Leverage And Its Role As A Takeover Defence Tool


A Literature Review


Leverage is one of the widely researched topics in the field of finance as it seems to be one of the most elusive and challenging financial concepts for researchers and managers alike. Diverse views on choice of debt as a prudent financing option are present in the extant literature. Debt, as a part of capital structure of a firm, has implications in terms of tax savings, cost of debt, agency issues, bankruptcy costs, signaling etc. It has an interplay with macroeconomic issues like corporate and personal tax rates in the country, prevalent interest rates, exchange rates in case of foreign borrowing and such other related factors.

Another branch of finance that is of great interest to researchers is mergers and acquisitions. Research in this field has been motivated by several “waves of acquisitions” (Shleifer & Vishny 1991) that have occurred in the last few decades as a corporate expansion and diversification strategy. In this paper, I will restrict my discussion to acquisitions only.

Recent research has also focused on impact of leverage on acquisitions and the key issues of that are discussed in the extant literature relate to role of debt in post acquisition returns, defensive moves by a target firm, abnormal returns following the announcement of an acquisition - target firms vs acquiring firms etc. However, I focus largely on use of debt as a defense tool and briefly mention its impact on acquisition gains.

The following sections of this paper review the literature on debt and related concepts followed by review of literature on role of debt in acquisition decision.

2) Debt

As mentioned above, the key issues that relate to choice of debt as a financing option are taxes, agency issues and optimal capital structure, each of which is discussed in the following paragraphs.

2a) Debt and Taxes

There is one school of thought which thinks that debt is expected to result in relatively higher value of the firm through higher net income resulting from deductibility of interest expense for calculation arising from a leveraged balance sheet. The other school of thought debates the extent to which interest deductibility benefit balances out with costs related to debt, the key ones being bankruptcy and agency costs.

One of the dominant ideas in this field is that of “irrelevance of capital structure” proposed by Modigliani and Miller (1958). Their main idea in this paper is that extent of leverage in the capital structure does not impact the value of the firm. The basic assumption here is the frictionless capital markets and absence of taxes.

However, in their subsequent paper “Corporate Income taxes and the cost of capital : a correction” (1963), they change their perspective and justify the role of leverage, tax rates in determining the returns of a firm and its relative valuation.

The initial view of Modigliani and Miller is supported by Merton Miller (1977). He uses a model to explain that in equilibrium, value of the firm will be independent of the capital structure when interest payments are fully deductible in computing corporate income taxes. He argues that main reason for the above behavior is that presence of personal taxes offsets the corporate tax savings on account of debt. He observes that bankruptcy costs and agency costs are disproportionately small relative to the tax savings that accrue from leverage and that there was no significant change in capital structure of non financial firms that followed the exponential increase in tax rates during the period 1920 – 1950.

On the contrary, DeAngelo and Masulis (1980) argue against the “leverage irrelevancy theorem” by using the argument that firms use alternative tax shields such as depreciation deductions or investment tax credits, bankruptcy costs to increase the value of the firm. They hypothesize that pure change in debt will impact market value of the firm and that there is a direct relationship between the rate of corporate tax and level of debt in the capital structure of the firm.

Fama and French (1998) use cross sectional regression of firm value on earnings, investment and financing variables to measure tax effects in the pricing of dividends and debt. Contrary to the expected belief that taxes have a positive impact on debt and negative impact on dividends, their empirical study presents evidence that while there is a marginal positive impact of taxes on dividend and that there is negative relationship between taxes and leverage. They also suggest that tax effects on dividend and debt could possibly convey some information about the profitability of the firm. Summarily, they do not find any empirical evidence of impact of tax effects of financing decision on firm value.

Graham (2000) also uses empirical evidence based on interest benefit function to conjecture that firms use leverage up to a certain point, beyond which interest deduction benefit of taxation begins to fade away. Hence, he infers that firms might use debt by observing as to where they locate on the interest benefit function.

Contrary to the above, a negative relationship between level of debt and tax shelters is observed by Graham and Harvey ( 2006).

