TESTING MERGER AND ACQUISITION SENSITIVITY TO CHANGES IN FIRM

RESOURCES

A DISSERTATION

SUBMITTED TO THE DEPARTMENT OF ECONOMICS

AND THE COMMITTEE ON GRADUATE STUDIES

OF STANFORD UNIVERSITY

IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF

DOCTOR OF PHILOSOPHY

Ryan Andrew Maddux

December 2009

http://creativecommons.org/licenses/by-nc/3.0/us/

This dissertation is online at: http://purl.stanford.edu/yh207br0582

© 2010 by Ryan Andrew Maddux. All Rights Reserved.

Re-distributed by Stanford University under license with the author.

This work is licensed under a Creative Commons Attribution-Noncommercial 3.0 United States License.

ii

I certify that I have read this dissertation and that, in my opinion, it is fully adequatein scope and quality as a dissertation for the degree of Doctor of Philosophy.

Peter Klenow, Primary Adviser

I certify that I have read this dissertation and that, in my opinion, it is fully adequatein scope and quality as a dissertation for the degree of Doctor of Philosophy.

Nicholas Bloom

I certify that I have read this dissertation and that, in my opinion, it is fully adequatein scope and quality as a dissertation for the degree of Doctor of Philosophy.

Jeffrey Zwiebel

Approved for the Stanford University Committee on Graduate Studies.

Patricia J. Gumport, Vice Provost Graduate Education

This signature page was generated electronically upon submission of this dissertation in electronic format. An original signed hard copy of the signature page is on file inUniversity Archives.

iii

iv

ABSTRACT

This dissertation adapts a model of market discipline developed by Zweibel (1994) to

describe how managers should use internal resources in the market for mergers and

acquisitions. Prior literature, namely Harford (1999), has argued that additional cash on

hand leads firms to undertake further merger activity. This paper argues that a more

careful examination of the data demonstrates that this pattern does not hold in the data

and also offers a simple model to explain why exogenous increases in a firm's cash

holdings should not lead a manager to spend more money on either mergers and

acquisitions or on capital expenditure, if both are viewed as wasteful or value decreasing

spending at the margin. This dissertation adapts Rauh's (2005) use of pension funding

status to identify exogenous changes in the level of cash holdings and then uses a Tobit

model to test whether or not additional cash holdings leads firms to accumulate more

capital or spend more on mergers and acquisitions. This dissertation finds that having

more exogenous cash on hand does not lead to more merger and acquisitions spending or

capital expenditure. The marginal expenditure on mergers and acquisition activity in also

calculated as part of the study. Whether one uses instruments or not, the marginal

expenditure is very small, suggesting that firms do not waste a significant amount of

resources on merger and acquisition activity on the margin. This finding also suggests

that stock price responses to merger and acquisitions announcements must be due to the

dilution of shareholders value, revelation of a manager's characteristics, or some other

factor besides the loss of a firm's assets.

v

ACKNOWLEDGMENTS

I would like to thank my mother, Andrea Garner, and my stepfather, Ronnie

Garner for all of their love, support, laughs, and perspective. My mother remains the

most decent person I have ever met and I will never be able to repay her for everything

that she has given to me. I could (and will) fail to live up to her example and still be

considered a kind and decent human being. My stepfather Ron has also done so much for

me and always kept my feet on the ground. Again, I thank you. I also thank the rest of

my family for all their support and love.

This dissertation could not have been written without the guidance and

encouragement of Pete Klenow. Pete guided me through the times where I was a more

dedicated golfer than economist and through the times where my dissertation was my

sole focus. He has always been kind, straightforward, and exceedingly generous.

Jeffery Zwiebel and Nick Bloom have also been exceedingly helpful in producing

this dissertation. Both offered feedback and ideas that have made this dissertation more

interesting, more relevant, and more readable.

Joanne Yoong, Andres Santos, Soo Lee, Ryoji Hiraguchi, Natalie Chun, and Sri

Nagavarapu have also provided excellent and helpful feedback and friendship. I

gratefully acknowledge Mark Tendall and Pete Klenow for allowing me to TA their

courses.

I would also like to thank Robert Godby, Duncan Harris, Shelby Gerking, Mitch

Kunce, and Shaun Wulff for getting me to Stanford in the first place. My dream of being

an economist was born at the University of Wyoming and you all believed in me when I

had no clue what I was doing and you supported me when I started to figure it out.

vi

Finally, I cannot continue without thanking the special friends in my life who

made me who I am and who supported me through this struggle. While there are too

many people to name here, I feel compelled to thank those mentioned earlier and (in

alphabetical order) Peter Duda, Jeff Gilmore, Noriko Kakihara, Saya Kitasei, Ryan

Lampe, Wendra Liang, Karl Maddux, Matt Manship, Jim McFadden, KC McKenzie,

Nicole Novotny, James Pade, Brian Perry, Justin Racette, Beverly Smith, Lauren Todd,

Brian Tran, Ian VanTrump, Nese Yildiz, and Zack Miller. My friends have done a great

deal to shape me and I owe them considerably.

TABLE OF CONTENTS

List of Tables ..................................................................................................................... ix 

Introduction ..........................................................................................................................1 

Chapter 1: A Review of the Relevant Literature .................................................................5 

Section 1: The Event Study Literature ...........................................................................6 

Merger Returns ........................................................................................................6 

Merger Probability ...................................................................................................8 

Section 2: Dividend Papers ............................................................................................9 

Section 3: Summary .....................................................................................................10 

Chapter 2: A Model of Market Discipline .........................................................................11 

Section 1: A Deterministic Model ...............................................................................13 

Timing ....................................................................................................................14 

Managerial Choices and Managerial Utility ..........................................................16 

Technology/Production ..........................................................................................17 

Raider .....................................................................................................................18 

Other Notation .......................................................................................................19 

Section 2: Solving The Model .....................................................................................19 

p = P = 3 ................................................................................................................20 

p = 2 .......................................................................................................................22 

p = 1 .......................................................................................................................27 

Section 3: When P ≠ 3 .................................................................................................32 

Section 4: Uncertain Returns .......................................................................................34 

Section 5: Conclusion ..................................................................................................34 

Chapter 3: Application to Mergers and Acquisitions ........................................................36 

Section 1: Theoretical Framework ...............................................................................40 

Timing ....................................................................................................................41 

viii

Managerial Choices and Managerial Utility ..........................................................43 

Corporate Raiders ..................................................................................................44 

Other Notation .......................................................................................................45 

Solving the Model ..................................................................................................46 

When P ≠ 3 .............................................................................................................48 

The Key Implications of the Model .......................................................................49 

Section 2: Competing Theories and their Implications................................................50 

Predictions of an Asymmetric Information Model with Value Maximizing

Managers ................................................................................................................51 

Predictions of an Agency Theory Model ...............................................................52 

Section 3: The Empirical Specification, Data, and Identification ...............................53 

The Empirical Specification ..................................................................................53 

The Data .................................................................................................................55 

Identification ..........................................................................................................58 

Section 4: Testing ........................................................................................................59 

Models of Acquisition Spending and Capital Expenditure ....................................60 

Models of Debt and Dividends ..............................................................................68 

Section 5: Conclusion ..................................................................................................78 

APPENDIX A: Additional Tables .....................................................................................82 

Bibliography ......................................................................................................................95 

ix

LIST OF TABLES

Number Page

Table 1: Tobit Models of Acquisition Spending................................................................61 

Table 2: IV Tobit Models of Acquisition Spending ..........................................................62 

Table 3: Average Marginal Effect of Cash on Acquisition Spending ...............................64 

Table 4: OLS Models of Capital Expenditure ...................................................................66 

Table 5: IV Models of Capital Expenditure .......................................................................67 

Table 6: Tobit Models of Dividends ..................................................................................70 

Table 7: IV Tobit Models of Dividends .............................................................................71 

Table 8: OLS Models of Debt ............................................................................................73 

Table 9: IV Models of Debt ...............................................................................................74 

Table 10: OLS Models of Cash on Hand ...........................................................................76 

Table 11: IV Models of Cash on Hand ..............................................................................77 

Table 12: Summary Statistics for Sample that Includes Governance Measures ...............82 

Table 13: Summary Statistics for Sample that Does Not Include Governance

Measures ..........................................................................................................83 

Table 14: Additional Tobit Models of Acquisition Spending ...........................................84 

Table 15: Additional IV Tobit Models of Acquisition Spending ......................................85 

Table 16: First Stage Approximation for Acquisition Models ..........................................86 

Table 17: Tobit Models of Acquisition without Governance Measures ............................86 

Table 18: OLS Models of Capital Expenditure .................................................................87 

Table 19: IV Models of Capital Expenditure .....................................................................88 

Table 20: Tobit Models of Dividends ................................................................................89 

Table 21: IV Tobit Models of Dividends ...........................................................................90 

Table 22: OLS Models of Debt ..........................................................................................91 

Table 23: IV Models of Debt .............................................................................................92 

x

Table 24: OLS Models of Cash on Hand ...........................................................................93 

INTRODUCTION

Cash on hand has been a variable of concern for investors, stock holders, managers, and

students of economics and corporate finance for some time. Some argue that holding

cash on hand is beneficial to the firm. Doing so allows the firm to finance projects

quickly, rather than wait for a bond or equity issue to finish, allowing the firm ample

resources to initiate time sensitive projects. Holding cash also allows the firm to finance

projects that the market may not value correctly (i.e. the market values the project as

being worth less than the firm believes because of inside information). Additionally,

holding large sums of cash and assets allows the firm to avoid the convexity of borrowing

costs, which may make several very large merger or investment plans exceedingly

expensive to initiate without large stores of investment funds. These are all examples of

how cash on hand could potentially help managers create value for their shareholders.

However, holding cash on hand need not be beneficial to shareholders and,

according to some theories, could actually be detrimental to shareholder value, relative to

reducing the level of cash on hand via an equity repurchase or a dividend. In particular,

holding cash on hand can allow the manager to waste firm resources by consuming perks,

expanding the firm (empire building) both internally (via too much capital expenditure)

and externally (via wasteful mergers and acquisitions), or through simple

misappropriation. These issues arise because of agency problems: the benefits and costs

of these choices are very different for the manager than they are for the shareholders of

the company.

2

This dissertation seeks to answer a specific question about a possible use of cash

on hand: Does having additional cash on hand makes a firm more, less, or equally likely

to conduct merger and acquisition activity? Since entering into a merger or acquisition

could affect how a firm finances many other related problems, this paper will look at the

merger and acquisition process from a corporate finance perspective and will examine the

sensitivity of dividends, debt, future cash holdings, and capital expenditure to changes in

cash on hand in a given period. In particular, this dissertation will argue using both a

theoretical model and empirical tests that having additional cash on hand will not result in

a firm spending more money, on average, on a merger or acquisition. To get to this

conclusion, this dissertation begins in the second chapter by looking at some of the

relevant literature. In particular, the second chapter will document prior studies that have

looked at the sensitivity of merger activity to a firm's cash holdings. The chapter will

also document the event study literature to look at how the market reacts to merger and

acquisition bids. For the most part, the literature argues that shareholders of acquiring

firms systematically lose value from such transactions, suggesting that mergers and

acquisitions are value decreasing for acquiring firms on the margin and on average. The

second chapter also documents some common explanations of dividend policy.

The third chapter of this dissertation develops a simple model of how a manager

should behave when he or she makes decisions in the presence of corporate raiders, who

are able to buy the firm and replace the manager if doing so would increase the value of

the firm enough to make such a takeover profitable. This model is a simple extension of

Jeffery Zwiebel's (1996) prior work and is used to examine how a manager makes debt,

dividend, and wasteful project decisions over time. The model differs from Zwiebel's

original contribution because it allows mangers to not only choose whether or not to

initiate a wasteful project, but to also specify the size of the wasteful project. The model

also makes the simplifying assumption that managers, when all else is equal, prefer less

debt to more debt. These extensions allow clean comparative statics to emerge from the

3

framework, which will be useful when taking the model to the data. In particular, the

model predicts that when a manager must make wasteful spending decisions in the

presence of a takeover threat, her/his wasteful spending should not change when level of

cash on hand changes exogenously, which is at odds with the empirical literature.

The fourth chapter of this dissertation examines the validity of three corporate

finance theories (including the one presented in chapter 3) by focusing on how merger

and acquisition behavior is influenced by the amount of cash on hand that a firm holds

and its governance policies, which may be a good proxy for entrenchment. The first

model, a pure agency theory, predicts that better governance will limit spending on

mergers and acquisitions while increased amounts of cash on hand lead to an increase in

such spending. An asymmetric information view of the world, where a manager

maximizes shareholder value by using accumulated internal resources, predicts that

governance would not explain a manager's merger and acquisition decisions. In a model

where the market disciplines a manager (the model presented in the third chapter), one

would expect to find that better governance decreases the amount that a firm spends on

mergers and acquisitions, but that increases in cash levels either do not alter a firm's

merger and acquisition spending or cause the level of spending to decline. The fourth

chapter presents evidence that the last theory, market discipline, best describes the

general merger and acquisition behavior observed in the data. In order to get an estimate

of the proportion of a dollar that is used in a merger or acquisition, this dissertation uses a

Tobit model, which also accounts for truncation (many firms do not spend any of their

cash on mergers and acquisitions) and utilizes the additional data (the size of merger

spending) used in this study. A Tobit model also reflects how the merger and acquisition

process is similar to an investment or project initiation decision.

This dissertation also differs from the prior literature, which does not use an

instrumental variable approach to deal with the endogeneity of cash (managers select the

size of cash holdings at the end of each period). This paper will build on Rauh's (2005)

4

suggestion that the funding status of a firm's pension plan is a reasonable instrument for

the size of internal resources that a firm holds. Taking into account the endogenous

variable problem turns out to be very important and doing so makes it appears that

managers will be either no more likely or even less likely to enter a merger and

acquisition if they have additional exogenous resources. This paper will show that

estimates from a traditional Tobit model without instruments will support a pure agency

theory of corporate finance, which predicts that managers will be more likely to enter a

merger or acquisition if they have resources at hand. This result mirrors other studies that

do not use an instrument to deal with the cash on hand variable. In particular,

coefficients on cash levels and cash flows will have positive, significant, and meaningful

levels when an instrument is not used. However, when the pension funding instrument is

included in the analysis, coefficients on cash levels and cash flows become negative and

are no longer statistically significant. In addition, the measures of poor governance,

which act as a proxy for the entrenchment level, grow in magnitude and become

significant, suggesting, as the theory predicts, that entrenchment and not internal resource

levels explain potentially wasteful spending. It is important to note that whether or not

one uses an instrument, the marginal effects are very small. This evidence indicates that

simply having cash on hand, on average, does not entice managers to make an

acquisition. The chapter also looks at capital expenditure, debt, and dividend sensitivity

to increases in exogenous cash on hand.

5

CHAPTER 1: A REVIEW OF THE RELEVANT LITERATURE

This chapter proceeds with two goals in mind: (1) to document the empirical work

describing the sensitivity of mergers and acquisitions to cash holdings and to see how

shareholders either benefit or suffer from such actions and (2) to look at potential

explanations for dividend and debt policy. The purpose of this investigation is to

motivate a closer look at the data regarding mergers and acquisitions. In particular, many

studies argue that having more cash on hand makes a firm more likely to be active in

mergers and acquisitions and that this activity is usually value destroying. This seems

somewhat inconsistent with reality. If managers systematically make value reducing

decisions, then one would expect that an outside investor or a buyout firm would find it

profitable to purchase the firm, replace the management, and sell the firm at a profit.

This chapter proceeds as follows: the first section explores the event study

literature. In particular, it focuses on how the market reacts to mergers and acquisitions.

The chapter documents a general trend in the literature: that most studies find that the

market reacts negatively in the short and long run to firms that make acquisitions. Most

studies also find that shareholders of firms that are acquired fare well after a merger is

announced. The section also examines the event study literature that pertains to mergers.

In particular, it looks at studies that measure whether or not the probability of entering a

merger is increasing in the level of cash and assets that a firm holds. The chapter cite

several studies that find a positive relationship between cash holdings and the probability

of entering a merger or acquisition. The second section of this chapter cites popular

explanations for dividend decisions.

6

SECTION 1: THE EVENT STUDY LITERATURE

The event study has allowed economists to look at what explains mergers and acquisition

and to analyze the impact of such events. In the first subsections, this chapter will

document the event study literature's finding regarding how mergers and acquisitions

affect the value of acquiring firms. The second subsection will look at how the

probability of entering a merger is affected by the cash assets controlled by a manager.

This section will show that the literature finds that mergers and acquisitions, on average,

are value decreasing for the shareholders of an acquiring firm. This section will also find

that the current literature finds that cash rich firms (in terms of cash on hand and cash

flows) are more likely to sink resources into mergers and acquisitions. These facts

appear to reflect an agency problem within firms. Managers have incentives to make

decisions that may hurt those that they represent. However, there are problems with this

finding. If managers systematically make value decreasing decisions when they have

resources, then another firm or investor may find it profitable to purchase control of the

firm, replace the manager, and profit. If this were the case, then one should expect to see

more firms being acquired and, ultimately, fewer mergers and acquisitions. This

observation will be the departing point for the second and third chapters of the

dissertation.

MERGER RETURNS

In their 2005 paper, Malmendier and Tate explore the role of overconfidence in the

merger and acquisition process. Malmendier and Tate report that publicly traded firms in

the United States spent more than $3.4 trillion on mergers and acquisitions in the last two

decades. While the goal of their paper is to argue that overconfident CEO's are more

likely to make value destroying mergers and acquisitions and that those acquisitions will

be worse for shareholders than those made by non-overconfident CEO's, Malmendier and

Tate (2005) find that the firms of overconfident CEO's lose 100 basis points in a three

day window surrounding a merger bid. They also find that the firms run by non-

7

overconfident CEO's lose 27 basis points in the three days surrounding a merger bid.

