Does Corporate After Mergers? Performance Improve: Paul M. Healy

Journal of Financial Economics 31 (1992) 135-175.
North-Holland
Does corporate performance improve

after mergers?*
Paul M. Healy
Massachusetts Institute of Technology, Cambridge, MA 02139, USA
Krishna G. Palepu and Richard S. Ruback

Haward Business School, Cambridge, h&l 02163, USA
Received April 1990, final version received January 1992
We examine post-acquisition performance for the 50 largest U.S. mergers between 1979 and
mid-1984. Merged firms show significant improvements in asset productivity relative to their
industries, leading to higher operating cash flow returns. This performance improvement is
particularly strong for firms with highly overlapping businesses. Mergers do not lead to cuts in
long-term capital afld R&D investments. There is a strong positive relation between postmerger
increases in operating cash flows and abnormal stock returns at merger announcements,
indicating that expectations of economic improvements underlie the equity revaluations of the
merging firms.
1. Introduction
This study examines the postmerger cash flow performance of acquiring
and target firms, and explores the sources of merger-induced changes in cash
flow performance. Our research is motivated by the inability of stock price
*We acknowledge the helpful comments of the referee, Michael Jensen (the editor), Robin
Cooper, George Foster, Robert Kaplan, Richard Leftwich, Mark Wolfson, Karen Wruck, and
seminar participants a’r Baruch College, Carnegie Mellon University, Columbia University,
Dartmouth College, Duke University, the Federal Reserve Bank (Washington, DC), Harvard
University, the London School of Economics, the University of Michigan, Massachusetts Insti-
tute of Technology, New York University, Northwestern University, the University of Minnesota,
the University of Rochester, Stanford University, the University of Southern California, the
University of Alberta, and the U.S. Department of Justice. We are thankful to Chris Fox and
Ken Hao, who provided research assistance, and the International Financial Services Center at
MIT and the Division of Research at the Harvard Business School for financial support.
0304-4OSX/92/$05.00 0 l992-Elsevier Science Publishers B.V. All rights reserved

136 F. Heady et al., Performance improcements after mergers
performance studies to determine whether takeovers create real economic

gains and to identify the sources of such gains.
There is near-unanimous agreement that target stockholders benefit from
mergers, as evidenced by the premium they receive for selling their shares.
The stock pric.d‘.p studies of takeovers also indicate that bidders generally
breakeven, and that the combined equity value of the bidding and target
firms increases as a result of takeovers. These increases in equity values are
typically attributed to some unmeasured source of real economic gains, such
as synergy. But researchers have had little success in relating the equity value
gains to improvements in subsequent corporate performance.’ Therefore, the
equity value gains could also be due to capital market inefficiencies, arising
simply from the creation of an overvalued security.
To determine whether the equity value increases in takeovers are from real
economic gains or capital market inefficiencies, stock price studies have
analyzed unsuccessful takeovers. * But these studies, too, are unable to
distinguish between the real economic gains and the market inefficiency
explanations. That the stock prices of unsuccessful merger targets return to
their preoffer level is consistent with the loss of an anticipated
premium - whatever its source. From the stock price perspective, the antici-
pation of real economic gains is observationally equivalent to market mispric-
ing. It is therefore difficult to conceive of a pure stock price study that could
resolve the ambiguity in the interpretation of the evidence.
Stock price studies are also unable to provide evidence on the sources of
any merger-related gains. Yet differences of opinion about the source of the
gains in takeovers underlie much of the public policy debate on their
desirability. Gains from mergers could arise from a variety of sources, such as
operating synergies, tax savings, transfers from employees or other stakehold-
ers, or increased monopoly rents. Equity gains from only some of these
sources are unequivocally beneficial at the social level.
Our approach is to use postmerger accounting data to test directly for
changes in operating performance that result from mergers.3 Our tests use
accounting data collected from company annual reports, merger prospec-
tuses, proxy statements, and analysts’ reports for 50 large mergers between
U.S. public industrial firms completed between 1979 and mid-1984. We
recognize that accounting data are imperfect measures of economic perfor-
‘See Caves (1989) for a review of the studies that examine the ex post performance of merged
firms.
2Dodd (19801, Asquith (19831, Dodd and Ruback (1977), Bradley, Desai, and Kim (1983), and
Ruback (1988).
“Three recent studies have examined earnings performance following management buyouts of
corporations [Bull (19881, Kaplan (1990), and Smith (199011.Our paper focuses on acquisitions of
one public company by another in either a merger or a tender offer, rather than on management
buyouts.
P. Healy et d., Performance improcements after mergers 137
mance and that they can be affected by managerial decisions. As we explain

in section 2, we use cash flow measures of economic performance to mitigate
the impact of the financing of the acquisition and the method of accounting
for the transaction. We also recognize that our cash flow variables measure
period-by-period performance, which is affected by firm-specific and industry
factors. We therefore use industry performance as a benchmark to evaluate
postmerger performance.
Results reported in section 3 show that the merged firms have increases in
postmerger operating cash flow returns in comparison with their industries.
These increases arise from postmerger improvements in asset productivity.
We find no evidence that the improvement in postmerger cash flows is
achieved at the expense of the merged firms’ long-term viability, since the
sample firms maintain their capital expenditure and R&D rates in relation to
their industries. Our results differ from the findings reported by Ravenscraft
and Scherer (1987) and Herman and Lowenstein (1988), who examine earn-
ings performance after takeovers and conclude that merged firms have no
operating improvements.
In section 4 we examine the relation between our cash flow measures of
postmerger performance and stock market measures used in earlier studies.
Postmerger improvements in operating cash flow returns explain a significant
portion of the increase in equity values of the merging firms at the announce-
ment of the merger. This suggests that the stock price F :action to mergers is
driven by anticipated economic gains after the merger.
Section 5 discusses the implications of our primary findings and explores
some popular hypotheses on factors that influence postmerger performance.
There is little evidence that transaction characteristics such as the method of
financing, whether the merger is hostile or friendly, or the size of the target
firm explain cross-sectional variation in postmerger performance. We fin3
some support, however, for the view that mergers between firms in overlap-
ping businesses lead to better performance than other mergers.
2. Experimental design
2. I. Sample
The analysis in this study is based on the largest 50 acquisitions during the
period January 1979 to June 1984. We limit the number of acquisitions
studied to make the hand data collection tasks manageable. The largest
acquisitions have several important advantages over a similarly sized random
sample. First, although the sample consists of a small fraction of the total
acquisitions in the sample period, the total dollar value of the 59 firms
selected accounts for a significant portion of the dollar value of domestic
138 P. Heal’! et al., Performance improcnements after mergers
merger activity4 Second, if there are economic gains from a takeover, they
are most likely to be detected when the target firm is large. Third, it is less
likely that the acquirers in the sample undertake equally large acquisitions
before or after the events we study, reducing the probability of confounding
events. Finally, public concern about the consequences of takeovers is typi-
cally triggered by the largest transactions, making them interesting in their
own right.
The sample period is selected to focus on recent mergers and also to have
sufficient postmerger performance data? To select the acquisition sample, we
iden@ the 382 merger-related delistings GJI the Center for Research in
Security Prices (CRSP) database in the sample period. The names of the
acquirers are identified from the Wall Street Journal Index. The sample
comprises acquisitions involving the 50 largest targets that satisfy the follow-
ing two criteria: the acquirer is a U.S. company liste on the New York Stock
Exchange (NYSE) or the American Stock Exchange (Amex), and the target
and acquirer are not financial or regulated companies. Target-firm size is
computed from Compustat as the market value of common stock plus the
book values of net debt and preferred stock at the beginning of the year
before the acquisition. Acquisitions are deleted from the sample if the
acquirers are non-U.S. or private companies, since post-acquisition financial
information is not available for these mergers. Regulated (railroads and
utilities) and financial firms are deleted because they are subject to special
accounting and regulatory requirements, making them difficult to compare
with other firms.
A summary of the sample is provided in the appendix. The information
provided includes target and acquiring firms’ names, a description of their
businesses and industries from Value Line reports, target equity v&ue before
the merger, the target’s assets as a percentage of the acquirer’s assets, and
the merger completion date. The sample targets and acquirers represent a
wide cross-section of Value Line industries. The target firms belong to 24
industries; the acquiring firms come from 33 industries.
The transactions are approximately evenly distributed over the sample
years: eight acquisitions in the sample were completed in 1979, seven in 1980,
twelve in 1981, eleven in 1983, and two in 1984. Since we focus on mergers
completed in only a few years, however, the sample firms’ postmerger
performance is likely to be influenced by economywide changes. Our tests,
therefore, control for these factors by comparing sample firms’ performance
with their corresponding industries’.
4The aggregate market value of equity of the 50 target firms in our sample one year before the
acquisition is $43 billion.
‘The sample period ends in June 1984 to ensure that when the study was initiated, at least five
years of postmerger data were available on Compustat for the sample firms. Compustat files end
in June each year.
P. Healy et al., Performance improvements after mergers 139
The sample acquisitions are significant economic events for purchasing

firms. On average, target firms are 42% of the assets of acquirers, where
assets are measured by the book value of net debt (long-term debt, plus
short-term debt, less cash and marketable securities) plus the market value of
equity one year prior to the merger.
2.2. Performance measurement

We use pretax operating cash flow returns on assets to measure improve-
ments in operating performance. Conceptually, we focus on cash flows
because they represent the actual economic benefits generated by the assets.
Since the level of economic benefits is affected by the assets employed, we
scale the cash flows by the assets employed to form a return measure that can
be compared across time and across firms. We measure assets employed
using market values, which represent the opportunity cost of the assets. In
our opinion, market-based measures of asset values dominate accounting and
other historical estimates in this context because they simplify intertemporal
and cross-sectional comparisons. Our market-based measure has a potential
limitation, however, because unexpected cash flow realizations can change
expectations about future cash flows, and hence market values. The sensitiv-
ity tests in section 3.2 show no evidence of such a feedback effect for our
sample of mergers.
We define operating cash flows as sales, minus cost of goods sold and
selling and administrative expenses, plus depreciation and goodwill expenses.
This measure is deflated by the market value of assets (market value of equity
plus book value of net debt) to provide a return metric that is comparable
across firms. Unlike accounting return on book assets, our return measure
excludes the effect of depreciation, goodwill, interest expense and income,
and taxes. It is therefore unaffected by the method of accounting for the
merger (purchase or pooling accounting) and the method of financing (cash,
debt, or equity). As discussed below, these factors make it difficult to
compare traditional accounting returns of the merged firm over time and
cross-sectionally.
2.2.1. Effects of purchase and pooling accounting

In our sample, 38 mergers (76%) use the purchase method and the
remaining 12 use the pooling of interests method. The purchase method
restates the assets and liabilities of target firms at their current market
values. No such revaluation is permitted under the pooling method. Further,
under the purchase method the acquirer records any difference between the
acquisition price and the market value of identifiable assets and liabilities of
the target company as goodwill, and amortizes it. No goodwill is recorded
140 P. Healy et al., Performance improvements after mergers
under the pooling-of-interests method. Finally, for the first year of the
merger, the purchase method consolidates results of the target with those of
the acquirer from the date the merger took place; the pealing method
consolidates results for the two firms from the beginning of the year regard-
less of when the merger took place.
The same transaction typically results in lower postmerger earnings under
purchase accounting than under pooling. The purchase method increases
depreciation, cost of goods sold, and goodwill expenses after the takeover.
Also, in the year of the merger, earnings are usually lower under purchase
acccunting because the target’s and acquirer’s earnings are consolidated for a
shorter period than under pooling. The lower earnings reported under the
purchase method are due to differences in the method of accounting for the
merger and not to differences in economic performance. Further, postmerger
book assets under the purchase method will be larger than those under
pooling because of the asset write-up under the purchase method. It is
theref3re misleading to compare post- and premerger accounting rate of
return for firms that use purchase accounting to infer whether there are
economic gains from merger:,
Our operating cash flow performance measure - unlike earnings-based
performance measures - is unaffected by depreciation and goodwill. It is
comparable cross-sectionally and on a time-series basis when firms use
different methods of accounting for the merger. We exclude the first year of
the merger in our analysis because of the differences between the purchase
and pooling methods in timing the consolidation of the target with the
acquirer. Excluding the first year also mitigates the effect of inventory
write-ups under the purchase method, since this inventory is usually included
in cost of sales in the merger year.6 Because the asset base in our return
metric is the market value of assets, rather than book value, it is also
unaffected by the accounting method used to record the merger.
2.2.2. Effects of method of financing mergers

