Abstract We present a model of mergers and acquisitions based on stock market misvaluations of the combining firms. The key ingredients of the model are the relative valuations of the merging firms and the market's perception of the synergies from the combination. The model explains who acquires whom, the choice of the medium of payment, the valuation consequences of mergers, and merger waves. The model is consistent with available empirical findings about characteristics and returns of merging firms, and yields new predictions as well. JEL classification: G34

Does CEO overconfidence help to explain merger decisions? Overconfident CEOs overestimate their ability to generate returns. As a result, they overpay for target companies and undertake value-destroying mergers. The effects are strongest if they have access to internal financing. We test these predictions using two proxies for overconfidence: CEOs' personal overinvestment in their company and their press portrayal. We find that the odds of making an acquisition are 65 % higher if the CEO is classified as overconfident. The effect is largest if the merger is diversifying and does not require external financing. The market reaction at merger announcement (–90 basis points) is significantly more negative than for non-overconfident CEOs (–12 basis points). We consider alternative interpretations including inside information, signaling, and risk tolerance.

We study shareholder returns for firms that acquired five or more public, private, and0or subsidiary targets within a short time period. Since the same bidder chooses different types of targets and methods of payment, any variation in returns must be due to the characteristics of the target and the bid. Results indicate bidder shareholders gain when buying a private firm or subsidiary but lose when purchasing a public firm. Further, the return is greater the larger the target and if the bidder offers stock. These results are consistent with a liquidity discount, and tax and control effects in this market. Takeovers are one of the most important events in corporate finance, both for a firm and the economy. Extensive research has shown that shareholders in target firms gain significantly and that wealth is created at the announcement of takeovers ~i.e., combined bidder and target returns are positive!. However, we know much less about the effects of takeovers on the shareholders of acquiring firms. Evidence suggests that these shareholders earn,

Does valuation affect mergers? Data suggest that periods of stock merger activity are correlated with high market valuations. The naïve explanation that overvalued bidders wish to use stock is incomplete because targets should not be eager to accept stock. However, we show that potential market value deviations from fundamental values on both sides of the transaction can rationally lead to a correlation between stock merger activity and market valuation. Merger waves and waves of cash and stock purchases can be rationally driven by periods of over and under valuation of the stock market. Thus, valuation fundamentally impacts mergers. One of the puzzles in finance is why there are periods when mergers are plentiful and other periods

Kyle, Jeremy Stein, and Jeff Wurgler, for useful discussions and ideas. We also thank workshop participants Merger intensity spikes in times of high market valuations (i.e., when average M/B ratios are at their highest). This is especially true for stock-based mergers, supporting recent theories by Rhodes-Kropf and Viswanathan (2002) and Shleifer and Vishny (2003). To explore whether this is the result of correlated valuation errors or behavioral mispricing we decompose M/B into three components: firm-specific deviation from short-run industry valuations; short-run industry deviations from long-run values, and long-run value to book. The fact that high M/B buys lower M/B is driven mostly by firm-specific deviations from short-run industry average pricing. However, both targets and acquires are priced above their long-run industry average. When we find differences between bidders and targets in long-run valueto-book, we find that low buys high. We also find that the industry-specific component of M/B is highly positively correlated with merger intensity, and correlated with the use of stock. However, long-run value-to-book is uncorrelated with cash merger intensity and negatively correlated with stock merger intensity, leading to little overall correlation between long-run

two anonymous referees for comments. Mehmet Yalin provided excellent research assistance. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.

This paper tests the hypothesis that irrational market misvaluation a#ects firms' takeover behavior. We employ two contemporaneous proxies for market misvaluation, pre-takeover book/price ratios and pre-takeover ratios of residual income model value to price. Misvaluation of bidders and targets influences the means of payment chosen, the mode of acquisition, the premia paid, target hostility to the o#er, the likelihood of o#er success, and bidder and target announcement period stock returns. The evidence is broadly supportive of the misvaluation hypothesis

We analyze several hundred firms that expand via acquisition and0or increase their number of business segments. The combined market reaction to acquisition announcements is positive but acquiring firm excess values decline after the diversifying event. Much of the excess value reduction occurs because our sample firms acquire already discounted business units, and not because diversifying destroys value. This implies that the standard assumption that conglomerate divisions can be benchmarked to typical stand-alone firms should be carefully reconsidered. We also show that excess value does not decline when firms increase their number of business segments because of pure reporting changes. DOES CORPORATE DIVERSIFICATION destroy value? Several recent papers attempt to answer this question by comparing the market value of firms that operate multiple lines of business to the value of a portfolio of stand-alone firms operating in the same industries as the conglomerate’s divisions. Lang and Stulz ~1994! use this approach and find that multisegment firms have low

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