Either way, it appears that the shareholders of acquiring firms lose value when their firm

moves to acquire another firm. This result is fairly robust in the literature. Moeller et al.

(2005) find that from 1980 to 2001, acquiring shareholder lost over $220billion at the

announcement of merger or acquisition bids. In particular, Moeller et al. claim that firms

lost 1.6 cents per every dollar spent on a merger and acquisition in the 1980's and 12

cents per dollar spent from 1998 to 2001, although the latter years appear to be driven by

a few very large and very poorly received mergers. Harford (1999) finds that the

acquisitions of cash rich firms are value decreasing and argues that cash rich firms

destroy seven cents in value for every excess dollar of cash reserves held.

Other studies confirm this finding. These studies include Dodd (1980), Firth

(1980), and Ruback and Mikkelson (1984). These studies argue that acquiring firms lose

value in the window surrounding a merger and acquisition. Another more recent study is

the survey paper by Andrade, Mitchell, and Stafford (2001). In their paper, Andrade,

Mitchell, and Stafford (2001) find that, in most cases, an acquiring firm will lose value

from a merger or acquisition over not only a two day window, but also over a three year

window. It is important to note that the authors acknowledge Barber and Lyon's (1997)

concern about using a long term event study in the case of mergers and acquisitions. Not

all studies, however, claim the same findings. One study that does not support this

finding is Asquith (1983). In his study, Asquith uses a list of mergers found in the Wall

Street Journal from 1962 to 19761 and finds that there is no economically or statistically

significant change in the value of an acquiring firm in the window surrounding a merger.

It should also be noted that many of the above mentioned studies find that the value of

target firms increases around the announcement of a merger and, in some cases, the value

of the combined firm increases surrounding a merger. However, most evidence still

1 Some years in this window are not included, such as 1964-1966.

8

seems to indicate that the shareholders of acquiring firms suffer from such activities over

both a short horizon and a much longer one as well.

MERGER PROBABILITY

Malmendier and Tate (2005) analyze the probability of entering a merger for several

large corporations. Their focus, as was mentioned in the prior subsection, was to

demonstrate that overconfident managers are more likely to make value destroying

mergers. Based on their two measures of overconfidence, their paper appears to

demonstrate this. As part of their estimation, they include cash flows in a probit

regression to model the probability of entering a merger. They find that firms with higher

cash flows are more likely to enter a merger or to make an acquisition. This makes sense

because firms with more assets do not have financial restraints that would prevent them

from doing so. It also suggests that many of these firms have an agency problem if such

mergers and acquisitions are value decreasing for the firm. Harford (1999), in a similar

analysis looks at how cash rich firms enter into mergers and acquisitions. In particular,

he finds that cash rich firms are more likely to enter a merger and acquisition. Like

Malmendier and Tate (2005), Harford (1999) uses a probit analysis to make this claim. If

one believes that mergers are value destroying, as the previous section suggests, then one

would find this behavior to be consistent with an agency problem, which is commonly

associated with the theoretical work introduced by Jensen (1976).

One other study is worth noting at this point. Blanchard, Lepez-de-Silanes, and

Shleifer (1994) study the behavior of firms who receive a cash windfall from favorable

legal settlements. This work seems most in line with the instrumental variable procedure

planned for later in this paper because it considers an experiment where a firm is given

exogenous money which the manager can potentially spend on mergers and acquisitions.

Blanchard, Lepez-de-Silanes, and Shleifer (1994) study a very small set of firms in a case

study setting. They find that almost all of their firms used a great deal of their lawsuit

money to finance some sort of merger or acquisition. It is difficult to see this case study

9

as slam dunk evidence for an agency theory view of merger and acquisition spending

because of data limitations. The firms studied by Blanchard, Lepez-de-Silanes, and

Shleifer are all low Q firms (firms with limited internal investment opportunities) that the

authors speculate may be near financial collapse anyway. The fact that these firms are

struggling very well might be what is explaining the merger and acquisition spending.

Because their panel does not include a diverse set of companies with varying investment

opportunities or outlooks, one cannot conclude that the windfall is precipitating the

additional merger and acquisition spending.

SECTION 2: DIVIDEND PAPERS

Miller and Rock (1985) illustrate how dividends can signal current earnings news in a

dynamically consistent framework. They use a Spence-like signalling model to show

under which conditions a separating signalling equilibrium exists in a model where a

manager has more information about the firm's returns than the shareholders of the firm.

The idea is that firms can credibly signal information but at the price of under-investing

relative to the optimal amount (firms with the best earnings end up having to sacrifice the

most in terms of optimal investment).

In their empirical paper Bernartzi, Michaely, and Thaler (1997) find that

dividends do not appear to provide any information about and increase in future earnings.

In fact, they argue that the evidence supports a story where a decrease in dividends may

actually signal a future increase in earnings. Part of the reason for this finding, the

authors argue, is that dividends signal (or, more accurately, reflect) information about the

past and present. So, when a dividend is reduced, it is often because earnings are

temporarily low. It is important to note that DeAngelo et. al (1996) argue that there is

limited evidence that dividends reflect past success, but, at the same time, do not believe

that dividends are good signals of future performance. They instead point to

overoptimism as a source of increased dividends. Given this, it may be interesting to

10

examine other explanations of dividends and returns of cash to shareholders. One such

examination is Bagwell's paper (1991) on stock repurchase. Bagwell argues that if a firm

faces a downward demand curve for shares, then the firm may be able to buy shares from

low valuation shareholders and make a potential takeover more costly. In addition, she

argues that a dividend would make a firm easier to purchase.

SECTION 3: SUMMARY

This literature review documents some key findings that inspired the theoretical and

empirical work that is presented later in this dissertation. In particular, this literature

review has cited several sources that argue that higher levels of internal resources are

correlated with greater activity in the market for mergers and acquisitions. Also, the

literature has argued that entering into a merger or acquisition is, on average, detrimental

to shareholders.

11

CHAPTER 2: A MODEL OF MARKET DISCIPLINE

As was first discussed by Michael Jensen and William Meckling (1976) and has been

discussed frequently since, there exist agency conflicts that may impact the capital

structure of a firm. In a later paper, Jeffrey Zwiebel (1996) explores how a manager's

desire to initiate wasteful projects could effect the debt level and dividend choices of a

firm. Zwiebel's key contribution is that he demonstrates how debt can prevent a manager

from undertaking wasteful pet projects in a dynamically consistent model. The reason

why debt can successfully restrain a manager is because debt forces the manager to have

enough cash available to make debt payments. In the model, when a manager cannot

make these payments, the firm enters bankruptcy and it becomes easier for a corporate

raider or shareholders to remove her/him from control. Because the manager has the

ability to just hold onto borrowed money and pay it back to the lender later (doing so

would not limit the manager in any way), the only way that managers can effectively

handcuff themselves is to issue excess cash to shareholders as dividends. Failure to do so

will give a raider incentive to buy the firm before the excess cash goes to waste, replace

the manager, and increase the value of the firm by insuring that the excess liquidity is not

wasted. By issuing excess cash as a dividend, the only way that a manager will have

enough money to make payments is if they manage responsibly and do not initiate poor

and wasteful projects.

Zwiebel's model (1996) is chosen as a point of departure for this chapter because

it is a simple and consistent model that emphasizes the disciplinary effects of debt. While

other corporate finance models capture the effects of asymmetric information (Ross

(1977), Leland and Pyle (1977)) or control motives (Harris and Raviv (1988)), Zwiebel's

model (1996) gives a simple and persuasive argument for why and how debt restricts

managerial waste in a world with full information. The paper leaves work to be done,

however, because it forgoes the opportunity to discuss how a firm's tolerance for

12

incapable employees depends on institutional arrangements (i.e. the entrenchment level)

and the financial freedom given to managers. The paper also does not specify unique

solutions for debt and dividend levels. This chapter will attempt to address these issues

by allowing the size of a bad project to be set by the manager subject to an arbitrary limit

that will be interpreted as the degree of discretionary freedom. This differs from the

original model, which only allowed a manager to pick a bad project that would cost the

firm a fixed amount. Under the assumption that the size of a wasteful project is fixed, a

manager, when not taking on productive projects, could choose between an incredibly

costly bad project and nothing. Allowing the size of a poor project to be chosen along an

interval allows the manager to pick smaller wasteful projects, if that is desirable. Besides

this minor change and some notational differences, this model is identical to Zwiebel's

(1996).

While this distinction appears minor, it allows this chapter to discuss how

wasteful spending changes due to differences in the entrenchment level and financial

freedom, as well as pin down specific debt and dividend policies for a firm based upon a

manager's ability. Most notably, this small addition allows one to find clean comparative

static results and closed form expressions, which were lacking in Zwiebel's (1996) paper.

In particular, expressions for how the value of a firm, dividend levels, debt levels, bad

project sizes and acceptable managerial type are derived and are found to change with

discretionary freedom, time, and managerial type in a three period model. This chapter

also generates expressions for the size of debt, the size of bad projects that are initiated,

and the value of the firm in terms of the manager's type, the level of financial discretion,

and the level of entrenchment. Finding sharper results will better enable the theory to be

taken to the data, which will occur in the final chapter of this dissertation. In light of

recent work by Rajan and Wulf (2004) and Yermach (2004), this may be of some

interest. Also, if one is willing to view merger and acquisitions as value decreasing

spending (at least at the margin), then this model is useful for looking at merger and

13

acquisition sensitivity to key variables in the model, namely cash holdings and

entrenchment.

This chapter will proceed as follows. The first section will present the basic

model. The section will specify the behavior of managers, stockholders, and corporate

raiders. It will also describe how a firm operates and how its technology produces

returns. The second section will solve the model for the three period case (P = 3). The

section will show how the value of the firm, the size of bad projects, the size of debt, and

the size of dividends vary with respect to time, managerial ability, entrenchment level,

and financial freedom. This includes all comparative statics results. The third section

will discuss two extensions to the model. The first extension considers solutions to the

model when time is allowed to be longer than three periods (P = N > 3). The second

extension will consider when liquidity may be a concern. These results will be compared

to those in Zwiebel's model (1996) in order to demonstrate how the simple changes in

this paper can make big differences. Finally, the paper will conclude by considering

extensions, discussing testing, and summarizing the results.

SECTION 1: A DETERMINISTIC MODEL

Those familiar with Zwiebel's paper (1996) will find this model very familiar

because this chapter considers the effects of a simple alteration. The extension of this

model gives the manager a choice over the size of pet projects along an interval. The

chapter also changes some of the notation to match up with convention and the dividend

stage is more clearly defined. While these changes are minor, they allow for interesting

comparative statics that were not available before. As was the case in Zwiebel's (1996)

original contribution, the basic idea is that a manager makes borrowing, dividend, and

project initiation decisions each period for a firm that has an existing set of projects as

well as new opportunities. While the manager has free reign over these decisions, subject

to financial freedom restrictions, he/she must account for an ever-present raider who will

14

take over the firm if the value of the firm under a new manager exceeds the value of a

firm with the current manager by enough to justify the cost of initiating a takeover.

Furthermore, the cost of a takeover is lessened to zero under bankruptcy. While the cost

of a takeover under bankruptcy is almost certainly not zero in reality, the fact that it is

easier to replace a manager during bankruptcy appears to be consistent with what

happens in actual takeovers. The specifics of the model follow.

TIMING

The model has P periods. In this paper, the main case to be considered is when

P = 3. Each period p ≤ P = 3 is identical and proceeds in the following order:

1. The period starts. A manager begins with some cash on hand. The manager

makes a capital structure decision. The manager can accrue debt in a given

period. In return for this debt, the manager receives the value of that debt, which

is added to cash on hand. The lending sector issues credit at the competitive

interest rate of zero.

2. Using cash on hand, the manager may choose to pay out a dividend if he/she

chooses. A dividend, if issued, must satisfy a non negativity restriction (firms

cannot charge shareholders a fee for holding company stock).

3. After making a dividend decision, the market for corporate control opens and

closes. Both the manager and the raider have perfect knowledge of the firm's cash

on hand and debt level. This implies that there is honest and perfect accounting.

All parties also know the manager's type. Whether or not all parties know what

the dividend payments or what the initial cash on hand was does not matter in the

analysis that will follow. If the value of the firm with a replacement is

sufficiently high relative to the value of the firm with the current management, the

raider will initiate a buyout and can choose to remove the manager and bring in a

replacement.

15

4. The manager learns if there is a good project or not.

5. The manager decides whether or not to take up a project (good or bad). Initiating

a project, whether it be good or bad, is costless. If a good one is available, he/she

can take it. If only poor projects are available, the manager picks the size of a bad

project. The size of the bad project is limited by the manager's choice and by

institutional rules. The idea is that bad projects are always readily available (one

can simply waste money on perks), but that bad projects can only get so far out of

hand before some outside force steps in and does not allow any further waste.

The magnitude of the maximum size of a poor project is interpreted as the degree

of fiscal or discretionary freedom. It is assumed that this limit has been set prior

to the manager's hiring and is not renegotiable.

6. The projects yield returns and the manager services debt.

7. Bankruptcy proceedings begin if the manager defaults on a debt. Under

bankruptcy, a raider may initiate a takeover. Unlike earlier in the period,

takeovers become costless under bankruptcy. Therefore, managers would like to

avoid bankruptcy and a greater possibility of being fired.

The timing of the model illustrates how managers will act in the model. The

manager will act wastefully if given the chance. More importantly, the manager knows

that the market knows this as well and that a raider will buyout the company and replace

management if anticipated waste is too high. In order to avoid this outcome, a manager

must somehow credibly commitment to not undertaking wasteful projects or commit to

taking a small enough wasteful project such that the market will not be able to remove

her/him because of it. It turns out that the only commitment device permitted in this

model is debt. The next subsection will describe in further detail how managers act. It

will also lay out the notation that will be used for the remainder of the paper.

16

MANAGERIAL CHOICES AND MANAGERIAL UTILITY

A manager either enjoys their work, the power associated with the position, or

some level of predetermined compensation and hence gets utility from being employed.

If he/she is employed in a given period, he/she gets utility A > 0. One can think of this as

the utility generated from a base salary and all other benefits regularly associated with

running a company. A manager is denoted by her/his type, which will be denoted as θ. A

manager's type is the probability that the manager will have a good project in a given

period. If the manager initiates a good project, the manager gets utility B ≥ 0. When a

good project is not available to the manager, he/she can also get utility from the size of a

bad project, if he or she chooses to costlessly initiate one. The size of a bad project will

be denoted as rbt and the return to the company of a bad project of size rbt is -rbt.

The size of a bad project is limited by the financial freedom given to managers.

This freedom may come from a board of directors or may be a consequence of the firm's

industry. Either way, the amount of financial freedom limits the size of a bad project.

This is represented by the expression rbt ≤ b, where b > 0. It is assumed that managers

find greater enjoyment in larger pet projects or empire building efforts. Because of this

assumption, the model requires that the manager's utility satisfy the following

monotonicity condition: U'(rbt) > 0. No conditions are imposed on the second derivative

at this time and doing so would add nothing to the analysis.

The following condition is also assumed to hold: B > u(b). The idea is that good

projects are always more desirable than bad projects. One could assume that good

projects bring better perks, enhance one's reputation, and/or provide a greater sense of

satisfaction. One could also assume that taking a bad project when a good project is

available cases sufficient damage to one's reputation to always make it undesirable. In

addition, a manager should not be irreparably harmed by doing nothing, particularly

when the opportunity to undermine the shareholder is always available. Because of this,

U(0) = 0. Also, the manager's outside opportunity is set at 0. Also, managers are unable

17

to take both a good project and a pet project in the same period. The argument is that a

manager has a limited amount of time to manage projects and can only look over one

project in a period.

This chapter will also assume that, when indifferent, managers would just assume

have less debt than more debt. Zwiebel does not make this specification and is still able

to demonstrate the restraining powers of debt. However, by not taking a stand on how

managers feel about debt, Zwiebel loses the ability to make precise claims about debt and

dividend levels. Specifying an indifference condition will enable me to pin down

precisely the levels of debt and the dividend payments in all periods. These sharper

predictions should facilitate testing in the next chapter.

TECHNOLOGY/PRODUCTION

Regardless of which manager is running the firm, it is assumed that each firm has

an existing technology that generates returns. For simplicity, it is assumed that the

permanent technology yields returns to the firm equal to y > 0 each period. In addition to

the permanent technology, a manager can initiate a project every period. With

probability θ the project is a good one and yields returns r. θ is a comparative static

parameter and is intended to capture the manager's ability. Under this assumption,

managers are drawn from some pool of prospective managers with some probability

density function f(θ) at the beginning of the model. It is also possible that θ could

represent some characteristic of the firm (i.e. firms in certain industries are more likely to

come across project opportunities).

If a manager does not get a good project, he/she is free to initiate a poor project at

zero cost. The manager is also free to pick the scale of a poor project. The size of the

poor project will be denoted as rbt and will satisfy the following condition: 0 < rbt ≤ b, as

was explained earlier in the paper. A poor project brings returns - rbt to the firm. Again,

the idea behind this feature of the model is that while a manager has power over project

18

selection and finances, accounting practices, contractual obligations, and/or

credit/resource constraints prevent a manager from wasting too much money on poor

projects.

RAIDER

There exist one or more raiders who will buyout the firm and possibly change

management if the value of the firm can be increased by more than e, the level of

entrenchment, by such a maneuver. The variable e represents the legal and organizational

costs to mounting a takeover bid or the cost of buying out a manager due to a poison pill

or golden parachute provision in the manager's contract. If a raider purchases the firm,

he/she can put in place a replacement manager who can maintain the original technology,

but, for some reason, is unable to initiate new projects. This assumption may be realistic

for several reasons. First of all, this is analogous to putting in place a manager of type θ

= 1/2, which is borrowed from the Zwiebel setup (1996). If this reason is unsatisfying,

one could simply plug in an alternative type into the model. The second reason why this

assumption may be acceptable is because it is also consistent with a new manager being

given a contract that limits her/his power to control finances and places more of that

responsibility into the hands of a board.