The method used to finance the sample transactions varies considerably.
Th,,iy percent of the sample mergers are stock transactions, 26% are
financed by cash, and the remaining 14% are financed by combinations of
cash, stock, and other securities. It is important to control for these financing
differences in measuring postmerger performance. If an acquisitioir is fi-
nanced by debt or cash, its post-acquisition profits will be lower than if the
“Firms using the LIFO inventory valuation method expense the written-up inventory as
inventory layers are depleted, making it difficult to determine when to adjust earnings for the
effect of the write-up. We therefore do not make any adjustments for these firms. This lack of
adjustment will not lead to a serious downward bias in our earnings measure, however, since
LIFO inventory liquidations are relatively infrequent.
same transaction is financed by stock, because income is computed after

deducting interest expenses (the cost of debt), but before allowing fcr any
cost of equity. Since the OifIerences in earnings reflect the financing choice
and not differences in economic performance, it is misleading to compare
reported accounting earnings, which are computed after interest income and
expense, for firms that use different methods of merger financing. We use
operating cash flows before interest expense and income from short-term
investments deflated by the market value of assets (net of short-term invest-
ments) to measure performance. This cash flow return is unaffected by the
choice of financing.
2.3. Performance benchmark

We aggregate performance data of the target and bidding firms before the
merger to obtain the pro forma premerger performance of the combined
firms. Comparing the postmerger performance with this premerger bench-
mark provides a measure of the change in performance. But some of the
difference between premerger and postmerger performance could be also
due to economywide and industry factors, or to a continuation of firm-specific
performance before the merger. Hence, we use abnormal industry-adjusted
performance of the target and bidding firms as our primary benchmark to
evaluate postmerger performance.
Abnormal industry-adjusted performance is measured as the intercept of a
cross-sectional regression of postmerger industry-adjusted cash flow returns
on the corresponding premerger returns. For each year and firm, industry-
adjusted performance measures are calculated by subtracting the industry
median from the sample firm value. The data for sample firms are excluded
when calculating the industry median. Value Line industry definitions imme-
diately before the merger are used for the target and acquirer in both the
premerger and the postmerger analysis. Industry data are collected from
Compustat Industrial and Research files.
2.4. Comparison with prior research
Earlier studies of postmerger performance have a number of methodologi-

cal problems, making their findings difficult to interpret. Ravenscraft and
Scherer (I987) examine the performance in 1974 to 1977 for firms acquired
between 1950 and 1977. Since the postmerger years examined are not aligned
with the merger, it is hard to know what to make of the performance
comparisons.
Ravenscraft and Scherer focus exclusively on acquired firms’ lines of
business. It is not obvious why gains from mergers would be reflected only in
the acquired segments; synergies are just as likely to improve the perfor-
142 P. Healy et al., Performance improLlements after mergers
mance of the other lines of business of the acquiring firms. Th-, authors also
use FTC line-of-business data, which have several potential problems. Defi-
nitions of business segments may change systematicAly after mergers if
acquirers restructure their operations. Results oi‘ tests using segment data
reported to the FTC are also likely to be difficult to interpret, since reporting
firms have incentives to use accounting discretion to mask superior perfor-
mance, thereby reducing the likelihood of antitrust suits by the FTC [see
Watts and Zimmerman (198611.
Herman and Lowenstein (1988) examine postmerger performance using a
sample of hostile acquisitions between 1975 and 1983. Complete postmerger
data are unavailable for transactions after 1979, however, which limits the
analysis to a small number of postmerger years for many sample firms.
Further, the return on equity measure, which is used to judge postmerger
performance, does not control for differences in pooling and purchase
accounting, methods of merger financing, or the effect of common industry
shocks. These limitations make it diflicult to interpret the study’s findings.
3. Cash flow return performance
3.1. Operating cash flow returns

As described in section 2, we aggregate pretax operating cash flows for the
target and acquiring firms to determine pro forma cash flows for the com-
bined firms in each of the five years before the merger (years - 5 to - 1).
Postmerger operating cash flows are the actual values reported by the
merged firm in years I to 5. We deflate the operating cash flows by the
market value of assets. Operating cash flow returns are the ratio of operating
cash flows during a given year to the market value of assets at the beginning
of that year. The market value of assets is recomputed at the beginning of
each year to control for changes in the size of the firm over time. For
premerger years the market value of assets is the sum of the values for the
target and acquiring firms. The market value of assets of the combined firm is
used in the postmerger years.
We exclude the change in equity values of the target and acquiring firms at
the merger announcement from the asset base in the postmerger years. For
the target the change in equity value is measured from five days before the
first offer is announced (not necessarily bv the ultimate acquirer) to the date
the target is delisted from trading on public exchanges. For the acquirer the
change in equity value is measured from five days before its first offer is
announced to the date the target is delisted from trading an public ex-
changes. In an efficient stock market these revaluations represent the capital-
ized value of any expected postmerger performance improvements. If merger
announcement equity revaluations are included in the asset base, measured
P. Healy et al., Performance impror-ements afser mergers 143
cash flow returns will not show any abnormal increase, even though the
merger results in an increase in operating cash flows.
For example, consider an acquiring firm (company A) and a target (com-
pany T) with annual operating cash flows of $20 and $10 forever. Both firms
have the same cost of capital (lo%), implying that their market values are
$200 and $100. Therefore, a portfolio conprising of A and T has a market
value of $300 and cash flows of $30, producing an annual return of 10%.
Suppose that when A acquires T combined cash ilows increase to $35 per
year. An efficient market capitalizes this $5 improvement at $50. If post-
merger cash flow returns are computed as the ratio of postmerger cash flows
($35) and postmerger assets including the premium ($350), measured perfor-
mance will be identical to the premerger operating return for the portfolio of
A and T (10%). There is no improvement in the measured cash flow return
even though cash flows per year have increased by $5. Our measure of
performance is computed as the ratio of postmerger cash flows ($35) and
postmerger assets excluding the asset revaluation ($350 - $50). This return
measure (11.7%) correctly reflects the improvement in operating perfor-
mance after the merger.
We also adjust the merging firms’ performance for the impact of contem-
poraneous unrelated events by measuring industry cash flow returns during
the same ten-year period. We use Value Line industry definitions, and
exclude the target and acquiring firms’ returns from the industry computa-
tions. Before the merger, industry values for the sample firms arc constructed
by weighting median performance measures for the target and acquiring
firms’ industries by the relative asset sizes of the two firms at the beginning of
each year. In all of the postmeiger years target and acquirer industry cash
flow returns are weighted by the relative asset sizes of the two firms one year
before the merger.
We focus our analysis on years -5 to - 1 arid 1 to 5. Year 0, the year of
the merger, is excluded from the analysis for two reasons. First, many of the
acquiring firms use the purchase accounting method, implying that in
the year of the merger the two firms are consolidated for financial reporting
purposes only from the date of the merger. Results for this year are therefore
not comparable across firms or for iniustry comparisons. Second, year 0
figures are affected by one-time merger costs incurred during that year,
makin? it difficult to compare them with results for other years.
3.1.1. Changes in cash flows and assets

Table 1 reports the changes in cash flows and assets in years 1 to 5 relative
to the year before the merger. The merged firms have a median increase in
cash flows of 14% in year 1, 17% in year 2, 16% in years 3 and 4, and 9% in
year 5. This cash flow growth does not indicate that the merged firms
144 P. Healy et a!., Performance improvements after mergers
Table 1
Postmerger firm and industry growth in operating cash flows and market value of assets for 50
combined target and acquirer firms in mergers completed in the period 1979 to mid-1584.a
Growth period Firm Firm Industry Industry

in relation cash flow asset cash flow asset
to merger growth rate growth rate growth rate growth rate
Year - 1 to 1 14% 15% 10% 20%

Year - 1 to 2 17 20 11 33
Year - 1 to 3 16 28 14 40
Year - 1 to 4 16 23 22 43
Year - 1 to 5 9 18 24 56
aOperating cash flows are sales less cost of goods sold, less selling and administrative
expenses, plus depreciation. The market value of assets, measured at the beginning of the year,
is the market value of equity plus the book values of preferred stock and net debt. Year - 1 cash
flow and asset values for the combined firm are weighted averages of target and acquirer values,
with the weights being the relative asset values of the two firms. Postmerger values use data for
the merged firms. Industry-adjusted cash flow and asset growth rates are computed for each firm
and year as the difference between the sample-firm growth rate in that year and growth rates for
aggregated cash flows and assets of other firms in the same industry (as defined by Value Line in
year - 1). Target and acquirer industry growth rates are weighted by the relative asset values of
the acquirer and target firms in year - 1.
bSignificantly different from zero at the 1% level, using a two-tailed test.
‘Significantly different from zero at the 5% level, using a two-tailed test.
performed better in the postmerger period, however, because assets also

increased during this period. Asset values increase by 15% in year 1, 20% in
year 2, 28% in year 3, 23% in year 4, and 18% in year 5. Also, the sample
firms’ industries experience growth in cash flows and assets in the postmerger
period. The cash flow return measures we use to gauge performance adjust
for changes in the size of the sample firms and their corresponding industries
that are evident in table 1.
3.1.2. Raw cash jlow returns

Panel A of table 2 reports median pretax unadjusted operating cash flo*.v
returns for the merged firms (column 2) in years -5 to - 1 and 1 to 5. The
median pretax operating returns range from 24.5% to 26.8% in lhe five years
before the merger, with a median annual value of 25.3%.‘After the merger,
the median pretax operating returns are lower, ranging from 18.4% to 22.9%
with a median annual value of 20.5% for the whole period. As indicated in
table 1, this decline arises because cash flows grow more slowly than assets in
‘To calculate the sample median pretax operating cash flow return for years -5 to - 1, we
first compute the median return in these years for each sample firm. The reported sample
median is the median of these values. Sample median returns in the postmerger period are
calculated the same way.
P. Healy et al., Performaxe improvements after mergers 145
the postmerger period. These changes cannot be attributed to the merger,

however, if there is a contemporaneous downward trend in industry cash flow
returns. Industry-adjusted returns, which are differences between values for
the merged firms and their weighted-average industry median estimates,
correct for this problem.
3.I .3. Industry-adjustedcash flow returns

