The purpose of this paper is to model the announcement returns of merging firms based on managerial overconfidence about merger synergy.
The paper applies continuous‐time real options techniques and game theoretic concepts. Managerial overconfidence and strategic interaction between the bidder and the target are incorporated into the model.
This model implies that: abnormal returns to bidding shareholders will be negative with a high degree of managerial overconfidence; combined returns to shareholders are usually positive; and both the bidder's and the target's abnormal returns are related to industry characteristics, the degree of managerial overconfidence, and the way merger synergies are divided.
This paper, for the first time, reconciles theoretically the following stylized facts: combined returns to shareholders are usually positive; and returns to the acquirer are, on average, not positive. In addition, the model generates new predictions relating these returns to industry characteristics and the degree of managerial overconfidence.