The raider can also make a takeover bid if the firm goes bankrupt. Under

bankruptcy, the raider can initiate a takeover at a cost e', where e > e' ≥ 0. As should

become clear in the solution section of this paper, the specific value of e' is unimportant

and that the fact that e > e' is important. In light of this, the paper will simply assume that

e' = 0 for the remainder of the paper. As was mentioned in the introduction, it appears

that the cost of replacing a manager does seem to fall in reality, so this assumption should

not be problematic. Because a raider has the ability to remove a manager under certain

circumstances, the raider acts as the discipliner in this model and prevents the manager

from wasting money without impunity.

19

OTHER NOTATION

The market will be able to anticipate managerial action due to the structure of the

game and the information available to them. In light of this, it is important to represent

the sequence of all future capital structure decisions. In this model, the sequence of all

future capital structure decisions will be denoted as:

Dp ≡ {Dτ}τ ≥ p

Likewise, one will need to keep track of the value of the firm under current management

and under a potential replacement as well. The model will denote vp(θ , pL , {D}p) as the

value of the firm after the market for control under a given manager of type θ. Similarly,

the value of a firm with a replacement will be denoted as ),( DLv Ppp . Because a raider

is interested in the potential gains from buying out a firm and replacing the manager, the

gains to replacement in a given period is denoted as:

),(),(),,( DLvDLvDLV Ppp

Ppp

PpP −=θ

All notation needed for the analysis has now been presented. At this point, the model

will be solved.

SECTION 2: SOLVING THE MODEL

A quick glance at the model revels that there is no incomplete information or

uncertainty. Also, no two agents act simultaneously. Given these facts, the chapter will

look for a subgame perfect Nash equilibrium solution to this model. This guarantees

dynamic consistency. It will also turn out that there exists a unique subgame perfect Nash

equilibrium, which is convenient. As is typical, the chapter will work backwards,

beginning at p = P = 3.

20

P = P = 3

The analysis will start by looking at the last period of the game p = 3. Suppose

the game is at the very end of the period and a manager has survived all markets for

corporate control and is still in power at the end of the period. At this point, the manager

has nothing to lose because the game is now over and he/she cannot be removed from

power in the future. The first consequence of this new found freedom is that the manager

will take on any project, whether it is good or not. Furthermore, if the manager has to

take a bad project, he/she will set rbt = b in order to maximize her/his utility (recall that

utility is monotonic in perk spending). Whether or not the firm goes bankrupt at the end

of the period is inconsequential for the manager, so this is not an issue that the manager

weighs.

Given what a manager will do at the end of the period, raiders in the market for

corporate control must decide whether or not to buy out the company and install new

management. A manager will avoid a raid as long as it is not profitable for the raider.

This is true when:

eDbrLyDLyDLvDLv ≤−−−++−−+=− ))1(()(),(),( 33333

333

33 θθθ

or

bre )1(0 θθ −−+≤

This last inequality will tell one which managers have the potential to be retained

at time p=3 (as well as all other periods). Those managers are of types

)/()( breb +−=≥θθ

This is a generalization of the firing rule found in Zwiebel's paper (1996) because

it takes into account possible changes in the firing rule due to different degrees of

21

financial freedom. The rule implies that, regardless of what the manager does prior to the

market for control, those managers of type θ ≥ θ and above will be retained and other

types will be fired. The first comparative static to note is that θ is decreasing in the

entrenchment level, as should be expected. In this model, if it is easy to get rid of bad

managers, shareholders most likely will. However, if laws, contract provisions, or other

institutional arrangements make replacing a manager more difficult, shareholders will

find it in their best to retain a manager who is not very good.

The second comparative static of interest is:

0)( 2 >

++

=∂∂

rber

bθ

This result also appears to be consistent with common sense. If a manager has the

potential to waste lots of money, then a corporation will be less likely to retain the lower

type managers who are more likely to be in situations where they can waste the

company's money. Therefore, firms that force managers to be more fiscally disciplined

due to company rules can better tolerate having an inferior manager because it will not

hurt the business as much as if that manager had far more discretionary freedom.

It should also be noted that the firing rule has nothing to do with the debt structure

at this juncture. Because the debt structure is independent of the market's decision to

retain a manager, the manager is free to do as he/she wishes with the capital structure

decision. When one goes back one step in the period to when a manager is making the

capital structure decision, one should first ask if the manager needs to borrow money or

issue a dividend. Since a manager will be retained or fired based only upon their type,

there is no need to construct a commitment device to insure that they act responsibly

(given that it is the end of the game, it is impossible to construct such a device anyway).

Also, the manager does not need any additional cash on hand to finance a project since

project initiation is assumed to be costless. Given these facts, D3 will be set to zero, as

22

will d3 because of the indifference condition imposed in section 2.2. The findings up to

this point are best summarized in the following proposition:

Proposition 1: From the beginning of p = 3 forward, the subgame perfect

equilibrium is:

1. All managers, regardless of type set D3 =0.

2. All managers, regardless of type and value of D3, set d3 = 0.

3. All managers of type θ < θ will be removed by a raider. If the manager is not

removed, the value of the firm is given by:

v3 (θ , 3L , D3) = L3 + y + θr - (1 - θ)b

4. All managers who survive the market for corporate control will initiate a project.

If it is a poor project, the manager will set rb3 = b.

P = 2

Now, I will go back to period two. At this point in the model, things become

somewhat complicated. In the final period, liquidity (L3) was never a problem. At t = 2, it

is possible that the amount of cash on hand, as well as a manager's type and the level of

entrenchment, may place limits on a manager's choice of bad projects. Since the purpose

of this paper is to build on the intuition given by Zwiebel (1996), the chapter will focus

on parameter conditions where liquidity is never a problem. This is achieved most easily

by assuming that y > b (the assumption made in Zwiebel's paper).

Regardless of how liquidity concerns enter the model, at the end of p = 2, a

manager of type θ < θ knows that they will be fired during the next period's market for

corporate control and, hence, will have nothing to lose. Therefore, managers of type θ < θ

23

that remain in control at the end of period two will take any project and, if they can only

take a bad project, they will set rb2 = b to maximize their utility.

Going back to the period two market for corporate control, it should become clear

that in equilibrium, however, these managers will be fired if they have made it to the

second period. The difference in value between the current manager and a replacement is

well above the entrenchment level, so a raider can profit by buying out the company and

installing a replacement manager.

If a manager is of type θ ≥ θ, they will set rb2 = y + 2L - D2 provided that y + 2L

- D2 < b and will set rb2 = b otherwise. This allows them to avoid bankruptcy. A manager

who sets rb2 < b has no incentive to set rb2 = b. Since there is no discounting and because

the surviving manager will get to take either a good project or a large bad project during

the next period, he/she will avoid bankruptcy and the firing that will be guaranteed by

raising rb2 to a level greater than y + 2L - D2. This follows because under bankruptcy

the cost of replacement is reduced and a firm will find it in their best interest to replace

these types of managers. Hence, managers who can force a firm into bankruptcy by

picking bad projects that are too large never exercise this option.

Whenever y > b, a manager of any type does not enter the period worried that the

size of a bad project will, without other debt arraignments, lead to bankruptcy. Under

this assumption, only a manager's type and the level of entrenchment will limit a

manager's bad project choice via debt. As argued above, managers will set rb2 = y + 2L

- D2 provided that y + 2L - D2 < b and will set rb2 = b otherwise. Again this is optimal

because a manager avoids bankruptcy this way. However, the actual size of a bad project

is pinned down by the market for corporate control, where raiders can anticipate a

manager's bad project size choice based on the amount of cash on hand available after the

debt and dividend decisions have been made. The market will retain a manager provided

24

that the value of replacement does not exceed the entrenchment level, which is true if

=− ),,(),( 222

222 DLvDLv θ

eDLybrLyDLy ≤−+−−−−++−−+ ))(1()1(22()2( 22222 θθθ

First, the class of agents who are not limited by the market and can have a bad

project of size rb2 = b without getting fired satisfy the following version of the above

equation:

eDbrLyDLy ≤−−−++−−+ 2222 )1(222()2( θθ

Manipulating this equation shows that a manager is free to set large bad project

sizes in both the last and next to last periods if he/she is of type:

brbe

++−

=≥2/

2θθ

Those managers of type 2θθ ≥ will be retained by the market regardless of

capital structure. This fact, as well as the indifference rule set earlier, pin down

equilibrium debt and dividend levels as well. Since these managers need not restrain

themselves, they have no incentive to borrow or to pay dividends. Hence, D2(θ) = 0 and

22 0)( θθθ ≥∀=d .

If a manager is not capable (i.e. θ < 2θ ), then a manager's bad project size is

pinned down by the equation governing whether or not a manager is fired. Substituting

rb2 into the equation in place of 22 DLy −+ and some simple algebra yields:

erb b =−+−+− 2)1()1(2 θθθ

which is equivalent to

25

θθθ

−−−+

=1

)1(22

brerb

As should be expected, rb2 is increasing in θ. Since rb2 = 22 DLy −+ , one can

pin down optimal debt and dividend decisions using the indifference condition given

earlier. An important thing to note here, as was noted in Zwiebel's paper (1996), is that

there will be no bankruptcy in equilibrium during the second period because all managers

make sure they avoid bankruptcy and maintain their jobs. So, w(D2) = D2. Returning to

equation rb2 = 22 DLy −+ and using the identity 2222 )( dDwLL −+= one gets:

D2 = y + L2 + b –rb2

Note that 0)1/()21(/ 22 <−++−−=∂∂ θθθθ erd , which implies that more

capable managers have to disgorge less cash at the margin. Also, d2 is increasing in cash

on hand, the size of guaranteed returns, and the size of waste potential. D2 is simply

equal to y - rb2 (after realizing returns, the manager has just enough money to pay off the

debt incurred). The subgame perfect Nash equilibrium starting from t=2 onward, given

that y>b is summarized in the following proposition:

Proposition 2: From the beginning of p = 2 forward, the subgame perfect

equilibrium is:

1. All managers of type θθ < will issue no debt or dividend and are replaced

regardless of the capital structure. If they were to survive the market for corporate

control, they would take any project, good or bad, and would set rb2 = b.

2. All managers of type ),( 2θθθ ∈ will take debt:

D2 = y - rb2

26

will issue a dividend equal to

θθ−+

−++=1

222

erbLyd

and will take a project, either good or bad. If the manager takes a bad project,

he/she will set:

θθθ

−−++

=1

)1(22

ererb

In period three, they will issue no debt, will pay no dividend, and will take a project,

either good or bad. If they take a bad project, they will set rb3 = b.

3. All managers of type 2θθ > will not borrow or issue a dividend. They will also

take a project, either good or bad. If they take a bad project, they will set rb2 = b.

In period three, they will issue no debt, will pay no dividend, and will take a project,

either good or bad. If they take a bad project, they will set rb3 = b.

4. In the off equilibrium path case of bankruptcy, a manager will be replaced if

θ < b/(r + b).

5. The value of a manager of type θ relative to a replacement is given by:

2)1()1(2),,( bt

tt rbrDLV θθθθ −−−−=

Where θ

θθ−

−++=

1)1(2

2ererb or rb2 = b if 2θθ > .

27

P = 1

Since y > b, a manager's choice of poor projects is only constrained by her/his

type. At the end of p=1, a manager of type θθ < knows that they will be fired the next

period and, hence, have nothing to lose. Therefore, managers of type θθ < will take any

project and, if they can only take a bad project, they will set rb2 = b to maximize their

utility. In equilibrium, however, these managers will be fired during the initial market for

corporate control. All other managers know that they have the potential to be retained at

times p=2 and p=3 and will set rb1 in such a way that they maximize utility, but do not

get fired.

As was the case before, we go to the market for corporate control to find out what

level of waste a manager can undertake, assuming the manager has the opportunity to do

so. The market will retain a manager provided that =− ),,(),( 111

111 DLvDLv θ

eDrrbrLyDLy bb ≤−−+−+−−++−−+ ))1()1()1(33()3( 112111 θθθθ

The first group of managers to consider are those who are bound only by the

potential size of a bad project. The market for corporate control will tolerate a manager

who will set rbt = b t∀ if 3θr - 3(1 - θ)b + e ≥ 0, or

)/()3/(1 breb +−=≥ θθ

These managers have no incentive to borrow or issue dividends at any period and

so, by virtue of the indifference condition, do not do so.

The next class of managers are those managers who can take bad projects in

periods two and three, but are limited in the size of their period one bad project, should a

bad project be the only one available. These managers are those of types ],[ 12 θθθ ∈ .

Simple algebra shows that these managers set bad project sizes according to the equation:

28

θθθ−

+−+=

1223

1ebbrrb

Which is increasing in e, decreasing in b, and increasing in θ. These comparative

statics are not surprising given the results regarding the period two and forward solution.

They also seem very reasonable as well. These managers issue no debt and pay no

dividends in periods two and three. However, they do issue debt in period one of D1 = y

- rb1 and pay dividends equal to θ

θ−

−+=111

ryLd at time p=1.

After this group, we must discuss whether or not there exists a class of managers

that are limited in the size of their second period bad projects by their type, but

constrained only by the bound on bad projects at time one (i.e. rb1 = b, but rb2 ≤ b). These

are those types such that:

1) θ ≤ 2θ and

2) e + 3θr - 2(1- θ)b - (1- θ)rb2 ≥ 0

Using the equation

θθθ

−−++

=1

)1(22

ererb

implies that the second condition can be rewritten as θ ≥ θ1* = b/(r+b). However, one

should notice that θ1* > θ1. In other words, there does not exist a class of managers that

can take a maximized bad project in period one, are limited in period two, but then can

set a maximal bad project in period three. The reason is that managers cannot commit to

restraining themselves in the future to the degree necessary to enjoy greater perks today.

The only managers that have the ability to take a poor project in period one of size rb1 = b

29

and a poor project in period two of size rb2 ≤ b without being replaced are those who are

capable of selecting rb1 = b ∀ p.

Those managers who have their first and second period projects limited by their

type are those of type ].,[ 2θθθ ∈ These managers are restricted to bad projects of size

θθ−

=11

rrb

Again, this value is increasing in r and θ. However, it is not at all dependant on b or e.

The reason being is that the market (correctly) predicts that these managers will extract

all of the benefits of entrenchment and large poor project sizes in the last two periods.

Therefore, they can only extract extra benefits equal to the marginal gain they provide the

company. These managers also set d1 = L1 + y - rb1 and D1 = y - rb1. The subgame

perfect Nash equilibrium solution to the entire three period model can now be

summarized in the following proposition:

Proposition 3: The unique subgame perfect Nash equilibrium when liquidity is not a

constraint (when y > b) is:

1. All managers of type θθ < will issue no debt or dividend during any time period.

If such a manager is around during any market for corporate control, he/she is

replaced regardless of the capital structure. If they were to survive the market for

corporate control, they would take any project, good or bad, and would set rbt = b.

2. Managers of type ],[ 2θθθ ∈ take on debt D1 = y - rb1 and pay out dividend d1 = L1

+ y - rb1 at t = 1, take on debt D2 = y - rb2 and issue dividend d2 = y + L2 + b - θ

θ−+

12 er

at p = 2, and issue no debt or dividend at p = 3. All managers will take a project at

every period and will take good ones if available. If bad ones are the only projects

30

available at any given time period, they will set rb1 = θ

θ−1r , rb2 =

θθθ

−−−+

1)1(2 bre ,

and rb3 = b. In equilibrium, all of these managers are retained at all time periods and

never bankrupt the company. Hence, their debt is valued at w(Dt) = Dt because of

the no profit condition for lenders.

3. Managers of type ],[ 12 θθθ ∈ borrow D1 = y - θ

θ−1r and pay dividends equal to d1 =

L1 + y - θ

θ−1r at time p = 1. At times p = 2 and p = 3, they set Dp = 0 and dp = 0.

These managers will take a project every period. If a bad project is the only one

available at p = 1, the manager will set .1

2231 θ

θθ−

+−+=

ebbrrb If bad projects are

available in times p = 2 and p = 3, they will set rbp = b. In equilibrium all managers of

these types are retained and never bankrupt the firm. Hence, their debt is valued at

w(Dp) = Dp because of the no profit condition for lenders.

4. All managers of type 1θθ > will not borrow or issue a dividend in any period.

They will also take a project, either good or bad in any period. If they take a bad

project at any p, they will set rbp = b.

5. In the off equilibrium path case of bankruptcy (for types θ < b/(r+b)), a manager

will be replaced if θ < b/(r + b).

6. The value of a manager of type θ relative to a replacement is given by:

12 )1()1()1(3),,( bbp

pp rbbrDLV θθθθθ −−−−−−=

31

As was true in Zwiebel's model (1996), debt can, to a degree, successfully

handcuff a manager and prevent her/him from wasting a firm's resources. Zwiebel also

showed that management cannot improve their outcome by issuing debt due at a future

date. What really matters in this model is when the debt is due. So, as was the case in

Zwiebel's model (1996), there is no loss in issuing all equilibrium debt at time one. This

implies that time one and time two debt can be interpreted as short-term and long term

debt. Adding a continuous choice over bad projects, however, allows one to see exactly

how this debt is arranged, which was not possible in previous contributions.

It is also interesting to discuss how managerial perks seem to change over time.