Columns 3 and 4 in panel A, table 2 show median industry-
adjusted cash flow returns and the percentage of sample firms with positive
industry-adjusted returns. Merged firms have higher operating cash flow
returns on assets than their industries’ in the postmerger period. Median
industry-adjusted operating returns for the merged firms are 3.0% in year 1,
5.3% in year 2, 3.2% in year 3, and 3.0% in year 4, all significantly different
from zero! Year 5 also shows better performance than the industry, but is
not statistically significant. The percentage of positive industry-adjusted re-
turns is 67% in year 1, 79% in year 2, 70% in year 3, and 68% in year 4, all
well above the value expected by chance alone (50%). Overall, the annual
median return for the sample firms in the five postmerger years is 2.8%,
about 16% larger than their industries’ returns.’
The benchmark for the significant postmerger industry-adjusted returns
depends on the relation between industry-adjusted returns before and
after the merger. If there is no relation between pre- and postmerger
industry-adjusted returns, the appropriate benchmark for the postmerger
industry-adjusted returns is zero. Alternatively, the appropriate benchmark is
the premerger industry-adjusted return if firms that perform above or below
their industries before the merger are likely to realize the same performance
after the merger.
For our sample, there is no evidence of superior industry-adjusted pretax
operating cash flow returns in the premerger period, Median returns are not
significantly different from zero in four of the five years. The percentage of
positive industry-adjusted returns is r,at significantly different from the value
expected by chance in four of the five years before the merger. The overall
median annual return in the premerger period is only 0.3%, which is
statistically insignificant. This suggests that, on average, the postmerger
performance is not due to a continuation of superior premerger industry
performance. In the next section we use a cross-sectional regression ap-
proach to compare performance before and after the merger.
‘Throughout the paper we use a two-tailed test and a 10% or lower cutoff significance level.
This is equivalent to a 5% cutoff or,e-tailed test for the many cases where the hypotheses
examined are directional,
(‘We calculate the percentage increase relative to the industry as 2.8/(20.5 - 2.8).
Table 2
Median operating cash flow return on actual market value of assets for 50 combined target and
acquirer firms in years surrounding mergers completed in the period 1979 to mid-1984.a
Panel A: Pre- and postmerger operating cash flow returns

Industry-adjusted Number of
Year relative
to merger median Median % positive observations
-5 24.5% 0.4% 50% 48

-4 26.2 0.1 51 49
-3 26.8 2.1d 63’ 49
-2 26.4 0.0 49 49
-1 25.4 1.2 54 46
Median annual
performance
for years - 5 to - 1 25.3% 0.3% 52% 50
1 21.5% 3.0%b 67%’ 48
2 22.9 5.3b 79b 47
3 20.6 3.2’ 7ob 46
4 18.4 3.0d 68b 44
5 18.5 2.5 60 40
Median annual
performance
for years 1 to 5 20.5% 2.8%b 73%” 48
Panel B: Abnormal industry-adjusted postmerger operating cash flow returns

(t-values in parentheses)
tiCRpiwr, i = 2.8% + 0.37 UCR,,,,iv R2 = 0.10, F-statistic = 5.3’ N = 47
(2.4)’ (2.3)’
aOperating cash fIow return on assets is sales less cost of goods sold, less selling and
administrative expenses, plus depreciation, divided by the market value of assets at the beginning
of the year. Change in equity values of the target and acquiring firms at the merger announce-
ment are excluded from the market values of assets in the postmerger years. Industry-adjusted
cash flow returns are computed for each firm and year as the difference between the sample firm
value in that year and median values for other firms in the same industry (as defined by Value
Line in year - 1). Premerger returns for the combined firm are weighted averages of target and
acquirer returns, with the weights being the relative asset values of the two firms. Postmerger
returns use data for the merged firms. Premerger industry returns are weighted averages of
target and acquirer industry median returns, with the weights being the relative asset values of
the acquirer and target firms each year. In the postmerger period the weights used to compute
industry returns are the relative asset values of the acquirer and target firms in year - 1.
L4CRp0sr,i and OCR,,,, i are the median annual industry-adjusted operating cash flow returns
in the post- and premerger periods for firm i.
Significantly different from zero at the 1% level, using a two-tailed test.
isignificantly different from zero at the 5% level, using a two-tailed test.
Significantly different from zero at the 10% level, using a two-tailed test.
P. Healy et al., Performance improcements after mergers 147
3.1.4. Abnormal industry-adjusted cash flows returns
Our measure of abnormal industry-adjusted returns extends the industry-

adjusted return measure to incorporate the relation between pre- and post-
merger industry-adjusted returns. Abnormal industry-adjusted cash flow
returns are estimated using the following cross-sectional regression:
uCRposr,i = (V + p UCR,,,,i + ei,
where LACR,,,;,, i is the median annual industry-adjusted cash flow return for
company i from the postmerger years and L4CRpre.i is the premerger
median for the same company. Our measure of the abnormal industry-
adjusted return is the intercept cy from (1). The slope coefficient p captures
any correlation in cash flow returns between the pre- and postmerger years
SO that /3 LciCR,,,i measures the effect of the premerger performance on
postmerger returns. The intercept Q!is therefore independent of premerger
returns.
As shown in panel B of table 2, for our sample, the estimate of /? is 0.37,
indicating that industry-adjusted cash flow returns tend to persist over time.
The estimate of ~1!shows ;hat there is a 2.8% per-year increase in postmerger
cash flow returns after premerger performance is controlled for. This evi-
dence indicates that there is a significant improvement in the merged firms’
cash flow returns in the post-merger period.”
3.2. SensitiGty analysis
3.2.1. Use of Value Line industry definitions
The industry-adjusted results are strikingly different from the operating

cash flow returns before industry adjustment. The industry-adjusted results
show a significant increase in postmerger performance and the unadjusted
returns show a decrease. We think that industry-adjusted returns are a more
reliable measure of performance, since they control for industry events
unrelated to the merger. But, they are also sensitive to the definitions of
industries used in the analysis. To test whether the industry-adjusted results
are sensitive to the particular industry definitions employed by Value Line,
we use a market performance benchmark. We estimate the market index
each year as the median operating cash flow return for all firms on the
Compustat Industrial and Research tapes. Median market-adjusted cash flow
returns for the sample firms are 1.3% (statistically insignificant) in the
“‘These results remain unchanged when we reestimate the model excluding outlier observa-
tions identified using Belsley, Kuh, and Welsch (1980) influence diagnostics. We also conduct
specification tests for regression equation (1) to assess whether the residuals are homoskedastic
[see White (1980)] and normally distributed, We cannot reject the hypotheses that the residuals
are homoskedastic and normally distributed at the 5% level.
148 P. Healy et al., Performance improcements after mergers
premerger period and 4.3% (statistically significant) in the postmerger years,

confirming improvements in industry-adjusted performance. A reestimation
of (1) using market-adjusted cash flow returns indicates that, on average,
returns increase by 5.4% per year in the postmerger period after premerger
performance is controlled for.
3.2.2. Change in market value of assets

Our measure of industry-adjusted returns can increase in the postmerger
period if investors lower their assessment of merged firms’ prospects in
relation to their industries. Since we use the market value of equity in our
computation of asset values, a postmerger decline in equity value will reduce
our measure of asset values. If cash flows are held constant, such a decline in
asset values would lead to an increase in cash flow returns, making the
postmerger improvements documented in the previous section spurious. To
examine this possibility, we compute the difference between annual stock
returns for the sample firms and their industries in years surrounding the
merger.
Summary statistics on equity returns in years surrounding the merger are
reported in table 3. We compute both raw equity returns and industry-
adjusted returns for years -5 to - 1 and 1 to 5 using Compustat data. These
same data are used to estimate the market value of assets to compute cash
flow returns. Because daily data are not available on Compustat, we use
CRSP returns to compute raw and industry-adjusted equity returns for three
subperiods in year 0: the premerger period, the period from the merger
announcement to completion, and the postmerger period.
Consistent with the evidence reported in the literature, the median returns
in the preannouncement and announcement periods in year 0 are -3.0%
and 7.7%, which are statistically significant. There is no evidence that the
market value of equity for the sample firms declines in comparison with their
industries in the postmerger period. Median industry-adjusted returns are
insignificant in the postmerger period in years 0 to 4, and are significantly
positive in year 5. Mean industry-adjusted returns, which are not reported
here, are comparable to the sample medians. Therefore, the postmerger cash
flow return improvements do not appear to be driven by a postmerger decline
in equity value, which is used in the denominator of our return measure.
3.2.3. Use of market Lyalueof assets to compute returns
We also evaluate the sensitivity of the results to the use of the market
value of equity in computing asset values by replicating the cash flow returns
using an alternative asset measure. Market equity values incorporate in-
vestor’s revaluations of firms’ growth opportunities, as well as existing assets.
We construct an alternative measure of equity values that excludes the effect
of revisions in growth opportunities after the merger announcement.
P. Healy et al., Performance improcements after mergers 149
Table 3
Median industry-adjusted and raw stock returns for combined target and acquirer companies in
the five years before the merger, and for the merged firm for five years after the merger, for
mergers completed in the period 1979 to mid-1984.a
Year relative to Industry-adjusted Number of

merger returns Raw returns observations
-5 2.8% 17.9% 48
-4 5.3c 22.6 49
-3 0.9 19.2 49
-2 -0.1 10.9 49
-1 -2.6 10.9 45
Premerger - 3.0c 4.9 42
Year 0 Merger 7.7b 12.0 50
Postmerger -3.8 4.7 46
0.1 10.0 48
0.8 18.5 48
0.8 10.0 46
- 2.5 9.8 41
7.1C 14.4 40
“Returns in years -5 to - 1 and 1 to 5 are taken from Compustat , consistent with the equity
values reported in table 1. Returns in year 0 are from CRSP. For target firms. the merger
announcement period is the date from the first announcement of a takeover offer for the target
to the date a merger is completed. For acquirers, the merger announcement period is the dete
from the first announcement of a takeover offer by the acquirer to the date a merger is
completed. Premerger returns for the combined firm are weighted averages of target and
acquirer values, with the weights being the relative equity values of the two firms. Postmerger
performance measures use data for the merged firms. Industry-adjusted returns are computed
for each firm and year as the difference between the sample-firm value in that year and median
values for other firms in the same industry (as defined by Value Line in year - 1). Premerger
industry returns are weighted averages of target and acquirer industry median returns, with the
weights being the relative equity values of the acquirer and target firms each year. In the
postmerger period the weights used to compute industry returns are the relative equity values of
the acquirer and target firms in year - 1.
‘Sig$ficantly different from zero at the 1% level, using a two-tailed test.
CSignificantly different from zero at the 10% level, using a two-tailed test.
To compute the value of equity for the combined firm at the beginning of
year 1, we start with the total market equity value for the target and acquirer
at the beginning of year - I. We then add year - 1 and year 0 values of the
merged firm’s after tax cash from operations (net of interest expense,
nonoperating income, and cash taxes) and cash from new share issues, and
subtract cash dividends to common and preferred stockholders and cash used
to acquire treasury stock. ” In each of years 2 through 5, we repeat this
procedure using the estimated equity at the beginning of the prior year, and
“For firms that use purchase accounting, new debt or equity issued at the merger includes the
merger premium for the target, whereas for firms that use the pooling method it does not. To
make the measure comparable across firms, we deduct the target premium for the purchase
accounting tirms in computing the quasi-market values of equity.
150 P. Hea!y et al., Performance improcements after mergers
adding changes in equity cash flows for the merged firm during the prior
year. The resulting quasi-market equity measure captures changes in equity
available for reinvestment, but does not reflect revaluations of growth oppor-
tunities after the merger announcement.
To provide a benchmark for evaluating the postmerger returns, we also
compute comparable equity values at the beginning of years -5 to - 1. For
yeas - 1 we use the actual market value of assets at the beginning of the
year. To compute the pro forma equity value for the combined firm at the
beginning of year - 2, we start with the total market value of equity for the
target and acquirer at the beginning of year - 1. We then subtract year - 2
values of the target’s and acquirer’s after-tax cash from operations (net of
interest expense, nonoperating income, and cash taxes) and cash from new
share issues, and add cash dividends to common and preferred stockholders
and cash used to acquire treasury stock. This procedure is repeated for years
-3 to -5.
We estimate the quasi-market value of assets in each of the years -5 to
+5 as the sum of the quasi-market value of equity estimated as above and
the book value of net debt. We then compute the ratio of operating cash flow
to the estimated quasi-market value of assets in each year to provide an
alternative return measure.
The main advantage of the cash flow return on the quasi-market value of
assets is that it excludes postmerger equity market revaluations from the
asset base. The measure preserves some important features of the original
measure: it is unaffected by the method of merger financing or asset write-ups,
and retie& funds invested in the firm in each year. But, it is not without
limitations. The measure does not take into account reductions in asset
values from economic depreciation. ‘This can lead to a significant overstate-
ment of asset values in the postmerger period, ieading in turn to an
understatement of measured postmerger performance. Also, for firms that
use purchase accounting, cash from operations for the target in year 0 is
reflected in the acquirers’ records only from the date the merger is consum-
mated. This leads to a small understatement of the postmerger asset values.
Both these limitations are avoided by the market value of assets used in our
original cash flow return measure.
Cash flow returns computed using the alternative measure of asset values
are reported in table 4. The results are generally consistent with the findings
reported in table 2. The merged firms continue to show higher cash flow
returns on assets than their industries in the postmerger period. Median
industry-adjusted pretax operating returns for the merged firms are 2.8% in
year 1, 2.6% in year 2, and 2.1% in year 3, all significantly different from
zero. The percentage of industry-adjusted returns that are positive is 67% in
year 1, 62% in year 2, and 65% in year 3, all above the value expected by
chance alone (50%;. Overall, the annual median pretax return in the five
postmerger years is 3.2%.
Table 4
Median operating cash flow return on quasi-market value of assets for 50 combined target and
acquirer firms in years surrounding mergers completed in the period 1979 to mid-19&La
Panel A: Pre- and postmerger operating cash flow returns
Year relative Industry-adjusted

