Essay: "If Managers Are Rational

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[. . .] Financing

A short note on financing, since that has been speculated as one of the reasons why mergers prove to be less successful than anticipated. Agrawal and Jaffe (1999) note that method of payment can affect post-merger performance, at least of stock prices. This creates a distortion where firms that feel their stock prices are overvalued are more likely to acquire with stock, whereas other firms might use cash. The former are naturally more likely to see their stock prices drop when the merger is announced (Agrawal & Jaffe, 1999). Modigliani and Miller (1958) argue that the method of financing should be irrelevant, and indeed it should be built into the discount rate used in the NPV calculation, such that the method of financing is not relevant. The only caveat to that is that there might be knock-on effects. An example would be if a firm uses debt for an acquisition, only to find that its debt is subsequently downgraded because of this and therefore its cost of capital ends up being much higher with the transaction that would have been reasonably expected prior to the transaction. At any rate, however, the method of financing should be built into the NPV already, and therefore it is more the post-merger cash flows that are going to affect the success or lack thereof of the merger.


If managers are rational, mergers always have an expected positive net present value, but of course in the real world there is a difference between expected positive net present value and actual positive NPV. This is one of the interesting quirks about how mergers and acquisitions are studied. The studies always focus on ex-post results rather than what the managers were looking at prior to the merger. This is a dangerous logical flaw. Managers may behave rationally and have outcomes end up dramatically different than what they had expected. Agrawal and Jaffe have noted this and sought to explain where some of the differences between expectations and outcomes come from. They rightly note that managers are going to extrapolate past performance, but embedded in this line of thinking is the idea that managers are going to be able to do this perfectly. They aren't.

Managers work with the best assumptions and forecasts that they have. There is little doubt that these techniques can be refined, and certainly it would be foolish to think that all managers are perfectly rational. We know that not to be the case. The problem in thinking that poorer-than-expected results from a merger are the result of some sort of error in estimating the NPV is that such error is inevitable. It is better to focus on refining forecasting techniques so that NPV estimates for mergers are more accurate. There is real value in helping managers to derive better forecasts, whereas there is limited value in critiquing managers for their lack of perfect foresight, when analyzing mergers ex post facto. Managers can and should be rational in their decision-making, but rationality as an input is by no means going to lead to perfect outcomes, nor should anyone expect it to.


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Rau, P. & Vermaelen, T. (1998).… [END OF PREVIEW]

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