Internal Growth, Tobin’s q and Corporate Diversification

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Internal Growth, Tobin’s q and Corporate Diversification Working Paper

FRANK FAN XIA

University of California at Los Angeles

Department of Economics

8283 Bunche Hall

405 Hilgard Avenue

Los Angeles, CA 90095

Tel: (310) 390-0172

Mobile: (310) 699-8349

e-mail: [email protected]

ABSTRACT

Corporate growth can be divided into two components: external growth, due to business

combinations, and internal growth, due to the expansion of existing assets and businesses. As one

of the first papers in this direction, this paper studies the interrelationships among internal

growth, external growth, Tobin’s q and corporate diversification in the US for the time period

1993 to 2002. We create a new dataset on business combinations by merging SDC data and

Mergerstat data, and adjust accounting data for a consistent way to measure Tobin’s q and asset

growth. We find that, although internal and external growths are positively correlated, internal

growth has a strong positive effect on Tobin’s q, while external growth has no significant effect,

or even negative effect after accounting data adjustment. Evidence shows that the absolute and

relative Tobin’s q levels of firms that grow externally become lower after business combinations.

We also find that diversification is accomplished more often by external growth than by internal

growth. In this context, diversification has a negative effect on Tobin’s q.

Keywords:

Growth; Performance; Diversification

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Internal Growth, Tobin’s q and Corporate Diversification

In this paper we decompose corporate growth into two components: internal growth and

external growth, then investigate the connections among internal growth, external growth,

Tobin’s q and diversification.

A firm can grow in two ways. One way is to expand its existing assets and businesses

(internal growth); the other way is to combine with other independent firms or other firms’

subsidiaries (external growth). The growth we directly observe is a combination of these two

processes. Meanwhile, it is worth noting that investors may respond differently to internal

growth and external growth, making the choice of means of growth an important managerial

decision. To the extent that past growth is an indicator of future profitable expansion, higher

rates of internal growth might generally be expected to lead to higher relative market valuations

– specifically, higher levels of Tobin’s q. External growth, achieved by Business Combinations

(Merger/Consolidation and Stock Acquisition), may involve higher costs than internal growth ―

it is generally more difficult to integrate a new subsidiary from outside the parent than to

accomplish expansion internally. The pattern of complementarities among the assets of the target

firm (the firm being merged or acquired) may be destroyed due to the combination. Resources,

especially intangible ones like the parent company’s culture and the managers’ experiences,

cannot easily be passed to an acquired/merged target firm as smoothly as it would be if the new

member were born from the parent company. But on the other hand, there may be synergies

created between the acquiror and the target firm due to the new complementarities among the

acquired assets and the existing assets. Thus, the signal that external growth gives to the market

is vague1. It is reasonable therefore, to expect that Tobin’s q will be influenced dissimilarly by

the signal of internal growth and the signal of external growth. Consequently, a study isolating

internal growth and external growth is demanded.

There has been a line of work studying the relationship between diversification, another

critical managerial decision, and performance2. If different levels of diversification are associated

with different ways of growth, then the relationship between performance and growth methods 1 The literatures studying the business combinations and the reaction of stock market include Mandelker (1974), Lang, Stulz and Walkling (1989), Franks, Harris and Titman (1991), Hearly, Palepu and Ruback (1992), Speiss and Affleck-Graves (1995), Loughran and Vijh (1997), Rau and Vermaelen (1998), Mitchell and Stafford (2000), Maksimovic and Phillips (2001), Andrade and Stafford (2004), etc. 2 The literatures include Rumelt (1974), Carter (1977), Feinberg (1985), Montgomery (1985), Grant and Jammine (1988), Wernerfelt and Montgomery (1988), Lichtenberg (1992), Montgomery (1994), Lang and Stulz (1994), Berger and Ofek (1995), Hatfield, Liebeskind and Opler (1996), Maksimovic and Phillips (1999), Villalonga (2004), etc.

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will be impacted differently too. Hence, it is worthwhile to study the relationship between

diversification and different types of growth. By definition, internal growth and external growth

may or may not lead to higher diversification, and vice versa. Both internal and external growth

can be limited inside of the firm’s original industries ― purchasing another firm in the original

industries will not make the firm any more diversified. Meanwhile, to diversify, firms can choose

to start a new segment in an unfamiliar industry (internal growth) or simply acquire/merge an

existing firm/subsidiary within that industry (external growth). Nonetheless, external growth is

innately a more convenient way to diversify. Usually, self-expanding into an unfamiliar industry

is more costly than inside of the original market ― the parent company's resources may not be

able to be applied in the new industry so that a lot of costs will have to be paid to initiate a brand

new business segment. However, acquiring an existing firm with industry oriented resources in

the unfamiliar industry may solve this problem. So although business combinations may bring in

higher internal costs than internal expansions, firms probably will still choose to enter a new

industry by acquiring a new subsidiary much more often than by expanding existing assets.

Taken together, we test the following hypotheses:

Hypothesis 1: The impact of internal growth on Tobin’s q will be significantly larger than

that of the same amount of growth achieved by external processes.

Hypothesis 2: Diversification should be accomplished more often by external growth

than by internal growth.

The paper proceeds as follows: First we describe the variable definitions, data sources

and the data manipulation procedure. The second part introduces the methods and initial results

― the contributions of internal and external assets growths on Tobin’s q are studied and the

overall effect of diversification on Tobin’s q is shown. We also investigate the contribution of

diversification increase to internal growth and external growth. The third part introduces the data

adjustment according to accounting rules. Results after such adjustment are presented. The forth

part presents some evidence that helps to explain the motivation for firms to conduct business

combinations. The remainder of the paper discusses the results.

DATA AND VARIABLES

Datasets and Samples

We use Standard and Poor’s Compustat North America Industrial Annual, Industrial

Quarterly, and Segments data files as sources for the information on firms’ market value, assets

book value, diversification and overall assets growth. We also use Securities Data Co. (SDC)

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Platinum U.S. Mergers & Acquisitions data files, together with Mergerstat U.S. data files3, to

obtain the information on acquisitions. These acquisition datasets are combined with Compustat

data to provide internal/external growth measures, and accounting adjustments, as described

below.

The period being studied is 1993 to 2002. We do not study years before 1993 because

Mergerstat data appears to be less complete before 1993. In addition, there are problems of data

comparability due to accounting rules changes as described in the accounting adjustment

appendix. We focus on firms that appear in Compustat Industrial Annual data from fiscal years

1992 to 2002, using the 1992 data only to compute 1993 growth rates. Then, following Lang and

Stulz (1994) and Villalonga (2004), we refine the sample as follows: (1) We omit enterprises in

“financial services” (SIC 6000-6999), “regulated utilities” (SIC 4900-4999), “government,

excluding finance” (SIC 9100-9199) and “non classifiable establishments”; (2) We require firms

to report no less than $20 million total assets in each of the 11 years from 1992 to 2002; (3) We

require firms to have Tobin’s q calculable in 1993 to 2002 fiscal years. This procedure leaves us

with 1,686 firms.

Among the 1,686 firms, we find segments data belonging to 1,682 of them from

Compustat Segments data files. We use segments data from fiscal year 1992 to 2002; the 1992

data is used for calculating the increase in diversification from 1992 to 1993. Segments are

selected as follows: (1) Only “Business” segments are studied, segments based on geography or

operating functions are omitted to avoid double counting; (2) We require segment SIC codes to

be available; (3) If a firm-year has multiple segments in the same four-digit SIC code, we

combine them into one “segment”; (4) We require segment assets to be available and positive.

The final segment sample contains 29,839 segment-years.

There are two types of business combinations in accounting: Merger/Consolidation and

Stock Acquisition. They are different in terms of the number of legal entities that will survive4.

In Merger/Consolidation cases, the target company (or companies) must be completely

purchased, its assets and liabilities are combined into the surviving company’s balance sheet

according to a certain accounting method and then the target company is liquidated. In this case,

the Compustat data we observe after the combination belong to the surviving company. On the 3 By studying the 10-K forms for some firms, including HP, Pepsi, Intel, and Northrop Grumman, we found that the SDC dataset is about 80% complete, Mergerstat dataset is about 70%, and if combined together, the completeness is improved to about 90%. 4 In a Merger, one company absorbs the other company or companies, and continues to exist as the only surviving legal entity. A Consolidation is very similar to a merger, except that the surviving company is a newly established one during the combination process while all the former companies, both the acquiror and the target, are dissolved.

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other hand, a Stock Acquisition occurs when the acquiror controls the target company by

purchasing more than 50% of the target’s voting common stock. Both the acquiror and the target

company will remain as separate legal entities. However, a single set of Consolidated Financial

Statements is required from them for external reporting purpose. In this case, the Compustat data

come from the consolidated statements. Our data samples contain both types of business

combinations. For both types, a control change of the target company occurs, and the Compustat

financial figures are subject to the influences of combination behaviors, which give rise to the

separate study of internal growth and external growth.

The SDC Platinum U.S. Mergers & Acquisitions data files provide a total of 40,567 deals

with control change for public ultimate acquirors during the calendar years 1992 to 2003.

Although the studied period is 1993 to 2002, we include 1992 and 2003 data initially, because

Compustat counts a fiscal year ending before June 1st in calendar year t as the fiscal year t-1, but

counts a fiscal year ending on or after June 1st as the fiscal year t, thus technically the acquisition

deals which happened in fiscal years 1993 to 2002 may actually dwell in calendar years 1992 to

2003.

For the calculation of the internal and external growth rates as described below, the

acquisition target’s total assets value must be available. Only a relatively small portion, 5,390

deals, is thus qualified. Extra deals come from Mergerstat U.S. data. The Mergerstat deals are

matched with SDC deals by the following procedure: (1) Mergerstat deals must also involve

control changes with ultimate acquirors being public; (2) in both SDC and Mergerstat, the

matched deals must have the same Announcement Dates (or no more than one week apart) and

the same Close/Effective Dates (or no more than one week apart); (3) deals are further matched if

the acquiror and the target can be matched by the name5, and/or CUSIP numbers6, and/or ticker

symbols. 14,328 control-change business combination deals with public acquirors are matched in

all. For a matched deal, the Mergerstat target assets value is used when this information is

missing in SDC. We thereby increase the amount of qualified deals to 6,358, among which 968

deals’ target total assets values come from Mergerstat. We then pick out 1,796 deals conducted

5 The match of names contains three steps: (1) the match of the original but uppercase names; (2) the match of the remaining names after the removal of special words, phrases and symbols, which are words like “inc, llc, lp, corp, co, ltd, advg, advertising, bus, business, plc, sa, llp, lc, ag, ab, fund, group, press, services, systems, svcs, svc, system, sys, partners, associates, service, affiliates, international, US, USA” and abbreviated US states names; the illustrative ending phrases starting with a “/”, “-”, “.”, “(”, “%”, “,” or “of”; the illustrative phrases in parentheses anywhere in the names; and the special symbols like “.”, “,”, “/”, “\”, “(”, “)”, “-”, “&”, and “%”; (3) the match of the remaining names after the removal of the last and the second to last words in the names. 6 In SDC, the CUSIP is six-digit; while in Mergerstat, the CUSIP is eight-digit with the last two digits representing the stock issue number. The matching is done after the unification of CUSIP formats.

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by the 1,686 firms above. Because of the initial inclusion of 1992 and 2003 data, we then identify

the deals’ fiscal years by using the fiscal year ending month data in Compustat Industrial Annual

data files, then keep 1,591 deals that occurred in fiscal years 1993 to 2002. These 1,591 deals

belong to 1,345 firm-years or 744 firms in the abovementioned 1,686-firm sample.