Number of
to merger median Median % positive observations
-5 31.7% - 2.5% 47% 43

-4 31.1 0.3 51 45
-3 32.5 2.7 59 46
-2 26.8 2.0 54 46
-1 25.4 1.2 54 46
Median annual
performance
for years - 5 to - 1 31.3% 2.1% 56% 49
23.9% 3.8%b 67%’ 48
: 20.3 3.0c 62’ 47
3 18.7 2.1d 65’ 46
4 15.6 0.8 56 43
5 18.2 0.5 53 39
Median annual
performance
for years 1 to 5 17.9% 3.2%’ 66%c 48
Panel B: Abnormal industry-adjusted postmerger operating cash flow returns

(t+alues in parentheses)
IACRpos,,i = 2.7% + 0.18 ~CR,,,i ) R2 = 0.05, F-statistic = 2.3, N = 46
(2.0JC (1.5)
aPretax operating c&h flow return on assets is sales less cost of goods sold, less selling and
administrative expenses, plus depreciation, divided by quasi-market value of assets at the
beginning of the year. The computation of quasi-market value of assets begins with market
values in year - 1 and adjusts for changes in capital available for reinvestment in other years.
Premerger returns for the combined firm are weighted averages of target and acquirer values,
with the weights being the relative asset values of the two firms. Postmerger returns are for the
merged firm. Industry-adjusted cash flow returns are computed for each firm and year as the
difference between the sample-firm value in that year and median values for other firms in
the same industry (as defined by Value Line in year - 1). Premerger industry returns are
weighted averages of target and acquirer industry median returns, with the weights being the
relative asset values of the acquirer and target firms each year. In the postmerger period the
weights used to compute industry returns are the relative asset values of the acquirer and target
firms in year - 1. L4CRposr i and L4CR,,,,i are the median annual industry-adjusted pretax
operating cash flow returns in the post- and premerger periods for firm i.
dSignificantly different from zero at the 10% level, using a two-tailed test.
In contrast to the postmerger performance, there is no strong evidence of

superior industry-adjusted pretax operating cash flow returns in the pre-
merger period. Median returns are not significantly different from zero in
each of the five years. Also, the percentage of positive industry-adjusted
returns is not significantly different from the value expected by chance in any
of the five years before the merger. The overall median annual industry-ad-
justed return in the premerger period is 2.1%, which is statistically insignifi-
cant.
To examine whether there are abnormal postmerger industry-adjusted cash
flow returns, we again estimate (1) using return on assets based on quasi-
market equity values. The slope coefficient, which captures any persistence of
performance between the pre- and postmerger years, is 0.18 and insignificant.
The intercept, which captures postmerger performance controlling for pre-
merger returns, is 2.7% and is statistically reliable. These results remain
unchanged when we reestimate the model excluding outliers identified using
Belsley, Kuh, and Welsch (1980) influence diagnostics.12
In summary, the evidence presented in this section indicates that the
postmerger performance improvements are not driven by the use of market
equity values in computing assets.
3.3. Components of industry-adjustedwsh flow returns

The improvements in cash flow returns in the postmerger period can arise
from a variety of sources. These include improvements in operating margins,
greater asBet productivity, or lower labor costs. Alternatively, they may be
achieved by focusing on short-term performance improvements at the ex-
pense of the long-term viability of the firm. In this section we provide
evidence on which of these sources contribute to the sample firms’ post-
merger cash flow return increases. The specific variables analyzed are itali-
cized in the text and defined in table 5. The results are reported in tabie 6.
3.3.1. Operatingperformance changes

The operating cash flow return on assets can be decomposed into cash flow
margin on sales and asset turnover. Cash flow margin on sales measures the
pretax operating cash flows generated per sales dollar. Asset turnover mea-
sures the sales dollars generated from each dollar of investment in assets.
The variables are defined so that their product equals the operating cash flow
return on assets.
l2We again conduct specification tests for (1) to assess whether the residuals are homoskedas-
tic [see While U930); acid normally distributed. We cannot reject the hypotheses that the
residuals are homoskedastic and normally distributed at the 5% level.
Table 5
Definitions of variables used to analyze actual performance of 50 targets and 50 acquirers in
years surrounding mergers.
Variable Definition
(AI Operating characteristics

Cash flow margin on saies Earnings before depreciation, interest, and taxes as
a percentage of sales
Asset turnover Sales divided by market value of assets at the
beginning of the year (the market value of
common equity plus the book values of debt and
preferred stock)
Employee growth rate Change in number of employees as a percentage of
number of employees in the previous year
Pension expense/employee Pension expense per employee
(I31 kestment characteristics

Capital expenditure rate Capital expenditures as a percentage of the market
value of assets at the beginning of the year
Asset sale rate - Cash value Cash receipts from asset sales as a percentage of
the market value of assets at the beginning of
the year
Asset sale rate - Book value Book value of asset sales as a percentage of the
market value of assets at the beginning of the
year
R&D rate Research and development expenditures as a per-
centage of the market value of assets at the
beginning of the year
The results in table 6 suggest that the increase in industry-adjusted

operating returns is attributable to an increase in asset turnover, rather than
an increase in operating margins. In years -5 to - 1 the merged firms have
industry-adjusted median asset turnover of -0.2, implying that they gener-
ated 20 cents less in sales than their competitors for each dollar of assets. In
years 1 to 5 they close this gap as they achieve asset turnovers comparable to
their industries’. The intercept in the cross-sectional regression of postmerger
industry-adjusted asset turnover on premerger turnover is 0.2 and is statisti-
cally significant. The evidence thus indicates that there is a significant
improvement in sample firms’ asset turnover in the postmerger period.
The merged firms also have higher pretax operating margins on sales than
their industries in the postmerger years. But these cannot be attributed to the
merger itself, because they are also higher in the premerger period. Before
the merger, the higher operating margins are primarily due to higher indus-
try-adjusted margins for acquirers. Targets do not show higher operating
Table 6
Firm and industry-adjusted operating performance and investment policy measures fo 50 combined target and acquirer firms in years surrounding
mergers completed in the period 1979 to mid-1984.”
.-
Abnormal
industry-adjusted
Firm medians Industry-adjusted medians postmerger
___-. Number of
“v’ariable Premerger Postmerger Premerger Postmerger performanceb observations
____ --~ -___ -~- WY
m
Opemting characteristics 2
?-
Cash flow margin on sales 14.3% 13.3% 1.4%c l.l%d 0.2% 46
Asset turnover 1.9x 1.9x -0.2x 0.0x 0.2x’ 48 3
Employee growth rate 3.0% - 3.0% 0.4% - 2.5%d - 2.3%d 44 3
Pension expense per employee $796.3 $840.7 $lO1.lC - $60.4 -$119.5 40 3
-- ~ ___________ _ -. --__ 2
Incestment characteristics 3
3’
Capital expenditure rate 14.4Y0 10.6% 1.0% -0.1% 0.5% 47
Asset sale rate - Cash value 0.6 0.6 0.0 0.1 0.3 45 a
Z
Asset sale rate - Book value 0.9 1.3 O.ld 0.6’ 0.9d 42 3
R&D rate 2.0 2.1 0.1 0.0 0.1 33 2
z:
aOperating performance and investment policy measures are defined in table 5. Industry-adjusted values of these variables are computed for each $
firm and year as the difference between the firm value in that year and the median value for other firms in the same industry (as defined by Value
Line in year - 1). Before the merger, performance measures for the merged firm are weighted averages of target and acquirer values, with the ;
weights being the relative sizes of the two firms. Performance measures for the merged firm’s industry in the premerger period are weighted averages G
of target industry and acquirer industry medians, with the weights being the relative sizes of the two test firms. Medians in the premerger 2
(ptstmerger) period are the median values of the variables in years - 5 to - 1 (1 to 5).
Postmerger industry-adjusted performance measures controlling for premerger performance are the estimated intercepts from regressing
postmerger industry-adjusted performance on premerger values.
eSignificantly different from zero at the 10% level, using a two-tailed test.
P. Healy et al., Performance impror*emerzrsajrer mergers 155
margins than their industries in these years. When we control for premerger
operating margins, there is no evidence of a significant change in margins
after the merger. Rather, merged firms seem to use their assets more
productively.
Mergers also give the acquirer an opportunity to renegotiate expiicit and
implicit labor contracts tc, lower labor costs and achieve a more efficient mix
of capital and labor [see Shleifer and Summers (1988)]. Because we are
unable to obtain sufficient data on wages directly, we examine employee
growth rates and pension expense per employee to analyze changes in labor
costs in years surrounding the mergers.
The median number of employees declines in each of the postmerger
years. Overall, the industry-adjusted employee growth rate is negative after
we control for the growth rate in the premerger period. There is also
evidence of a decline in pension expense per employee after the merger.
Before the merger the sample firms have a significant!;l higher pension
expense per employee than their industries. After the merger the pension
expense of the merged firms is reduced to the industry level. There are two
ways to view these findings. One interpretation is that mergers are followed
by improvements in operating efficiency achieved through reduced labor
costs. Alternatively, mergers lead to a wealth redistribution between employ-
ees and stockholders through renegotiations of explicit and implicit employ-
ment contracts. Whatever the explanation, the labor cost reductions in the
postmerger period do not appear to be large, since they do not lead to
significant changes in postmerger operating margins.;”
.3.3.2. Inrestmen t policy changes