An interesting story can be told about managers of type ],[ 2θθθ ∈ . These managers start

time one by being somewhat restrained, if given the chance to select a poor project. They

also return more money to stock holders via dividends. As time goes on though, the size

of bad projects grows and the size of dividends may not grow. This suggests that the

incentive system captured by the model makes a manager in the beginning of her/his

career a better manager than that same manager at a later date. This is because a manager

is given less freedom today to compensate for the extra waste he/she will certainly

partake of in the future. This seems like a natural story of how young, eager managers do

better work than old, entrenched managers. However, this story could be viewed as a

flaw of the model. Perhaps one may believe that pride, sentiment, and loyalty would lead

a manager to serve the company better if he/she is around longer. Still, this paper has

taken a stand on how managers value perks and will stick to those assumptions.

Another property of the model is that it's robust to incomplete information. The

outside actors (i.e. the market and the raider) do not need to observe whether or not a

good investment opportunity was available or not. Also, the market for corporate control

takes place prior to the manager learning whether or not there is a good project available.

Hence, the market only takes into account the expected value of the project. As long as

the market and the manager agree on the probability of a good project arriving, then

32

nothing will change. Managers will make the same capital structure and dividend

decisions as they would if there were perfect information. Regardless of whether or not

the market can see if a good project arrived, the manager makes a capital structure

decision that commits himself/herself to not taking on large or wasteful projects (unless

they are of sufficiently high quality that they are worth keeping around even if they make

wasteful decisions when good projects are not available). The market sees the capital

structure decision. If the manager does not act in a disciplined fashion, then the the firm

faces bankruptcy where he/she will most likely be replaced. Additionally, if the market

can observe the cash on hand and debt levels, which they should be able to observe,

particularly for large companies who are required to report this information in SEC

filings, as well as whether or not the firm goes bankrupt, then the outside investors can

infer whether or not a bad project was available. In addition, if the market has a good

idea of the manager's type, they will make their decision regarding the decision to retain

to manager when a firm does go in to bankruptcy.

SECTION 3: WHEN P ≠ 3

This section relaxes the requirement that P=3 and instead allowing P=N. This is

a straightforward extension that was also considered by Zwiebel (1996). It is interesting

to note a major difference between this model and the model proposed by Zwiebel

(1996). In Zwiebel's model, one finds that sometimes a manager can pick a bad project

in period one, not pick one in period two, and then pick a bad one at period three. In a

sense, the manager's choices alternate at times. This occurs because of the binary choice

involving a bad project in his model. In Zwiebel's model (1996), a manager, provided he

chooses to select a poor project, has to set rbp = b. This leads to a slightly complicated

formula for when a manager of a given type will have to pay dividends if the formula is

generalized to p=N periods long. By allowing a manager to arbitrarily choose the size of

bad projects, one gets a much simpler equation for when a manager must borrow. To get

33

this expression, simply look at the condition that must hold if a manager is to be able to

set rbp = b at time p = N – n + 1:

e + nθr - n(1 - θ)b ≥ 0

Solving for n yields:

bbren−+

−≥

)(θ

which yields the following proposition:

Proposition 4: Along the equilibrium path of the N period model, a manager of type

θ will not borrow or pay dividends and will set rbp = b for all periods p ≥ N-n+1

where n is the solution to:

⎟⎟⎠

⎞⎜⎜⎝

⎛−+

−=

bbren)(

intθ

Where the int(x) is simply the largest integer smaller than x. In period p = N - n, the

manager sets θ

θθ−

+−−−=

1)1)(1( ebnrnrbp . For all p < N - n, the manager sets

θθ−

=1

rrbp .

The reason that this formula is much simpler is that the continuous choice over

bad projects gets rid of the alternating behavior in Zwiebel's original model.

34

SECTION 4: UNCERTAIN RETURNS

This dissertation did not specifically study a model with uncertain returns. In

Zwiebel's paper, adding uncertainty did not change the major implication emphasized in

this study: that the level of spending is a function of the entrenchment level and the

manager's ability parameter. Allowing the manager to choose the size of a bad project

(rather than to simply choose whether or not to initiate a bad project of fixed size) will

not change the fact that the level of managerial spending will be pinned down by the

shape of the distribution of returns, the manager's type, and the entrenchment level.

SECTION 5: CONCLUSION

This paper sought to discuss how agency conflicts can potentially affect capital

structure decisions in a dynamically consistent model. Because of its simplicity and

effectiveness at illustrating this point, Zwiebel's model (1996) was chosen as a point of

departure. This paper adopted Zwiebel's environment, but allowed managers to have a

choice over the size of a project when they chose to pursue a pet project. Because

managers fear a potential takeover by a raider and because the threat of takeover

increases under bankruptcy, managers will seek ways to restrain themselves so that they

can maintain control of the firm. The way that a manager does this is by issuing debt,

which he/she must pay back at a future date, and disgorging cash through dividends so

that the only way to make debt payments is to not take pet projects.

The model with this simple addition allows one to find closed form expressions

for the value of the firm, the size of debt, and the size of dividend payments. While other

factors, such as asymmetric information and uncertainty, certainly contribute to an

explanation of the price of assets, the size of dividends, and the debt level, this set up

could potentially allow one to test the power of the agency theory question in and of

itself. The fact that this model also allows one to derive testable comparative statics adds

to this possibility. In particular, this additional assumption (choice over size of bad

35

projects) allows one to talk about how the value of the firm, the size of debt, and the size

of dividend payments vary with respect to a manager's type, the degree of financial

freedom given to the manager, time, and the contractual and institutional forces that

entrench a manager and thus make it difficult to replace her/him.

The model also allows one to do what Zwiebel's paper (1996) allowed him to do:

tell a coherent story about the term structure of debt. Firms may want debt payments to

be due at different times in order to restrain a manager at different points in her/his

career. In reality, raiders appear to give new managers debt when they install them.

Raiders may do this in hopes of preventing a replacement manager from engaging in

empire building activities. As is typical, this paper leaves many tasks to be completed.

The first is that it invites a serious empirical evaluation of this story. While this story is

in no manner complete, with a little work, it would still be testable. Another interesting

question would be to ask if: assuming the model is true, can a board screen managers by

making A and b options over a menu of contracts? Perhaps managers of different abilities

would be willing to sacrifice less of a payment for greater ability to initiate projects.. It

would also be interesting to consider the consequences of what would happen if e were

not known with certainty. In particular, what if a raider, who may have more takeover

experience, knows more about e than a manager? Would this allow managers to act more

conservatively? This also invites questions about the value of insider information

regarding the potential gains from a takeover.

Similar questions may arise when one considers what would happen if the

manager, who may know her/his own firm, knows more about e than a raider. Both cases

would surely affect dividend policy: managers might offer higher dividends and act with

more caution to avoid a takeover if the raider knows e or managers might behave

differently knowing that their dividend and bad project size choices send a signal to a

raider concerning the true value of e. Again, this also invites questions about how one

could value insider information.

36

CHAPTER 3: APPLICATION TO MERGERS AND ACQUISITIONS

”If a dividend would reward the shareholders as much as buying

StorageTek, I think we would definitely consider that. But we went with

StorageTek and our eyes went like this (eyes widening) when we saw the

synergies and opportunities that we have.”

Scott McNealy, Sun Microsystems CEO

The San Francisco Chronicle, June 26, 2005

Scott McNealy's quote illustrates a possible conflict between shareholders and

managers over what a manager do with a firm's cash on hand. Should managers return

cash on hand to shareholders via stock buy back or dividend or should a manager use the

funds to expand the firm via merger and acquisition? A slew of recent work has looked at

mergers and acquisition and much of that work has been critical, citing overconfidence,

empire building incentives, and other such reasons why managers hold cash to undertake

mergers, which tend to harm shareholders of the acquiring company. Work by

Malmendier and Tate (2004) and Andrade, Mitchell, and Stafford (2001) use event study

methodology to argue that merger behavior, on average, harms acquiring shareholders.2

This line of thinking is in line with the agency theory approach to corporate finance,

which includes seminal works by Jensen and Meckling (1976), Grossman and Hart

(1982), Stulz (1990), and Hart and Moore (1995). These papers argue that managers do

not always act in the best interest of their shareholders and can use the firm's resources to

serve their own interests. However, there are reasons why a firm might want to keep cash 2 Malmendier and Tate estimate a negative 40 basis point abnormal stock return of an acquiring firm over

the three day window surrounding a merger announcement while others report a negative 70 basis point abnormal stock return over a three day window and a negaitive 380 basis point abnormal stock return over a 142 day window (although their results are not statistically significant).

37

on hand, even if external financing is readily available. The most often cited is

asymmetric information in debt markets, as in Myers and Majluf (1984) and Greenwald,

Stiglitz, and Weiss (1984). Additionally, there may be convex borrowing costs that make

large scale borrowing difficult or The main point of this literature is that firms might

have better information about the success of a given investment or acquisition than the

market, making market financing relatively expensive. This might make firms more

likely to accumulate cash on hand to finance projects, which could include mergers and

acquisitions.

This paper will test the validity of three corporate finance theories by focusing on

how merger and acquisition behavior is influenced by the amount of cash on hand that a

firm holds and its governance policies. In addition to testing agency and asymmetric

information theories of corporate governance, this paper will examine an agency theory

model with an outside disciplining device. Zwiebel (1996) constructs a model of market

discipline to show how the possibility of takeover forces a firm to issue dividends and

curb wasteful spending. Zweibel (1996) allows managers to initiate wasteful projects,

but they face a takeover threat if their actions make it profitable for an outsider to

purchase the firm and replace the manager. In a pure agency model, one expects

governance to limit spending on mergers and acquisitions and increased amounts of cash

to increase such spending. In an asymmetric information view of the world where a

manager maximizes shareholder value by using accumulated internal resources, one

would expect that governance would not explain a manager's merger and acquisition

decisions. In a model where the market disciplines a manager, one would expect to find

that better governance decreases the amount that a firm spends on mergers and

acquisitions, but that increases in cash levels either do not alter a firm's merger and

acquisition spending or cause the level of spending to decline. In particular, this paper

will present evidence that argues that this last theory, market discipline, best describes the

general behavior observed in the data.

38

The prior literature has looked at the roles of there two variables and has also

asked if having additional cash on hand makes a firm more likely to use these assets to

acquire stakes in other firms. Papers by Malmendier and Tate (2005) and Harford (1999)

use probit and logit analysis to show that cash flows and cash levels make managers more

likely to enter into value decreasing mergers and acquisitions (although, in all fairness,

Malmendier and Tate (2005) focus on overconfidence as an explanation of mergers). The

problem with the use of probit and logit models in these papers is twofold. First of all,

the approach does not use all of the information available (the amount of cash used in a

transaction and the size of a merger or acquisition are available data) and thus do not take

into account the importance of the size on a merger or acquisition, creating inefficient

estimates of the role of resource in the merger and acquisition decision. Second of all,

probit and logit models only allow one to calculate probabilities and marginal

probabilities when, in reality, the size of possible wasteful spending is key to

understanding whether or not the market is imposing discipline on managers. In order to

take advantage of the additional data and to to get an estimate of the proportion of a

dollar that is used in a merger or acquisition, this paper will use a Tobit model to account

for truncation, utilize the additional data, and to better reflect how the acquisition process

is similar to an investment or project initiation decision. Secondly, the prior literature

does not use an instrumental variable approach to deal with the endogeneity of cash

(managers select the size of cash holdings at the end of each period). This paper will

build on Rauh's (2005) suggestion that the funding status of a firm's pension plan is a

reasonable instrument for the size of internal resources that a firm holds.

Taking into account the endogenous variable problem turns out to be very

important and doing so makes it appears that managers will be either no more likely or

even less likely to enter a merger and acquisition if they have additional exogenous

resources. This paper will show that estimates from a traditional Tobit model without

instruments will support a pure agency theory of corporate finance, which predicts that

39

managers will be more likely to enter a merger or acquisition if they have resources at

hand. In particular, coefficients on cash levels and cash flows will have positive,

significant, and meaningful levels. However, when the pension funding instrument is

included in the analysis, coefficients on cash levels and cash flows be negative but are no

longer statistically significant. In both cases, the marginal effects are very small. This

evidence indicates that simply having cash on hand, on average, does not entice managers

to make an acquisition. Additionally, the marginal effects indicate that the scale of

merger and acquisition sensitivity is very small, further validating a theory of market

discipline. This paper will also look at how firms spend money to expand a company

internally by examining changes in capital expenditure due to variation in levels of cash

on hand. This paper presents evidence that an increase in cash on hand causes no

statistically significant change in the amount of spending on capital expenditure, adding

further evidence that markets impose discipline on managers.

This paper will proceed as follows. The first section presents a simple model of

managerial waste and restrain under the threat of takeover by a corporate raider in order

to develop the intuition for why market discipline would cause a manager to not spend

additional resources on mergers and acquisitions. This model is very similar to the model

developed by Zweibel (1996). The second section discusses the earlier mentioned

competing theories and their implications. The third section of this paper presents the

empirical specification used to test the three theories, describes the data used for the

analysis, and discusses how exogenous changes in cash can be identified. The fourth

section presents the results of a series of regressions and argues that the data supports a

story of managerial restraint. Finally, the paper concludes with a summary of the findings

and contributions and an idea of what future research into this topic might look like.

40

SECTION 1: THEORETICAL FRAMEWORK

This paper will begin by considering the implications of a very simple model of

market discipline. This model is based on the idea that actors in the market may find it

profitable to buy the firm and replace the manager if the wasteful choices made by a

manager make it profitable to do so. To prevent this from occurring, managers discipline

themselves. They issue debt and then return money to shareholders via dividends so that

taking on a large amount of wasteful projects will leave the firm in a position where they

do not have enough cash to service the debt. The firm will enter bankruptcy, where the

manager will be replaced. Since managers prefer to run the firm, the market knows that a

manager will behave (to some degree) and will not initiate a takeover. This approach is

used because one can view merger and acquisition activity (and possibly even some

capital expenditure) as managerial waste aimed at empire building. In particular, this

paper extends a simple model developed by Zwiebel (1996), which will not be discussed

in length because this paper presents the entire setup of the model and only considers the

effects of a small alteration. While Zwiebel's original model of market discipline gave the

manager a discrete choice about whether or not to take a poor project, the model

presented in this paper allows the manager to choose any sized wasteful projects

(including a project of size zero). While this change is minor, it allows for interesting

comparative statics that were not available before.

As was the case in Zwiebel's (1996) original contribution, the basic idea is that a

manager makes borrowing, dividend, and project initiation decisions each period for a

firm that has an existing set of projects as well as new opportunities. While the manager

has free reign over these decisions, subject to financial freedom restrictions, he/she must

account for an ever-present raider who will take over the firm if the value of the firm

under a new manager exceeds the value of a firm with the current manager by enough to

justify the cost of initiating a takeover. Furthermore, the cost of a takeover is lessened to

zero under bankruptcy. While the cost of a takeover almost certainly is not zero in

41

reality, the fact that it is easier to replace a manager during bankruptcy appears to be

consistent with what happens in actual takeovers. The specifics of the model follow.

TIMING

The model has P periods. In this paper, the main case to be considered is when P

= 3. Each period p ≤ P is identical and proceeds in the following order:

1. The period starts. A manager of type θ begins with some cash on hand (Lpt). The

manager makes a capital structure decision. The manager can accrue debt (Dp)in

a given period. In return for this debt, the manager receives the value of that debt,

which is added to cash on hand. The lending sector issues credit at the

competitive interest rate of zero.

2. Using cash on hand, the manager may choose to pay out a dividend (dt) if he/she

chooses. A dividend, if issued, must satisfy a non negativity restriction (firms

cannot charge shareholders a fee for holding company stock).

3. After making a dividend decision, the market for corporate control opens and

closes. Both the manager and the raider have perfect knowledge of the firm's cash

on hand and debt level. This implies that there is honest and perfect accounting.

All parties also know the manager's type, θ, which represents the probability that

a manager will be able to generate a good project in a period. Whether or not all

parties know what the dividend payment or the initial cash on hand was does not

matter in the analysis that will follow. If the value of the firm with a replacement

is sufficiently high relative to the value of the firm with the current management,

the raider will initiate a buyout and can choose to remove the manager and bring

in a replacement.

4. The manager learns if there is a good project or not.

42

5. The manager decides whether or not to take up a project (good or bad). Initiating

a project, whether it be good or bad, is costless. If a good one is available, he/she

can take it. If only poor projects are available, the manager picks the size of a bad

project rbp. The size of the bad project is limited by the manager's choice and by

institutional rules. This maximum size is denoted as b. The idea is that bad

projects are always readily available (one can simply waste money on perks), but

that bad projects can only reach a certain size before some outside force steps in

and does not allow any further waste. The magnitude of the maximum size of a

poor project is interpreted as the degree of fiscal or discretionary freedom. It is

assumed that this limit has been set prior to the manager's hiring and is not

renegotiable.

6. The projects yield returns and the manager services debt.

7. Bankruptcy proceedings begin if the manager defaults on a debt. Under

bankruptcy, a raider may initiate a takeover at a reduced cost (in this particular

model, that reduced cost is zero). The plausibility of this assumption will be

discussed in the next section. Therefore, managers would like to avoid bankruptcy

and a greater possibility of being fired.

The timing of the model illustrates how managers will act in the model. The

manager will act wastefully if given the chance. More importantly, the manager knows

that the market knows this as well and that a raider will buyout the company and replace

management if anticipated waste is sufficiently large. In order to avoid this outcome, a

manager must somehow credibly commitment to not undertaking wasteful projects or

commit to taking a small enough wasteful project such that the market will not be able to

remove her/him. It turns out that the lone commitment device permitted in this particular

model is debt. The next subsection will describe the in further detail how managers act.

43

It will also lay out any additional notation that will be used in the presentation of the

model.

