

activities.

Previous chapters assumed that a firm’s risk profile—that is, the kinds of risks

they are exposed to—is taken as given. This chapter moves back one step and exam-

ines how firms determine their risk profiles. For example, if Intel chooses not to hedge,

or take offsetting positions, to eliminate its Euro exposure arising from its sales in Ger-

many, Intel’s stock would probably show some sensitivity to movements in the Euro

relative to the U.S. dollar. By hedging that exposure, Intel’s stock is less sensitive to

those sorts of currency movements.

The idea that corporations should manage exposure to various sources of risk is

relatively new, but it is becoming increasingly important. In contrast to the past, when

the chief financial officer (CFO) of a corporation would spend a small portion of his

time on hedging, many corporations now have entire departments devoted to hedging

and risk management. Asurvey conducted in the last decade for a group of financial

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740Part VIRisk Management

institutions known as the Group of Thirty reported that more than 80 percent of the

surveyed corporations considered derivatives either very important (44 percent) or

imperative (37 percent) in controlling risk. Of the respondents, 87 percent used inter-

est rate swaps, 64 percent currency swaps, 78 percent forward foreign exchange con-

tracts, 40 percent interest rate options, and 31 percent currency options.

Since the publication of the Group of Thirty study, derivative usage has continued

to grow, as documented by a series of Wharton School surveys.¹The growth in deriv-

ative usage is not just a U.S. phenomenon. For example, in a recent comparison of U.S.

and German firms, Bodnar and Gebhardt (1999) showed that German firms tend to use

derivatives more than U.S. firms. In their sample, 78 percent of the German firms used

derivatives compared to 57 percent of U.S. firms.

The trend toward greater attention to risk management is due to a number of fac-

tors, most notably, the increased volatility of interest rates and exchange rates,²and the

increased importance of multinational corporations. In addition, the growing under-

standing of derivative instruments (see Chapters 7 and 8) has also contributed to their

increased acceptance as tools for risk management.

The motivation for risk management comes from a variety of sources: taxes, financial

distress costs, executive incentives, and other important issues discussed in earlier chapters.

Understanding these motives is important because they provide insights into which risks

should be hedged and how a firm’s hedging operations should be organized.