Since our analysis is limited to five years after the merger, we cannot
provide direct evidence on cash flows beyond this period. To assess whether
the merged firms focus on short-term performance improvements at the
expense of long-term investments, we examine their capital outlays and
research and der:eZopment (R&LD) expense. These expenditure patterns are
reported in table 6. The median capital expenditures as a percentage of
assets is 14.4% in the premergLr period and 10.6% in the postmerger years.
The median R&LD expense is 2% of assets in years - 5 to - 1 and 2.1% in
years 1 to 5. The capital expenditures and R&D of the sample firms are not
significantly different from those of their industry counterparts in either the
pre- or the postmerger period.
‘“Pontiff, Shleifer, and Weisbach (1990) report that 11% of takeovers involve pension fund
reversions, accounting for lo-13% of takeover premiums in these transactions. Thus for their
sample as a whole pension fund reversions ac,‘otint for an average l-2% of the takeover
premium. Similarly, Rosett (1990) reports tl;:dt labor union wealth changes in the six years
following takeovers account for l-2% of the premiums. Our conclusions are consistent with the
results uf both these studies.
Asset sales also reflect changes in merged firms’ investment policies. It is

possible that postmerger improvements in asset turnover arise from the sale
of assets with low turnover. We therefore examine cash proceeds from asset
sales and their book values in the pre- and postmerger years. Statistics on
asset sales as a percentage of the market value of assets are reported in table
6. The median cash proceeds from asset sales for the merged firms is 0.6% of
assets in both the pre- and postmerger periods, not significantly different
from their industry level in either period. The book values of asset disposals
before and after the merger are 0.9% and 1.3% of assets. Both of these rates
are significantly higher than the rates for their industry counterparts. Fur-
ther, controlling for the level of premerger book values of asset sales, there is
an increase in asset sales in the postmerger period.
There are two potential explanations for the increase in book value of
asset sales, but not in cash proceeds from disposals. First, the merged firms
sell poorly performing assets after the merger. This could in part explain the
improved asset productivity and the decline in employee growth rates.‘”
Second, the assets sold are written up at the merger to a value higher than
their true market value. Managers have considerable discretion in allocating
merger premiums to assets and goodwill, azri have incentives to write up
assets as high as possible to increase depreciation tax shields. If these assets
are subsequently sold, cash proceeds from the sale are likely to be below the
written-up book values. Whatever the explanation, the effect of asset sales on
postmerger performance is unlikely to be significant, because disposals in all
years are very small in relation to capital expenditures or the market value of
total assets. This is confirmed by the insignificant correlation between asset
sales and postmerger cash flow return improvements.i5
In summary, we find that improvements in cash flow operating returns in
the five years follouving mergers arise from increased asset productivity.
There is no evident: of decreased capital expenditures or R&D following
mergers, indicating that the cash flow improvements do not come from
policies that impede the long-term viability of the merged firms.
at io een cas stock price performance

Our postmerger data on cash flow performance are consistent with the
hypothesis that the stock market revaluation of merging firms at merger
announcements reflects expected future improvements in operations. A more
powerful test of this hypothesis is to correlate the merger-related stock
‘4Kaplan and Weisbach (1992) find that acquirers of firms in unrelated businesses are more
likely to later divest their targets than acquirers of related businesses. They find no evidence,
however. that divested businesses are systematically poor performers.
“We reestimate (1) after including asset sales in the pre- and postmerger periods. The
coefficients on both these variables are insignificant, and the intercept remains positive and
significant.
P. Healy et al., Performance impror*ements after mergers IS7
Table 7
Unexpected equitv and asset returns at merger announcements for target, acquirer, and
combined firms, and tests of the relation between unexpected asset returns and ex post cash flow
returns for 50 target and acquiring firms merging in the period 1979 to mid-1984.”
Panel k Distribution of unexpected equity returns at merger announcement

Target Acquirer Combined
Mean 45.6%” - 2.2% 9.1%b

First quartile 21a._I
3% - 16.6% - 2.9%
Median 41 .8%b - 3.6% 6.6%b
Third quartile 64.1% 3.4% 16.7%
Panel B: Distribution of unexpected asset returns at merger announcement

Target Acquirer Combined
Mean 40.6% b 0.6% 8.8%b

First quartile 19.0% - 9.3% - 2.3%
Median 32.59rcb - 2.2% 5.2%b
Third quartile 55.0% 6.1% 15.1%
Panel C: Relation between median postmerger industry-adjusted cash flow returns and
unexpected asset returns at merger announcement (t-values in parentheses)
EACRpOsr.i = 1.9% + 0.26 L4CR,r,, i + 0.24 (AV/v’)
(1.6) (1.7Y (3.4Jb
R* = 0.30, F-statistic = 8.5,b !V = 42
aUnexpected merger announcement equity returns are the sum of market-adjusted changes in
equity values for the target and acquirer firms in the merger anrwncement period as a
percentage of the sum of the premerger equity values for the two firms. Unexpected merger
announcement asset returns (AV/V) are unlevered market-adjusted equity returns. LACRposr
and IACR,,,, are median industry-adjusted cash flow returns for eacn firm in the five years after
and the five years before the merger.
market performance and the postmerger cash flow performance. If the stock
market capitalizes expected improvements, there should be a significant
positive correlation between the stock market revaluation of merging firms
and the actual postmerger cash flow improvements.
4.1. Stock returns at merger announcements

Market-adjusted stock returns for the target and acquirer at the announce-
ment of the merger are reported in pase! A. of table 7.‘” Returns for the
target are measured from five days before the first offer is announce
“Risk-adjusted returns, computed using premerger market model estimates, are similar to t
market-adjusted returns reported in the paper.
necessarily by the ultimate acquirer) to the date the target is delisted from
trading on public exchanges. Returns for the acquirer are measured from five
days before its first offer is announced to the date the target is delisted from
trading on public exchanges. Much as earlier studies have found, target
shareholders earn large positive returns from mergers (mean 45.6% and
median 44.8%), and acquiring stockholders earn insignificant returns.
We also compute the aggregate market-adjusted return for the two firms in
the merger announcement period. This return is the weighted average of the
market-adjusted returns for the target and acquirer, where the weights are
the relative market values of equity of the two firms before the merger
announcement period. The mean aggregate return, reported in panel A of
table 7, is 9.1%, and the median is 6.6%. Both these values are significantly
different from zero. These findings are consistent with those of Bradley,
Desai, and Kim (1988).
4.2. Asset returns at merger announcements

Our tests examine whether the change in equity values at merger an-
nouncements can be explained by cash flow return improvements in the
postmerger period. In section 3 we measured postmerger performance using
cash flow return on assets, whereas the merger announcement returns
computed above are returns on equity. Therefore, before we correlate
merger announcement returns and postmerger cash flow improvements, we
compute asset returns at merger announcements from equity returns to
ensure that the anticipated gains from mergers and the measured gains are
comparable.
Asset returns at the merger announcement AV/V are weighted averages
of returns to equity BE/E and debt AD/D:
AV AE E ADD
-=-- --
V E V+ D V’ i‘2J
Assuming that the valuf: of debt does not change at takeover announcements,
asset returns equal the equity announcement returns multiplied by the
equity-to-assets ratio E/i?’ We use leverage at the beginning of the year of
the takeover announcement to compute the equity-to-assets ratio. We use the
book value of debt and the market value of equity to measure leverage.
Summary statistics on the estimated asset returns at the announcement of
the merger for the target firms, acquiring firms, and combined firms are
reported in panel B of table 7. The mean and median asset returns for the
“A number of studies, including Asquith and Kim (1982), report evidence consistent with this
assumption.
targets are 40.6% and 32.5% and for the combined firms 8.8% and 5.2%. The
asset returns for the bidding firm are insignificant.
4.3. Relation between announcement returns and postmerger cash flow

improvements
The hypothesis that merger-induced abnormal returns reflect the capital-
ized value of future cash flow improvements implies:
ACF
AV=- (3)
0 ’
where AV is the change in the market value of assets at the merger

announcement, l/O is the present value operator, and ACF is the vector of
cash flow improvements. Transposing (3) and dividing both sides by I/, to
express both sides as returns:
ACF AV
-=ov*
V
(4)
We measure ACF/V as abnormal industry-adjusted cash flow returns

[(l) in section 31:
ACF
- = (Y= IACRposl,i - p IAcR,,,,i - &i, (5)
V
where 01CRposr.i and LACR,~~,i are the median annual industry-adjusted

operating cash flow returns in the post- and premerger periods for firm i. We
measure asset returns, Al//V, as unlevered market-adjusted stock returns for
the combined target and acquirer firms at the merger announcement, dis-
cussed in section 4.2. Substituting these two measures for variables in (4) and
rearranging yields:
AV
LACRPosr, i = p LACR,,., , i + @I/’ + Ei’ (6)
Eq. (6) forms the basis for our tests of the relationship between ex post
cash flow improvements and the anticipated gains represented by merger
announcement returns. Since AV/V is the capitakzed value of future cash
flow return improvements and LACRpOSris the pretax cash flow return
improvement per year, the coefficient 0 in (6) equals the pretax capitaliza-
tion rate. For example, if the cash flgw return improvements are permanent
and the pretax capitalization rate is 20%, the coefficient WOU
160 P. Healy et al., Performance improcem?pnts after mergers
Although (6) does not have a constant, we estimate a regression equation

with an intercept and test whether it is zero.
The regression results are shown in panel C of table 7. The estimated
model has an R* of 30%. The estimated slope coefficient on asset returns at
the merger announcement is 0.24 and is statistically reliable, implying that if
cash flow return improvements are permanent, the pretax discount rate for
the sample firms is 24%. This estimated discount rate is economically
plausible, although it exceeds the pretax cost of capital for our sample firms
assuming a 10% pretax risk-free rate and an 8% risk premium. Consistent
with findings reported earlier, the estimated coefficient on premerger perfor-
mance is positive and statistically significant. Finally, as predicted by (6), the
intercept is insignificant.”
As an alternative specification, we estimate a regression equation with
merger announcement returns, AV/V, as the dependent variable and abnor-
mal industry-adjusted cash flow returns from (l), AU/V, as the independent
variable. The estimated coefficient for the abnormal industry-adjusted cash
flow returns is 1.01 and is statistically significant with a t-statistic of 3.2. The
implied capitalization rate from this specification is 100%. Since this specifi-
cation, as well as the specification in (6), suffers from potential errors-in-vari-
ables problems, the actual rate at which the market capitalizes postmerger
cash flow improvements is likely to be between 24% and 100%.
There are two interpretations of the statistically and economically signifi-
cant relation between our measure of postmerger performance improvements
and the market’s revaluation of the merged firms’ equity at the merger
announcement. First, if equity markets are efficient, the findings indicate that
our estimates of postmergcr performance are reasonable. Alternatively, the
findings can be viewed as evidence that the stock price gains at the merger
announcement are related to expectations of subsequent cash flow improve-
ments.
5. Discussion
Our finding that there are postmerger cash flow increases advances the
debate on mergers from whether there are cash flow changes after these
transactions to why these cash flow improvements OCC~LThe improvements
in samb’e firms’ cash flow returns are primarily a result of increased asset
‘HSpecification tests are conducted for (6) to assess whether the residuals are homoskedastic
[see White (1980)] and normally distributed. We cannot reject the hypotheses that the residuals
are homoskedastic and normally distributed at the 5% level. We also reestimated the regression
excluding observations more than two standard deviations from the mean for each variable. The
results are very similar to those reported. Finally, we estimate Spearman rank correlation
coefficients between the median annual postmerger industry-adjusted cash flow return and
unexpected asset returns at the merger announcement. The correlation is 0.41 and is significant
at the 1% level.
P. He&y et ul., Performance improvements after mergers 161
productivity. The reported postmerger gains cannot be attributed to tax

benefits, since the cash flow returns are pretax. Although there is some
evidence that gains come at the expense of labor, reduced labor costs do not
significantly increase sample firms’ cash flows. Finally, there is no decrease in
capital outlays and R&D expenditures after the merger, indicating that
merged firms do not reduce their long-term investments.
Our findings raise two interesting questions. First, are the increases in cash
flow returns and asset productivity caused by the merger, or would they have
occurred without it? Mergers can !ead to increased asset productivity if
suboptimal policies pursued by the target or the acquirer before the merger
are eliminated, or if they provide new opportunities to use existing resources
of the merging firms. In contrast, if mergers arise from undervaluation of the
target firms by the stock market, cash flow returns will improve whether or
not there is a merger. Managers who anticipate the cash flow improvements
will pay a premium to acquire the targets.
Our findings also raise another question: what economic factors explain
the cross-sectional variation in postmerger cash flow changes? Although cash
flow performance improves on average, a quarter of the sample firms have
negative postmerger cash flow changes. These firms may have performed
poorly because of bad luck. Alternatively, systematic business and managerial
reasons may have led to these outcomes.
These questions, which have important managerial and public policy impli-
cations, can be answered only through development of structural models of
how mergers improve cash flows. We do not attempt to undertake such an
ambitious exercise in this paper, but, we do provide some preliminary
evidence and suggest directions for future research.
5. I. Business orlerlap of merging firms and postmerger performance
One popular hypothesis on how mergers improve cash flows is that they
provide opportunities for economies of scale and scope, synergy, or product
market power. This implies that mergers by firms that have overlapping
businesses will show greater cash flow improvements than mergers between
firms with no overlap. We examine this proposition by classifying our sample
mergers as those with high, medium, and low business overlap between the
target and acquiring firms. This classification is made by reading the line of
business discussion in the merging firms’ annual reports, merger prospec-
tuses, Value Line reports, and Moody’s Industrial Manuals.
The following cases illustrate our classifications. The combination of Best
Products and Modern Merchandising, both of which are catalog showroom
retailers, is classified as a high overlap transaction. The merger between
Holiday Inns and Harrahs is treated as a transaction with medium overlap
because Holiday Inns operates a hotel chain and arrahs operates casinos
162 P. Hea!:) et al., Performance improL*ements after mergers
and associated hotels. Emon Corp’s acquisition of Rehance Electric is an