The controversy relating to impact of debt related tax benefit on value of the firm is further highlighted when Sunder and Myers (1999) present a model using the pecking order theory and information asymmetry to present evidence that the increase in the value of the firm can be equated to the present value of the tax shield available on account of interest payment. However, this view is later corrected by Fernandes (2004), who suggested that the increase in firm value on account of debt is due to the difference between the present value of taxes of an unlevered company and that of a levered company and not as is stated by Sunder and Myers (1999).

2b) Debt and Agency Costs:

As per Jensen and Meckling (1976) the concept of agency costs emerges from a view that there is a principal and agent relationship between shareholder and managers of the firm, respectively. Therefore, if each is expected to maximize the utility and given that there is “separation of ownership and control”, then it is unlikely that an agent will act in the best interest of the principal. Consequently, the principal will have to incur cost to monitor the behavior and actions of the principal. This cost is called agency cost and is a sum of :

a) Monitoring expenditures by the principal
b) Bonding expenditure by the agent and
c) Residual loss

They conjecture that introduction of agency costs will invalidate the M&M capital structure “irrelevance theorem” because the probability of incurrence of agency and bankruptcy costs will change the probability distribution of future cash flows.

Parrino & Weisbach (1999) use Monte Carlo simulation to show the impact of shareholder – bondholder conflicts on the investment decision of the managers. They expect managers of firms with higher debt levels to be more likely to invest in negative NPV projects. They also emphasis that existence and magnitude of agency cost is likely to vary across firms and hence it may be too small to be able to singularly offset the tax benefit of debt.

2c) Optimal Capital Structure

From the above mentioned views, it is clear that
a) There are divergent opinions if capital structure matters.
b) Second, if there is a capital structure, it has costs and benefits associated with it.
c) Capital structure influences the value of the firm.

Therefore, going with the views that capital structure exists and influences the value of the firm, it is plausible that firms will try to have a capital structure or an optimal debt equity ratio that not only helps to increase firm value but minimizes the costs associated therewith.

One of the key studies in this regard is that of Flannery and Rangan (2006), who provide empirical data of non financial firms for the period 1966- 2000 to posit that the firms have a targeted long term capital structure and they make “partial adjustments” towards it. The rate at which the convergence towards that target happens is estimated to be more than 30% per year. Even after they introduce market timing and pecking order variables, change in capital structure is attributed largely to the targeting behavior. Their results seem to pass robustness checks in terms of estimation horizon, firm size, time and alternative leverage definitions. Thus, they believe that both the under and over levered firms will correct themselves in the long run to arrive at the target capital structure.

The issue relating to a optimum capital structure continues to invite controversial views given the multitude of factors that affect choice of debt as a financing option. Trade off Theory and Pecking Order Theory provide views which do not exactly match those of the Flannery and Rangan (2006). The issue of information asymmetry proposed by Pecking order theory is definitely a good reason for the choice of debt as the second best financing option but is beyond the purview of this review.

3) Debt and Acquisitions

Debt has implications not only for the operating and financing decisions of a firm but also in the takeover decisions. Although the literature available on the role of leverage in acquisitions is limited, it offers significant empirical evidence largely in favor of role played by debt in the acquisition process and subsequent acquired gains. Related literature review is presented below:

3a) Debt as tool for takeover defence

Stulz (1988) is amongst the earliest available research paper on this theme. The main idea of Stulz’s paper is that while higher proportion of managerial (insider) shareholding reduces the possibility of a hostile takeover on one hand, it increases the amount of premium that an acquirer would pay in case of an acquisition. He argues that leverage can be used as a tool to increase the proportion of managerial shareholding. One of the hypotheses in his paper is as quoted below:

“If we hold constant the manger’s investment in their own firm and if a change in the debt-equity ratio affects the potential bidder only because it changes management‘ s control of voting rights, (a) there is a positive debt-equity ratio that maximizes the date 1 value of the firm, (b) the probability of a hostile takeover attempt is negatively related to the target’s debt-equity ratio, and (c) an unexpected increase in the probability of a hostile takeover attempt increases the target’s debt-equity ratio.”