MANAGERIAL CHOICES AND MANAGERIAL UTILITY

It is assumed that a manager either enjoys their work, the power associated with

the position, or some level of predetermined compensation. In other words, the manager

derives utility from employment. If he/she is employed in a given period, he/she gets

utility A > 0. One can think of this as the total utility generated from a base salary and all

other benefits regularly associated with running a company. A manager is characterized

by her/his type, which will be denoted as [ ]1,0∈θ . A manager's type is the probability

that a manager will have access to a good project in a given period, which has a payoff of

r ≥ 0. If the manager initiates a good project, the manager gets utility B ≥ 0. When a

good project is not available to the manager, he/she can also get utility from the size of a

bad project, if he or she chooses to initiate one. The size of a bad project will be denoted

as rbp and the return to the company of a bad project of size rbp is -rbp.

The size of a bad project is limited by the financial discretion given to managers.

This freedom may come from a board of directors, may be a consequence of the firm's

industry, or the original charter. Either way, the amount of financial freedom limits the

size of a bad project. This is represented by the expression rbp ≤ b, where b is bounded

above zero (all managers have some discretion). It is assumed that managers find greater

enjoyment in larger pet projects or empire building efforts. Because of this assumption,

the model requires that the manager's utility satisfy the following monotonicity condition:

U'(rbp) > 0. I have not imposed any conditions on the second derivative at this time and

doing so would add nothing.

It is also assumed that B > u(b). The idea is that good projects are always more

desirable than bad projects. One could assume that good projects bring better perks,

enhances one's reputation, and/or provide a greater sense of satisfaction. One could also

44

assume that taking a bad project when a good project is available cases sufficient damage

to one's reputation to always make it undesirable. In addition, a manager should not be

irreparably harmed by doing nothing, particularly when the opportunity to undermine the

shareholder is always available. Because of this, U(0) = 0. Also, the manager's outside

opportunity is set at 0. Also, managers are unable to take both a good project and a pet

project in the same period. The argument is that a manager has a limited amount of time

to manage projects and can only look over one project in a period.

The paper also assumes that, when indifferent, managers would prefer less debt to

more debt. Zwiebel (1996) does not make this specification and is still able to

demonstrate the restraining powers of debt. However, by not taking a stand on how

managers feel about debt, Zwiebel loses the ability to make precise claims about debt and

dividend levels. Specifying an indifference condition will allow one to find precise

levels of debt and the dividend payments in all periods, which will be useful in testing.

CORPORATE RAIDERS

There exist one or more raiders who will buyout the firm and possibly change

management if the value of the firm can be increased by more than e, the level of

entrenchment, by such a maneuver. The variable e represents the legal and organizational

costs to mounting a takeover bid or the cost of buying out a manager due to a poison pill

or golden parachute provision in the manager's contract. If a raider purchases the firm,

he/she can put in place a replacement manager that can maintain the original technology,

but, for some reason, is unable to initiate new projects. This assumption may be realistic

for several reasons. First of all, this is analogous to putting in place a manager of type θ

= 1/2, which is borrowed from the Zwiebel setup (1996). If this reason is unsatisfying,

one could simply plug in an alternative default type into the model. The second reason

why this assumption may be acceptable is because it is also consistent with a new

manager being given a contract that limits her/his power to control finances and places

more of that responsibility into the hands of a board or the raider.

45

The raider can also make a takeover bid if the firm goes bankrupt. Under

bankruptcy, the raider can initiate a takeover at a cost e', where e > e' ≥ 0. As should

become clear in the solution section of this paper, the specific value of e' is not important.

The key assumption is that e > e'. In light of this, the paper will simply assume that e' =

0. As was mentioned previously, it appears that the cost of replacing a manager does

seem to fall in reality. Because a raider has the ability to remove a manager, the raider

acts as the discipliner in this model and prevents the manager from wasting money

without impunity.

OTHER NOTATION

Because everything is observable, the market will be able to anticipate managerial

actions correctly. In light of this, it is important to represent the sequence of all future

capital structure decisions. In this model, the sequence of all future capital structure

decisions will be denoted as:

tp DD ≥≡ ττ }{

Likewise, I will need to keep track of the value of the firm under current

management and under a potential replacement as well. The model will denote

( )ppp DLv ,,θ as the value of the firm after the market for control under a given manager

of type θ. Similarly, the value of a firm with a replacement will be denoted as

( )ppp DLv , . Because a raider is interested in the potential gains from buying out a firm

and replacing the manager, I shall denote the gains to replacement in a given period as

( )ppp

ppp

ppp DLvDLvDLV ,),,(),,( −= θθ . All notation needed for the analysis has

now been presented.

46

SOLVING THE MODEL

Finding the subgame perfect Nash Equilibrium of the model is not difficult. The

solution can be summarized in the following proposition:

Proposition 5: The unique subgame perfect Nash Equilibrium when liquidity is not

a constraint (when y > b) is:

1. All managers of type θθ < will issue no debt or dividend during any time

period. If such a manager is around during any market for corporate

control, he/she is replaced regardless of the capital structure. If they were to

survive the market for corporate control, they would take any project, good

or bad, and would set rbp = b.

2. Managers of type [ ]2,θθθ ∈ take on debt D1 = y - rb1 and pay out dividend d1

= L1 + y - rb1 at p = 1, take on debt D2 = y - rb2 and issue dividend d2 = y +L2 +

b -θ

θ−+

12 er at p = 2, and issue no debt or dividend at p = 3. All managers will

take a project at every period and will take good ones if available. If bad

ones are the only projects available at any given time period, they will set

θθ−

=11

rrb , θ

θθ−

−−+=

1)1(2

2brerb , and rb3 = b. In equilibrium, all of these

managers are retained at all time periods and never bankrupt the company.

Hence, their debt is valued at w(Dp) = Dp because of the no profit condition

for lenders.

3. Managers of type [ ]12 ,θθθ ∈ borrow θ

θ−

−=11

ryD and pay dividends equal

to θ

θ−

−+=111

ryLd at time p = 1. At times p = 2 and p = 3, they set Dp = 0

and dp = 0. These managers will take a project every period. If a bad project

47

is the only one available at p = 1, the manager will set θ

θθ−

+−+=

1223

1ebbrrb .

If bad projects are available in times p = 2 and p = 3, they will set rbp = b. In

equilibrium all managers of these types are retained and never bankrupt the

firm. Hence, their debt is valued at w(Dp) = Dp because of the no profit

condition for lenders.

4. All managers of type 1θθ > will not borrow or issue a dividend in any

period. They will also take a project, either good or bad in any period. If

they take a bad project at any p, they will set rbp = b.

5. In the off equilibrium path case of bankruptcy, a manager will be replaced if

brb+

<θ .

6. The value of a manager of type θ relative to a replacement is given by:

12 )1()1()1(3),,( bbp

pp rrbrDLV θθθθθ −−−−−−=

As was true in Zwiebel's model (1996), debt can, to a degree, successfully

handcuff a manager and prevent her/him from wasting a firm's resources. Management

cannot improve their outcome by issuing debt due at a future date. What really matters in

this model is when the debt is due. So, there is no loss in issuing all equilibrium debt at

time one. This implies that time one and time two debt can be interpreted as short-term

and long term debt. Adding a continuous choice over bad projects, however, allows one

to see exactly how this debt is arranged, which was not possible in previous

contributions.

48

WHEN P ≠ 3

It is interesting to note a major difference between this model and the model

proposed by Zwiebel (1996). In Zwiebel's model, one finds that sometimes a manager

can pick a bad project in period one, not pick one in period two, and then pick a bad one

at period three. In a sense, the manager's choices alternate over time. This occurs because

of the binary choice involving a bad project in his model. In Zwiebel's model, a manager,

provided he chooses to select a poor project, has to set rbp = b. This leads to a slightly

complicated formula for when a manager of a given type will have to pay dividends if the

formula is generalized to p = N periods long. By allowing a manager to arbitrarily

choose the size of bad projects, one gets a much simpler equation for when a manager

must borrow. To get this expression, simply look at the condition that must hold if a

manager is to be able to set rbp =b at time p = N – n + 1:

e + nθr - n(1-θ)b ≥ 0

Solving for n yields:

bbren−+

−≥

)(θ

which yields the following proposition:

Proposition 6: Along the equilibrium path of the N period model, a manager of type

θ will not borrow or pay dividends and will set rbp = b for all periods p ≥ N – n + 1

where n is the solution to:

⎥⎦

⎤⎢⎣

⎡−+

−=

bbren)(

intθ

49

Where the int(x) is simply the largest integer smaller than x. In period p = N - n, the

manager sets θ

θθ−

+−−−=

1)1)(1( ebnrnrbp . For all p < N – n, the manager sets

θθ−

=1

rrbp .

THE KEY IMPLICATIONS OF THE MODEL

This study will look at mergers and acquisitions as, on average, a value

decreasing endeavor, making it a wasteful project initiated by an entrenched manager.

The model allows that some merger and acquisition activity is value increasing (i.e. a

positive net present value project), but relies on the assumption that some part of this

spending is wasteful. The paper even considers the possibility that, on the margin, capital

expenditure might be wasteful spending. In light of this, the paper is particularly

interested in the results regarding the size of wasteful projects and how the size relates to

the amount of financial assets held by a firm in a given time period. Proposition 1 lays

out the key results that this paper will look for when examining the data. In particular, the

model predicts that the size of a wasteful project is never a function of the amount of cash

that a firm holds. So, when modeling the size of a wasteful project, one should expect

that exogenous changes in cash holding should have no effect on the size of a merger or

acquisitions, if the simple model setup is an accurate description of reality.

However, the model involves perfect information and does not allow for

unexpected or truly exogenous changes in liquidity. However, it makes sense that

shareholders could react in one of two ways to a manager holding more cash than

anticipated after a given time period (something that never happens in the model).

Shareholders could be happy that the firm has more assets, but would still expect the

manager to not make decisions that would make her/his replacement optimal. In such a

scenario, one would still expect the size of a poor project to be unaltered by exogenous or

unexpected changes in the cash holdings of a firm. Alternatively, shareholders could be

50

weary of a manager who ends up having more assets at her/his disposal than anticipated.

In the model, weariness can only be expressed in one variable: the level of entrenchment.

If shareholders are truly worried about this excess amount of cash holdings, which would

have been disgorged in a world with no uncertainty, then one might believe that

entrenchment would increase when cash in unexpectedly high. In this case, on may

anticipate that having additional exogenous cash might lead to less acquisition activity

and capital expenditure.

The results also make clear predictions about how governance should influence a

firm's merger and acquisition activities. Proposition 6 also shows that managers that are

deeply entrenched (have high e) are allowed to initiate more wasteful projects. There is

no clear measure of entrenchment available in reality, but one might believe that better or

more strictly governed firms have lower entrenchment levels. If this is the case, one

would expect empirical models to find that better measures of governance are correlated

with lower levels of spending on mergers and acquisitions. These two predictions (that

higher levels of exogenous cash leads to either no change or a reduction in acquisitions

spending and that better governed firms spend less money on acquisitions) will be tested

later in this paper when the empirical model is specified and fit to the data. In addition,

the paper will test the model's predictions of how cash on hand should influence debt, and

dividend decisions. However, this paper focuses primarily on the model's predictions for

merger and acquisitions behavior.

SECTION 2: COMPETING THEORIES AND THEIR IMPLICATIONS

The two other models to be considered are well documented and their findings are

pretty intuitive. Those two two models are the agency theory model (as best explained in

by Jensen and Meckling (1976), Grossman and Hart (1982), Stulz (1990), and Hart and

Moore (1995)) and a more benign theory that managers use internal cash stock to make

value maximizing decisions to avoid asymmetric information costs (as discussed in

51

Myers and Majluf (1984) and Greenwald, Stiglitz, and Weiss (1984)). The previous

section of the paper discussed how two key empirical variables, cash and assets on hand

and governance, should be correlated with merger and acquisition spending in a model

where the takeover market can restrain managers. The remainder of this section will

briefly discuss these two models and their implications in terms of what predictions they

make for how cash and assets on hand and governance should be correlated with merger

and acquisition spending.

PREDICTIONS OF AN ASYMMETRIC INFORMATION MODEL WITH VALUE MAXIMIZING

MANAGERS

The first model to be considered is a model where managers make value

maximizing decisions with a firm's financial resources. One may be sceptical of this

view based on the event study literature citing the loss of value experienced by

shareholders of acquiring firms in mergers and acquisitions. If a manager is maximizing

a firm's value using cash on hand to create value for her/his shareholders, the manager

will spend additional dollars on a merger and acquisition activities until the marginal

benefit of such activities is equal to the marginal cost of using internal finances (which is

assumed to be lower than the market cost of borrowing), if those finances are available.

If not, then one would expect the manager to invest all available assets in those projects

that best maximize the firms value. If this model were an accurate description of reality,

then one would expect governance to have no effect on a manager's choices. The

manager would make value maximizing decisions, so the entrenchment constraint would

never bind.

Also, one would expect that an exogenous change in the level of available

financial assets would have one of two possible effects. If the firm has already invested

in all projects where the marginal benefit of such activities is equal to the marginal cost

of using internal finances, then having additional financial assets will not change the

manager's choice of how much to spend on mergers and acquisitions. The optional

52

decision has already been made and any further financial flexibility does not change that

fact. However, it is possible that prior to the discovery of exogenous cash, a firm may

have been constrained by the firm's level of financial resources and did not initiate all

projects where the marginal benefit of such activities is equal to the marginal cost of

using internal finances. If this were the case, additional cash would either remove the

constraint on a manager's decision or it would at least reduce the constraint and allow

further investment in other firms. If this were the case, one would expect a manager's

spending on mergers and acquisitions to be increasing in the level of cash available.

PREDICTIONS OF AN AGENCY THEORY MODEL

The agency theory of corporate finance has quite different predictions about these

two key variables. Suppose that a manager's incentives are not aligned with those of

her/his shareholders. In particular, it seems reasonable to assume that a manager may

enjoy power and value the size of a company more so than shareholders, who care more

about the value of their shares. If this were the case, managers, if unconstrained by a

market, would be expected to spend more money in mergers and acquisitions than their

shareholders would prefer. If left unconstrained, they would decide how much money to

spend on mergers and acquisitions today relative to opportunities in the future. If the

amount of cash on hand changed unexpectedly, then one would think that a manager

would be able to spend more money on such activities in the both the current period and

in future periods. For this reason, one would expect that merger and acquisition spending

would be weakly (taking into account the possibility that all money may be saved for

future merger activity) increasing with exogenous changes in the amount of cash that a

firm has on hand.

It is a bit more difficult to figure out how governance should be correlated with

merger and acquisition spending. If a manager is in complete control of her/his firm,

then he/she will not be hindered by governance provisions. The manager will simply

make choices to maximize her/his utility subject to other constraints placed on the

53

manager by the firm (i.e. their financial assets) or from the outside (minimum returns

standards). If this were the case, one would expect governance to be uncorrelated with

merger and acquisition spending. However, it seems feasible/reasonable that firms with

stronger governance either make it more difficult for managers to enter into mergers and

acquisitions or have some sort of restraint built into their charters. If this were the case,

one would expect to see that managers who controlled firms with better governance

provisions would be less likely to make mergers and acquisitions and would spend less of

a firm's cash on hand in those deals.

SECTION 3: THE EMPIRICAL SPECIFICATION, DATA, AND

IDENTIFICATION

This section outlines the methodology used in the paper. First, this section

outlines the empirical specification used to investigate the hypothesis that markets

effectively constrain managers and limit the level of wasteful spending that they

undertake. In particular, this section argues that a Tobit model of cash acquisitions is a

more appropriate tool than either a probit/logit model or simple OLS. Next, this section

discusses the data sources used in the analysis, the construction of key variables, and

some simple facts about variables involved. Finally, the section argues that data

regarding a firm's pension funding status can be used to identify exogenous changes in a

firm's level of cash on hand.

THE EMPIRICAL SPECIFICATION

The paper assumes that a manager decides whether or not to enter the merger

market in each period based upon the characteristics of their firm. The amount that the

firm wants to spend or is willing to spend will be the variable yti. This may lead one to

believe that a simple OLS model with the level of cash spending on acquisitions and

mergers as the dependent variable would be appropriate. However, the observations are

censored. One can only observe the amount of money that a manager is willing to spend

54

in a merger or acquisition if the manager actually makes such an offer. I will assume that

yti = β0 + β1*Cti + β2*Gti+ β*Xti + μti where Cti is firm i's amount of cash on hand at

time t, Gti is that firm's measure of governance, Xti are other variables useful for

describing a firm's merger and acquisition spending and mti are normally distributed error

terms. In this particular paper, the vector Xti includes several variables that are often

included in other similar papers. These variables include cash flows, a dummy variable

that indicates whether Tobin's Q is less than one, and a measure of the size of the firm.

The manager makes a tender offer if yti > 0. In this case, we observe the value of

the tender offer yti. If he or she does not make a tender offer, we assume that yti < 0 and

we do not observe yt1. This is the classic Tobit specification, which has been traditional

used to estimate the determinants of hours worked and investment in other economic

settings. An additional benefit of this specification is that it allows for a clear estimate of

the proportion a firms' cash on hand that will be invested (or diverted, depending on one's

view) in mergers and acquisitions. This cannot be achieved by a simple probit or logit

model, which only allows one to calculate marginal probabilities. The Tobit is also more

efficient than the other two models because it fully utilized the data available while a

probit or logit model would throw away data related to the size of the acquisition.

However, the study will include probit and logit results as a point of comparison with

existing studies.

In addition to examining merger and acquisition activity, this paper will also test

whether of not the amount of internal investment is sensitive to exogenous changes in a

firm's cash holdings. A firm can grow in one of two ways. Mergers and acquisitions

allow a firm to expand by adding some of the size (if not all of it) of another firm to its

own. Capital expenditure allows a firm to grow by expanding the size of its own

holdings. Since nearly all firms make some capital expenditure decision, a simple OLS

model should be appropriate for the analysis and will be used in this study. Since the

model presented in the first section makes predictions about debt and dividend levels as

55

well, this paper will also test those predictions. Since all firms have some level of debt,

the paper will use a simple OLS specification to investigate the usefulness of a market

discipline model in explaining changes in debt. Since dividend decisions are censored,

this paper will use a Tobit model to investigate how dividend decisions change when key

variables change.