All the 16,860 firm-years of the 1,686 firms are included in the calculation of the pure-

play Tobin’s q (described below) for each firm-year. Undiversified firm-years’ q averages serve

as the corresponding industries’ (industries are defined by the first three digits of SIC codes)

Tobin’s q levels. If a firm has multiple segments in a certain fiscal year, it is kept in the sample

only if all segments’ industry q levels are available. Firm-years selected in this way are then

matched with the 1,345 firm-years who have selected acquisition deals, leaving 1,149 firm-years.

We then exclude the outliers7 of internal growth rate fraction (described below). The remaining

firm-years are stacked with the 10,214 firm-years that definitely did not have any combination

deals occur8 (not including those firm-years in which one or more deals occurred but the targets’

assets data are missing). We calculate the ratio of market value to property, plant and equipments

(an approximation of Tobin’s q for easier computation) for each firm-year, and then subtract the

ratios’ industry average from the ratio to get differences. Then we remove the outliers of these

differences. The final sample we have contains 8,755 firm-years (including 743 firm-years with

at least one business combination deal whose targets’ assets value is available), which belongs to

1,503 firms. There are 2,134 diversified firm-years. We employ this sample for the studies in

Table 1 to Table 3 below.

Variables

Growth Measures

We study the growth in firms’ total assets, where at the end of fiscal year t a firm has

assets tTA . The total growth rate ( )Ga t in fiscal year t is defined as ( )1/ 1t tTA TA − −⎡ ⎤⎣ ⎦ . If this

firm made no business combination during this period, then this growth is, by definition, all

internal and the internal growth rate ( )Gi t equals the total growth rate ( )Ga t . However, if the

firm made an business combination during this period, the ending assets, and thus ( )Ga t , reflect

three processes: (1) the internal growth of the original assets 1tTA − ; (2) the addition of the 7 Outliers in this paper are defined as observations more than one interquantile range (the value difference between 75% and 25% quantiles) above the 75% quantile or below the 25% quantile. 8 Such firm-years’ internal growth rates will just be the total growth rates, and the external growth rates will be zero.

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acquired target’s assets, ta , which is added at instant (1 )τ− , 1τ ≤ (the whole fiscal year t is

regarded as length 1 in time); and (3) the internal growth of the acquired assets over the time

fraction τ . Our critical simplifying assumption is that the same internal growth rate applies to all

assets owned by the firm. Thus, given this business combination described, the internal growth

rate ( )Gi t solves:

1[1 ( )] [1 ( )]t tTA Gi t TA Gi t taτ−= + + +

The extension of the single acquisition case to multiple acquisition deals in a year is

straightforward.

Given the internal growth rate ( )Gi t for the year, the external growth rate ( )Gx t is

simply:

( ) ( ) ( )Gx t Ga t Gi t= −

Diversification Measures

We employ two9 measures of diversification for a certain firm-year: one is the count of

segments (defined by four-digit segment SIC codes), the other is the Herfindahl index based on

the distribution of the firm’s assets across these segments. More precisely, if kρ is the fraction of

a firm’s assets in a four-digit-SIC industry k, then the Herfindahl index for that year is defined as:

21 kkH ρ= −∑

Both the measures will increase when the diversification level increases.

For the examination of the effect that a fraction increase in diversification has on internal

growth and external growth, the Herfindahl measure, which takes continuous values, is more

desirable. However, this measure is zero for undiversified firm-years. To avoid undefined

fraction increases in diversification, we use:

( ) ( )( )

exp ( ) exp ( 1).

exp ( 1)H t H t

H t− −

−

as the measure of the fraction increase in diversification from fiscal year (t-1) to (t).

Tobin’s q and The Chop-Shop Approach

9 We also examined the entropy measure and the specialization ratio as measures of diversification. All four measures are highly correlated and it appears that the choice of measure, given the quality of the data, is immaterial.

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Tobin’s q, as a measure of performance10, is defined as the ratio of a firm’s market value

to the sum of the individual replacement values of its assets. The market value is calculated as

the sum of the common stock market value, the preferred stock carrying value and the total debt.

The replacement value is initially approximated by the reported value (book value) of the firm’s

total assets11, and will be subjected to accounting adjustment later.

t

t

MVqTA

=

where tMV is the calculated market value of the surviving firm at the end of the fiscal year t; tTA

is defined as before.

Following Lang and Stulz (1994), we use their “chop-shop” approach to get the industry-

adjusted value of Tobin’s q for each firm-year in order to capture the industry (defined by the

first three digits of SIC codes) effects. The approach assumes that for a diversified firm, were

each segment of this firm an independent single-business firm, the Tobin’s q of such a stand-

alone segment would be the average q of all the single-business firms in this segment’s industry.

Weighted by assets, we can construct the Tobin’s q of a portfolio of independent single-business

firms that is equivalent to the original diversified firm. This constructed Tobin’s q is called the

“pure-play” q for this diversified firm in this particular year. This “pure-play” Tobin’s q captures

the overall industry effects from all the segments on a diversified firm’s q. In the case the firm is

undiversified in a year, it is regarded as one-segment. To calculate, we assign to each segment of

a firm-year the average Tobin’s q for undiversified firms in that industry in the same year. If in a

certain year, the average Tobin’s q for all undiversified firms in industry i is iq , the “pure-play”

q̂ for a firm with a fraction kρ of its assets in industry k would be:

ˆ k kk

q qρ=∑

In like manner, we also construct pure-play total growth rates using the chop-shop methodology.

Correlations Test

Table 1 shows the basic statistics and correlations among some of the measures used in

this study.

------------------------------

Insert Table 1 about here

10 Please see Lang and Stulz (1994) for a discussion on the validity of Tobin’s q as the performance measure. 11 During periods of high inflation it would be advisable to correct total assets for inflation.

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From the correlations, we observe: Tobin’s q is positively correlated with Ga and Gi, but

not so significantly with Gx; Gi and Gx are positively correlated; N4, the count of segments, and

Herfindahl are generally equivalent; both N4 and Herfindahl have a small but negative

correlation with Tobin’s q; both N4 and Herfindahl are positively and more significantly

correlated with Gx than with Gi. These initial implications provide support to both of our

hypotheses. Moreover, they turn out to be consistent with the regression results we obtain below.

METHODS AND INITIAL RESULTS

Tobin’s q and Growth

The effects of internal and external asset growths on Tobin’s q are estimated by a set of

regressions across the 8,755 selected firm-years. Table 2 contains OLS regression results when

the dependent variable Tobin’s q is regressed on selected independent variables.

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The inclusion of the pure-play q̂ corrects for the possibility that some industries may

have systematically higher or lower Tobin’s q’s. Regression (1) shows that asset growth is a

strong positive predictor of q, while in this context, diversification, measured by the count of

four-digit industries (N4), contributes negatively and significantly to Tobin’s q. Whether

spurious or causal, the raw negative impact of diversification on value is consistent with a

number of other studies, including Wernerfelt and Montgomery (1988), and Lang and Stulz

(1994). Regression (2) repeats regression (1), substituting the Herfindahl index for N4, obtaining

similar results.

In regressions (3) and (4) we split total assets growth into the internal and external parts.

In both regressions, the coefficient of the internal growth Gi is consistently positive and

significant, both statistically and economically. By contrast, the coefficient of external growth,

Gx, is much smaller and statistically insignificant. This serves as strong evidence for Hypothesis

1.

This result suggests that the market responds vividly to the internal growth signal. The

interesting result we uncover here is that, even though internal growth and external growth are

positively correlated, the market does not respond to external growth as much as it does to

internal growth.

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Growth and Diversification

The relationship between diversification and Tobin’s q (or other performance measures)

is widely studied. If diversification behavior is associated differently with the means of growth,

the association between means of growth and performance will be influenced accordingly. To

study the association between diversification and internal/external growth, we need to control for

variables other than diversification that are related to growth. In Berry (1971) and Jacquemin and

Berry (1979), the size of the firm, the scaled earnings, and the projected growth are found to be

associated with the total asset growth12. They found that the size of the firm is negatively related

to total growth, probably because the larger a firm, the more its growth is constrained by the size

of its markets. Also higher growth rates were found along with higher scaled earnings, and

higher projected growth rates.

Table 3 reports a set of analyses which respectively regress internal growth and external

growth on the measure of change in diversification and the three control variables (firm size,

scaled net income, and pure-play total growth rate), for the 743 firm-years who had at least one

business combination deal. In the table, variables followed by a (t) sign are valued at the end of

the fiscal year of each firm-year; variables followed by a (t-1) sign are valued at the end of the

last fiscal year.

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A noteworthy result is the estimated coefficient of the fraction change in the

diversification measure. The coefficients are small and statistically insignificant in regressions

(I1) to (I4), indicating a weak or nil relationship between increases of diversification and internal

growth. By contrast, increases in diversification are significantly and positively associated with

external growth. This is evidence that firms do not tend to grow into unfamiliar industries when

the growth is internal, supporting Hypothesis 2. It is worth noting that whereas Berry (1971) and

Jacquemin and Berry (1979) found a positive relationship between increases in diversification

and overall growth, our decomposition suggests that it is only external growth that is thus driven.

12 The projected growth in Berry (1971) is calculated as the output weighted sum of industry-average growths of each segment, which is very similar to the pure-play growth rate in this paper.

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Table 3 provides some other interesting results. Firm size appears to have a negative

significant impact on both internal growth and external growth. This result is consistent with the

well-documented result that there is a slightly negative impact of corporate size on growth.

The relationship between profitability (the last-year net-income/assets ratio) and growth

is positive and significant for internal growth but insignificant and sometimes negative for

external growth. It suggests that internal growth is associated with higher profitability, while

external growth does not. This result will be mentioned again when we look at the motivation for

firms to grow externally.

Higher industry growth rates (pure-play growth rates) give rise to higher internal and

external growth rates. All the coefficients of pure-play growth rate are less than one, indicating

firms’ individual characteristics decide part of both types of growth, and actually play a major

role, especially with respect to internal growth.

ACCOUNTING DATA ADJUSTMENTS

The Issue

Tobin’s q is defined as the ratio between the market value and the sum of individual

replacement values of each asset. In our calculation, the denominator is approximated by the total

assets from accounting statements. After business combinations happen, the valid approximation

for the denominator is the sum of the acquiror’s and the target’s total assets book values. Unless

the assets become scarce, the individual asset’s book value should be close to the replacement

value.

However, discrepancies in accounting data might happen in the cases of business

combinations. In the analyses above, the combined companies’ assets book values data ( tTA )

comes from the balance sheets of the surviving companies (when the purchased company is

liquidated) or the consolidated balance sheets that combine both the parent and the subsidiary

companies. The same tTA data are used as the fiscal-year-end assets values when the growth

rates of assets are calculated. This data can be quite different from the sum of the acquiror’s and

target’s original assets book values. The accounting methods and procedures used to record the

business combination can significantly influence the data, making the data a sum of original

assets book values and some market values. For example, in a stock acquisition, when 100% of

the target company’ stocks are purchased by using the Pooling-of-Interests accounting method,

the consolidated asset value is just the sum of the asset book values of the parent and the target

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companies, which is what we want; but if the same acquisition is recorded by using the Purchase

Method, then it is the asset market value rather than the book value of the target company13,

together with new goodwill if there is no bargain, that will be added into the consolidated assets.