unrelated transaction: Exxon is an oil company and Reliance Ekctric is a
producer of industrial equipment. Classification of the degree of business
overlap of each of the sample transactions is reported in the appendix, where
we describe our sample mergers in detail.
To evaluate whether postmerger performance improvements differ by the
degree of business overlap, we estirmate the following regression:
~q3os,, i = Q! + p LAC’Rpr,,i+dMEDIUMi+~HICHi+&i, m
where LACRpost,i and IAcRp,,,i are the median annual industry-adjusted

cash flow returns in the post- and premerger periods for firm i, HIGH is a
dummy variable that is one if the target and acquirers are in highly overlap-
ping businesses and zero otherwise, and MEDIUM is a dummy variable that
is one if there is a medium overlap between the target and acquiring firms’
businesses and zero otherwise. The intercept coefficient car) represents the
postmerger abnormal cash flow returns for firms in nonoverlapping busi-
nesses, whereas the coefficients 8 and + show the differential postmerger
returns of firms in medium and high overlapping businesses. As in (0, the
variable LKR,,, is included in the model to control for premerger perfor-
mance.
The results are reported in panel A of table 8. The estimated coefficient on
MC&? is positive and significant, similar to that reported in earlier regres-
sions The estimated intercept and coefficients on MEDIUM and HIGH are
not significant, indicating that the degree of business overlap has no impact
on postmerger performance improvements. These results, however, are sensi-
tive to two extreme observations identified using Belsley, Kuh, and Welsh
(1980) outlier diagnostics. We reestimate the model excluding these observa-
tions and report the results in panel B of table 8. The intercept and the
coefficient of MEDIUM remain insignificant, indicating that there is no
performance improvement associated with mergers between firms with little
or medium business overlap. Transactions with a high business overlap,
however, have 5.1% improvements in postmerger performance. Mergers with
a high business overlap, therefore, show significant postmerger improvement,
whereas other types of mergers do not.
The two outhers in the above analysis are the LTV-Republic Steel merger
and Penn Central’s acquisition of G.K. ‘Technologies. LTV and Republic
Steel have highly overlapping businesses, yet the combination performed very
n contrast, there is little overlap between the businesses of Penn
Technologies, yet the merger was followed by excellent
se two observations are obviously exceptions to the conclu-
ting that the relation between the merging firms’ businesses
is not the sole determinant of postmerger performance.
P. Healy et al., Perjb?nance improl*ements after merge?: 163
Table 8
Comparison of postmerger performance fx nergers between firms whose industries have high,
medium, and low overlap for 50 target and acquiring firms merging in the period 1979 to
mid- 1984.a
___- -.~ -
.Panel A: Full sample
(waiues in parentheses)
IA CFR po.5:.1= 0.018 + 0.005 MEDIUM, + 0.033 HIGH, + 0.35 IACR,,,.;
(0.9) (0.2) (1.3) (2.2jC
R2 = 0.13, F-statistic = 2.2,d N = 47
__~ ----____ _____-
Panel B: Sample excluding ou tliers b
{t-values in parentheses)
IACFR,~,,,,i = 0.006 + 0.016 IbEDIV.~i + 0.051 HlGHi + 0.33 ~CRp,r,,
(0.3) (0.6) .- o\d
(1.0, (2.lY
R2 = 0.17 F-statistic = 2.9’ N = 45
‘IACRpuv, and IACR,,, are median industry-adjusted cash flow returns for each firm in the
five years after and the five years before the merger. MEDIUM and HIGH are dummy variables
that take the value one if the merger is between two firms whose product markets have medium
and high overlap.
‘This sample excludes two observations identified as influential outliers using Belsey, Kuh,
and Welsch (1980) diagnostics. These transactions are the LTV-Republic Steel and the Penn
Central-GK Technologies mergers.
5.2. Transaction characteristics tif merging firms and postmerger performance
Transaction characteristics, such as the form of financing, whether the

transaction is hostile or friendly, and the size of the target firm, are fre-
quently cited as important to the ultimate success of mergers. We use
postmerger cash flow returns for different types of transactions to examine
each of the hypotheses associated with these characteristics. We estimate a
cross-sectional regression similar to (7) with dummy variables representing
the form of financing and find no significant postmerger performance differ-
ences between transactions financed with equity, cash, or a mixture of
securities. We also do not find any relation between the merger-related
abnormal stock returns for the combined firm and the form of financing.‘”
A similar approach is used to test whether postmerger performance differs
for nostile and friendly transactions. Using the information from Wall Street
Journal articles that discuss the initial offer, we classify transactions as
hostile, friendly, white knight, and indeterminate. We do not find a
“‘Previous studies examine the relation between stock returns and the form of financing for
acquiring and target firms separately. See Huang and Walkling (1987) and Asquith, Bruner, and
Mullins (1990).
164 P. Healy et al., Performance improl-ements after mergers
evidence of postmerger cash flow performance or merger-related abnormal

stock return differences among any of these transaction types.
Finally, we er*amine whether size of the acquisition influences postmerger
performance. Two variables are used in this analysis: the log of target assets
and the ratio of target assets to acquir& assets, both one year prior to the
acquisition. Neither variable explains cross-sectional variation in postmerger
performance.
In summary, while there is some evidence that the degree of business
overlap between merging firms influences postmerger performance, there is
little evidence that transaction characteristics have a significant impact.20 We
view our analysis on the determinants of postmerger performance as Grelimi-
nary, however, since our study is designed to examine whether performance
improves after a merger.
Given the complexity and heterogeneity of reasons for mergers, we believe
that large-sample studies will provide limited new insights into factors that
influence the outcomes of mergers. A promising approach is to examine a
smaller number of mergers in greater detail. These clinical studies can
provide valuable evidence on the mechanisms through which mergers in-
crease cash flows, and are likely to be fruitful avenues for future research.21
6. Summary
T?is paper examines the post-acquisition operating performance of merged
firms using a sample of the 50 largest mergers between U.S. public industrial
firms completed in the period 1979 to mid-1984 We develop a methodology
to deal with a number of measurement issues that arise in studying the
consequences of takeovers. Further, we integrate accounting and stock return
data in a consistent fashion to permit richer tests of corporate control
theories. This general approach has been adopted by several recent studies to
examine mergers and acquisitions - Tehranian and Cornett (1991) and
Linder and Crane (1991) analyze performance in bank mergers, and Jarrell
(1991) investigates postmerger performance using analysts’ forecasts of sales
margins.
Our findings indicate that merged firms have significant improvements in
operating cash flow returns after the merger, resulting from increases in asset
productivity relative to their industries. These improvements are particularly
strong for transactions involving firms in overlapping businesses. Postmerger
cash flow improvements do not come at the expense of long-term perfor-
“‘The findings on the relation between transaction characteristics and postmerger perfor-
mance are not sensitive to outliers.
“Recent examples of clinical studies on corporate control issues include Baker and Wruck
( 1989), Kaplan ( 1989), and Donaldson ( 1990).
mance, since sample firms maintain their capital expenditure and R&D rates
relative to their industries after the merger. Finally, there is a strong positive
relation between postmerger increases in operating cash flows and abnormal
stock returns at merger announcements, indicating that expectations of
economic improvements explain a significant portion of the equity revalua-
tions of the merging firms.
Appendix
Acquiring / target firms and their industries

This appendix provides a detailed description of the sample used in the
analysis. The business descriptions and industry classifications of acquirer
and target firms are based on Value Line reports before the merger. The
relation between the firms is a subjective classification by the authors of the
degree of overlap between the target’s and acquirer’s businesses. Relative
size of the target is the ratio of the target’s assets to acquirer’s assets one
year before the merger. Assets are measured as the market value of common
equity plus the book values of preferred stock and net debt. Acquisition date
is the date the merger was completed and the target was delisted from the
public exchange. Target equity values are the market value of common equity
one year before the merger. Acquirer stock return is the market-adjusted
stock return from five days before the acquirer’s offer announcement to the
merger completion. Target stock return is the market-adjusted stock return
from five days before the first offer announcement (not necessarily by the
ultimate acquirer) to the merger completion.
1. American Medical International / Lifemark (Acquirer/Target)

American Medical owns and operates proprietary hospitals and other health-care businesses
(94% of revenue in 1982) and offers medical-technical support. Lifemark owns and manages
general hospitals (90% of 1982 revenues) and provides cardiopulmonary, physical therapy,
pharmacy, and clinical laboratory services.
Acquirer industry: Medical services Target industry: Medical services
Acquisition date: Jan. 20 1984 Relation between firms: High overlap
Target equity value; $808.0 million Relative size of target: 34%
Acquirer stock return: - 16.0% Target stock return: 55.1%
2. Anheuser-Busch Companies /Campbell Taggart

Anheuser-Busch is the world’s largest brewer of beer. Campbell Taggart’s business is baking and
distributing bread, rolls, crackers, cake and other sweet products, and food products.
Acquirer industry: Brewing Target industry: Food processing
Acquisition date: Nov. 2 1982 Relation between iirms: Low overlap
Target equity value: $536.3 million Relative size of tjrget: 15.8%
Acquirer stock return: - 3.0% Target stock return: - 4.8%
166 P. Healy et al., Performcxe impror*ements after mergers
3. Associated Dry Goods /Caldor Inc.