THE DATA

The data for this paper comes from three common sources: the Investor

Responsibility Research Center (IRRC) database, the Compustat database, and the

Securities Data Corporation (SDC). This section of the paper will describe the sources,

discuss which data came from which sources, and discuss how the variables in the

analysis were constructed. Two distinct data sets were formed using these data sets. The

main data results come from a data set that includes data that is common across all three

data sources. This data set includes 12004 firm year observations. The main results are

re-enforced by looking at a data set that does not require that a firm year include data

from the IRRC governance data set. This data set includes 43523 observations.

The Investor Responsibility Research Center database provides the backbone of

the data set being used because it is the most limited (i.e. covers the fewest firms). The

IRRC database tracks whether or not firms have given governance provisions in their

charters in a given year. The data set ranges from 1995 to 2005. The individual

provisions tracked in the IRRS database are well described in Gompers, Ishii, and Metric

(2002). In this particular study, two variables are used to help measure the effect

governance has on cash acquisition decisions: the total governance measure (labeled

gindex in tables) and the Delaware incorporation dummy, which prior literature suggests

is important. Also, it is important to note that the GIM index adds a point to one's

measure for every provision in the charter that harms shareholders. It also adds a point to

one's measure if the firm does not have a provision in its charter that helps shareholders.

Hence, larger governance values are supposed to proxy for worse governance. This data

56

set has one important peculiarity. The IRRC is only updated every two or three years, so

there are many years where there is no year specific governance data available. To

follow convention, the paper uses previous year governance data for observations without

current year governance data.

The Compustat database provides many of the key independent variables needed

in the analysis. In particular, Compustat is used to collect data regarding firm size,

investment, cash holdings, cash flows, debt, Tobin's Q, and dividends. Much of the

following discussion borrows liberally from Malmendier and Tate (2003). To follow

convention, I measure firm size as the level of assets (item 6) at the beginning of the year,

investment as capital expenditures (item 128), and cash flow as earnings before

extraordinary items (item 18) plus depreciation (item 14). Sales (item 12), the liquidating

value of stock (item 10), and property, plant, and equipment (item 7) are also used in

robustness checks as other proxies for the size of the firm. Cash is measured by the

variable cash and short term investments (item 1). Dividends are measured as the sum of

common dividends (item 21)and preferred dividends (item 19). The debt measurement is

given by long term debt (item 9). The amount of money spent reacquiring company

stock is measured through the variable purchase of common and preferred stock (item

115).

The paper measures Tobin's Q as the ratio of market value of assets to book value

of assets. The market value of assets is defined as total assets plus market equity minus

book equity. Market equity is defined as common shares outstanding (item 25) times

fiscal year closing price (item 199). Book equity is calculated as stockholders' equity

(item 216) minus preferred stock liquidating value (item 10) [or the first available of

redemption value (item 56) or par value (item 130)] plus balance sheet deferred taxes and

investment tax credit (item 35) when available minus post retirement assets (item 330)

when available. Book value of assets is total assets. Lang, Stultz, and Walkling (1991)

warn about the use of Tobin's Q itself as a measure of a firm's opportunity set in these

57

sorts of studies. This makes sense because Tobin’s Q is a measure of an average value

rather than its marginal value, not to mention that Q itself is rather difficult to measure.

However, they do not argue for finding another measure of marginal opportunities.

Instead, this paper will classify firms where Tobin's Q is less than one as low growth

firms and include a low growth dummy variable rather than Tobin's Q itself, as is done in

Lang Stultz, and Walkling (1991). Measures of the key dependent variable, the total

level of cash spent in merger and acquisition activities, comes from the Securities Data

Corporation (SDC) database. The database gives a list of all deals, completed or not

completed, that take place in a given year. The database also includes the total value of

each deal, the percentage of the deal that was completed using cash, the consulting costs

of each merger or acquisition, and the percentage of the target that was purchased. The

tender offer and general mergers and acquisitions data in the Securities Data

Corporation's database does not limit the size of the tender offer (the smallest percentage

of cash used in a deal in the full mergers in acquisition data set is .67 percent while that

largest is 100 percent) or the percentage of the firm sought (this varies similarly). One

also observes that some firms make multiple acquisitions of various size in a given year.

The total measure of the firm's use of cash in mergers in acquisitions is simply the sum of

the total reported value of cash used in each completed deal added to the total consulting

costs used to complete these deals.

Rather than use individual firm fixed effects, this paper will use pre-sample

merger and acquisition data to account for unobserved heterogeneity between firms. This

methodology was suggested in Blundell, Griffith, and Van Reenen (1999) and has been

used in subsequent studies (Bloom, Schankermab, and Van Reenen). The idea is that

some firms may have natural propensities to acquire other firms or businesses. The pre-

sample merger and acquisition should measure this and correct for such unobserved

endogeneity in a manner similar to firm level fixed effects. I’ve collected SDC merger

and acquisition data from 1981 onward. Because companies begin reporting pension

58

information in 1993, the pre-sample period ranges from 1981 to 1992. I sum the total

amount of merger and acquisition cash spending during these years and denote that as my

pre-sample merger and acquisition value.

IDENTIFICATION

One potential problem with this study and many other similar studies is that the

level of cash held by a manager is an endogenous variable. The endogeneity of cash has

been well documented in the literature. Recent work by Rauh (2006) suggests that

information regarding pension funding (whether or not a fund is over or under funded)

represents an exogenous change in cash levels because changes in interest rates or the

value of a firm's portfolio (which occur outside the firm's ability to choose) cause a firm's

pension to be either over or under funded and could either free up or take away cash from

a firm. Rauh claims that the government's pension contribution requirements (when a

fund is underfunded) is a complex, non-linear function of the gap between the expected

value of pension assets when they are needed and expected pension obligations, making

the pension funding gap a useable instrument.

Compustat has a great deal of information about pension funding status, but firm

level data has been aggregated when, in reality, firms can have many defined benefit

pension funds. Rauh argues that one needs to use the actual IRS funding statements for

each individual company to determine the true level of over/underfunding of a pension

because firms may have both over and underfunded pensions at a particular point in time.

The problem with this approach, as it applies to this data, is that the IRS has only released

the appropriate forms for years up to 1998. Hence, there is not enough data available to

get reasonable results given that the data set is already restricted by requiring that all

observations be included in both Compustat and the IRRC databases. However, this does

not change the fact that an aggregate pension gap should still be exogenous and

correlated with a firm's cash on hand in a given period. In light of this, the paper will use

an aggregate measure of the pension gap to instrument for a firm's cash holdings. This

59

gap will be defined as projected pension plan obligations (item 286) minus pension plan

assets (item 287). Firms begin to report this information on their SEC 10-K filings in

1993, which establishes the study period for this dissertation. This completes the

description of all data used in the paper.

For the most part, the sample includes large companies that control a great deal of

financial assets. Hence, the analysis that follows may not be applicable to all firms.

However, the data comes from common sources and should be comparable to previous

work on similar questions (namely Malmendier and Tate (2005)). Summary statistics for

the two data sets described are provided in the appendix in Tables 12 & 13.

SECTION 4: TESTING

As discussed in sections one and two, the following analysis hopes to shed light

on whether or not the market for corporate control effectively disciplines a manager and

prevents her/him from using exogenous financial resources in potentially wasteful merger

and acquisition spending or in excessive internal expansion of the firm via capital

expenditure. If this were the case, then having extra cash would not push firms into the

acquisition market. Also, firms with stronger governance provisions would be less active

in these markets. This section will first look at regression models of cash spending on

mergers and acquisitions and capital expenditure to test the main hypothesis of this paper.

Evidence will suggest that the amount of money used in merger and acquisition activity

will either not change when there are exogenous sources of cash on hand or it will

actually decrease. Similarly, capital expenditure will also either not be sensitive or

decrease when there are exogenous changes to the firm's level of cash on hand.

The simple model presented in section one makes other predictions about how a

manager should react to having additional cash on hand. In particular, this section will

also look at how a firm accumulates debt and disgorges cash when there are unexpectedly

high levels of cash on hand. This is of particular interest because acquisition spending

60

and capital expenditure evidence will suggest that market forces do discipline managers.

This section will look to see if firms assume greater levels of debt when they have

exogenously high levels of cash. It will also check to see if firms disgorge this cash via a

dividend. The section will finish by looking at simple probit models of cash acquisitions.

These regressions will show that including an instrument for cash holdings causes the

results found in prior literature to change significantly.

MODELS OF ACQUISITION SPENDING AND CAPITAL EXPENDITURE

As discussed in the previous section, this paper will use a Tobit specification to model the

level of cash spending on mergers and acquisitions. As a point of comparison, the paper

will first fit a standard Tobit model to demonstrate what happens when one does not use

an instrument for cash on hand. Next, the paper fits a Tobit model with instrumental

variables under the assumption of joint normality of the error terms. The dependent

variables in the first set of regressions are a dummy variable indicating whether or not the

firm is incorporated in Delaware, the GIM governance index measure (which assigns

higher values to firms with worse governance), the level of a firm's cash flows in the

given year. The lagged value of cash on hand, a lagged indicator variable stating whether

or not a firm has a Tobin's Q that is less than one, and the lagged level of assets that a

firm holds. Lagged levels are used because they indicate the levels of these variables at

the beginning of a fiscal year. In particular, Tobin's Q, assets, and the level of cash on

hand will change based on any merger and acquisition decision made in a given time

period. In the second set of regressions, the lagged level of a firm's assets are replaced

with a measure of lagged property, plant, and equipment as a measure of firm size. All

results include annual fixed effects. Tobit Models are presented in Table 1 and IV Tobit

models are presented in Table 2. Further robustness checks using the liquidating value of

stock and sales as proxies for the size of the firm are reported in the Appendix in Table

14 and Table 15.

61

Table 1: Tobit Models of Acquisition Spending

Variable Tobit Model 1

Tobit Model 2

Tobit Model 3

Tobit Model 4 (s.e.)

Cash .0098* .0102* .0306* .0306* (lagged 1 period) (.0025) (.00253) (.00428) (.00428)

Cashflow .248* .252* .243* .246* (.0108) (.0109) (.0112) (.0114)

High Tobin Q 842.99* 834.46* 930.94* 925.91* (lagged 1 period) (70.29) (70.31) (72.84) (72.91)

Log(Assets) 206.18* 199.65* - - (size, lagged 1) (14.17) (14.35) - -

Log(PPE) - - 165.52* 161.29* (size, lagged 1) - - (13.31) (13.64)

Delaware -1.645 12.99 576.50 588.06 Incorporation (299.74) (299.32) (352.46) (352.23)

IRRC Governance - 20.41* - 11.10

Index - (7.34) - (7.769)

Constant -3154.79* -

3293.048* -2786.24* -2886.82* Term (148.45) (154.93) (140.94) (148.55)

Time FE Yes Yes Yes Yes Sigma 1829.35 1828.75 1831.73 1831.66

Log Likelihood -48260.90 -48257.03 -

44776.025 -

44775.004 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance.

62

Table 2: IV Tobit Models of Acquisition Spending

Variable IV Tobit Model 1

IV Tobit Model 2

IV Tobit Model 3

IV Tobit Model 4 (s.e.)

Cash -.013 -.011 .0118 .0123 (lagged 1 period) (.0061) (.0061) (.0085) (.0085)

Cashflow .239* .239* .202* .204* (.015) (.015) (.0140) (.0140)

High Tobin Q 855.54* 847.66* 925.75* 919.88* (lagged 1 period) (70.41) (70.43) (72.81) (72.87)

Log(Assets) 212.17* 205.01* - - (size, lagged 1) (15.05) (15.34) - -

Log(PPE) - - 149.54* 144.40* (size, lagged 1) - - (13.37) (13.70)

Delaware -186.44 -171.74 340.3 353.53 Incorporation (303.31) (302.80) (354.57) (354.24)

IRRC Governance - 17.64* - 13.22

Index - (7.40) - (7.76) Pre-Sample .139* .141* .170* .171*

M&A Spending (.0178) (.0178) (.0173) (.0173) Constant -3251.77* -3353.58* -2723.05* -2808.35*

Term (151.10) (159.29) (140.67) (149.46) Time FE Yes Yes Yes Yes Sigma 1819.33 1819.03 1823.9 1823.8

Log Likelihood -

169489.34 -

169486.48 -

151890.34 -

151885.77 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance. Pre-Sample Cash is also used in the first stage model of Cash. A representative first stage model of cash is presented in the Appendix in Table 16.

Again, when looking at the result for the governance index, it is important to

remember that larger measures of the GIM governance index are associated with worse

governance. This leads one to believe that firms with greater measures of GIM have

more entrenched management (many of these provisions, such as golden parachute

63

provisions, make it very costly to replace managers). Results for governance are mixed.

While the coefficient is always positive, results are statistically significant in results with

assets as a measure of size, but not when property, plant, and equipment is used (this is

similarly observed when other measures of size are used). The results indicate that

making management more powerful (or further entrenched) allows them to be more

active in the market for merger or acquisition properties (with varying degrees of

confidence in the result). These results seem to exclude the possibility that managers are

making value maximizing decisions on behalf of their shareholders, because governance

should not affect the manager's acquisition decisions if he/she is making value

maximizing decisions (the marginal costs and values of new projects should be the only

forces governing a manager's decisions in this case).

The results that use assets as a measure of firm size illustrates the difference

between this analysis and Harford's (1999) results. Harford found that cash on hand was

positively correlated with merger and acquisition behavior.3 The results in the first two

columns are similar to typically reported findings, which seem to indicate that a pure

agency theory of corporate finance explains managerial acquisitions behavior. However,

one sees that instrumenting leads to vastly different results and implications. Once cash

on hand is identified, one sees that cash on hand has either no effect on merger activity

(since the coefficient is not statistically significant) or that it causes such activities to

decrease (the magnitude of the coefficient is much larger in the regression with an IV).

This result is duplicated in additional robustness checks reported in Tables 14 and 15 and

both regressions with property, plant, and equipment as a measure of size seem to

indicate that additional cash on hand does not lead a firm to undertake additional merger

projects (regressions with sales as a measure of size do not behave similarly to others, but

have the property that cash is not viewed as a significant regressor). It does not matter if

3 Malmendier and Tate (2004) report similar results, although their focus is on managerial overconfidence,

not cash holdings.

64

one believes that spending either does not change or decreases when cash levels are

exogenously high because both results, as argued earlier, are consistent with a market

discipline story of corporate governance. If one believes that merger and acquisition

spending, on average, is harmful to shareholders, as the previous event study literature

suggests, then these results, combined with the previously discussed governance results,

suggest that the market for corporate control is disciplining managers. These results are

reaffirmed with a larger sample that excludes governance variables (as reported in table

17).

As alluded to earlier, the Tobit model has the pleasant feature (relative to probit

and logit models) that it allows one to find a true marginal effect rather than a marginal

probability. In particular, using a Tobit model allows one to estimate what proportion of

an additional dollar of exogenous cash will be spent on a merger or acquisition. Table 3

reports these calculations of average marginal effects and marginal effects evaluated at

the average for the models that exclude and include instrumental variables.

Table 3: Average Marginal Effect of Cash on Acquisition Spending

Model Average

Marginal Effect Marginal Effect at the Average

Tobit Model 0.0022 0.0019

IV Tobit Model -0.0031 -0.0042

When instruments are not included in the analysis (as is typical in the prior literature),

one sees that increasing exogenous cash on hand by one dollar increases merger and

acquisition spending by roughly two tenths of a cent while including instruments leads to

results that predict that the same increase in cash on hand would lead to a three tenths of a

cent decrease. These small numbers, multiplied out over all companies and all increases

in cash lead to large amounts of money being spent on mergers in acquisitions, which has

65

motivated a great deal of the merger and acquisitions literature. However, in either case,

the effects are very small (if not negligible) for an individual firm at the margin. This

suggests that managers don't view additional resources, under any scenario, as a reason to

be more active in expanding the size of the firm through the acquisition of other

businesses. If mergers and acquisitions are value decreasing, in general, it cannot be

because managers are destroying firm value by wasting internal resources. The loss in

internal resources relative to the decline in abnormal returns does not match up.

The paper next looks at models of capital expenditure to see if this spending is

altered by exogenous changes in the level of cash on hand. As described earlier, almost

all firms in the sample make some capital expenditure decision and some firms even

choose to decrease their levels of capital. In light of this, the analysis will use a simple

OLS model with capital expenditure as the dependent variable. The same independent

variables that were used in the analysis of merger and acquisitions spending are used in

this analysis. The results of these regressions are found in Tables 4 and 5. As was the

case with the merger and acquisitions results, further robustness checks were conducted

with sales that the liquidating value of stock as proxies for firm size. The results of these

robustness checks are found in Tables 18 and 19.

66

Table 4: OLS Models of Capital Expenditure

Variable OLS Model 1

OLS Model 2

OLS Model 3

OLS Model 4 (s.e.)

Cash -.0397* -.0340* -.0106* -.0106* (lagged 1 period) (.0011) (.0011) (.0018) (.0018)

Cashflow .524* .522* .515* .511* (.0047) (.0047) (.0047) (.0047)

High Tobin Q -239.30* -236.01* -198.10* -191.20* (lagged 1 period) (23.26) (24.26) (23.37) (23.35)

Log(Assets) 38.12* 41.46* - - (size, lagged 1) (5.270) (5.350) - -

Log(PPE) - - 77.14* 84.45* (size, lagged 1) - - (4.796) (4.914)

Delaware -77.87 -81.97 -89.27 -100.79 Incorporation (114.16) (114.11) (139.84) (139.59)

IRRC Governance - -10.09* - -18.77*

Index - (2.76) - (2.85) Constant 2.266 68.886 -243.09 -120.99*

Term (52.06) (55.13) (47.93) (51.29) Time FE Yes Yes Yes Yes

R2 0.5891 0.5896 0.6319 0.6334 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance.