In the latter case, the denominator of our calculated Tobin’s q is the sum of the acquiror and the

target’s assets book values, plus the difference between assets market values and book values,

then plus new goodwill if any. This is inconsistent with the calculated q for internally growing

firms. If on average, the market value of the whole target firm is higher than the book value, then

the Tobin’s q may be systematically undervalued for the high external growth firm-years; this

discrepancy may be a reason for the weak impact of Gx for Tobin’s q. The asset growth rates are

discrepant as well because some of the growth is contributed by the difference between the

target’s market value and book value, also by new goodwill (if any) included in the accounting

figure, but not by real asset value growth. In Lang and Stulz (1994), when diversification is

analyzed with Tobin’s q, this issue was noticed (1994: 1274), but no efforts were done to adjust

accounting data; instead, Lang and Stulz focused on firm-years that do not change the number of

segments, hoping these firm-years are free of business combinations so no accounting

discrepancy may happen. The weakness of their treatment is apparent because business

combination behaviors are not necessarily companied with change in the number of segments:

firms may combine an acquired single-business firm into one existing segment so the total

number of segments remains the same; or the purchasing of one or more new segments may

occur in the year that the same amount of old segments are sold. Thus the best way is to look into

the accounting rules and adjust for this problem accordingly.

The ideal asset value used as the denominator should only reflect the sum of the original

purchasing company’s assets book value (without any goodwill from previous business

combinations, for this item comes from the part of previous prices exceeding previous targets’

market values14), the target company’s assets book value (also without any previous goodwill),

and any asset changes due to business operations and ordinary accounting adjustments

(depreciation and amortization) in that year. If 1tTA − and 1tGW − are the acquiror’s total assets

13 The market values of the acquired assets are actually the replacement values, while the book values are only approximations to replacement values; but for assets that are not acquired, like the assets of firms that do not conduct business combinations, there is no way for us to get the exact market values. Hence, to make all calculated Tobin’s q comparable, we stick with book values of assets and try to adjust the business combination accounting data to obtain the sum of the book values of assets from the acquiror and the target. 14 The ideal treatment is to do the same accounting adjustment to 1tTA − and ta just like what is done to tTA . But the information for doing so is generally not available, so the best thing we can do is to remove the original goodwill (accumulated from previous business combination behaviors) from the acquiror and the target’s total assets.

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book value and goodwill book value observed at the end of fiscal year t-1, respectively, then we

define

1 1 1t t tTA TA GW− − −= −

to be the acquiror’s total goodwill-free assets value. Similarly, if ta and taGW are the target’s

total assets book value and goodwill book value right at the business combination date, we define

tata ta GW= −

to be the target’s goodwill-free assets value. It follows that the ideal total assets value that should

be used as the denominator of Tobin’s q after the business combination is

1 1comb t

t t t combTA TA TA ta TA− −= + ∆ + + ∆

where 1combtTA −∆ is the assets book value change due to business operations and ordinary

accounting adjustments (like depreciation and amortization, we call them “ordinary change”)

from the end of fiscal year t-1 to the date of business combination, and tcombTA∆ is the ordinary

change from the combination date to the end of year t. The surviving/consolidated company’s

Tobin’s q should use tTA as the denominator. Similarly, in the growth measure formulas above,

1tTA − and ta should be 1tTA − and ta respectively, while tTA should be tTA , so that the

calculated growth rates of assets can represent the pure growth in assets, without the “growth”

caused by the difference between the target’s market value and book value or goodwill. The

extension of this single acquisition case to multiple acquisition deals is straightforward.

The Adjustment Formulae

The procedure to obtain tTA is complicated by the various accounting situations. The

detailed discussion is included in the Appendix. Still the formulas we developed to be used to

calculate tTA turn out to be quite simple, as presented in the table below:

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Pool

ing-

of-I

nter

ests

M

etho

dPu

rcha

se M

etho

d

100%

Pur

chas

e, <

100%

Pur

chas

e or

Ste

p-by

-Ste

p Pu

rcha

se

No

Bar

gain

or B

arga

inSu

per B

arga

in

( )1 .0 1,0.5 1

t t t taTA TA GW GW P TgtLiabMV taα β βα β

−= − + + + −

≤ ≤ < ≤

( )1 .0 1,0.5 1

t t t taTA TA GW GW P TgtLiabMV taα β π βα β

−= − + + + + −

≤ ≤ < ≤

( )1 .t t t taTA TA GW GW−= − +

In the table, P refers to the price paid for the control-achieving transaction (the only

transaction if the control is not achieved through step-by-step purchases); α refers to the weight

of equity and/or debt securities paid in the price of the combination deal (in contrast to payments

in the form of cash or other assets), so that Pα represents the portion of price paid in the form of

equity and/or debt securities; β refers to the accumulated controlled portion of the target from

this deal and the previous deals (if any), β must be bigger than 0.5 for the control of the target to

be obtained; TgtLiabMV is the market value of the target firm’s liabilities, so that TgtLiabMVβ

represents the amount of target’s liabilities assumed by the acquiror during the business

combination; π is the gain enjoyed by the acquiror (if any), it is the part of target’s priority

accounts market value exceeding the price paid during the combination (please see Appendix for

details); the other items are defined as before.

Because the Super Bargain case is very rare (please see Appendix for details), we just

need to use

15

( )1 .0 1,0.5 1

t t t taTA TA GW GW P TgtLiabMV taα β βα β

−= − + + + −

≤ ≤ < ≤

for the Purchase Method business combinations, and use

( )1t t t taTA TA GW GW−= − +

for the Pooling-of-Interests Method combinations. If there are multiple deals conducted by an

acquiror in a certain year, simply use the sum of all the targets accounting figures in the formula.

The Data

The categorical identification for the Purchase/Pooling methods, the amount of price paid

in the form of equity and/or debt securities ( Pα ), the amount of the target’s liabilities assumed

by the acquiror during the business combination ( TgtLiabMVβ )15, and the amount of target’s

assets value purchased ( taβ ) all come from the SDC data set. Because 1tTA − , ta and tTA are

adjusted to 1tTA − , ta , and tTA respectively, a number of variables we have used in the previous

analyses are influenced, including Tobin’s q, Pure-play Tobin's q ( q ), Total Growth Rate (Ga),

Internal Growth Rate (Gi), External Growth Rate (Gx) and Pure-play Total Growth Rate. We

made the adjustments upon the dataset stacked by the 1,149 firm-year dataset and the 10,214

non-combination firm-years mentioned in an earlier section (the dataset before the removal of

any outliers), and then removed the outliers subject to adjusted variable. The total amount of

observations is 8,766, slightly different from the 8,755 firm-years before adjustment (due to the

outlier removal procedure). This dataset contains 756 firm-years with at least one business

combination.

The Results

Based on the adjusted datasets, we adjust Table 2 and Table 3.

------------------------------


------------------------------

------------------------------

15 There are some deals whose Target Liabilities Assumed item is missing in SDC, it is either because the acquiror did not assume any target’s liabilities, or because the information is not available. Thus, to be complete, we also computed estimated liabilities of the target using the target’s industry average Liabilities to Total Assets ratio and the target’s Total assets, and then use the estimated liabilities for missing items. The results remain similar so the conclusions are the same, thus not presented here.

16


------------------------------

Most of the results remain similar to those obtained before, and still support the

hypotheses16. The significant difference is that, in Table 4, the coefficients of Accounting

Adjusted External Growth Rate to the Accounting Adjusted Tobin’s q are now significantly

negative. This suggests that the market does not just expect no benefits from an external growth

signal, it actually expect such a growth to impair the performance of the firm.

WHY DO FIRMS GROW EXTERNALLY?

The empirical results above show that Tobin’s q is weakly or negatively associated with

external growth, while significantly and positively associated with internal growth. This raises a

question for those firms who conduct business combination: why do those firms grow externally?

Were they originally low-q firms before external growth behavior, or did their Tobin’s q become

lower through external growth?

------------------------------


------------------------------

To answer this question, it is helpful to look at firms’ Tobin’s q level before and after

business combinations occur. In Table 6, we compare two groups of firm-years: those with

business combinations and those without. The first group consists of firm-years that conducted

external growth (say, firm-years with nonzero external growth rates), and the other group

consists of those firm-years that did not (say, firm-years with zero external growth rates). All

standardized statistics are presented in both mean and median. Consider a firm F that acquired

some other firms during fiscal year 1996, the “Last Year Economy-Adjusted Tobin’s q” is

computed by subtracting the average of all firms’ Tobin’s q at the end of year 1995 from firm F’s

1995 Tobin’s q. Then we take the average of this statistic for all firm-years in this group to get its

mean. To obtain the median, a similar calculation is done except that we subtract the median of

all firms’ Tobin’s q in 1995, and then take the median of this group. The “Last Year Economy-

Adjusted Tobin’s q” evaluates the relative performance of this group compared with all the firms

in the whole economy (all the firms in the dataset), in the year before combinations. The current

16 In regressions X1 to X4, the coefficients of fraction change in the Herfindahl measure, although less significant than those in Table 3, remain economically and statistically more significant than those in regressions I1 to I4.

17

year’s economy-adjusted q is calculated in the same way. Using the current year’s mean or

median minus last year’s, we get the “Economy-Adjusted Change in Tobin’s q”, which measures

how much the relative performance position of this group has changed from last year to this year.

The “Last Year Industry-Adjusted Tobin’s q” is the difference between last year’s q and last

year’s pure-play q, the pure-play q is calculated in the same way described before, except that

this time last year’s data is used. This variable captures how well this group’s firms perform

within their industries. Again the difference between this year’s mean/median and last year’s is

the “Industry-Adjusted Change in Tobin’s q”. The “Absolute Change in Tobin’s q” is simply the

difference between this year’s q and last year’s q. The same procedures are repeated for the

group of zero-external-growth-rate firm-years. Both original Tobin’s q and the Accounting

Adjusted Tobin’s q are studied, but the results do not differ significantly in this table17.

The firms with business combinations performed pretty well in the year before. Both the

mean and the median of those firms are significantly higher, both statistically and economically,

compared with the whole economy (all the firms in the dataset). This suggests that before

business combinations, those firms were out-performing the average of all the manufacturing

firms in the economy in terms of a higher Tobin’s q. The mean of last year industry-adjusted q is

small economically while the median is just zero; namely those firms were about average in their

industries before business combinations. Combined together, it suggests that the externally-

growing firms were average firms in outstanding industries. However, the statistics that measure

the changes in q are all negative for both mean and median. They are all significantly positive,

and also economically large for most of the cases. Hence, this is evidence that after business

combinations, firms’ q levels are lowered in absolute value, and their relative positions of q are

also lower, be it in the whole economy, or in their own industries. Thus supports the view that

firms’ Tobin’s q becomes lower after external growth.

On contrast, firms without external growth perform about average in the whole economy.

And they were below the average and the median in their industries. However, they did not

acquire or merge with any other firms/divisions, and all the statistics measuring the change of

Tobin’s q are all small in an economic sense and even statistically insignificant in some cases.

This suggests that these firms’ performance positions remain unchanged in absolute values, in

the economy and in their industries.

17 We also further categorize each of these two groups (externally-growing and non-externally-growing firm-years) in Table 6 into firm-years that diversified (a increase in segment count) and firm-years that focused (a decrease in segment count), but only obtain similar results.

18

Why do we observe these phenomena? One possible explanation is that, firms that chose

to grow externally were actually overvalued by the market beforehand. The fact that they were

average firms in outstanding industries suggests that their high Tobin’s q were more likely driven

by industry effects, but not by their own firm-specific effects. These firms might be actually

short of internal investment opportunities (it is consistent with the findings in Table 3 and Table

5, where internal growth is found to be strongly accompanied with high profitability while

external growth does not). External growth became their choice because of its ambiguous nature:

as discussed at the beginning, on one hand external growth may bring extra internal costs in

contrast to internal growth, but on the other hand possible synergies may be created between

existing assets and acquired assets. Thus, hoping to give the market an ambiguous signal, those

overvalued firms chose to use their overvalued stocks to acquire/merge with other firms instead

of other obvious choices like purchasing bonds. The market, on the other hand, still takes the

external growth as a signal that the firms are out of investment opportunities, and reacts by

lowering the prices of their stocks, hence bringing about a lower q afterwards.