Associated Dry Goods operates general department stores in 25 states. Caldor operates 65
promotional discount department stores in five states.
Acquirer industry: Retail stores Target industry: Retail stores
Acquisition date: May 27 1981 Relation between firms: High overlap
Target equity value: $309.5 million Relative size of target: 47.5%
Acquirer stock return: 9.3% Target stock return: 36.7%
4. Avon Products Inc./ Mallinckrodt
Avon is the world’s largest manufacturer of cosmetics and toiletries, and also sells costume
jewelry and ceramics. Maiiinckrodt develops and manufactures fine chemicals, drugs and other
health care products, and chemicals for the food, cosmetics, laboratory, petrochemical, and
printing industries.
Acquirer industry: Toiletries/cosmetics Target industry: Speciality chemical
Acquisition date: March 8 1982 Relation between firms: Low overlap
Acquirer stock return: -5.9% Target stock return: 18.3%
5. Best Products /Modern Merchandising Inc.
Best Products and Modern Merchandising sell general merchandise through catalog showrooms.
Acquirer industry: Retail-special lines Target industry: Retail-special lines
Acquisition date: Sept. 15 1982 Relation between firms: High overlap
Target equity value: $114.3 ni~llion Relative size of target: 55.6%
Acquirer stock return: - 16.7Y~ Target stock return: 15.7%
6. Brown-Forman Distillers / Lenox Inc.
Brown-Forman manufactures a wide variety of alcoholic beverages. Lenox produces home
furnishings (including china and crystal) and personal-use products (including jewelry and
luggage).
Acquirer industry: Distilling and Target industry: Household
tobacco products
Acquisition date: July 21 1983 Relation between firms: Low overlap
7. Burroughs Cor p./ Memorex Corp.
Burroughs is a major participant in the data processing and business computer equipment
industry. Memorex develops, manufactures, markets, and services a wide range of computer
perimheral equipment systems, and products employed in the recording, retrieval, communica-
tion, and storage of information.
Acquirer industry: Computer/data Target industry: Computer/data
processing products processing products
Acquisition date: Dec. 3 1981 Relation between firms: High overlap
Acquirer stock return: - 2.7Yc Target stock return: 52.9%
8. Coca Coia Co./Columbia Pictures Industries Inc.
Coca Cola is the largest manufacturer and distributor of soft drink concentrates and syrups in
the world. The company also manufactures citrus, coffee, tea, wine, and plastic products.
Columbia Pictures produces and distributes theatrical motion pictures, television series and
features, amusement games, and commercials.
Acquirer industry: Soft drinks Target industr : Retreat ion
Acquisition date: June21 1982 Relation betwten firms: Low overlap
9. Con Agra Inc./
Con Agra is a diversified food processor engaged in agriculture (agricultural chemicals, formula
feed, and fertilizers), grain (flour, by-products, and grain and feed merchandising), and food
P. Healy et al., Performance improrements after mergers 167
(frozen foods. broiler chicken, eggs, seafood, and pet products) industries. Peavey is also a
diversified food processor and retailer engaged in grain merchandising, food processing (flour,
bakery mixes, and jams), and the operation of specialty retail stores.
Acquirer industry: Food processing Target industry: Food processing
Acquisition date: July 20 1982 Relation between firms: High overlap
Target equity value: $186.5 million Relative size uf target: 71.9%
10. Cooper Industries /Gardner-Denver
Cooper is a diversified, international corporation that produces consumer and industrial tools,
aircraft services, mining and construction, and energy services. Gardner-Denver makes portable
and stationary air compressors, drilling equipment for above- and underground, and air-operated
tools. Drilling equipment for mining, petroleum, and construction industries makes up 67% of
sales.
Acquirer industry: Machinery Target industry: Construction and
mining machinery
Acquisition date: April 30 1979 Relation between firms: Medium overlap
11. Dart Industries / Krafi Inc.
Dart is a diversified company that manufactures and markets consumer products (including
Tupperware containers, Duracell batteries, and West Bend appliances), chemicals, plastics, and
packaging products. Kraft manufactures food products and markets them to retail, industrial,
and food service customers.
Acquirer industry: House hold products Target industry: Food processing
Acquisition date: Sept. 25 1980 Relation between firms: Low overlap
Target equity value: $1,099.4 million Relative size of target: 78.7%
12. Diamond Shamrock/ Natomas Co.
Diamond Shamrock is a domestic integrated oil and gas company vith interests in coal and
chemicals. Natomas is principally engaged in petroleum exploration and production. Its opera-
tions also include ocean shipping, coal, real estate, and geothermal energy.
Acquirer industry: Integr. petroleum Target industry: Integr. petroleum
Acquisition date: Aug. 31 1983 Relation between firms: High overlap
13. E. I. Du Pans de Nemours/Conoco Inc.
Du Pont manufactures diversified lines of chemicals, plastics, specialty products, and fibers.
Conocc is engaged in the exploration, prod:ntion, and transportation of crude oil, coal, and
natural gas; petroleum refining; and the production, processing, and transportation of chemicals.
Acquirer industry: Basic chemicals Target industry: Integr. petroleum
Acquisiti,,n date: Sept. 30 1981 Relation between firms: Low overlap
14. Eaton Corp./ Cutler-Hammer Inc.
Eaton is engaged in areas of transportation, materials handling, industrial automation, security,
construction, agriculture, and consumer durabies. Cutler-Hammer designs and manufactures
electronic and electrical components and systems for industrial, aerospace, air traffic control,
semiconductor, housing, and consumer markets.
Acquirer industry: Replacement auto Target industry: klectricai
parts equipment
Acquisition date: Jan. 2 1979 Relation between firms: Low overlap
168 P. Healy et al., Performance improl*ements after mergers
15. Exxon Corp./Reliance Electric Co.

Exxon is engaged in the exploration, production, and transportation of crude oil and natural gas,
and in the production and transportation of petroleum and chemicals. Reliance develops,
manufactures, and services a broad line of industrial equipment, including electric motors and
drives, mechanical power transmission components, industrial and retail scales and weighting
systems, and telecommunications equipment.
Acquirer industry: Integr. petroleum Target industry: Electrical equipment
Acquisition date: Dec. 27 1979 Relation between firms: Low overlap
16. Fairchild Industries /WI Corp.

Fairchild produces military aircraft and parts, commercial aircraft and parts, spacecraft and
parts, and domestic communications systems. VSI is a diversified manufacturer of a wide range
of precision metal products, including fastening systems for aircraft and missiles, steel mold
bases for the plastics industry, door knobs, stainless steel cabinets, and building hardware.
Acquirer industry: Diversified Target industry: Machinery
aerospace
Acquisition date: Nov. 7 1980 Relation between firms: Medium overlap
17. Fluor Corp./St. Joe Minerals Corp.

Fluor designs, engineers, procures, and constructs complex manufacturing plants, processing
plants, and related facilities for energy, natural resources, and industrial clients. St. Joe is a
diversified producer of natural resources (principally lead, gold, zinc, silver, coal, oil and gas, and
iron ore).
Acquirer industry: Building Target industry: Lead, zinc &
minor metals
Acquisition date: Aug. 3 1981 Relation between firms: Low overlap
18. Fort Howard Paper Co./Maryland Cup Corp.

Fort Howard manufactures a broad line of disposable sanitary paper products, principally table
napkins, paper towels, toilet tissue, industrial and automotive wipes, and boxed facial tissues.
Maryland Cup manufactures a variety of single-use paper and plastic products for food and
beverage service, including plates, cups, bowls, cutlery, drinking straws. and toothpicks. Mary-
land Cup markets its products to major fast-food chains, restaurants, vending operators, soft
drink bottlers, contract feeders, and dairy and other food packagers.
Acquirer industry: Paper and forest Target industry: Packaging and
products container
.4cquisition date: Aug. 31 1983 Relation between firms: Medium overlap
19. Freeport inerals Co./McMoran Oil & Gas Co.

Freeport Minerals is a diversified company engaged in exploration and development of natural
resources, including agricultural minerals, uranium, oxide ano kaolin, and oil and gas. (Oil and
gas account for 3% of Freeport’s sales.) McMoran is engaged in the acquisition, exploration, and
development of oil and gas properties, and the production and salt of oi! and natural gas.
Acquirer industry: Metirls ano mining Target industry: Oil and gas
Target equity value: $455. I million Relative size of target: 22.5%
Acquirer stock return: 14.7% Target stock return: 27.4@G
P. t4ealy et al., Perjmmdrtce inlprot~enzeilts afFer mergers 169
20. Gannett Co. Inc./Co unications Corp.

Gannett and its subsidia ally newspapers. Combined Communications Corporation
is engaged in outdoor advertising (45% of revenues), television and raoro broadcasting (30% of
revenues), and newspaper publishing (25% of revenues).
Acquirer industry: Newspaper Target industry: Broadcasting
Acquisition date: June 7 1979 Relation between firms: m overlap
Target equity value: $309.6 million Relative size of target:
Acquirer stock return: - 1.4% Target stock return: - 5.OVf
21. General Foods Corp./Oscar Mayer & Co. Inc.
Genera! Foods is a leading processor of packaged grocery products. Oscar Mayer operates in the
meat packing and processing industry.
Acquirer industry: Food processing Target industry:
Acquisition date: May5 :981 Relation between firms:
Acquirer stock return: 5.6% Target stock ret urn: 66.2%
22. Genstar Ltd./ Flintkote Co.
Genstar manufactures building materials and cement (31% of revenues), and is engaged in
housing and land development (36% of sales), construction (10% of sales), marine transporta-
tion, financial services, and venture capital investment. Fiintkote is engaged in mining, and
manufactures various building and construction materials, including gypsum wallboard, floor tile,
sand and gravel products, concrete, cement, and various lime products.
Acquirer industry: Building Target industry: Building
23. Gulf & Western Industries /Simmons Co.
Gulf & Western is a conglomerate with interests in the manufacture of automotive and
air-conditioning components, paper products, leisure, financial services, automotive replacement
parts, consumer products, sugar growing and processing, citrus farming, natural resources, and
apparel. Simmons produces furnishings for home, commercial, and institutional customers.
Acquirer industry: Conglomerate Target industry: Building
Acquisition date: Jan. 5 1979 Relation between firms: Low overlap
24. Harris Corp./Lanier Business Products Inc.
Harris designs and produces voice and video communication, and information processing
systems, equipment, and components. Lanier develops, manufactures, and services a broad line
of dictating equipment, several models of video-display text-editing typewriters, and spall-busi-
ness computers.
Acquirer industry: Electronics Target industry: Office equipment
Acquisition date: Oct. 28 1983 Relation between firms: Medium overlap
Target equity value: $275.3 million Relative size oi target: 22.5%
25. Holiday Inns Inc./ Harrahs
Holiday Inns owns and operates hotels tiP,-oughout the world. Harrahs operates two luxury
casinos.
Acquirer industry: Travel services Target industry: Recreation
Acquisition date: Feb. 28 1980 Relation between firms: Medium overlap
Internorth owns and operates natural gas businesses; produces, transpor’s, and markets liquid
fuels and petrochemicals; and is involved in the exploration and production of oil and gas. Beico
is engaged in the exploration and production of crude oil and natural gas and in the production
of coal.
Acquirer industry: Natural gas Target industry: Integr. petroleum
27. Kroger Inc./Dillon Companies Inc.

Kroger operates the country’s second largest supermarket chain, manufactures and processes
food for sale by these supermarkets, and operates one of the country’s largest drugstore chains.
Dillon distributes retail food through supermarkets and convenience stores.
Acquirer industry: Grocery store Target industry: Grocery store
28. Litton Industries / Itek Corp.

Litton industries is a conglomerate. Its businesses include production of office equipment,
material handling equipment, machine tools, microwave cookers, medical equipment, and oil
drilling equipment. Litton is also engaged in geophysical exploration, ship building, and produc-
tion of advanced electronics products for defense, industrial automation, and geophysical
markets. Itek develops and manufactures a variety of aeria! reconnaissance and survei!!ance
products based on optical and electronic technologies.
Acquirer industry: Conglomerate Target industry: Precision
instruments
29. LTV Group/Republic Steel

LTV is the nation’s third largest steel producer. In addition, the company manufactures oil field
equipment and commercial aerospace and defense products. Republic Steel is the nation’s
seventh largest steel producer. Republic Steel also produces coal that is used in its steel
operations.
Acquirer industry: Integrated steel Target industry: Integrated steel
Acquisition date: June 29 1984 Relation between firms: High overlap
30. Mapco Inc./Earth Resources Company

Mapco is a diversified energy company principally engaged in the exploration and production of
coal, oil, natural gas, and natural gas liquids; pipeline transportation of natural gas liquids and
anhydrous ammonia; and marketing of natural gas liquids, refined petroleum products, domestic
and foreign crude oil, and liquid fertilizers. Earth Resources is a diversified energy and resources
development company engaged primarily in refining, transporting, and marketing petroleum
products.
Acquirer industry: Coal/uranium,, Target industry: Integr. petroleum
geothermal
3 dison Co.1 Studebaker Worthington Inc.