Stulz assumes that a firm can borrow at more favorable terms than a manager can and hence it is beneficial for firm to borrow rather than for managers to borrow money to buy shares to consolidate their position in the capital structure of the firm. He also believes that given the bankruptcy cost associated with debt, managers would have the ability to balance the marginal cost and benefit of debt. Further, he argues that in case the debt is issued, the resulting increase in debt equity ratio can reduce the possibility of a takeover by reducing the gains accruing to the bidder from control in the following three ways:

a) Citing Jensen (1986 a,b), he states that issuance of new debt can be a way for management to bond itself to higher payout and reduced investment expenditures that raise the value of the firm and make acquisition of the target less valuable for a potential bidder.

b) Target’s debt may include covenants which restrict ‘the bidder’s ability to use these assets in the way it wants to.

c) Increase in the debt-equity ratio can make a takeover less likely because the bidder may have included in its computation of the gain from the acquisition, an increase in the debt of the target. Since an increase in the debt-equity ratio of the target reduces the target’s ability to issue additional debt, the gain from the acquisition would fail as debt equity ratio increases.

The key result of the author is that leverage as a tool for increasing the value of the firm can be effectively used when the existing proportion of insider holding in the target firm is low. Debt would help to consolidate voting rights in the hands of the management, which would consequently compel the bidder to pay a higher amount of premium to acquire control. Using another assumption that managers have superior information about the probability of the firm becoming a target given the level of managerial holding, he states that if a firm with high managerial holding decides to issue debt, the announcement of this decision will negatively impact the value of the firm because a successful takeover is then perceived as less likely.

Stulz concludes this section on a note of caution that if the debt equity ratio adversely impacts the bidder’s borrowing cost, then the incumbent management is more likely to lose control while still receiving high premium for higher proportion of managerial holding.

Harris and Raviv (1988) discuss impact of takeover method on the value of the firm and the effect of leverage on takeover method used in the acquisition. While discussing the latter part, authors acknowledge the fact that incumbent management invariably resists any acquisition move and that it could use any of resistance techniques such as leverage, voting trusts, targeted share repurchase (greenmail), stock pyramids and nonvoting equity. However, they choose leverage as a technique and establish the relationship between the level of debt and take over method (tender offer vs proxy fights) used for acquisition. Their intuition is similar to that of Stulz on the impact of debt on ownership concentration and they use the same to conjecture that takeover targets increase their level of debt as compared to those firms that are not targets. The level of debt that the incumbent management issues, however, depends upon the level of control that it wants to exercise and the incumbent’s belief in its relative managerial capability. In the former case, high level of debt is likely to be issued and in the latter case, if the management beliefs itself to have better ability, then it will issue less debt and rely more on passive votes. Thus, the firm issues debt to the extent it can offset the increase in voting power of the incumbent management against the possibility of incurring bankruptcy cost and incumbent management eventually losing control.

Israel (1991) presents a capital structure theory based on corporate control considerations. He argues that risky debt is issued to maximize expected target firm value when there is a potential acquirer. This could result in increase in value for the shareholders of the target firm through sharing of appreciation of equity value between acquiring and target firms. However, in case the acquisition does not materialize post the increase in leverage because the acquirer finds it less profitable, then there could be a decrease in the value for the shareholders of the target firm. Thus, as per Israel’s model, optimal level of debt is that which balances decrease in probability of acquisition against a higher share of synergy for the target’s shareholders in case of an acquisition. The key implications of the model are :

a) Probability of firms becoming acquisition targets decreases with leverage.
b) When acquisition is initiated, target firms’ stock price, target firm’s debt value and acquiring firm’s value increase.
c) Acquirer firm’s share of total gain increases with target firm’s degree of leverage.
d) During the acquisition, there are additional price changes in which the expected change is zero and the variance decreases with target firm’s leverage.

Unlike Stulz (1988) and Harris & Raviv (1988), Israel (1991) model is based on the assumptions that home- made leverage is possible, equity ownership structure does not play any role and that there are no agency problems between shareholders of target firms and their incumbent management. Also, It is assumed that acquirer has only equity outstanding and that acquisition is financed through cash.

Summarily, while Harris and Raviv (1988) and Stulz (1988) argue that capital structure affects the acquisition decision through distribution of voting power or control between management and outside equity, Israel (1991) theorizes that capital structure affects the outcome of takeover decision through distribution of cash flows between voting and non-voting securities.