DISCUSSION

Internal growth brings a firm a higher Tobin’s q, but external growth does not. Our

preliminary interpretation is that internal growth and Tobin’s q are both indicators of a rich set of

investment opportunities. By this view, internal growth does not so much cause a higher q as it

affirms the presence of opportunities which, in turn, are valued by the market. This interpretation

of the association is supported by the result (Table 3 and Table 5) that profitability is also

positively associated with internal growth, but not external growth.

External growth may not increase or even decrease Tobin’s q for a number of reasons.

First, from the implications of Table 6, firms that have been overvalued chose to grow externally,

and the market takes it as a signal that the firms are out of self-investment opportunity; hence the

stock prices drop. Second, external growth is more likely to be diversification (Table 3 and Table

5), which is found to have a negative effect on value in quite a few studies (Wernerfelt and

Montgomery (1988), Lang and Stulz (1994), Berger and Ofek (1995), Maksimovic and Phillips

(1999)). Third, the internal costs associated with integrating acquisitions into a firm may cancel

out any gains from such activities.

Yet, one cannot simply take this result to mean that external growth has no value or

negative value. Internal growth and external growth are positively correlated, and external

19

growth is a predictor of internal growth even when industry effects are controlled.18 Thus, it may

be that external growth enhances internal growth, which is, in turn, value enhancing.

There is a line of work studying the relationship between diversification and Tobin’s q.

The study by Wernerfelt and Montgomery (1988) found a general negative relationship, and

Lang and Stulz (1994) reported a generous diversification discount after correcting for industry

effects. More recently, Villalonga (2004) has called these results into question, arguing that the

“discount” is an artifact of a subtle form of selection bias. Our results on diversification are in

line with the main findings in this literature: we also find a significant negative impact on

Tobin’s q after controlling for industry effects. We do not find any impact of increases in

diversification on internal growth, but do find that increased diversification tends to predict

higher levels of external growth.

CONCLUSIONS

This paper reports on a method for decomposing corporate growth into internal and

external components, as one of the first efforts in this direction. Also this paper employs matched

SDC-Mergerstat dataset and Tobin’s q/growth rate accounting adjustment for the first time in the

literatures. The results with these new measures show intriguing patterns that deserve further

investigation. More importantly, internal growth is a strong predictor of increased market

valuation, whereas external growth is not or even predicts negative change in market valuation;

yet the two types of growth are correlated, so one cannot say that external growth has no value. It

may be that external growth, while having no independent effect on value, helps engender

internal growth, which does. Our evidence is supportive of the view that firms’ performance

becomes lower after external growth. A plausible explanation for this result is that overvalued

firms in high performance industries, short of internal investment opportunities, are trying to

signal the market ambiguously by external growth. Out results suggest a more detailed work on

untangling the nest of causal relationships among internal growth, external growth, and value

would be useful.

18 The partial correlation between Gi and Gx, holding pure-play growth rate constant, is positive and non-zero at the 0.0001 level of significance.

20

APPENDIX

Accounting Data Adjustments

This Appendix will examine a method to adjust assets data from balance sheets in

different business combination cases, in order to obtain the value of tTA .

An Overview of Accounting Rules for Business Combinations

As we discussed in an earlier section, there are several types of business combinations:

Merger/Consolidation and Stock Acquisition. However whether a combination is a

merger/consolidation or stock acquisition has little significance for the concern of accounting

rules, because the combined financial statements for the surviving entity in a

merger/consolidation will be the same as the consolidated financial statements in a 100% stock

acquisition, ceteris paribus. Similarly, the means of purchase is not important here because a net

asset purchase will have the same financial statements as a 100% stock purchase deal, ceteris

paribus. The things that actually influence the final amount of recorded assets are the accounting

method, the price, and the types of considerations paid. Therefore, we will first focus on a variety

of stock acquisition cases since these results can be directly applied to other situations.

Changes of Accounting Rules

The first change of accounting rules happed to stock acquisition deals. Prior to the

issuance of FASB Statement No. 9419 in 1987, GAAP only required controlled subsidiaries

whose operations were homogeneous with those of the parent to be included in the consolidated

statements. This would clearly undervalue the assets in the consolidated statements after the

combination, and require our study period to start after 1987. Our study period, fiscal year 1993

to 2002 (which may cover the calendar time period from July 1992 to May 2003), satisfies this

requirement well.

Additionally, FASB Statement No. 14220, which was issued in July 2001, changed the

way goodwill is amortized. Before that, goodwill was amortized up to 40 years; but after that,

goodwill is no longer amortized: it is only tested for, and adjusted for impairment if necessary.

Since goodwill was amortized slowly, and there is only one fiscal year after 2001 included in our

data, this change is of little consequence. 19 Statement of Financial Accounting Standards No. 94, Consolidation of All Majority-Owned Subsidiaries (Stamford, CT: Financial Accounting Standards Board, 1987). 20 FASB Statement No. 142, Goodwill and Other Intangible Assets (Norwalk, CT: Financial Accounting Standards Board, June 2001).

21

Accounting Methods in a Business Combination

Prior to the issuance of FASB Statement No. 14121 in July 2001, both

Merger/Consolidation and Stock Acquisition deals can use either the Pooling-of-Interests

Method or the Purchase Method.

The Pooling-of-Interests Method uses the book values of the target company’s assets for

combination transactions because this method regards the combination not as a sale, but as an

agreement between the shareholders to combine the companies together. Before July 2001, APB

Opinion 1622 required twelve separate criteria to all be met for a combination to be accounted for

by the pooling method. The requirements include that the combination must be completed in a

single transaction, only common stock of the acquiror can be paid as considerations, and at least

90% of the target’s voting common stock or all the assets must be acquired. As we will see from

the examples below, these restrictions allow a relatively simple way to adjust the accounting data

of pooling deals.

The other widely used method is the Purchase Method. This method basically records the

target’s assets and liabilities at their market value, and the excess of the price paid (if any) will

become new goodwill in the combined/consolidated balance sheets. The situation is more

complicated when the price is less than the market value of target’s net assets, or when the

acquired part is less than 100% of the target. Besides that, different types of considerations paid

(like cash, stock, and debt securities) will result in a significant difference in the final combined

asset value. Step-by-step purchases, like two purchases which acquire 30% of the target the first

time and 40% of the target the second time, will also bring in variables.

In the sections below, we will carefully study the different ways to adjust data in each of

the situations described.

Accountings Subsequent to a Business Combination

Usually, there is a time period from the date at which the combinations happened to the

ending date of that fiscal year. Thus the year-end assets value of the surviving company reflects

not only the accounting procedures on the combination date, but also the accountings

21 FASB Statement No. 141, Business Combinations (Norwalk, CT: Financial Accounting Standards Board, June 2001). 22 Accounting Principles Board Opinion No. 16, Business Combinations (New York: American Institute of Certified Public Accountants, 1970).

22

subsequently. The question is: do we also need to adjust the asset values for the subsequent

accountings?

For a Merger/Consolidation, since the combined company is liquidated, once the

combination is recorded on the effective date, subsequent accountings are the same as those for a

single company. Therefore, any accounting records influencing the combined asset values after

that date can only come from business operations and ordinary accounting adjustments and

should be included in the calculation of Tobin’s q and growth rates. We have:

.tt comb combTA TA TA= + ∆

where tTA is the total assets value on the combined/consolidated balance sheet at the end of

fiscal year t, it is the asset value we observe from the data sample for year t. combTA is the value

on the combined/consolidated balance sheet right on the business combination date, and tcombTA∆

represents the ordinary change from combination date to the year end, as defined before. Because tcombTA∆ is also a component of tTA , and tTA is observed, it would be possible to calculate tTA

as long as we can figure out the components of combTA .

The situation seems to be more complicated for Stock Acquisitions. There are three

methods available for the parent to maintain its investment in a subsidiary company: the Equity

Method, the Sophisticated Equity Method, and the Cost Method. But no matter which method is

used, the investment in the subsidiary will be eliminated when consolidating anyway. Other

accounts that are influenced by this choice of maintaining methods, like the “Subsidiary

Income/Loss” account on the parent’s balance sheet, have no effect on the consolidated asset

values. Another concern for stock acquisitions is that the subsidiary may or may not close its

books as of the purchase date. But again this choice will only influence accounts irrelevant to the

consolidated asset values (like the sales account and the subsidiary’s retained earnings account).

Thus, same as Merger/Consolidation, any changes after the Stock Acquisitions date must come

from ordinary changes and need not be adjusted, we still have tt comb combTA TA TA= + ∆ .

In the next section, we will illustrate the components of combTA and the formulae to

calculate tTA in difference circumstances.

Examples and Adjustment Formulae

Depending on the accounting method used, the way of purchase (either purchasing the

target’s stock or assets), the percentage of the target stock purchased (including step-by-step

23

purchase deals), the price paid, and the consideration types, the accounting procedure for the

combined/consolidated asset value may vary from case to case. The following chart shows

different types of combinations.

------------------------------

Insert Figure A1 about here

------------------------------

To illustrate, we make up a business combination example where an acquiring company

(Acquiror Company) acquired/merged with a target (Target Company) in 1996. Their balance

sheets right before the combination are shown blow:

------------------------------

Insert Table A1 about here

------------------------------

------------------------------


------------------------------

The total assets value of Acquiror Company, $2,733,000, is the sum of 1tTA − and

1combtTA −∆ . The total assets value of Target Company, $87,600, is the ta defined before.

Case 1: Purchase Method, 100% Purchase

This type of combinations can be achieved by purchasing either target’s 100% common

stock or all the target’s net assets (usually, target’s liabilities are also assumed by the acquiror). If

the net assets are purchased, the combined balance sheet will be exactly the same as the 100%

stock purchase consolidated balance sheet. So in the illustrations for this case, we will only show

the preparation of the consolidated balance sheet for a 100% stock acquisition.

Case 1-1: Price Exceeds Target Goodwill-Free Net Assets Market Value – No Bargain

The price paid for an acquisition includes the considerations and the direct acquisition

costs (fees paid to attorneys and accountants). The price paid is compared with target’s net

assets’ market value (assets market value minus liabilities market value, but excluding target’s

original goodwill taGW ) to decide whether there is new goodwill or not. In the above balance

sheet, the Target Company’s goodwill-free net assets market value is $120,000. If the price is

24

higher than that value, then there is no bargain, target’s assets and liabilities accounts will be

recorded at the market values, the excess part of price will be recorded as goodwill. Let’s

suppose the price paid, including direct acquisition costs, is $140,000. With this price, the

goodwill resulted is $20,000. Because the Target already had $4,000 goodwill taGW before

combination, only their difference, $16,000, will be added to the consolidated goodwill account.

• Considerations Paid with Cash or Other Assets

Suppose the Acquiror Company paid cash. Then first the Acquiror will record the

following entry: Investment in Target Company …………...... 140,000

Cash ……………………………………………………… 140,000

Because both Cash and the investment account are asset accounts, after this entry the acquiror’s

total assets value remains unchanged.

