M & A - Method of Payment

Insiders of both firms (acquirer and target) have private information about their own firm values. Medium of payment largely depends on private information hold by acquirer and target. The medium of exchange in this setting is driven by the trade-off between the overpayment cost (lower in a stock offer) and the probability that the bid will be unsuccessful (higher in a stock offer).

Cash Offer (cash against target shares)

• Higher Tax Liabilities for Target: Cash offer attracts higher tax liabilities which gets compensated by higher cash bids.

• Overpayment Risk for Acquirer: Since the target itself has private information about its own value, acquirers making cash offers are in danger of overpaying for the target. The expected overpayment cost is greater when the level of information asymmetry the acquirer faces in evaluating the target is greater.

• Negative Market Reaction for Acquirer:High cash flow reserves may encourage management to undertake acquisitions for empire building motives, which frequently lead to a reduction in shareholder value. The use of internally generated funds as a source of acquisition financing, is likely to trigger a negative market reaction at the takeover announcement as this type of financing may identify acquisitions driven by free cash flow motives.

Stock Offer (acquirer shares against target shares)

• Risk-Sharing with Target: The stock offer allows the acquirer to share the risk of the target's overvaluation with target's owners.

• Overvaluation Risk for Target:Unlike the value of cash offer, the value of a stock offer depends on the cash flows of the combined firm. Which, in turn, depends on the true values of the acquirer, the target, and any synergies between the two firms. However, the target may view an acquirer making a stock offer as being potentially overvalued (and may reject this offer).

• Maintaining Corporate Control:It is believed that the managers with a significant ownership in their firm who wish to retain control will tend to finance acquisitions (or any other large investment) with cash or debt rather than with stock in order not to dilute their control and risk losing it. It suggests the fact that stock financed acquisitions are more likely to be undertaken by firms with low managerial ownership.

• Market Reaction based on Management Ownership: The research suggests the negative abnormal returns in the stock-financed acquisitions are concentrated in the group of firms with low managerial ownership. It is perceived by investors as financial policies applied by firms with relatively high managerial ownership as being consistent with shareholders' wealth maximization.