Chapter 10 – Mergers and Acquisitions
Chapter Ten
Mergers and Acquisitions
OVERVIEW
Chapter 10 describes how excessive optimism and overconfidence lead
managers involved in mergers and acquisitions to destroy value for their shareholders.
Because of hubris, the managers of acquiring firms are vulnerable to the winner’s curse
whereby they overpay for target firms. By trusting inefficient market prices, the managers
of target firms are vulnerable to accepting overvalued equity in exchange for their firms.
The chapter presents some theoretical examples to explain how excessive
optimism and overconfidence lead managers to behave differently than they do if they are
free from these biases. The discussion focuses on both the case when market prices are
Chapter 10 – Mergers and Acquisitions
LEARNING OBJECTIVES
The main objective of this chapter is for students to demonstrate that they can identify the
manner in which biases and framing adversely impact the behavior of managers when
they make decisions about mergers and acquisitions. After completing this chapter
students will be able to:
4. Identify the manner in which reference point heuristics impact valuation
CHAPTER OUTLINE
Traditional Approach to M&A
Chapter 10 – Mergers and Acquisitions
The Winner’s Curse
On average acquiring firms overpay for targets, which is part of a general
Optimistic, Overconfident Executives
Press coverage often characterizes CEOs as excessively optimistic or
overconfident. CEOs who hold their executive stock options too long also appear to be
overconfident. These CEOs are more likely to engage in acquisition than CEOs who do
Theory
When market prices are efficient and all managers are rational, the acquiring firm
and target firm divide the synergy according to how competitive is the M&A market.
Chapter 10 – Mergers and Acquisitions
Hewlett-Packard and Compaq Computer: Board Decisions
Of Hewlett-Packard’s three main businesses in 1999, enterprise computing,
personal computers, and imaging and printing, only the latter was profitable.
Subsequently HP acquired Compaq Computer, pitting HP’s CEO Carly Fiorina against
several behavioral traits, notably overconfidence and aversion to a sure loss. HP’s board
and managers valued the synergy associated with the merger using the P/E heuristic.
TEACHING TIPS FOR POWERPOINT SLIDES
Before showing the first PowerPoint slide, instructors might indicate to students
that the traditional framework for mergers and acquisitions involves the market values of
Slides 6-78
Slides 6-8 indicate that in the aggregate, for the United States, acquirers suffered
from the winner’s curse during the period 1991-2001. A few very large losses between
1998 and 2001 were predominant. Instructors might ask students where the term
Chapter 10 – Mergers and Acquisitions
winner’s curse originated. The answer involves oil companies who might have overpaid
Slide 5
Slide 5 introduces the concept of the hubris hypothesis. Press coverage and the
longholder criterion serve to identify excessively optimistic, overconfident CEOs. Firms
headed by CEOs who are identified as being overconfident on these criteria tend to be
Slide 10
Slide 10 indicates that financially constrained firms run by excessively optimistic,
overconfident CEOs are less apt to make acquisitions. They tend not to go to the capital
markets to raise funds, viewing their firms as undervalued by investors. Instructors can
Chapter 10 – Mergers and Acquisitions
Slide 41
Slide 41 informs students that AOL paid $165 billion in stock to acquire Time
Warner, a record amount for an acquisition. AOL had a large base of subscribers who
Slide 43
Slide 43 indicates that the combination of AOL and Time-Warner in 2000 took
place at the height of the Internet bubble. AOL’s market value was over twice that of
Time Warner. At the time the market’s judgment of the combination was positive, with
Slide 47
Slide 47 points out that Steve Case, AOL’s CEO, engaged in market timing when
Chapter 10 – Mergers and Acquisitions
Slide 49
Slide 7 points out that Gerald Levin, Time Warner’s CEO, trusted market prices.
Slide 52
Slide 52 displays exhibit 10-1, which shows the decline in the market
capitalization of AOL Time-Warner over the next two years. Although most of Time
Slide 53
Slide 53 indicates that consistent with the hubris hypothesis, hubris was an
Slide 55
Slide 55 introduces the acquisition by Hewlett-Packard of Compaq Computer in
2002. At the time, HP had three main businesses, of which only one was profitable,
Chapter 10 – Mergers and Acquisitions
Slide 60
Slide 11 provides a bit of history, noting that HP CEO Carly Fiorina had raised
the issue of acquiring Compaq with her board of directors. The board was initially
resistant. Instructors might ask students if they can understand why Sam Ginn might have
been skeptical. The answer is that margins in the personal computer business were small,
Slide 61
Slide 61 lists three questions that CEO Fiorina posed to her board in order to
induce them to support her proposal. Instructors might read the three questions out loud,
Slide 62
Slide 62 asks students to consider the behavioral aspect attached to these
questions. Did the questions frame the decision task in a way that appealed to directors’
Chapter 10 – Mergers and Acquisitions
Slides 64-65
Slides 14 and 15 display Exhibits 10-2 and 10-3. Exhibit 10-2 shows how the
managers at HP valued the synergy associated with the acquisition. Notably, they used
the P/E heuristic. Exhibit 10-3 traces the time path for the cumulative returns associated
Slides 66-67
Slides 66 and 67 pertain to the conclusion of the illustrative example involving
HP. The Wall Street Journal noted that HP was losing out to industry leader Dell in the
Additional Resources for Chapter 10 Available on the Web
On the web at www.mhhe.com/shefrin, instructors will find additional resources
that relate to chapter 10. This material is intended for instructors who wish to delve into
Chapter 10 – Mergers and Acquisitions
©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the
classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
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the Monty Hall problem to understand framing when asymmetric information and
conflicts of interest are pertinent, and a series of illustrative examples of M&A.