When consolidating, the investment amount is eliminated. For a non-bargain case, the

investment amount will first offset Target’s equity which equals the net assets’ book value (the

target’s equity is eliminated because the target’s assets and liabilities now belong to the acquiror,

not to any outside owners), then the rest of investment will be allocated to assets and liabilities

accounts, making up the difference between their book and market values, then the remaining

amount will become new goodwill. The entries are: Common stock – Target ………….................... 3,000

Paid-in capital in excess of par – Target ……... 26,000

Retained Earnings – Target …………………… 49,100

Investment in Target Company ……………………….. 78,100

Inventory (adjust to market value) ……......... 2,000

Land (adjust to market value) ……............... 8,000

Buildings (net) (adjust to market value) …… 28,000

Equipments (net) (adjust to market value) … 6,400

Copyright (adjust to market value) ……........ 5,000

Premium on bonds payable (adjust

liabilities to market value) ……………………………… 3,500

Goodwill (adjust to $20,000).……………...... 16,000

25

Investment in Target Company ……………………….......... 61,900

Then the following worksheet for consolidated balance sheet is prepared accordingly. To

clearly see the change of assets value, we have removed the step to transfer the payment into the

investment in Target account, directly credited the price paid from the Cash account:

------------------------------


------------------------------

The total assets value on the consolidated balance is $2,746,000 (including $344,000 of

goodwill), it is combTA as defined before. Suppose the fiscal year ends on December 31, 1996,

then this total assets value, plus any ordinary assets value change from May 31 to December 31

( tcombTA∆ ), becomes the Acquiror Company’s 1996 total assets value tTA that we observe from

the data sample.

To find out the components of combTA , we first notice that although the price paid was

removed from cash, all that amount was added back as Target’s equity (which equals the assets

book value (including previous goodwill) minus the liabilities book value of Target) and the

difference between market and book values of Target’s assets and liabilities accounts, so

basically, the price paid is cancelled out, except that the Target’s liabilities book value and the

difference between Target’s liabilities’ market value and book value are not a part of the combTA ,

but both of them have been included in the cancellation of the price paid, so we need to add them

back.

Strictly, looking at the asset accounts and adjustments from left to right in the worksheet,

we have:

( ) ( )1 1comb

comb t t combTA TA TA ta taMV ta GW P− −= + ∆ + + − + −

where P is the price paid; taMV is the Target’s total assets market value23 (not including taGW ,

for taGW is included in combGW 24); combGW is the $20,000 goodwill resulting from the

23 The equation is still valid if the market values of some assets are actually lower than their book values. In that case, those accounts will be credited for a decrease to be adjusted to their market values. 24 Even if combGW is less than taGW , say, price is only $121,000 so that combGW is only $1,000, this equation is still valid, because the goodwill account, instead of being debited, will be credited for $3,000 to decrease to the value of combGW . In fact, taGW is assigned no value in the combination, what important is the value of combGW , which decides how much should be debited or credited to the goodwill account. The same thing happens to the formula of price.

26

combination, it equals to the difference between price and the target’s net assets (excluding

taGW ). Besides, we know

( ) ( )( ) ( ) ( )

133000 13000 20000140000

comb

comb

comb

P TgtEquityBV taMV ta TgtLiabMV TgtLiabBV GW

ta TgtLiabBV taMV ta TgtLiabMV TgtLiabBV GWtaMV TgtLiabMV GW

= + − − − +

= − + − − − +

= − +

= − +=

where TgtEquityBV is the Target’s equity book value, TgtLiabBV is the Target’s book value of

liabilities right before the combination; TgtLiabMV is the liabilities market value. Thus we have

( )( )

1 1

1 1

2733000 130002746000

combcomb t t comb comb

combt t

TA TA TA ta taMV ta GW taMV TgtLiabMV GW

TA TA TgtLiabMV

− −

− −

= + ∆ + + − + − + −

= + ∆ +

= +=

A simple calculation revealed that this equation is valid.

To obtain tTA , we notice

( )

( )( )

1 1

1 1 1

1 1 1

1 .

tt comb comb

comb tt t comb

comb tt t t comb

comb tt t comb t

t t ta

TA TA TA

TA TA TgtLiabMV TA

TA GW TA TgtLiabMV TA

TA TA ta TA GW TgtLiabMV ta

TA GW GW TgtLiabMV ta

− −

− − −

− − −

−

= + ∆

= + ∆ + + ∆

= + + ∆ + + ∆

= + ∆ + + ∆ + + −

= + + + −

Therefore,

( )1 .t t t taTA TA GW GW TgtLiabMV ta−= − + + −

In this equation, we can observe 1tGW − and ta (note that 1tGW − is not the goodwill in Table 1, it

should be the goodwill of Acquiror Company at the end of fiscal year 1995), some deals also

provide data for taGW and TgtLiabMV .

• Considerations Paid with Equity or Debt Securities

If the price were paid by issuing stock or increasing debts, a significant difference is that

price is no longer cancelled in the consolidated balance. Suppose the price is still $140,000, the

Acquiror Company exchanges 20,000 shares common stock for 100% common stock of Target

Company. Suppose the par value of Acquiror’s common stock is $1 per share, and their market

value is $7 per share. No costs occurred. The Acquiror’s entry will be:

27

Investment in Target Company ………….......... 140,000

Common stock, $1 par ………………………………… 20,000

Paid-in capital in excess of par ……………………….. 120,000

The entries to eliminate the investment in Target will remain unchanged. Then the

worksheet for Consolidated Balance Sheet will be:

------------------------------


------------------------------

As we can see, the amount of consolidated assets is higher because there are no cash

expenses. We have

( ) ( )( )

1 1

1 1 .

combcomb t t comb

combt t comb

TA TA TA ta taMV ta GW

TA TA taMV GW

− −

− −

= + ∆ + + − +

= + ∆ + +

And from the formula for price, we can deduce:

( )combtaMV GW P TgtLiabMV+ = +

Plugging it in, we get:

( )1 1 .combcomb t tTA TA TA P TgtLiabMV− −= + ∆ + +

To obtain tTA , we notice

( )

( )( )

1 1

1 1 1

1 1 1

1 .

tt comb comb

comb tt t comb

comb tt t t comb

comb tt t comb t

t t ta

TA TA TA

TA TA P TgtLiabMV TA

TA GW TA P TgtLiabMV TA

TA TA ta TA GW P TgtLiabMV ta

TA GW GW P TgtLiabMV ta

− −

− − −

− − −

−

= + ∆

= + ∆ + + + ∆

= + + ∆ + + + ∆

= + ∆ + + ∆ + + + −

= + + + + −

Therefore,

( )1 .t t t taTA TA GW GW P TgtLiabMV ta−= − + + + −

• Considerations Paid with both Cash/Assets and Equity/Debt Securities

The most common case is that some portion of the consideration was paid by cash or/and

other assets, the rest was paid by stock or debt securities. Suppose the equity/debt securities

weight is α ( )0 1α< < , because the part paid by cash/assets is cancelled for combTA , we will have

28

( )1 1 .combcomb t tTA TA TA P TgtLiabMVα− −= + ∆ + +

Then the same procedures lead us to

( )1 .t t t taTA TA GW GW P TgtLiabMV taα−= − + + + −

And this equation can server as the general equation for all the payment forms above, for

0 1α≤ ≤ .

Case 1-2: Price Lower than Target Goodwill-Free Net Assets Market Value, but

Higher than Net Priority Assets Market Value – Bargain

If the price is lower than target net assets market value, then there is a bargain, no

goodwill will be recorded, and after offsetting the target’s equity, remaining price paid will not

be enough to adjust every target assets and liabilities accounts to their market values. Some asset

accounts and all the liabilities accounts are required to be recorded at the market value, they are

called the Priority Accounts; the other asset accounts, except for goodwill, are Non-priority

Accounts, they are allocated with the rest of the price paid, if any. The priority accounts include

all liabilities accounts and all current asset accounts, plus investments and deferred tax assets

(except for influential investments accounted for under the equity method), etc. For the Target

Company in Table 2, its priority accounts are: Cash, Accounts Receivable, Inventory, Current

Liabilities, and Bonds Payable. The net priority assets market value is $11,000. Suppose the price

paid is $105,000. All the priority accounts will be recorded at their market values, which will

leave $94,000 of the price to be allocated into non-priority asset accounts. The amount allocated

into each non-priority asset account is decided by its market value weight among all non-priority

assets. For our example, the Target Company’s non-priority asset accounts have the following

allocation table:

Market Total Amount Allocated BookTarget nonpriority assets Value Percent to Allocate Amount Value Adjustment Land 12,000$ 11% 94,000$ 10,349$ 4,000$ 6,349$ Buildings (net) 70,000 64% 94,000 60,367 42,000 18,367 Equipment (net) 15,000 14% 94,000 12,936 8,600 4,336 Copyright 12,000 11% 94,000 10,349 7,000 3,349 Here the allocated amount in each account equals to the product of the total amount to allocate

and the market value weight of that account. If any market value is less than the book value, then

the adjustment amount would be negative.

• Considerations Paid with Cash or Other Assets

29

If the price is paid by cash or other assets, the worksheet for Consolidated Balance Sheet

right on the combination date is:

------------------------------


------------------------------

Similarly, we have

( ) ( )( ) ( )

1 1

1 1

combcomb t t priority nonpriority ta ta

combt t priority nonpriority

TA TA TA ta taMV taALC ta GW P GW

TA TA taMV taALC P

− −

− −

⎡ ⎤= + ∆ + + + − − − −⎣ ⎦

= + ∆ + + −

where prioritytaMV is the market value of target’s priority asset accounts; nonprioritytaALC is the

allocated values of non-priority asset accounts. Since taGW was assigned no value and will be

eliminated, it is removed from the target’s total assets ta .

And the price formula is

( )( )( ) ( ) ( )

24000 94000 1

priority nonpriority ta

ta

priority nonpriority


P TgtEquityBV taMV taALC ta GW

TgtLiabMV TgtLiabBV GW

ta TgtLiabBV taMV taALC ta TgtLiabMV TgtLiabBV

taMV taALC TgtLiabMV

⎡ ⎤= + + − −⎣ ⎦− − −

= − + + − − −

= + −

= + − 3000105000=

Combining them together:

( ) ( )( )( )

1 1

1 1

combcomb t t priority nonpriority


combt t

TA TA TA taMV taALC

taMV taALC TgtLiabMV

TA TA TgtLiabMV

− −

− −

= + ∆ + +

− + −

= + ∆ +

This is exactly the same formula for combTA when there is no bargain. It leads us to the same

formula for tTA :

( )1 .t t t taTA TA GW GW TgtLiabMV ta−= − + + −

• Considerations Paid with Equity or Debt Securities

Suppose the $105,000 consideration is paid by 15,000 shares of Acquiror’s common

stock, each share has a par value of $1 and a market value of $7, then the worksheet for

Consolidated Balance Sheet right on the combination date is:

------------------------------

30


------------------------------

The formulae are:

( ) ( )( ) ( )( )

1 1

1 1

1 1

combcomb t t priority nonpriority ta ta


combt t

TA TA TA ta taMV taALC ta GW GW

TA TA taMV taALC

TA TA P TgtLiabMV

− −

− −

− −

⎡ ⎤= + ∆ + + + − − −⎣ ⎦

= + ∆ + +

= + ∆ + +

and

( )1 .t t t taTA TA GW GW P TgtLiabMV ta−= − + + + −

Again it coincides with the non-bargain case.

• Considerations Paid with both Cash/Assets and Equity/Debt Securities

As one can derive, the general formula of tTA when considerations are paid with weight

α ( )0 1α≤ ≤ to be equity/debt securities is

( )1 .t t t taTA TA GW GW P TgtLiabMV taα−= − + + + −

Case 1-3: Price Lower than Target Net Priority Assets Market Value– Super Bargain

A rare scenario happens when the price is even lower than target’s priority accounts net

assets, which is $11,000 in our example. Still the priority accounts must be recorded at their

market values, but no value will be allocated to non-priority asset accounts since there is no price

left after covering priority accounts’ market value. In fact, the extra priority accounts market

value exceeding the price paid will become a gain, which increases the retained earnings of the

acquiror.

The following table shows the preparation for the Consolidated Balance Sheet when price

paid is $7,000 in the form of common stock (1,000 shares, $1 par per share, $7 market price per

share).

