CHAPTER 3

DATA AND RESEARCH METHODOLOGY

3.1. Testable Hypotheses

3.1.1 Mitigation of Agency Cost of Equity

Taking a firm private is a mean to resolve agency conflict when the firm has idle cash

flow but few valuable investment opportunities (Jensen, 1986). When a firm has few positive

net present value investments, the excess cash flow is not being disgorged to shareholders.

Instead, it is spent by the management on pet projects and to increase their control over the

firm. The agency problem of free cash flow is reduced when a firm opts to exit stock market

through going private exercise because increased level of debt associated with the going

private transaction forces the managers to service interest payment and principal using free

cash flow. Lehn and Poulsen (1989) lent support to free cash flow theory proposed by Jensen

and Meckling (1976) and Jensen (1986). Lehn and Poulsen (1989) found that free cash flow

is significant in explaining shareholder wealth gains. The free cash flow theory was

empirically tested by Lehn and Poulsen (1989), Carow and Roden (1997), Andres et al.

(2007) and Renneboog et al. (2007). According to Jensen (1986), a company is said to have

free cash flow when all the investments with positive net present values have been funded.

Therefore, capital expenditure such as expenditure on plant and equipment need to be

subtracted from the operating cash flow. Accordingly, free cash flow is defined as cash flow

from operation minus capital expenditure and cash dividend in this study. Free cash flow

variable tests whether going private candidates have higher propensity to misuse the excess

cash on organizational slack and inefficiency. Agency problem of free cash flow inhibits firm

performance. Therefore, a public listed company which suffers from serious agency conflict

benefits from taking the company private. Improved organizational efficiency after going

private transaction increases expected shareholder wealth gains. Hence, the following

hypothesis is formed:

H1: A higher free cash flow leads to higher shareholder returns.

3.1.2 Profitability

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.

H2: A higher profitability leads to higher shareholder returns.

3.1.3 Insider ownership

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H3: …..

3.2 Cross Sectional Regression

To test the hypotheses of incentive realignment (Jensen & Meckling, 1976; Jensen,

1986), undervaluation and information asymmetry (Akerlof, 1970; Ikenbery, Lakonishok,

Vermaelen, 1995), payment method (Wansley et al., 1983a), agency problem of free cash

flow (Jensen & Meckling, 1976; Jensen, 1986), tax benefit (Kaplan, 1989), inefficient

management (Manne, 1965) and size effect on excess returns, a cross sectional regression

model is employed. The following model is adapted from Lehn and Poulsen (1989), Smith

and Amoako-Adu, (1992), Goergen and Renneboog (2004), Andres et al. (2007), Renneboog

et al. (2007). The model specification is given as follows:

(4)

where,ER = excess returns one day after the event date for firm i; CASH = cash/total asset; FCF = funds from operation-capital expenditure-cash dividend; INSIDER = beneficial interest attributable to board of directors/total

ordinary shares;TA = total asset; DIVPAYOUT = dividend per share/earnings per share;

DE = debt/shareholder equity;SALESGR = (current year’s net sales/last year’s next sales) -1PE = market price per share/earnings per share; PAYSTOCK = dummy variable proxy for mode of payment (1 if it is share

exchange and 0 otherwise); ROE = earnings available to common stockholders/shareholders

equity; andINTENTION = dummy variable equals to 1 if target firm will be de-listed when bidder receives more than 75% or 90% of shares or

else coded as 0 if target firm will only be de-listed when the bidder receives more than 90% of acceptance level.

The proxy variables and the expected signs for each explanatory variable are

summarized in Table 3.1. A plus sign indicates that the higher the financial variable, the

higher are the excess returns generated to target shareholders. On the contrary, a minus sign

indicates lower announcement returns.

Table 3.1: Proxy Variable DefinitionsVariable Definition Expected

SignCash to asset ratio (CASH)

Cash/ total asset +

Free cash flow (FCF) Funds from operation-capital expenditure-cash dividends +Insider ownership (INSIDER)

Beneficial interest attributable to board of director/total ordinary shares

-

Total asset (TA) Total asset -Dividend payout ratio (DIVPAYOUT)

Dividend per share/earnings per share -

Debt-to-equity ratio (DE)

Debt/equity -

Sales growth (SALESGR)

(current year’s net sales/last year’s next sales) -1 -

Price-earnings ratio (PE)

Market price per share/earnings per share -

Stock offer (PAYSTOCK)

Dummy variable equal to 1 if it is stock offer and 0 otherwise -

Return on equity (ROE)

Earnings available to common stockholders/ shareholder equity -

Intention to go private (INTENTION)

Dummy variable equals to 1 if target firm will be de-listed when bidder receives more than 75% or 90% of shares or coded as 0 if target firm will only be de-listed when the bidder receives more than 90% of acceptance level.

+

3.3 Data and Sample Selection

In order to study the stock price response to going private proposal and the

determinants of announcement returns, going private announcements were obtained from

Bursa Malaysia website (www.bursamalaysia.com). Next, the sample was verified using a list

of de-listed companies provided by Bursa Malaysia Library. From the list, firms de-listed due

to the reason of privatization were selected. The initial date of going private announcement

was undertaken as event date. The intention of firms going private can be identified from the

notice of offer released by the offeror through Bursa Malaysia corporate announcement.

To be included in the sample, the firms must not be suspended during the event

period, which is 40 days before the announcement through 20 days after the event date. In

addition, share prices, financial data and director shareholdings must be available in Thomson

DataStream, EquityTracker.com (an independent equity research portal)

(www.klsetracker.com), Bursa Malaysia and company annual reports. The samples must have

the most recent financial reports immediately before the going private announcements. The

secondary data collected are then tested using Eviews version 6.