In his seminal paper, Lewellen (1971) argues that a conglomerate merger between two firms with imperfectly correlated cash flows could reduce the risk of default and hence increase debt capacity. He predicts that such mergers produce a coinsurance effect that benefits both shareholders and bondholders. However, subsequent studies debate whether the coinsurance effect results in real wealth creation or a mere wealth transfer from stockholders to bondholders. Under varying model conditions, these studies generate different predictions about the distribution of merger gains between bondholders and stockholders. In a recent article, Leland (2007) argues that the coinsurance effect is not always positive, as postulated by Lewellen (1971). In addition, he suggests that the corporate coinsurance can be either wealth creation or wealth transfer depending on the specific merger conditions.
Leland (2007) proposes some criteria that determine the change in total firm value. However, his propositions do not indicate whether stockholders or bondholders take more gains from the total firm value change arising from a merger. To address this issue, we investigate the distinct value changes accruing to shareholders and bondholders based on Leland’s (2007) model. We identify the impact of several determinants of the coinsurance effect on the wealth implications to firm owners and creditors. To the best of our knowledge, ours is the first study that shows the directions of wealth changes to stockholders and bondholders related to the specific merger conditions.
First, the increase in the correlation between cash flows of merging firms cash flow correlation enhances shareholder wealth while it reduces bondholder wealth. Second, the rise in market capitalization weighted difference of cash flow volatilities plays a dual role, depending on the level of cash flow correlation. Third, there is a positive cash flow correlation where the size-weighted volatility difference switches its role from enhancing to reducing stockholder wealth as cash flow correlation rises. Fourth, the increase in the marginal tax rate of merging firms is favorable to shareholder wealth while it is unfavorable to bondholder wealth. Further more, synergy sharing mergers that simultaneously benefit firm owners and creditors occur more frequently in high marginal tax rates than in low marginal tax rates.
We test our theoretical predictions on a sample of 365 completed mergers between non-financial firms that were announced between 1981 and 2006. All of our predictions are supported by the test results when we utilize the conventional measure of wealth implication to combined stockholders by Bradley, Desai, and Kim (1988). A rise in cash flow correlation significantly enhances the shareholder’s value. Specifically, the test result suggests that a one standard deviation increase in cash flow correlation enhances the combined stockholder wealth by about 1 percent. A strong interaction between cash flow correlation and volatility difference is also observed; the increase in volatility difference benefits shareholders when cash flow correlation is low but deteriorates the equity value when cash flow correlation is high.
In our total merger sample, the best estimate of cut-off correlation is 0.2. The existence of positive cut-off correlation implies that stockholders have a sweet spot area in cash flow correlation and volatility difference space where increases in both cash flow correlation and volatility difference improve shareholder value. The increase in marginal tax rates of merging firms also enhances equity value. Consistent with our predictions, bondholder wealth changes go against shareholder wealth changes in terms of cash flow correlation and interaction, if bondholder wealth changes are measured by separate bond rating changes of bidding firms and target firms.