------------------------------


------------------------------

The formulae in this case will be:

( ) ( )( )

1 1

1 1 .

combcomb t t priority priority nonpriority ta

combt t priority

TA TA TA ta taMV taBV taBV GW

TA TA taMV

− −

− −

= + ∆ + + − − −

= + ∆ +

31

where prioritytaBV is the priority asset accounts’ book value, nonprioritytaBV is the non-priority asset

accounts’ book value, together with taGW they sum up to ta .

And the price is

24000 13000 40007000.

priorityP taMV TgtLiabMV π= − −

= − −=

where π is the $4,000 gain, the extra priority accounts market value ($11,000) exceeding the

price paid ($7,000).

Thus,

( )1 1 .combcomb t tTA TA TA P TgtLiabMV π− −= + ∆ + + +

Therefore

( )

( )( )

1 1

1 1 1

1 1 1

1 .

tt comb comb

comb tt t comb

comb tt t t comb

comb tt t comb t

t t ta

TA TA TA

TA TA P TgtLiabMV TA

TA GW TA P TgtLiabMV TA

TA TA ta TA GW P TgtLiabMV ta

TA GW GW P TgtLiabMV ta

π

π

π

π

− −

− − −

− − −

−

= + ∆

= + ∆ + + + + ∆

= + + ∆ + + + + ∆

= + ∆ + + ∆ + + + + −

= + + + + + −

( )1 .t t t taTA TA GW GW P TgtLiabMV taπ−= − + + + + −

It follows that the general formula of tTA when weight α ( )0 1α≤ ≤ of considerations

is in the form of equity/debt securities is

( )1 .t t t taTA TA GW GW P TgtLiabMV taα π−= − + + + + −

Case 2: Purchase Method, <100% Purchase

Since only a part ( )0.5 1β β< < of the target is purchased, this type of combinations

cannot be achieved by net assets acquisitions. Only stock acquisitions may qualify.

A major difference here is that the price is compared with only the purchased part of

target’s goodwill-free net assets market value to see if there is a bargain. Suppose 80% ( )0.8β =

of Target Company in our sample is purchased, the following table shows the benchmarks:

32

100% 80%Target net priority assets (market value) 11,000$ 8,800$ Target goodwill-free net assets (market value) 120,000 96,000

If the price is higher than $96,000, there is no bargain; between $8,800 and $96,000, there is a

bargain; lower than $8,800, there is a super bargain.

In all bargain or non-bargain cases, the non-purchased part (20%) of Target’s net assets

(including taGW ) becomes Noncontrolling Interest in the consolidated balance. It is equivalent to

say that 20% of Target’s equity is not controlled by Acquiror Company.

Case 2-1: No Bargain

Suppose the price is $100,000 with $65,000 cash ( )0.35α = and $35,000 common stock

(5,000 shares, $1 par per share, $7 market price per share). For the market value adjustment, the

common practice is to follow the Parent Company Approach: only to the controlled part (80%)

of Target’s non-goodwill asset accounts market values that these accounts will be adjusted.

Market Book 80%Target Value Value (MV-BV) (MV-BV)

Inventory 12,000$ 10,000$ 2,000$ 1,600$ Land 12,000 4,000 8,000 6,400 Buildings (net) 70,000 42,000 28,000 22,400 Equipment (net) 15,000 8,600 6,400 5,120 Copyright 12,000 7,000 5,000 4,000

For Target’s goodwill taGW , 20% of it will be kept, 80% of it will be adjusted to the total

goodwill resulting from the combination ( combGW ), which is the difference between price and

80% of target’s goodwill-free net assets market value.

( )combGW P taMV TgtLiabMVβ= − −

In this example combGW is $4,000, while 80% of taGW is $3,200, so we need to debit the

goodwill account by there difference $800.

The consolidating worksheet is demonstrated below:

------------------------------


------------------------------

From left to right, we have

33

( ) ( ) ( ) ( )( ) ( ) ( )( ) ( ) ( ) ( )( ) ( )

1 1

1 1

1 1

1 1

1

1 1

1 1

1 .

combcomb t t ta comb ta

combt t comb

combt t

combt t

TA TA TA ta taMV ta GW GW GW P

TA TA taMV ta GW P

TA TA taMV ta P taMV TgtLiabMV P

TA TA P TgtLiabMV ta

β β α

β β α

β β β α

α β β

− −

− −

− −

− −

= + ∆ + + − − + − − −⎡ ⎤⎣ ⎦

= + ∆ + + − + − −

= + ∆ + + − + − − − −

= + ∆ + + + −

Therefore:

( ) ( )( )

( ) ( )

1 1

1 1 1

1 1 1

1

1

1

1

tt comb comb

comb tt t comb

comb tt t t comb

comb tt t comb t

t t ta

TA TA TA

TA TA P TgtLiabMV ta TA

TA GW TA P TgtLiabMV ta TA

TA TA ta TA GW P TgtLiabMV ta ta

TA GW GW P TgtLi

α β β

α β β

α β β

α β

− −

− − −

− − −

−

= + ∆

= + ∆ + + + − + ∆

= + + ∆ + + + − + ∆

= + ∆ + + ∆ + + + + − −

= + + + +( ).abMV taβ−

( )1 .t t t taTA TA GW GW P TgtLiabMV taα β β−= − + + + −

Case 2-2: Bargain

If price is lower than the purchased part of target’s goodwill-free net assets ($9,600 in our

example), then no new goodwill will be recorded, and again we need to distinguish between

priority and non-priority accounts. Similarly, the non-priority asset accounts will be allocated

with the difference between price and the net priority assets, but only 80% book value will be

adjusted.

Market Total Amount Allocated 80%Target nonpriority assets Value Percent to Allocate Amount Book Value Adjustment Land 12,000$ 11% 61,200$ 6,738$ 3,200$ 3,538$ Buildings (net) 70,000 64% 61,200 39,303 33,600 5,703 Equipment (net) 15,000 14% 61,200 8,422 6,880 1,542 Copyright 12,000 11% 61,200 6,738 5,600 1,138

Thus, if the price paid is $70,000, half in cash and half in common stock (5,000 shares,

$1 par per share, $7 market price per share), then the worksheet is:

------------------------------


------------------------------

The equation for the price is:

34

( )( )( ) ( )( )

0.

priority nonpriority ta

ta




TgtLiabMV TgtLiabBV GW

ta TgtLiabBV taMV taALC ta

TgtLiabMV TgtLiabBVtaMV taALC TgtLiabMV

β β β

β β

β β β

ββ β

⎡ ⎤= + + − −⎣ ⎦− − −

= − + + −

− −

= + −

= 8 24000 61,200 0.8 1300070000

× + − ×=

which directly implies

( ) .priority nonprioritytaMV taALC P TgtLiabMVβ β+ = +

The worksheet, from left to right, shows the consolidated total asset value is:

( ) ( )( )( ) ( ) ( ) ( )( ) ( ) ( )( )

1 1

1 1

1 1

1 1

1

1 1

1 1

1

combcomb t t priority nonpriority ta

ta


combt t

combt t

TA TA TA ta taMV taALC ta GW

P GW

TA TA ta taMV taALC P

TA TA ta P TgtLiabMV P

TA TA

β β

α β

β β α

β β α

− −

− −

− −

− −

⎡ ⎤= + ∆ + + + − −⎣ ⎦− − −

= + ∆ + − + + − −

= + ∆ + − + + − −

= + ∆ + ( ) .ta P TgtLiabMVβ α β− + +

This is the same as in the no bargain case. Hence we still have

( )1 .t t t taTA TA GW GW P TgtLiabMV taα β β−= − + + + −

Case 2-3: Super Bargain

In this rare case, price is lower than purchased part of the target’s net priority assets

market value. The purchased part of priority accounts must still be recorded at their market

values, the rest will remain at book values. Non-priority asset accounts will only be kept for 20%

book values. The difference between the 80% net priority assets and the price is recorded as a

gain, increasing retained earnings of Acquiror Company. If the price is $5,000 ($1,500 by Cash

and $3,500 by 500 shares common stock, $1 par, $7 market price), the worksheet is below:

------------------------------


------------------------------

Price’s equation is

( ) .priorityP taMV TgtLiabMVβ π= − −

Thus,

35

( ) ( ) ( )( ) ( ) ( )( ) ( ) ( )( ) ( )

1 1

1 1

1 1

1 1

1

1 1

1 1

1

combcomb t t priority priority nonpriority ta

combt t priority

combt t

combt t

TA TA TA ta taMV taBV taBV P GW

TA TA ta P taMV

TA TA ta P P TgtLiabMV

TA TA ta P TgtL

β β α β

β α β

β α π β

β α π β

− −

− −

− −

− −

= + ∆ + + − − − − −

= + ∆ + − − − +

= + ∆ + − − − + + +

= + ∆ + − + + + .iabMV

( ) ( )( )

( ) ( )

1 1

1 1 1

1 1 1

1

1

1

1

tt comb comb

comb tt t comb

comb tt t t comb

comb tt t comb t

t t ta

TA TA TA

TA TA ta P TgtLiabMV TA

TA GW TA ta P TgtLiabMV TA

TA TA ta TA GW ta P TgtLiabMV ta

TA GW GW P

β α π β

β α π β

β α π β

α

− −

− − −

− − −

−

= + ∆

= + ∆ + − + + + + ∆

= + + ∆ + − + + + + ∆

= + ∆ + + ∆ + + − + + + −

= + + + +( ).TgtLiabMV taπ β β+ −

The final formula for tTA is:

( )1 .t t t taTA TA GW GW P TgtLiabMV taα β π β−= − + + + + −

Case 3: Pooling-of-Interests Method

When the combined is recorded by using the pooling method, according to APB Opinion

16, the consideration can only be paid in the form of common stock of the acquiror, and the price

paid is basically ignored since it is assumed that there was no purchase, but a combination of

those entities. So we only need to consider two cases: 100% purchase and <100% purchase (must

be no less than 90% though). Besides, what complicated in a pooling method is the combination

of shareholder’s equity, but that has no influence on the consolidated asset value. So we will find

pooling method a much easier case to deal with.

Case 3-1: Pooling-of-Interests Method, 100% Purchase

This case is very simple for the calculation of combTA , because the consolidated assets

book value is exactly the sum of the acquiror’s assets book value and the target’s assets book

value, say,

( )1 1 .combcomb t tTA TA TA ta− −= + ∆ +

We therefore have:

36

( )( )

( )

1 1

1 1 1

1 .

tt comb comb

comb tt t comb

comb tt t comb t

t t ta

TA TA TA

TA TA ta TA

TA TA ta TA GW ta ta

TA GW GW

− −

− − −

−

= + ∆

= + ∆ + + ∆

= + ∆ + + ∆ + + −

= + +


Case 3-2: Pooling-of-Interests Method, <100% Purchase

In only difference in this case, say, a 90% purchase, is that the non-controlling part of the

target’s equity will be recorded as “Noncontrolling Interest” in the Consolidated Balance Sheet,

but that will have no influence of the consolidated asset value. Thus we still have:


Case 4: Purchase Method, Step-by-Step Purchase (Piecemeal)

Sometimes, the control over the target is not achieved in a single deal. Instead, there may

be multiple deals and not until the last time that the target is controlled. Banned by APB Opinion

16, this type of purchase cannot be done by pooling method. The combination deal that will enter

our data sample is the one in which the acquiror accumulated more than 50% ownership of the

target.

Because the acquiror did not control the target in the previous deal(s), no consolidation

was needed. Neither the acquiror’s assets value at the end of year t-1 nor the one right before the

control-achieving deal was consolidated. The previous investments in the target were not

eliminated in the acquiror’s balance sheet. However, the elimination will be performed when the

balance sheets are consolidated after the control-achieving deal, as if the total share controlled by

the acquiror were purchased at once with a summed price. The elimination of the investment

account from assets is just like the elimination of a cash/assets payment.

