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Introduction and motivation
A number of studies in the finance literature attempted to explain the method of payment chosen to finance mergers. Hansen (1987) argues that the target will only accept cash when it believes that its value is less than the offer. Rappaport and Sirower (1999) trace the change in the financing used during the 1990s from cash to stock, emphasizing that when a bidder offers cash, it sends a strong positive signal to the market that it is confident about the outcome of the deal. Shleifer and Vishny (2003) argue that target managers who accept stock are "likely to have relatively short horizons" when agreeing to the deal.
Recently, a different, behavioral strand of literature has also been used to explain merger financing. Harford (2005) suggests that managers tend to use overvalued stock to buy less overvalued firms. However, Malmendier and Tate (2008) argue that overconfident managers are more likely to finance mergers internally, which results in the use of more cash. Billett and Qian (2008) point to the self-attribution bias[1] as a reason for overconfidence. They predict that managers who become overconfident based on a prior successful experience will "exhibit greater optimism regarding firm prospects" and will pursue mergers and share repurchases. Confident managers put too much emphasis on their skills and too much faith in the positive outcome of the merger, choosing to finance mergers with stock rather than cash as they believe the value of the stock will increase following their financial decisions. Baker et al. (2012) use the reference point theory, defined as the high price the target company recorded within the one year (52 weeks) before the merger announcement date, scaled by the base price to explain the variation in premiums paid for targets.
We build on prior behavioral studies by investigating an alternative explanation for the mix of financing used in mergers. To the extent that the reference point can influence the perception of valuation necessary to derive the proper premium to be paid, it can also influence the decision of using cash or stock financing in a merger. While Baker et al. (2012) focus on how the target reference point can influence the appeal of a bid, we build on their work by showing...