McGraw-Edison manufactures and distributes electrical appiiances, tools, and other products for
the consumer market; power-system and related equipment for electrical utilities and industry;
lind a wide range of services and equipment for industrial and commercial uses. Studebaker
P. Heady et al., Performance improvements after mergers 171
Worthington has diversified business operations that deal with the manufacture of process
equipment and industrial products.
Acquirer industry: Home appliance Target industry: Diversified manufg.
Acquisition date: Oct. 23 1979 Relation between firms: Medium overlap
32. Motorola Inc./ Four-Phase Systems Inc.
Motorola produces data communication equipment and systems, semiconductors, and other
high-technology electronic equipment. Four-Phase produces clustered video display computer
systems for distributed data processing applications.
Acquirer industry: Electronics Target indu ,try: Computer/data
processing
Acquisition date: March 2 1982 Relation between firms: Medium overlap
33. Morton-Norwich Products / Thiokol Cerporation
Morton-Norwich produces ethical and proprietary drugs, salt for domestic and industrial uses,
household cleaning and laundry products, and specialty chemicals. Thiokol manufactures spe-
cialty chemical products (44% of revenues), and propulsion and ordnance products and services
for the government.
Acquirer industry: Proprietary drug Target industry: Aerospace/
diversified
Acquisition date: Sept. 24 1982 Relation between firms: Low overlap
34. Occidental Petroleum /Cities Service Company
Occidental produces and markets crude oil and coal, and manufactures industrial chemicals and
plastics, metal finishes, agricultural chemicals, and fertilizers. Oil and gas business accounts for
70% of the company’s sales. Cities Service is an integrated oil company.
Acquirer industry: Integr. petroleum Target industry: Integr. petroleum
Acquisition date: Dec. 2 1982 Relation between firms: High ovellap
Target equity value: 3,792.5 million Relative size of target: 130.1%
35. Pan Am Corp./National Airlines Inc.
Pan Am is primarily an international commercial air carrier providing services to 73 cities in 43
foreign countries. National Airlines is a domestic air carrier with routes extending from its hub
in Miami to New York, San Francisco, and Los Angeles. Although the company also has
transatlantic service to London, Paris, Frankfurt, and Amsterdam, 96% of its revenues are
derived from domestic routes.
Acquirer industry: Air transportation Target industry: Air transportation
Acquisition date: Jan. 7 1980 Relation between firms: Medium overlap
36. Penn Central Corp./GK Technologies Inc.
Penn Central is a diversified company whose primary businesses include oil refining, the
transportation and marketing of refined petroleum products and crude, real estate development,
operation of amusement parks, and production of offshore drilling rigs. GK Technologies
produces wire and cable, primarily for the telecommunications industry, and electronic compo-
nents, and provides engineering services for weapons systems and environmental products.
Acquirer industry: Conglomerate Target industry: Electronics
Acquisition date: May 14 1981 Relation between firms: Low overlap
37. Phillips Petroleum /General American Oil of Texas

Phillips Petroleum is a fully integrated oil company engaged in petroleum exploration, produc-
tion, and refining. General American is primarily engaged in oil and gas production and
exploration.
Acquirer industry: Integr. petroleum Target industry: Petroleum
production
Acquisition date: March 8 1983 Relation between firms: High overlap
38. Raytheon Corp./Beech Aircraft Corp.
Raytheon develops and manufactures electronic systems for government and commercial use.
Raytheon also supplies energy services, manufactures major home appliances, designs and
manufactures heavy construction equipment, and publishes textbooks. Beech Aircraft designs,
manufactures, and sells airplanes for the general aviation market. Beech is also a substantial
aerospace contractor producing a variety of military aircraft, missile targets, and cryogenics
systebms for aerospace vehicles.
Acquirer industry: Electrical equipment Target industry: Aerospace/
diversified
39. Revlon Inc./ Technicon Corp.
Revlon is in the beauty products (65% of revenues) and health products and service business
(35% of revenues). Technicon designs and produces automated testing systems for blood and
other biological fluids, chemical reagents and consumables, industrial analytical instruments, and
medical information systems.
Acquirer industry: Toiletries/cosmetics Target industry: Health care/
hospital supplies
Acquisition date: May 2 1980 Relation between firms: Medium overlap
40. RJ. Reynolds Corp./ Del Monte Corp.
R.J. Reynold’s lines of business are the domestic and international manufacture and sale of
tobacco products (64% of revenues), transportation (14% of revenues), energy (15% of revenues),
food and beverage products (5% of revenues), and aluminum products and packaging (2% of
revenues). Del Monte’s principal business is in food products (primarily processed foods and
fresh fruit) and related services (including transportation and institutional services).
Acquirer industry: Tobacco Target industry: Food processing
Acquisition date: Feb. 2 1979 Relation between firms: Low overlap
41. Signal Companies / Wheelabrator Frye Inc.
Signal is a diversified, technology-based company that manufactures aerospace equipment,
professional audio-video systems, and heavy trucks. Wheeiabrator Frye’s products and services
include environmental, energy, and engineered products and services, and chemical and specialty
products.
Acquirer industry: Auto and trucks Target industry: Machinery
Acquisition date: Feb. 1 1983 Relation between firms: Low overlap
ine Corp./ Beckman Instruments Inc.
!MthK.line researches, develops, manufactures, and markets ethical drugs, proprietary medicines,
animal health products, ethical and proprietary eye care products, and ultrasonic and electronic
instruments. Beckman is an international manufacturer of laboratory analytical instruments and
P. Healy et al., Performance improL*ements after mergers 173
related chemical products that are used widely in medicine and science and in a broad range of
industrial applications.
Acquirer industry: Et hical drugs Target industry: Precision
instruments
Acquisition date: March 4 1982 Relation between firms: Medium overlap
Acquirp: stock return: 3.1% Target stock return: 85.4%
43. Yohio / Kennecott Corp.
Sohio is an integrated petroleum company engaged in all phases of the petroleum business.
Kennecott produces copper, gold, silver, molybdenum, and lead; manufactures industrial abra-
sive and resistant materials; manufactures and markets industrial engineered systems; and owns
two-thirds of a Canadian producer of titanium dioxide slag, high-purity iron, and iron powders.
Acquirer industry: Integr. petroleum Target industry: General metals and
mining
Acquisition date: June 3 1981 Relation between firms: Low overlap
Target equity value: $1,760.4 million Relative size of target: 11 ,/-%
44. Standard Brands /Nabisco Inc.
Standard Brands is a manufacturer, processor, and distributor of food and related products.
Nabisco is a manufacturer and marketer of food products (specializing in cookies and crackers,
which account for 60% of total sales), toiletries, pharmaceuticals, and household accessories.
Acquirer industry: Food processing Target industry: Food processing
Acquirer stock return: 1.0% Target stock return: - 5.7%
45. Tenneco/ Houston Oil & Minerals Corp.
Tenneco is a diversified company. Its major businesses include natural gas, petrochemicals,
construction and farm equipment, automotive components, shipbuilding, chemicals, packaging,
agriculture and land management, and life insurance. The recent business emphasis of Houston
Oil & Minerals has been on exploration for oil and natural gas on undeveloped properties, and
the development of production upon discovery. In 1980, the breakdown of revenues was oil 2l%,
gas 61%, and pipeline and other 21%.
Acquirer industry: Natural gas Target industry: Petroleum
producing industry
46. Tosco Corp./ AZL Resources Inc.
Tosco owns and operates petroleum refineries and related wholesale distribution facilities. Prior
to the merger AZL had been in the process of changing its focus from agricultural-based
businesses to oil and gas exploration ano production.
Acquirer industry: Integr. petroleum Target industry: Agricultural
products
Acquisition date: Dec. 31 1982 Relation between firms: Low overlap
47. U.S. Steel /Marathon Oil Co.
U.S. Steel’s principal businesses include steel, chemicals, resource development, fabricating and
engineering, and transportation. Marathon is an integrated petroleum company engaged in the
production, refining, and transoortation of crude oil, natural gas, and petroleum products.
Acquirer industry: Integr. steel Target industry: Integr. petroleum
Acquisition date: March 11 1982 Relation between firms: Low overlap
48. United Technologies J Carrier Corp.

United Technologies designs and produces high-technology power systems, flight systems, and
industrial products and services. Carrier’s principal business is the manufacture and sale of air
conditioning equipment.
Acquirer industry: Aerospace/ Target industry: Building
diversified
Acquisition date: July 6 1979 Relation between firms: Low overlap
49. Westinghouse Electric /Teleprompter Corp.
Westinghouse Electric is a diversified corporation primarily engaged in the manufacture and sale
of electrical equipment. Westinghouse’s wholly owned subsidiary WBC operates six TV stations,
12 radio stations, and cable television systems. Teleprompter is the nation’s largest cable
television company and owns MUZAC, the leading supplier of music to offices and other
commercial establishments.
Acquirer industry: Electrical equipment Target industry: Broadcasting
Acquisition date: Aug. 18 1981 Relation between firms: Medium overlap
50. Williams Companies / Northwest Energy Company
Williams is primarily engaged in the chemical fertilizer (49% of revenues), natural gas (27% of
sales), and metals (24% of sales) businesses. Northwest is primarily engaged in interstate natural
gas transmission, oil and gas exploration, and the marketing of natural gas liquids.
Acquirer industry: Chemical/ Target industry: Natural gas
diversified
Acquisition date: Nov. 30, 1983 Relation between firms: Medium overlap
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Journal of Financial Economics 31 (1992) 135-175.

Does corporate performance improve

Krishna G. Palepu and Richard S. Ruback

Received April 1990, final version received January 1992

0304-4OSX/92/$05.00 0 l992-Elsevier Science Publishers B.V. All rights reserved

performance studies to determine whether takeovers create real economic

mance and that they can be affected by managerial decisions. As we explain

The sample acquisitions are significant economic events for purchasing

2.2. Performance measurement

2.2.1. Effects of purchase and pooling accounting

2.2.2. Effects of method of financing mergers

same transaction is financed by stock, because income is computed after

2.3. Performance benchmark

2.4. Comparison with prior research

Earlier studies of postmerger performance have a number of methodologi-

3. Cash flow return performance

3.1. Operating cash flow returns

3.1.1. Changes in cash flows and assets

Growth period Firm Firm Industry Industry

Year - 1 to 1 14% 15% 10% 20%

performed better in the postmerger period, however, because assets also

3.1.2. Raw cash jlow returns

the postmerger period. These changes cannot be attributed to the merger,

3.I .3. Industry-adjustedcash flow returns

Panel A: Pre- and postmerger operating cash flow returns

-5 24.5% 0.4% 50% 48

Panel B: Abnormal industry-adjusted postmerger operating cash flow returns

3.1.4. Abnormal industry-adjusted cash flows returns

Our measure of abnormal industry-adjusted returns extends the industry-

uCRposr,i = (V + p UCR,,,,i + ei,

3.2. SensitiGty analysis

3.2.1. Use of Value Line industry definitions

The industry-adjusted results are strikingly different from the operating

premerger period and 4.3% (statistically significant) in the postmerger years,

3.2.2. Change in market value of assets

Year relative to Industry-adjusted Number of

Panel A: Pre- and postmerger operating cash flow returns

Year relative Industry-adjusted

-5 31.7% - 2.5% 47% 43

Panel B: Abnormal industry-adjusted postmerger operating cash flow returns

In contrast to the postmerger performance, there is no strong evidence of

3.3. Components of industry-adjustedwsh flow returns

3.3.1. Operatingperformance changes

(AI Operating characteristics

(I31 kestment characteristics

The results in table 6 suggest that the increase in industry-adjusted

.3.3.2. Inrestmen t policy changes

Asset sales also reflect changes in merged firms’ investment policies. It is

at io een cas stock price performance

Panel k Distribution of unexpected equity returns at merger announcement

Mean 45.6%” - 2.2% 9.1%b

Panel B: Distribution of unexpected asset returns at merger announcement

Mean 40.6% b 0.6% 8.8%b

4.1. Stock returns at merger announcements

4.2. Asset returns at merger announcements

4.3. Relation between announcement returns and postmerger cash flow

where AV is the change in the market value of assets at the merger

We measure ACF/V as abnormal industry-adjusted cash flow returns

where 01CRposr.i and LACR,~~,i are the median annual industry-adjusted