From the date(s) of previous deals(s) to the date of the control-achieving deal, the

previous investments probably have been adjusted. If the acquiror had only less than 20% of the

target, the investment account has been accounted for under the Cost Method; if the controlled

share was between 20% and 50%, then according to APB Opinion No. 1825, the Sophisticated

Equity Method should have been used to adjust the investment account. Nevertheless, since we 25 Opinions of the Accounting Principles Board No. 18, The Equity Method of Accounting for Investments in Common Stock (New York: American Institute of Certified Public Accountants, 1971), par. 17.

37

are focused on the control-achieving deal only, we just need to know that the acquiror’s total

assets value does include previous investments in the target.

To demonstrate, first we assume there was an investment account with $30,000 balance

in the Acquiror Company’s balance sheet before the control-achieving deal26, paid by cash for

20% of Target Company.

------------------------------


------------------------------

Suppose the control-achieving deal purchases 60%, after this transaction the total

controlled portion of Target will be 80% ( 0.8β = ). The price paid this time is $50,000, among

it, $15,000 is paid by cash, $35,000 is paid by common stock (5,000 shares, $1 par per share, $7

market price, the weight of equity/debt securities in the $50,000 is 0.7α = ). Therefore the sum

of this price and the existing investment account (previous prices paid) is $80,000. Comparing

the sum with Target’s 80% good-will free net assets $96,000, the deal is a bargain in the total.

The allocations to non-priority assets are:

Market Total Amount Allocated 80%Target nonpriority assets Value Percent to Allocate Amount Book Value Adjustment Land 12,000$ 11% 71,200$ 7,839$ 3,200$ 4,639$ Buildings (net) 70,000 64% 71,200 45,725 33,600 12,125 Equipment (net) 15,000 14% 71,200 9,798 6,880 2,918 Copyright 12,000 11% 71,200 7,839 5,600 2,239

The worksheet for the Consolidated Balance Sheet is:

------------------------------


------------------------------

In this case, the price of $50,000 for the 60% control-achieving purchase is:

26 If the investments were accounted for under the equity method, the investment account should be under the acquiror’s non-priority assets; if the cost method was used, the investment should be a priority asset account. This will not make a difference here because it is the target’s net priority assets that will be used to judge whether the transaction was a super-bargain or not. So without loss of generality, here we list the investment account as a non-priority account.

38

( )( )( ) ( )( )

control priority nonpriority ta

ta invest


invest

priority


TgtLiabMV TgtLiabBV GW TA

ta TgtLiabBV taMV taALC ta

TgtLiabMV TgtLiabBV TAtaMV taALC

β β β

β β

β β β

ββ

⎡ ⎤= + + − −⎣ ⎦− − − −

= − + + −

− − −

= +

0.8 24000 71200 0.8 13000 3000050000.

nonpriority investTgtLiabMV TAβ− −

= × + − × −=

where controlP is the price for the control-achieving deal; investTA is the existing value for the

investment in Target account. We therefore have:

( ) ( )( )( ) ( ) ( ) ( )( ) ( )

1 1

1 1

1 1

1

1 1

1

combcomb t t priority nonpriority ta

control invest ta

combt t priority nonpriority control invest

combt t con

TA TA TA ta taMV taALC ta GW

P TA GW

TA TA ta taMV taALC P TA

TA TA ta P

β β

α β

β β α

β

− −

− −

− −

⎡ ⎤= + ∆ + + + − −⎣ ⎦− − − −

= + ∆ + − + + − − −

= + ∆ + − + ( )( ) ( )1 1

1

1 .

trol invest control invest

combt t control

TA TgtLiabMV P TA

TA TA ta P TgtLiabMV

β α

β α β− −

+ + − − −

= + ∆ + − + +

The final formula for tTA :

( )1 .t t t ta controlTA TA GW GW P TgtLiabMV taα β β−= − + + + −

What is noticeable is that although α is a weight within the price of the control-achieving deal

only, β is the accumulated controlled part of the target from all the previous and the current

deals. This formula is also true for the non-bargain case.

As for the super-bargain case, the formula is:

( )1 .t t t ta controlTA TA GW GW P TgtLiabMV taα β π β−= − + + + + −

Summary of Formulae

As we have illustrated above, some cases can be generalized into one formula. The

formulas for all studied cases are summarized in the following table:

39

Pool

ing-

of-I

nter

ests

M

etho

dPu

rcha

se M

etho

d

100%

Pur

chas

e, <

100%

Pur

chas

e or

Ste

p-by

-Ste

p Pu

rcha

se

No

Barg

ain

or B

arga

inSu

per B

arga

in

( )1 .0 1,0.5 1

t t t taTA TA GW GW P TgtLiabMV taα β β

α β−= − + + + −

≤ ≤ < ≤

( )1 .0 1,0.5 1

t t t taTA TA GW GW P TgtLiabMV taα β π β

α β−= − + + + + −

≤ ≤ < ≤


And this is the table of formulae we introduced in the paper.

40

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enterprise in Germany. Journal of Economic History, 42: 629–658. Tirole, J. 1995. The theory of Industrial Organization. Cambridge, MA: MIT Press. Villalonga, B. 2004. Does diversification cause the “diversification discount”?. Financial

Management, 33(2): 5–27. Wernerfelt, B., & Montgomery, C. A. 1988. Tobin’s q and the importance of focus in

firm performance. The American Economic Review, 78(1): 246–250.

Williamson, O. E. 1985. The Economic Institutions of Capitalism. New York, New York: The Free Press.

43

Mean StandardMeasures (Median) Deviation

Tobin's q 1.34 0.96 1.00(1.07)

Total Growth Rate (Ga ) 0.12 0.41 0.14 1.00(0.05) (0.33)

Internal Growth Rate (Gi ) 0.09 0.35 0.15 0.91 1.00(0.05) (0.33) (0.97)

External Growth Rate (Gx ) 0.03 0.17 0.02 0.51 0.11 1.00(0) (0.10) (0.32) (0.18)

Number of 4-digit Industries (N4 ) 1.38 0.78 -0.06 0.004 -0.01 0.04 1.00(1.00) (-0.05) (-0.03) (-0.04) (0.11)

Herfindahl from assets (H ) 0.10 0.20 -0.06 -0.01 -0.03 0.04 0.91 1.00(0) (-0.05) (-0.03) (-0.04) (0.10) (0.99)

Correlation(Spearman Rank Correlation)

Ga

TABLE 1

Mean, Median, Standard Deviation, and Correlations of Mesures, 8,755 Firm-Years, 1993-2002

Gi Gx N4 Hq

44

Independent

Variables (1) (2) (3) (4)

Pure-play Tobin's q ( ) 0.91 0.91 0.91 0.91(<.01) (<.01) (<.01) (<.01)

Total Growth Rate (Ga ) 0.17 0.16(<.01) (<.01)

Internal Growth Rate (Gi ) 0.21 0.20(<.01) (<.01)

External Growth Rate (Gx ) 0.02 0.02(0.69) (0.69)

Number of 4-digit Industries (N4 ) -0.04 -0.04(<.01) (<.01)

Herfindahl from assets (H ) -0.20 -0.19(<.01) (<.01)

Ajusted 0.43 0.43 0.43 0.43

TABLE 2

Regression Coeffcients and p-Values, Tobin's q on Selected Independent Variables, 8,755 Firm-Years, 1993-2002

Regression Coefficients and p-Values

2R

q̂

45

Independent

Variables (I1) (I2) (I3) (I4) (X1) (X2) (X3) (X4)

Log Total Assets (t-1 ) -0.04 -0.04 -0.04 -0.04 -0.05 -0.04(<.01) (<.01) (<.01) (<.01) (<.01) (<.01)

Net Income (t-1 ) / Total Assets (t-1 ) 0.25 0.28 0.16 0.03 0.06 -0.07(0.05) (0.03) (0.22) (0.88) (0.76) (0.72)

Pure-play Total Growth Rate (t ) 0.20 0.21 0.24 0.31 0.31 0.34(<.01) (<.01) (<.01) (<.01) (<.01) (<.01)

Fraction Change 0.07 0.05 0.08 0.13 0.28 0.25 0.28 0.34Exponentiated Herfindahl from assets (t ) (0.33) (0.50) (0.31) (0.10) (0.02) (0.05) (0.02) (<.01)

Ajusted 0.12 0.08 0.12 0.06 0.08 0.05 0.09 0.06

Regression Coefficients and p-Values Regression Coefficients and p-Values

TABLE 3

Regression Coefficients and p-Values, Internal Growth Rate (Gi (t )), External Growth Rate (Gx (t )) on Selected Independent Variables, 743 Firm-Years, 1993-2002

Dependent Variable: Internal Growth Rate (Gi (t ))

Dependent Variable: External Growth Rate (Gx (t ))

2R

46

Independent

Variables (1) (2) (3) (4)

Adjusted Pure-play Tobin's q ( ) 0.79 0.79 0.79 0.79(<.01) (<.01) (<.01) (<.01)

Adjusted Total Growth Rate (Ga ) 0.10 0.10(<.01) (<.01)

Adjusted Internal Growth Rate (Gi ) 0.17 0.17(<.01) (<.01)

Adjusted External Growth Rate (Gx ) -0.12 -0.12(0.03) (0.03)

Number of 4-digit Industries (N4 ) -0.04 -0.04(<.01) (<.01)

Herfindahl from assets (H ) -0.16 -0.15(<.01) (<.01)

Ajusted 0.34 0.34 0.34 0.34

TABLE 4

Regression Coeffcients and p-Values, Ajusted Tobin's q on Selected Adjusted Independent Variables, Variables Adjusted for Accounting Rules, 8,766 Firm-Years, 1993-2002

Regression Coefficients and p-Values

2R

q̂

47

Independent

Variables (I1) (I2) (I3) (I4) (X1) (X2) (X3) (X4)

Adjusted Log Total Assets (t-1 ) ( ) -0.07 -0.08 -0.06 -0.05 -0.07 -0.05(<.01) (<.01) (<.01) (<.01) (<.01) (<.01)

Net Income (t-1 ) / Adjusted Total Assets (t-1 ) 0.42 0.49 0.28 -0.11 -0.02 -0.23(<.01) (<.01) (0.07) (0.54) (0.92) (0.23)

Adjusted Pure-Play Total Growth Rate (t ) 0.28 0.29 0.33 0.37 0.37 0.40(<.01) (<.01) (<.01) (<.01) (<.01) (<.01)

Fraction Change 0.07 0.03 0.08 0.16 0.19 0.14 0.19 0.26Exponentiated Herfindahl from assets (t ) (0.45) (0.73) (0.41) (0.12) (0.13) (0.28) (0.13) (0.05)

Ajusted 0.21 0.13 0.20 0.12 0.15 0.06 0.15 0.11

Regression Coefficients and p-Values Regression Coefficients and p-Values

TABLE 5

Regression Coefficients and p-Values, Adjusted Internal Growth Rate, Adjusted External Growth Rate on Selected Adjusted Independent Variables, Variables Adjusted for Accounting Rules, 756 Firm-Years, 1993-2002

Dependent Variable: Adjusted Internal Growth Rate at t

Dependent Variable: Adjusted External Growth Rate at t

2R

( )1tLog TA −

48

Accounting Adjustment for Tobin's q Unadjusted Adjusted Unadjusted Adjusted Unadjusted Adjusted Unadjusted AdjustedNumber of Firm-Years 713 726 713 726 7,778 7,776 7,778 7,776

VariablesLast Year Economy-Adjusted Tobin's q 0.41 0.40 0.34 0.32 -0.04 -0.04 -0.03 -0.03

(<.01) (<.01) (<.01) (<.01) (<.01) (<.01) (<.01) (<.01)