67

Table 5: IV Models of Capital Expenditure

Variable IV Model 1

IV Model 2

IV Model 3

IV Model 4 (s.e.)

Cash -.0801* -.0817* -.0199* -.0205* (lagged 1 period) (.0025) (.0025) (.0034) (.0035)

Cashflow .583* .582* .523* .519* (.0059) (.0059) (.0053) (.0053)

High Tobin Q -228.03* -222.53* -198.75* -191.90* (lagged 1 period) (24.51) (24.60) (23.39) (23.38)

Log(Assets) 66.93* 73.06* - - (size, lagged 1) (5.774) (5.901) - -

Log(PPE) - - 77.12* 84.43* (size, lagged 1) - - (4.802) (4.920)

Delaware -147.03 -155.59 -94.11 -105.93 Incorporation (120.32) (120.67) (140.01) (139.78)

IRRC Governance - -15.78* - -18.77*

Index - (2.93) - (2.85) Constant -218.89* -122.87 -241.85* -119.71

Term (57.11) (59.98) (47.99) (51.36) Time FE Yes Yes Yes Yes

R2 0.5441 0.5416 0.6311 0.6324 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance.

The regression results for the governance index measure effect on capital

expenditure are much different than the acquisition spending results. Six of the eight

regressions (including the four robustness check regressions) report significant measures

of the effect and many of the coefficients on these variables have a negative sign, which

means that firms with worse governance invest less in the firm. The Delaware

Incorporation dummy also has a negative sign, suggesting that managers protected by

governance measures do not build empires internally. The cash on hand results for

68

capital expenditure, however, seem to be very similar to those found in the acquisition

spending regressions. Having higher levels of exogenous cash on hand seems to be

correlated with a modest decrease in capital expenditure (the coefficients, while

significant, are small). Having additional resource at hand does not appear to make a

manager more likely to expand her/his empire internally. As a whole, this is a mixed

result for the market discipline story given that we do not observe empire building when

there are additional resources, but we also do not observe empire building when

governance is weak.

MODELS OF DEBT AND DIVIDENDS

The cash acquisition size and capital expenditure results indicate that managers

are unlikely to use exogenous, random increases in cash holdings to expand the resources

under their control. The above results indicate that having additional resources may even

make a firm less likely to enter into a merger or acquisition or to expand the firm through

capital accumulation. These findings offer support to a theory that a manager can be

disciplined by the threat of takeover or replacement. This part of the paper will

investigate two more issues: first, is there further evidence for a theory of market

discipline and second, if firms are not spending exogenous increases money on firm

expansion, what are they doing with it? In particular, this part of the paper will look at

how debt levels, dividend issues, and cash levels vary with exogenous changes in cash.

First, the paper looks at dividend data for the firms in the sample. Since one can

observe the level of dividend issue and because one might believe that whether or not to

issue a dividend is a discrete choice, the paper will use a Tobit model with and without

instrumental variables to model dividend issue. As was the case with the acquisition cost

and capital expenditure regressions, the independent variables in each regression are a

dummy variable indicating whether or not the firm is incorporated in Delaware, the GIM

governance index measure, the level of a firm's cash flows in the given year, the lagged

value of cash on hand, a lagged indicator variable stating whether or not a firm has a

69

Tobin's Q that is less than one, and the lagged level of assets that a firm holds. Again,

property, plant, and equipment, sales, and the liquidating value of stock are used as

alternative measures of firm size as a robustness check. All regressions include annual

fixed effects.

Results for these regressions are found in Tables 6 and 7. The results for further

robustness checks are found in Tables 20 and 21. The results for the governance

measures completely contradict the findings of the model with market discipline. The

model predicts that dividend issues (or the general disgorging of cash) should be larger

for firms with strong governance (dividend is decreasing in entrenchment). In the

empirical work, the GIM governance measure (higher measures indicate worse

governance and proxy for higher levels of entrenchment) and the Delaware Incorporation

dummy proxy for entrenchment. The coefficients on these variables are actually positive,

indicating that firms with worse governance appear to issue greater levels of dividends.

This result is strengthened once instruments are used for cash on hand. In these

regressions, both the Delaware incorporation dummy and the GIM measure are positive

and the GIM measure is statistically significant. These results are generally replicated in

the robustness checks.

70

Table 6: Tobit Models of Dividends

Variable Tobit Model 1

Tobit Model 2

Tobit Model 3

Tobit Model 4 (s.e.)

Cash .0102* .0106* .0029* .0029* (lagged 1 period) (.0007) (.0007) (.0012) (.0012)

Cashflow .197* .200* .197* .201* (.0029) (.0029) (.0031) (.0031)

High Tobin Q 34.98* 28.06 44.72* 36.94* (lagged 1 period) (15.38) (15.39) (16.28) (16.29)

Log(Assets) 57.97* 52.94* - - (size, lagged 1) (3.530) (3.563) - -

Log(PPE) - - 58.24* 51.82* (size, lagged 1) - - (3.423) (3.494)

Delaware 98.78 108.76 115.60 132.02 Incorporation (74.29) (74.13) (98.90) (98.51)

IRRC Governance - 17.06* - 17.08*

Index - (1.806) - (1.974) Constant -567.34* -675.83* -532.68* -637.91*

Term (35.42) (37.11) (34.47) (36.38) Time FE Yes Yes Yes Yes Sigma 500.77 500.16 512.98 512.49

Log Likelihood -

65442.757 -

65397.975 -

59585.05 -

59547.46 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance.

71

Table 7: IV Tobit Models of Dividends

Variable IV Tobit Model 1

IV Tobit Model 2

IV Tobit Model 3

IV Tobit Model 4 (s.e.)

Cash -.0019 -.0002 -.0137* -.0128 (lagged 1 period) (.0016) (.0016) (.0023) (.0023)

Cashflow .210* .210* .197* .200* (.0041) (.0041) (.0038) (.0038)

High Tobin Q 39.33* 32.51 41.41* 33.60 (lagged 1 period) (15.54) (15.50) (16.29) (16.29)

Log(Assets) 66.31* 60.49* - - (size, lagged 1) (3.779) (3.824) - -

Log(PPE) - - 54.85* 48.30* (size, lagged 1) - - (3.438) (3.508)

Delaware 62.83 73.18 50.04 65.89 Incorporation (75.26) (74.88) (99.90) (99.42)

IRRC Governance - 15.33* - 17.21*

Index - (1.832) - (1.975) Constant -627.97* -730.63* -514.61* -626.07*

Term (36.35) (38.59) (34.49) (36.86) Time FE Yes Yes Yes Yes Sigma 497.22 496.94 507.93 507.54

Log Likelihood -

186669.5 -

186633.53 -

166678.54 -

166639.47 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance.

The cash on hand is a more damaging result to the predictions of the simple

model.4 As Tables 6 and 7 document, dividends decrease with increases in cash on hand

when one uses an instrument. While the estimates are statistically significant, these

4 Again, the model is very simple and is designed to serve as a tool for understanding how market

discipline may work. Dividends can be used to signal information about the firm or to return money to managers who hold a large amount of company stock.

72

effects are relatively small, given that exogenous changes in cash are small relative to the

size of the firm and even relative to some firms' dividend issues. Nonetheless, the results

do not support the dividend finding of the simple model presented in the first section.

The last variable that the model describes is the debt level. According to the

simple model, managers increase their level of debt in order to restrain themselves. If this

were an accurate description of reality, one might expect the firm to take on more debt as

a way of constraining itself. Since all firms in the sample carry debt, the use of a discrete

choice model is not longer appropriate, so the paper uses a simple OLS framework to

measure the impact of the same key variables used throughout this analysis on the level

of debt carried by a firm. The results for regressions that use the level of assets and

property, plant, and equipment as measures of firm size are presented in Tables 8 and 9,

while results that use the liquidating value of stock and sales as measures of size are

presented in Tables 22 and 23. Again, all regressions include time fixed effects.

73

Table 8: OLS Models of Debt

Variable OLS Model 1

OLS Model 2

OLS Model 3

OLS Model 4 (s.e.)

Cash .9685* .9584* .6333* .6334* (lagged 1 period) (.0197) (.0197) (.0130) (.0130)

Cashflow 1.369* 1.292* 1.775* 1.758* (.0823) (.0824) (.0332) (.0335)

High Tobin Q -938.9* -790.5 -1703.5* -1676.4* (lagged 1 period) (411.7) (410.5) (165.5) (165.6)

Log(Assets) 1337.6* 1488.7* - - (size, lagged 1) (93.28) (94.34) - -

Log(PPE) - - 317.4* 346.2* (size, lagged 1) - - (33.98) (34.86)

Delaware -2161.8 -2346.9 -1122.4 -1167.8 Incorporation (2020.9) (2013.7) (990.7) (990.3)

IRRC Governance - -455.2* - -74.00* Index - (48.68) - (20.18)

Constant -8763.1* -5756.5* -529.49 -48.24 Term (921.6) (972/9) (339.6) (363.9)

Time FE Yes Yes Yes Yes R2 .3320 .3369 .4789 .4795 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance.

74

Table 9: IV Models of Debt

Variable IV Model 1

IV Model 2

IV Model 3

IV Model 4 (s.e.)

Cash 2.107* 2.077* 1.841* 1.827* (lagged 1 period) (.0478) (.0478) (.0376) (.0378)

Cashflow -.2922* -.3090* 1.842* 1.827* (.1116) (.1109) (.0376) (.0378)

High Tobin Q -1257.1* -1151.7* -1709.1* -1682.1* (lagged 1 period) (465.7) (462.9) (165.8) (165.9)

Log(Assets) 524.3* 641.7* - - (size, lagged 1) (109.7) (111.0) - -

Log(PPE) - - 317.2* 346.0* (size, lagged 1) - - (34.04) (34.92)

Delaware -209.6 -373.5 -1163.9 -1210.1 Incorporation (2286.5) (2270.6) (992.5) (992.0)

IRRC Governance - -302.6* - -73.98* Index - (55.16) - (20.22)

Constant -2555.9* -713.4 -518.9 -37.60 Term (1085.3) (1128.7) (340.1) (364.52)

Time FE Yes Yes Yes Yes R2 .1470 .1590 .4771 .4777 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance.

In models that do not identify cash, having more cash on hand appears to be

correlated with increasing debt levels. This is as predicted by the model (debt is

increasing in the liquidity of the firm). It appears that this finding is strengthened when

using an instrument. Management expands debt even further when accounting for an

exogenous increase in the level of cash holdings in all of the regressions. Again, this is

consistent with a story of market discipline where a manager assumes more risky debt in

order to prevent himself/herself from undertaking value decreasing projects in the future.

The results involving governance also help advance a theory of market discipline. In all

regressions (besides the uninformative sales as a measure of size robustness checks),

75

firms are less likely to issue debt when they are more deeply entrenched (i.e. when

governance is poor). This is in line with the prediction that more entrenched managers

are subject to less debt discipline.

One may wonder where all of the exogenous cash is going if it is not going into

dividends, mergers and acquisitions, or capital expenditure. The natural place to look is

the next period's level of cash on hand. Firms may simply take these additional resources

and add them to cash reserves. Tables 10 and 11 explore this idea. Tables 10 and 11

report the results from OLS models of cash level using the same dependent variables used

in other estimation models. The pension gap is again used as an instrument. In both

cases, on sees that firms appear to be hoarding additional resources that come into the

firm (cash levels grow from period to period) and appear to do even more hoarding when

the resources are exogenous. These results are statistically significant when one usesany

of the four measures of firm size and the cash level coefficient increases when one uses

any of the four measures. Cash holdings appear to grow more rapidly when they are

added to exogenously. This suggests that finding additional resources leads a manager to

hoard them.

76

Table 10: OLS Models of Cash on Hand

Variable OLS Model 1

OLS Model 2

OLS Model 3

OLS Model 4 (s.e.)

Cash 1.097* 1.097* 1.136* 1.136* (lagged 1 period) (.0027) (.0027) (.0026) (.0026)

Cashflow .0724* .0728* .0058 .0058 (.0112) (.0113) (.0066) (.0067)

High Tobin Q 13.69 13.00 22.36 22.40 (lagged 1 period) (56.11) (56.15) (32.89) (32.92)

Log(Assets) -1.611 -2.315 - - (size, lagged 1) (12.71) (12.90) - -

Log(PPE) - - -5.249 -5.203 (size, lagged 1) - - (6.750) (6.929)

Delaware -97.00 -96.14 -96.01 -96.08 Incorporation (275.4) (275.4) (196.8) (196.8)

IRRC Governance - 2.121 - -.1168

Index - (6.658) - (4.012) Constant 16.56 2.555 51.26 52.02

Term (125.6) (133.1) (67.46) (72.33) Time FE Yes Yes Yes Yes

R2 .9486 .9486 .9522 .9522 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance.

77

Table 11: IV Models of Cash on Hand

Variable IV Model 1

IV Model 2

IV Model 3

IV Model 4 (s.e.)

Cash 1.115* 1.116* 1.133* 1.133* (lagged 1 period) (.0058) (.0058) (.0049) (.0049)

Cashflow .0458* .0461* .0084 .0084 (.0135) (.0135) (.0075) (.0075)

High Tobin Q 8.591 6.965 22.14 22.18 (lagged 1 period) (56.23) (56.29) (32.89) (32.92)

Log(Assets) -14.66 -16.47 - - (size, lagged 1) (13.25) (13.50) - -

Log(PPE) - - -5.255 -5.210 (size, lagged 1) - - (6.751) (6.930)

Delaware -65.69 -63.16 -97.63 -97.73 Incorporation (276.1) (276.1) (196.8) (196.9)

IRRC Governance - 4.672 - -.1159

Index - (6.708) - (4.012) Constant 216.5 188.1 51.67 52.43

Term (131.0) (137.3) (67.46) (72.34) Time FE Yes Yes Yes Yes

R2 .9484 .9484 .9522 .9522 N 12004 12004 11192 11192

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. PPE is shorthand for property, plant, and equipment The IRRC Index increases with BAD governance.

78

SECTION 5: CONCLUSION

This paper has presented a model of managerial discipline based on work by

Zwiebel (1996) and argued that this model best explains how firms spend cash reserves

on mergers and acquisitions. In particular, the model argues that governance should

decrease merger and acquisition spending while increases in exogenous levels of cash on

hand should have either no effect on this spending or will cause the level of merger and

acquisitions spending to decrease. The paper also described two competing theories (a

pure agency theory and a value maximizing manager theory) and their implications. In

contrast to a model with market discipline, a pure agency theory model would argue that

increases in exogenous levels of cash on hand should cash spending to increase and a

theory where a manager makes decisions to maximize the value of the firm predicts that

increases in the level of cash on hand would either bring no change in merger and

acquisitions spending or else cause it to increase.

To test which theory best described the data, a series of Tobit regressions were

used to measure the sensitivity of merger and acquisitions spending to changes in cash

flow. Data on firm characteristics, governance, and merger and acquisition spending was

gathered from three commonly used sources (Compustat, the IRRC, and the SDC,

respectively) to accomplish this task. This methodology differed greatly from the prior

literature, namely Harford (1999). While the prior literature accounted for the censoring

in merger and acquisition activity (not all firms enter into the market every year), it did

not fully utilize the available data. Instead, it used simple discrete choice models to

measure changes in the marginal probability of entering into a merger and acquisition.

By using a Tobit specification and the level of merger and acquisition spending, this

paper was able to quantify the marginal expenditure on merger and acquisition activity

rather than a marginal probability (this marginal effect is reported in Table 7 and will be

discussed momentarily). Also, theory suggests that utilizing all of the available data

79

(namely the size of merger and acquisition spending) increases efficiency, as the results

seem to verify.

Additionally, the paper differed from traditional work by using an instrument to

identify exogenous changes in cash holding. This particular instrument, the pension

funding gap, is based on reasoning presented in Rauh's (2005) recent work on capital

formation. Once the new model and the instrument were used, the paper demonstrated

that increases in cash on hand caused spending on mergers and acquisitions to either

decrease or not change. Similarly, the paper found that spending on capital expenditure,

another way for a manager to build up an empire, also either decrease or did not change

when cash on hand changes exogenously. The only model that could have predicted this

finding was a model of market discipline. Prior work, which had not used an instrument,

had found that additional cash holdings led to a greater probability of entering into the

market for mergers and acquisitions. These results were repeated in this work when a

model without instruments was used to analyze the data. The results indicate that using

an instrument for cash holdings causes the results of corporate finance and merger and

acquisitions empirical work to change dramatically. In addition, the paper demonstrated

that further entrenched managers, as measured by the level of corporate governance, were

more likely to enter into mergers and acquisitions and, once they had entered that market,

were likely to spend more money than managers who are not as firmly entrenched by

their governance structure. Again, this result was in line with the predictions described

by the model in this paper.

Interestingly, the marginal effect of additional cash on merger and acquisition

spending is very small, even if one does not instrument. In the regression results for

Tobit models with instruments, the average marginal effect of having an additional dollar

in exogenous cash is that merger and acquisitions spending decreases by .3 cents while a

model without instruments suggests that having an additional dollar in cash holdings

increases merger and acquisitions spending by .22 cents. While these numbers are not

80

trivial, given that firms spend millions of dollars on such deals every year, they are not

very big relative to the size of cash holdings and relative to the operations of firms in

general. This suggests that significant decreases in stock value when firms enter into

mergers and acquisitions has little to do with the loss of liquid assets and the possible

things that those funds could have been used for (dividends, stock buy backs, alternative

mergers, internal investment, etc.). This suggests that the share value of the acquiring

firm is lost because such activities either bring in very unproductive assets or signal some

other information about the firm, the manager, or the firm's specific market.

