...enormous variation these return (Fuller, Netter, and Stegemoller, 2002). A recent strand of business press reports that a majority of acquiring firms in the 1990s experienced a sharp decline in stock price at a merger announcement. Although acquiring firms are not winners, however, all studies agree that acquisitions on average increase the combined equity value of the target and acquiring firms, suggesting that acquisitions create shareholder value. The positive overall wealth gains are attributed to the financial market's anticipation of post-acquisition improved performance.

The evidence of improvement in the post-acquisition firm's performance is not conclusive. There are two general approaches employed in the existing literature to measure the long-term performance. The first group of studies examine acquiring firms' stock returns over the three to five years following the acquisition completion. In an efficient stock market in which share price gains at the time of announcements represent any expected post-acquisition performance improvement, post-acquisition share price performance should not be different from the benchmark return. Early studies find a long-term negative move in acquiring firm stock prices (Magenheim and Mueller, 1988; Loderer and Martin, 1992; Agrawal, Jaffe, and Mandelker, 1992). Mitchell and Stafford (2000) and Franks, Harris, and Titman (1991), however, attribute negative post-acquisition performance to estimation bias. There are a number of methodological concerns with long-term event studies. [See Andrade, Mitchell, and Stafford (2001) for a summary of the concerns.] Addressing the statistical reliability of long-term event studies, Mitchell and Stafford (2000) calculate three-year statistically significant abnormal returns of-5 percent for equal-weight portfolio and statistically insignificant -1.4 percent for value-weight portfolio. In addition, a few recent studies report significant cross-sectional variations depending on the type of acquisition (merger versus tender offer), the method of payment (cash versus stock), and the book-to-market equity ratio of acquiring firms ("value" firms versus "growth" firm). Acquiring firms earn higher abnormal returns in tender offers than mergers (Loughran and Vijh, 1997) and cash acquisitions than stock acquisitions (Loughran and Vijh, 1997; Rau and Vermaelen, 1998; Mitchell and Stafford, 2000). Acquiring firms identified as low book-to-market (growth firms) earn higher abnormal returns than firms identified as high book-to-market (value firms) (Rau and Vermaelen, 1998; Mitchell and Stafford, 2000).

The second approach directly assesses the acquiring firm's operating performance using financial and accounting data. The advantage of this approach is to measure the actual economic benefit of acquisition on the firm's performance. If acquisitions do truly create shareholder value, the firm's operating performance should eventually reflect the economic gains. Studies using accounting data offer mixed results. According to Fowler and Schmidt (1988) and Ravenscraft and Scherer (1987), acquiring firms' accounting rate of returns and profitability after acquisitions either deteriorate or show little improvement. Healy, Palepu, and Ruback (1992, 1997), however, report that the industry-adjusted cash flow returns after takeover vary depending upon whether the premium paid to target firms is taken into account in the analysis. If the cash flow returns are calculated assuming no premium was paid to target companies (i.e., the premium is excluded in the asset base), the median is 2.8 percent, indicating that takeovers improve profitability. If this adjustment is not made, the return becomes insignificant. Healy, Palepu, and Ruback interpret these findings as evidence that acquisitions were zero net present value investments for acquiring firms. Cornett and Tehranian (1992) find that a sample of 30 mergers in the banking industry are associated with improved operating performance.

A New Performance Measure

Accounting rate of returns and profitability measures, however, are criticized for their deficiencies in guiding shareholder wealth maximization. Ignoring the cost of capital, these measures lack a formal mechanism for determining whether achieving such goals creates value for shareholders. Although a firm earns a positive net income and high accounting rate of return, it may reduce shareholder wealth because earnings fall short of the required rate of returns that shareholders could earn by investing in other securities of comparable risk. In addition, the accounting measures may possibly be manipulated. It is well-known that companies can use creative accounting techniques that may imply that their published accounts may not be a true and fair reflection of the companies' financial position, as in the well-publicized Enron case.

These problems are particularly severe in measuring surviving acquiring firms' operating performance. Post-Acquisition accounting income can be distorted by the choice of financing, the accounting method (i.e., purchase versus pooling), and other accounting treatments. In general, cash payment financed by debt and purchase accounting lower post-acquisition accounting earnings.

As an alternative measure that can overcome these deficiencies, economic value added (EVA), which is closely related to the net present value concept, has received growing attention in recent years in both business and academics. EVA is an estimate of a business's true economic profit for the year, and it differs sharply from accounting profit. EVA is essentially the residual income that remains after all costs have been recognized, including the opportunity cost of the equity capital employed. Accounting net income is overstated in an economic sense because the cost of equity capital is not deducted when net income is calculated. EVA overcomes this flaw in conventional accounting to measure a firm's true operating performance.

As the value of a company depends on the extent to which future cash flows exceed the cost of capital, theoretically EVA is the performance measure directly linked to the creation of shareholder wealth. EVA takes into account riskiness of investment which is factored into the cost of equity capital. Stewart (1994) argues that the use of EVA as the financial performance measure links all decision making with a common focus: how to maximize shareholder wealth.

The Purpose of This Study

This study reexamines pre- and post-acquisition performance of target and acquiring firms using EVA. The purpose of this study is three-fold. First, the impact of acquisition on the acquiring firm's financial performance is assessed by comparing pre- and post-acquisition EVA relative to the industry average. Industry-adjusted EVA is measured in each of five years prior to the acquisition and, where available, up to as much as five years after the acquisition. Many earlier studies find considerable variation in the acquiring firms' performance (regardless of whether measured in stock returns or accounting returns) across the transaction characteristics that include (1) types of acquisition (mergers or tender offers), (2) method of payment (cash or stock), and (3) business similarity between the acquiring firm and the target firm. Therefore, the second goal of this study is to examine cross-sectional variation in EVA performance according to the transaction...

NOTE: All illustrations and photos have been removed from this article.



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