Last Year Industry-Adjusted Tobin's q 0.09 0.08 0.00 0.00 -0.16 -0.17 -0.19 -0.19(0.01) (0.03) (0.62) (0.85) (<.01) (<.01) (<.01) (<.01)

Absolute Change in Tobin's q -0.22 -0.26 -0.09 -0.16 -0.05 -0.05 -0.02 -0.01(<.01) (<.01) (<.01) (<.01) (<.01) (<.01) (<.01) (<.01)

Economy-Adjusted Change in Tobin's q -0.16 -0.20 -0.08 -0.14 0.01 0.02 0.00 0.00(<.01) (<.01) (<.01) (<.01) (0.05) (0.06) (0.88) (0.37)

Industry-Adjusted Change in Tobin's q -0.13 -0.17 -0.04 -0.10 0.02 0.02 0.00 0.00(<.01) (<.01) (<.01) (<.01) (0.02) (0.08) (<.01) (<.01)

(p-value for t Test) (p-value for Sign Test)(p-value for t Test) (p-value for Sign Test)Median

TABLE 6 Mean, Median and p-Values, Tobin's q of Firm-Years with and without Business Combinations, 1993-2002

Firm-Years without Business Combination(s)Firm-Years with Business Combination(s)Mean Median Mean

49

PurchaseMethod No Bargain

Bargain

SuperBagain

No Bargain

Bargain

SuperBagain

Pooling-of-Interests

100%Purchase

<100%Purchase

100%Purchase

<100%Purchase

Step-by-StepPurchase

May be either Stockor Assets Purchase

Paid by Cash orother assets

Paid by stock ordebts











Figure A1Business Combination

Accounting Types

50

Priority assets Current liabilities 185,000$ Cash 170,000$ Bonds payable 426,000 Accounts receivable 140,000 Total liabilities 611,000$ Inventory 295,000 Total priority assets 605,000$ Nonpriority assets Shareholder's equity Land 260,000$ Common stock, $1 par value 70,000$ Buildings (net) 970,000 Paid-in capital in excess of par 420,000 Equipment (net) 464,000 Retained earnings 1,632,000 Patent 110,000 Total Shareholder's equity 2,122,000$ Goodwill 324,000 Total nonpriority assets 2,128,000$ Total Assets 2,733,000$ Total liabilities and equity 2,733,000$

Acquiror CompanyTABLE A1

Assets Liabilities and Equity

Balance SheetMay 31, 1996

51

Assets Book Value Market Value Liabilities and Equity Book Value Market Value

Priority assets Current liabilities 2,000$ 2,000$ Cash 7,000$ 7,000$ Bonds payable 7,500 11,000 Accounts receivable 5,000 5,000 Total liabilities 9,500$ 13,000$ Inventory 10,000 12,000 Total priority assets 22,000$ 24,000$ Nonpriority assets Shareholder's equity Land 4,000$ 12,000$ Common stock, $1 par value 3,000$ Buildings (net) 42,000 70,000 Paid-in capital in excess of par 26,000 Equipment (net) 8,600 15,000 Retained earnings 49,100 Copyright 7,000 12,000 Total Shareholder's equity 78,100$ Goodwill 4,000 - Total nonpriority assets 65,600$ 109,000$ Total Assets 87,600$ 133,000$ Total liabilities and equity 87,600$

TABLE A2Target Company

Balance Sheet and Market ValuesMay 31, 1996

52

ConsolidatedAcquiror Target Dr. Cr. Balance Sheet

Cash 170,000 7,000 140,000 37,000 Accounts receivable 140,000 5,000 145,000 Inventory 295,000 10,000 2,000 307,000 Land 260,000 4,000 8,000 272,000 Buildings (net) 970,000 42,000 28,000 1,040,000 Equipment (net) 464,000 8,600 6,400 479,000 Patent 110,000 110,000 Copyright 7,000 5,000 12,000 Goodwill 324,000 4,000 16,000 344,000

Current liabilities (185,000) (2,000) (187,000) Bonds payable (426,000) (7,500) (433,500) Discount (premium) 3,500 (3,500) Common stock -- Target (3,000) 3,000 Paid-in capital in excess of par -- Target (26,000) 26,000 Retained earnings -- Target (49,100) 49,100 Common stock -- Acquiror (70,000) (70,000) Paid-in capital in excess of par -- Acquior (420,000) (420,000) Retained earnings -- Acquiror (1,632,000) (1,632,000) Noncontrolling Interest

Totals 0 0 143,500 143,500 0

Prior Balance Adjustments

TABLE A3Acquiror Company and Target Company

Wooksheet for Consolidated Balance SheetMay 31, 1996

53


Cash 170,000 7,000 177,000 Accounts receivable 140,000 5,000 145,000 Inventory 295,000 10,000 2,000 307,000 Land 260,000 4,000 8,000 272,000 Buildings (net) 970,000 42,000 28,000 1,040,000 Equipment (net) 464,000 8,600 6,400 479,000 Patent 110,000 110,000 Copyright 7,000 5,000 12,000 Goodwill 324,000 4,000 16,000 344,000

Current liabilities (185,000) (2,000) (187,000) Bonds payable (426,000) (7,500) (433,500) Discount (premium) 3,500 (3,500) Common stock -- Target (3,000) 3,000 Paid-in capital in excess of par -- Target (26,000) 26,000 Retained earnings -- Target (49,100) 49,100 Common stock -- Acquiror (70,000) 20,000 (90,000) Paid-in capital in excess of par -- Acquior (420,000) 120,000 (540,000) Retained earnings -- Acquiror (1,632,000) (1,632,000) Noncontrolling Interest

Totals 0 0 143,500 143,500 0




54



Current liabilities (185,000) (2,000) (187,000) Bonds payable (426,000) (7,500) (433,500) Discount (premium) 3,500 (3,500) Common stock -- Target (3,000) 3,000 Paid-in capital in excess of par -- Target (26,000) 26,000 Retained earnings -- Target (49,100) 49,100 Common stock -- Acquiror (70,000) (70,000) Paid-in capital in excess of par -- Acquior (420,000) (420,000) Retained earnings -- Acquiror (1,632,000) (1,632,000) Noncontrolling Interest

Totals 0 0 112,500 112,500 0




55


Cash 170,000 7,000 177,000 Accounts receivable 140,000 5,000 145,000 Inventory 295,000 10,000 2,000 307,000 Land 260,000 4,000 6,349 270,349 Buildings (net) 970,000 42,000 18,367 1,030,367 Equipment (net) 464,000 8,600 4,336 476,936 Patent 110,000 110,000 Copyright 7,000 3,349 10,349 Goodwill 324,000 4,000 4,000 324,000

Current liabilities (185,000) (2,000) (187,000) Bonds payable (426,000) (7,500) (433,500) Discount (premium) 3,500 (3,500) Common stock -- Target (3,000) 3,000 Paid-in capital in excess of par -- Target (26,000) 26,000 Retained earnings -- Target (49,100) 49,100 Common stock -- Acquiror (70,000) 15,000 (85,000) Paid-in capital in excess of par -- Acquior (420,000) 90,000 (510,000) Retained earnings -- Acquiror (1,632,000) (1,632,000) Noncontrolling Interest

Totals 0 0 112,500 112,500 0




56


Cash 170,000 7,000 177,000 Accounts receivable 140,000 5,000 145,000 Inventory 295,000 10,000 2,000 307,000 Land 260,000 4,000 4,000 260,000 Buildings (net) 970,000 42,000 42,000 970,000 Equipment (net) 464,000 8,600 8,600 464,000 Patent 110,000 110,000 Copyright 7,000 7,000 - Goodwill 324,000 4,000 0 4,000 324,000

Current liabilities (185,000) (2,000) (187,000) Bonds payable (426,000) (7,500) (433,500) Discount (premium) 3,500 (3,500) Common stock -- Target (3,000) 3,000 Paid-in capital in excess of par -- Target (26,000) 26,000 Retained earnings -- Target (49,100) 49,100 Common stock -- Acquiror (70,000) 1,000 (71,000) Paid-in capital in excess of par -- Acquior (420,000) 6,000 (426,000) Retained earnings -- Acquiror (1,632,000) 4,000 (1,636,000) Noncontrolling Interest

Totals 0 0 80,100 80,100 0




57


Cash 170,000 7,000 65,000 112,000 Accounts receivable 140,000 5,000 145,000 Inventory 295,000 10,000 1,600 306,600 Land 260,000 4,000 6,400 270,400 Buildings (net) 970,000 42,000 22,400 1,034,400 Equipment (net) 464,000 8,600 5,120 477,720 Patent 110,000 110,000 Copyright 7,000 4,000 11,000 Goodwill 324,000 4,000 800 328,800

Current liabilities (185,000) (2,000) (187,000) Bonds payable (426,000) (7,500) (433,500) Discount (premium) 2,800 (2,800) Common stock -- Target (3,000) 3,000 Paid-in capital in excess of par -- Target (26,000) 26,000 Retained earnings -- Target (49,100) 49,100 Common stock -- Acquiror (70,000) 5,000 (75,000) Paid-in capital in excess of par -- Acquior (420,000) 30,000 (450,000) Retained earnings -- Acquiror (1,632,000) (1,632,000) Noncontrolling Interest 15,620 (15,620)

Totals 0 0 118,420 118,420 0




58




Totals 0 0 91,620 91,620 0




59


Cash 170,000 7,000 1,500 175,500 Accounts receivable 140,000 5,000 145,000 Inventory 295,000 10,000 1,600 306,600 Land 260,000 4,000 3,200 260,800 Buildings (net) 970,000 42,000 33,600 978,400 Equipment (net) 464,000 8,600 6,880 465,720 Patent 110,000 110,000 Copyright 7,000 5,600 1,400 Goodwill 324,000 4,000 0 3,200 324,800

Current liabilities (185,000) (2,000) (187,000) Bonds payable (426,000) (7,500) (433,500) Discount (premium) 2,800 (2,800) Common stock -- Target (3,000) 3,000 Paid-in capital in excess of par -- Target (26,000) 26,000 Retained earnings -- Target (49,100) 49,100 Common stock -- Acquiror (70,000) 500 (70,500) Paid-in capital in excess of par -- Acquior (420,000) 3,000 (423,000) Retained earnings -- Acquiror (1,632,000) 3,800 (1,635,800) Noncontrolling Interest 15,620 (15,620)

Totals 0 0 79,700 79,700 0




60

Priority assets Current liabilities 185,000$ Cash 140,000$ Bonds payable 426,000 Accounts receivable 140,000 Total liabilities 611,000$ Inventory 295,000 Total priority assets 575,000$ Nonpriority assets Shareholder's equity Investment in Target Company 30,000$ Common stock, $1 par value 70,000$ Land 260,000 Paid-in capital in excess of par 420,000 Buildings (net) 970,000 Retained earnings 1,632,000 Equipment (net) 464,000 Total Shareholder's equity 2,122,000$ Patent 110,000 Goodwill 324,000 Total nonpriority assets 2,158,000$ Total Assets 2,733,000$ Total liabilities and equity 2,733,000$

Assets Liabilities and Equity

TABLE A11Acquiror Company

Balance SheetMay 31, 1996

61


Cash 140,000 7,000 15,000 132,000 Accounts receivable 140,000 5,000 145,000 Inventory 295,000 10,000 1,600 306,600 Investment in Target Company 30,000 30,000 Land 260,000 4,000 4,639 268,639 Buildings (net) 970,000 42,000 12,125 1,024,125 Equipment (net) 464,000 8,600 2,918 475,518 Patent 110,000 110,000 Copyright 7,000 2,239 9,239 Goodwill 324,000 4,000 3,200 324,800


Totals 0 0 101,620 101,620 0




Documents

Internal Growth, Tobin’s q and Corporate Diversification