Question: Cain Denis and Denis CDD 2011 studied a sample of

Cain, Denis, and Denis (CDD; 2011) studied a sample of acquisitions in the United States during the years 1994– 2003. The target firms for most of these acquisitions were non-publicly traded companies. A problem faced in any acquisition, especially if the target company’s shares are not publicly traded, is how much the acquirer company should pay. When there is disagreement between buyer and seller, a solution is to include an earnout contract in the acquisition agreement. In such contracts, the acquirer pays an additional amount to the vendors, contingent on the performance of the acquired company over a few years following the acquisition. Such contracts also help to retain and motivate key managers of the acquired company, since, to motivate them to work hard, an efficient contract should base compensation on a risky performance measure. The higher is the performance measure following acquisition, the greater is manager compensation.
As CDD pointed out, the performance measure in such contracts is usually based on some risky accounting variable, such as earnings or sales, although some contracts are based on risky non- financial variables, such as successful clinical trials or attainment of large contracts.

a. CDD reported that earnout payments to the acquired firm (and hence to management) under the earnout contracts are positively related to the need to motivate acquired company management effort. Specifically, they found that earnout payments are larger the greater the riskiness of the acquired company’s industry, measured as the variability of the share price of the average firm in that industry. They also found that earnout payments are greater the greater the growth options ( i. e., prospects for future growth) of the acquired company’s industry, where growth options are measured as the ratio of share market value to book value ( this ratio is commonly known as Tobin’s Q) of the average company in that industry. Are these findings consistent with agency theory concepts? Explain why of why not. In your answer, also explain why the ratio of share value to market value is commonly used as a measure of a firm’s potential for future growth.
b. CDD reported that for 50% of their sample firms, the term of the earnout contract was between one and three years. They found that the contract term is greater the greater the riskiness of the acquired company. Is this latter finding consistent with agency theory concepts? Explain why or why not.
c. CDD reported that while the performance measure is earnings in many earnout contracts, sales is another common measure. They found that the relative likelihood of a sales- based earnout contract increases when the acquired firm is from an industry with higher risk and higher prospects for future growth. Is this finding consistent with agency theory contracts? Explain why or why not. Use concepts of sensitivity and precision of a performance measure in your answer.

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