The model also successfully predicted that exogenous changes in cash on hand

would increase debt holdings. It also successfully predicted that greater entrenchment

would lead to less debt being held. The model had mixed results when attempting to

predict what would happen to the amount of money disgorged by the firm when

exogenous cash levels increased. In a Tobit model of dividend issues, the paper found

that firms with greater level of exogenous cash on hand issued fewer dividends and firms

with worse governance issue more dividends. These results directly contradict the

model's predictions that worse governance should decrease dividends and increased

amounts of exogenous cash on hand should increase them. Further investigation

indicated that exogenous increases in the level of cash on hand lead firms to grow their

stock of cash on hand.

The paper's findings make some suggestions for future research. First and

foremost, the paper's findings suggest that value lost because of mergers and acquisitions

is not purely because of a waste of resources because the cash used in these activities is

relatively small. Future research on shareholder loss should focus on other reasons

(namely acquiring unproductive firms or signaling) why mergers and acquisitions appear

to cause the value of acquiring firm stock to decline. Additionally, the poor showing of

the model when describing dividend activities suggests that an alternative model of

dividends should be explained and tested to better reflect the data. Alternatively, it may

81

be the case that firms have other ways of disgorging cash on hand that were overlooked

in this paper. Discussion and analysis of this other avenue for disgorging cash could

possibly re-enforce a model of market discipline. In addition, the paper documents a

general move by managers to hoard exogenous resources and to add to these resources by

limiting capital expansion, merger activity, and dividend issues. To the author's

knowledge, there is no formal theory for why this would happen, suggesting the need for

a theory of resource hoarding by managers.

APPENDIX A: ADDITIONAL TABLES

Table 12: Summary Statistics for Sample that Includes Governance Measures

Variable Mean Std Dev. Min Max Annual M&A Spending 268.36 1235.925 0 40054.2 Capital Expenditure 332.13 1267.96 -0.181 33143 Total Dividends 136.01 608.06 -1013 36968 Lagged Cash on Hand 1163.77 7666.56 0 217315 Total Debt 2773.09 17618.56 0 486876 Delaware Incorporated Dummy 0.0047 0.068 0 1 Cashflow 636.64 2009.99 -13778 50916 Lagged High Tobin Dummy 0.88 0.325 0 1 Lagged Total Assets 12590.6 60560.52 2.194 1494037 Log Lagged Total Assets 7.624 1.7 0.79 14.22 Governance Index 9.22 2.77 2 18 Pre Sample M&A 36.36 151.67 0 2582.79

Pre Sample Cash 232.66 1036.85 0 14493.33 Twice lagged Pension Gap -820.45 4277.76 -99909 924 Lagged Property, Plant, & Equipment 3569.59 10885.58 0 242422 Log Lagged Property Plant, & Equipment 6.6 1.79 -1.75 12.4 Lagged Liquidating Value of Stock 43.61 230.42 0 9108 Log Lagged Liquidating Value of Stock 3.78 2.54 -6.91 9.12 Lagged Sales 5122.27 14503.95 0 328213 Log Lagged Sales 7.32 1.52 -1.91 12.7

83

Table 13: Summary Statistics for Sample that Does Not Include Governance Measures

Variable Mean Std Dev. Min Max

Annual M&A Spending 80.57 662.81 0 40054.2 Capital Expenditure 123.27 735.34 -43.4 33143 Total Dividends 47.00 337.59 -1013 36968 Lagged Cash on Hand 417.5 4651.3 -0.636 243874 Total Debt 956.7 9417.8 0 486876 Delaware Incorporated Dummy 0.0042 0.0647 0 1

Cashflow 217.2 1197.2 -38979 50916 Lagged High Tobin Dummy 0.802 0.3985 0 1

Lagged Total Assets 4403.9 33789.2 0.001 1494037 Log Lagged Total Assets 5.156 2.612 -6.9078 14.22 Pre Sample M&A 84.04 651.2 0 20662.3 Pre Sample Cash 96.65 713.1 -0.2033 21467.3 Twice lagged Pension Gap -275.22 2362.3 -99909 4138 Lagged Property, Plant, & Equipment 1288 6512.3 0 242422 Log Lagged Property Plant, & Equipment 4.119 2.698 -6.9078 12.40

84

Table 14: Additional Tobit Models of Acquisition Spending

Variable Tobit Model 5

Tobit Model 6

Tobit Model 7

Tobit Model 8 (s.e.)

Cash .0071 .0073 .0149* .0151* (lagged 1 period) (.00367) (.00366) (.00249) (.00249)

Cashflow .385* .393* .230* .233* (.0252) (.0253) (.0110) (.0111)

High Tobin Q 864.97* 806.85* 801.19* 796.00* (lagged 1 period) (159.97) (160.38) (70.01) (70.04)

Log(LVS) 53.35 64.90* - - (size, lagged 1) (24.80) (25.12) - -

Log(Sales) - - 259.78* 253.73* (size, lagged 1) - - (15.78) (16.05)

Delaware 1072.70 1294.90 135.02 142.85 Incorporation (589.28) (591.83) (302.08) (301.68)

IRRC Governance - 66.71* - 14.84

Index - (22.20) - (7.36) Constant -2287.61* -2540.88* -3464.8* -3554.92*

Term (282.16) (368.04) (153.48) (160.07) Time FE Yes Yes Yes Yes Sigma 2239.07 2232.54 1823.67 1823.38

Log Likelihood -8549.78 -8545.26 -48218.67 -48216.64 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance.

85

Table 15: Additional IV Tobit Models of Acquisition Spending

Variable IV Tobit Model 5

IV Tobit Model 6

IV Tobit Model 7

IV Tobit Model 8 (s.e.)

Cash .0144 .0184 .0026 .0037 (lagged 1 period) (.0091) (.0090) (.0057) (.0057)

Cashflow .262* .250* .211* .212* (.0545) (.0539) (.0157) (.0157)

High Tobin Q 852.48* 786.37* 811.46* 806.11* (lagged 1 period) (160.78) (161.43) (70.06) (70.07)

Log(LVS) 45.63 55.33 - - (size, lagged 1) (25.03) (25.32) - -

Log(Sales) - - 241.96* 235.40* (size, lagged 1) - - (15.96) (16.26)

Delaware 394.01 618.67 -30.03 -21.91 Incorporation (603.01) (605.38) (304.92) (304.44)

IRRC Governance - 66.50* - 15.02

Index - (22.21) - (7.38) Pre-Sample .298* .315* .140* .142*

M&A Spending (.0661) (.0658) (.0175) (.0176) Constant -2194.46* -2839.80* -3385.55* -3470.36*

Term (282.64) (360.14) (153.73) (158.10) Time FE Yes Yes Yes Yes Sigma 2228.37 2223.08 1816.54 1816.34

Log Likelihood -31349.27 -31339.61 -

169396.82 -

169394.32 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance. Pre-Sample Cash is also used in the first stage model of Cash.

86

Table 16: First Stage Approximation for Acquisition Models

Variable With No Governance Governance

Pre-Samp 3.69* 3.62* Cash (.0601) (.0263)

Pension -.071* -.067* Gap (.0145) (.0080)

Constant 246.5* 48.44* (61.49) (18.36)

R2 0.2629 0.3204

Table 17: Tobit Models of Acquisition without Governance Measures

Variable Tobit Model 1

IV Tobit Model 1 (s.e.)

Cash 0.0089* -0.021 (lagged 1 period) (0.0020) (0.0405)

Cashflow 0.205* .173* (.0083) (.0112)

High Tobin Q 437.99* 433.20* (lagged 1 period) (30.44) (30.05)

Log(Assets) 213.54* 211.50* (size, lagged 1) (5.13) (5.16)

Delaware -263.99 -372.77 Incorporation (166.94) (168.69) Pre-Sample - 0.221*

M&A Spending - (.014) Constant -2705.82* -2647.13*

Term (60.99) (60.45) Time FE Yes Yes Sigma 1321.7 1297.00

Log Likelihood -66810.13 -484278.45 N 43523 43523

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. Pre-Sample Cash is also used in the first stage model of Cash.

87

Table 18: OLS Models of Capital Expenditure

Variable OLS Model 5

OLS Model 6

OLS Model 7

OLS Model 8 (s.e.)

Cash -.0431* -.0431* -.0388* -.0388* (lagged 1 period) (.0020) (.0020) (.0011) (.0011)

Cashflow .538* .539* .520* .517* (.0136) (.0136) (.0047) (.0047)

High Tobin Q -243.63* -248.07* -245.83* -242.64* (lagged 1 period) (68.88) (69.28) (23.23) (23.23)

Log(LVS) 60.82* 61.87* - - (size, lagged 1) (11.60) (11.74) - -

Log(Sales) - - 50.67* 55.66* (size, lagged 1) - - (5.728) (5.844)

Delaware -132.80 -112.40 -42.63 -43.82 Incorporation (318.88) (320.71) (113.99) (113.90)

IRRC Governance - -6.391 - -11.74*

Index - (10.59) - (2.773) Constant 192.69 127.54 -72.35 -1.111

Term (133.09) (171.37) (53.13) (55.69) Time FE Yes Yes Yes Yes

R2 0.4574 0.4574 0.5900 0.5906 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance.

88

Table 19: IV Models of Capital Expenditure

Variable IV Model

5

IV Model

6

IV Model

7

IV Model

8 (s.e.) Cash -.0981* -.0969* -.0730* -.0740*

(lagged 1 period) (.0044) (.0044) (.0024) (.0024)

Cashflow .751* .747* .578* .577* (.0214) (.0213) (.0060) (.0061)

High Tobin Q -141.66 -143.61 -239.61* -235.46* (lagged 1 period) (80.43) (80.48) (24.16) (24.20)

Log(LVS) 78.94* 78.52* - - (size, lagged 1) (13.55) (13.63) - -

Log(Sales) - - 55.06* 61.44* (size, lagged 1) - - (5.962) (6.097)

Delaware -686.96 -676.22 -81.25 -83.58 Incorporation (372.86) (373.11) (118.54) (118.66)

IRRC Governance - -2.73 - -14.79*

Index - (12.26) - (2.894) Constant 74.67* 79.92 -112.40 -24.95

Term (155.04) (198.33) (56.30) (58.90) Time FE Yes Yes Yes Yes

R2 0.2655 0.2735 0.5568 0.5559 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance.

89

Table 20: Tobit Models of Dividends

Variable Tobit Model 5

Tobit Model 6

Tobit Model 7

Tobit Model 8 (s.e.)

Cash .0132* .0132* .0118* .0120* (lagged 1 period) (.0006) (.0006) (.0007) (.0007)

Cashflow .1729* .1728* .1994* .2030* (.0042) (.0043) (.0030) (.0030)

High Tobin Q 26.66 27.37 24.11 18.07 (lagged 1 period) (21.59) (21.70) (15.37) (15.37)

Log(LVS) 3.689 3.493 - - (size, lagged 1) (3.685) (3.734) - -

Log(Sales) - - 52.61* 45.53* (size, lagged 1) - - (3.943) (4.004)

Delaware 479.3* 475.86* 149.27 155.1 Incorporation (99.09) (99.65) (74.36) (74.15)

IRRC Governance - -1.071 - 17.26*

Index - (3.322) - (1.819) Constant 37.59 41.37 -507.84* -612.27*

Term (39.42) (54.07) (36.67) (38.37) Time FE Yes Yes Yes Yes Sigma 392.34 392.31 501.61 500.92

Log Likelihood -

15127.10 -

15127.05 -

65439.40 -

65394.23 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance.

90

Table 21: IV Tobit Models of Dividends

Variable IV Tobit Model 5

IV Tobit Model 6

IV Tobit Model 7

IV Tobit Model 8 (s.e.)

Cash .0050* .0045* .0043* .0028* (lagged 1 period) (.0016) (.0016) (.0015) (.0015)

Cashflow .243* .246* .206* .207* (.0095) (.0095) (.0042) (.0041)

High Tobin Q 45.57 47.23 25.98 19.85 (lagged 1 period) (21.47) (21.64) (15.39) (15.37)

Log(LVS) 7.745 7.663 - - (size, lagged 1) (3.675) (3.726) - -

Log(Sales) - - 51.22* 43.94* (size, lagged 1) - - (3.995) (4.058)

Delaware 695.8* 692.3* 122.5 127.89 Incorporation (99.28) (100.11) (74.68) (74.36)

IRRC Governance - -1.202 - 16.67*

Index - (3.281) - (1.826) Constant -12.28 -1.503 -504.71* -596.42*

Term (39.26) (51.39) (36.88) (37.90) Time FE Yes Yes Yes Yes Sigma 378.21 377.78 498.92 498.45

Log Likelihood -

37870.39 -

37863.72 -

186625.83 -

186584.13 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance.

91

Table 22: OLS Models of Debt

Variable OLS Model 5

OLS Model 6

OLS Model 7

OLS Model 8 (s.e.)

Cash .9265* .9173* 1.008* 1.002* (lagged 1 period) (.0504) (.0497) (.0196) (.0196)

Cashflow 1.706* 1.466* 1.609* 1.526* (.3412) (.3378) (.0841) (.0845)

High Tobin Q 1464.4 2886.0 -1140.5* -1029.9* (lagged 1 period) (1723.3) (1708.6) (414.5) (413.5)

Log(LVS) 1865.0* 1525.7* - - (size, lagged 1) (290.3) (289.5) - -

Log(Sales) - - 696.7* 869.7* (size, lagged 1) - - (102.2) (104.0)

Delaware -4721.2 -11263.6 -988.9 -1029.9 Incorporation (7978.2) (7909.8) (2033.2) (2027.6)

IRRC Governance - -2049.9* - -407.0* Index - (261.2) - (49.36)

Constant -5360.9 15533.7* -3861.6* -1392.1 Term (3330.0) (4226.6) (947.7) (991.4)

Time FE Yes Yes Yes Yes R2 .3025 .3223 .3242 .3280 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance.

92

Table 23: IV Models of Debt

Variable IV Model

5

IV Model

6

IV Model

7

IV Model

8 (s.e.) Cash 2.256* 2.174* 2.157* 2.136*

(lagged 1 period) (.1088) (.1059) (.0459) (.0457) Cashflow -3.449* -3.389* -.3633* -.3969*

(.5312) (.5176) (.1177) (.1173) High Tobin Q -1000.8 447.8 -1349.0* -1262.1*

(lagged 1 period) (1994.7) (1958.6) (470.2) (468.0) Log(LVS) 1426.7* 1137.1* - -

(size, lagged 1) (336.2) (331.7) - - Log(Sales) - - 549.5* 682.7*

(size, lagged 1) - - (116.0) (117.9) Delaware 8676.4 1897.6 306.7 256.4

Incorporation (9247.7) (9079.9) (2306.7) (2294.5) IRRC Governance - -1894.3* - -308.4*

Index - (298.4) - (55.95) Constant -2507.4 16645.4* -2559.2* -738.0

Term (3845.5) (4826.6) (1095.6) (1139.0) Time FE Yes Yes Yes Yes

R2 .0723 .1165 .1304 .1397 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance.

93

Table 24: OLS Models of Cash on Hand

Variable OLS Model 5

OLS Model 6

OLS Model 7

OLS Model 8 (s.e.)

Cash 1.095* 1.095* 1.097* 1.097* (lagged 1 period) (.0069) (.0069) (.0027) (.0027)

Cashflow .1766* .1817* .0767* .0774* (.0465) (.0467) (.0114) (.0115)

High Tobin Q 51.35 20.87 14.20 12.30 (lagged 1 period) (235.0) (236.3) (56.11) (56.15)

Log(LVS) -2.600 4.675 - - (size, lagged 1) (39.59) (40.04) - -

Log(Sales) - - -13.15 -14.56 (size, lagged 1) - - (13.83) (14.12)

Delaware -641.0 -500.8 -99.15 -98.82 Incorporation (1088.1) (1094.0) (275.3) (275.28)

IRRC Governance - 43.94 - 3.314

Index - (36.12) - (6.701) Constant -727.7 -1175.6 96.34 76.23

Term (454.1) (584.6) (128.3) (134.60) Time FE Yes Yes Yes Yes

R2 .9515 .9516 .9486 .9486 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance.

94

Table 21: IV Models of Cash on Hand

Variable IV Model

5

IV Model

6

IV Model

7

IV Model

8 (s.e.) Cash 1.141* 1.143* 1.114* 1.114*

(lagged 1 period) (.0130) (.0130) (.0055) (.0055)

Cashflow -.0010 -0009 .0478* .0484* (.0635) (.0634) (.0141) (.0141)

High Tobin Q -33.60 -70.86 11.15 9.797 (lagged 1 period) (238.4) (239.9) (56.22) (56.25)

Log(LVS) -17.70 -9.944 - - (size, lagged 1) (40.17) (40.63) - -

Log(Sales) - - -15.31 -17.38 (size, lagged 1) - - (13.87) (14.17)

Delaware -179.4 5.629 -80.19 -79.43 Incorporation (1105.0) (1112.2) (275.8) (275.81)

IRRC Governance - 49.79 - 4.800

Index - (36.55) - (6.726) Constant -629.4 -1133.7 216.2 187.9

Term (459.5) (591.2) (131.0) (136.9) Time FE Yes Yes Yes Yes

R2 .9505 .9505 .9484 .9484 N 2123 2123 11997 11997

Date Sources: SDC, IRRC, and Compustat *denotes variables that are significant at the 95% confidence level. LVS is shorthand for the liquidating value of stock The IRRC Index increases with BAD governance.

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