The above studies indicate that debt is used as a tool for takeover defense by target firms. But it is important to analyze to what extent was this tool effective and what happened to the firms that successfully resisted a takeover using high debt equity ratio but also ended up with increased leverage on their books.

An empirical study of 573 unsuccessful attempts during 1982 to 1991 was conducted and presented in Safieddine and Titman (1999) paper. Their key findings are as below:

a) Targets of hostile takeover attempts increase debt three times more than targets of friendly acquisitions do. This supports the above mentioned view that debt is used as a defensive tool in takeover attempts. In addition, they find evidence that increase in leverage and other defensive techniques such as stock lock up, white knight, white squire, greenmail etc are possibly substitutes.

b) Empirical evidence of this study presents a different view as to how debt acts as a deterrent. Contrary to the belief in the above mentioned studies that higher leverage acts just as a deterrent by increasing the cost of the target through enhanced bargaining power without improving the value of the target firm, this paper states that high leverage ratio is associated with performance improvements in the target firm.
They find evidence of increase in operating performance of former targets following a failed attempt even after controlling for factors like management turnover, sale of assets, change in industry, change in level of employment, change in insider ownership etc. This view is supported by Jensen (1986).

c) Last, they suggest that increase in leverage leads to further entrenchment of management, which acts in the interest of the shareholders. This is indicated by their result that firms that terminated takeover attempts using debt levels which were higher than the median of the sample firms reported higher stock returns in the following years than those which reported leverage lower than the median.

While there is study by Bradley et al (1983), which talks about failed targets being eventually taken over after five years of initial takeover attempt as a result of better operating and stock performance, but since this study is not using leverage as a factor in any of the relationships, I will not discuss it in further detail.

Considering the limitations associated with use of debt, which are discussed in the earlier part of his paper, use of debt as a takeover mechanism seems to be moderated by the anti takeover laws prevalent in the country.

A study by Garvey and Hanka (1999) uses adoption of “second generation” state level antitakeover laws to present evidence in this regard. They compare data of firms in the states that had antitakeover laws with those that did not adopt antitakeover laws initially, along with firm specific controls and present evidence that protected firms have less debt and reduced their leverage ratios over time. They posit that anti takeover laws act as substitute for debt as a means of attracting higher premiums. This was supported by the observation that adoption of “second generation” state level antitakeover laws resulted in significant increase in takeover premiums (Comment and Schwert, 1995). Also, use of debt as a means of concentration of voting power in the hands of insiders is supported by the following evidence in this study:

a) When insider holding was more than 25%, antitakeover laws do not have a significant impact on the capital structure, i.e. the firm is indifferent towards the existing debt equity ratio.
b) If the insider holding ranged between 5 – 25%, adoption of antitakeover law resulted in a significant decline in debt levels of the firm.
c) Maximum reduction in debt levels was undertaken post the adoption of antitakeover law if the insider holding was less than 5% before the law was passed.

Thus, we can deduce that while debt can be used as effective tool for takeover defense, firms protected by antitakeover laws use it as a substitute for debt as a takeover defense tool and hence reduce their current debt level.

3b) Leverage and Takeover gains

There is limited evidence in the literature explaining the relationship between leverage and gains to the target firm post the acquisition. However, a brief overview of the results of two main research articles related to the field is as presented below:

Billet and Ryngaert (1997) is considered one of the most important empirical works that developed a model of equity takeover premium and tested the relationship between leverage and takeover gains. Using a sample of 145 cash tender offers between the period 1980 - 1989, they find that target abnormal returns increase with the target's debt to equity ratio and decrease with the target's financial asset to equity ratio. They present two key findings:

a) Debt financing helps to increase the percentage takeover premium paid to shareholders
b) Premium paid for control is sensitive to nature of target’s assets. They conjecture that non financial assets can be redeployed or reallocated to generate higher value than the financial assets, thus generating better returns post acquisition.

Jandik and Makhija (2005) use the above (Billet and Ryngaert) study as a base to discuss the impact of leverage on acquisition gains. They find evidence of role of debt in increasing the complexity of the acquisition procedure through delays and complex negotiations because of presence of multiple bidders. Further, they posit that leverage and positive changes in offer prices affect target gains positively and that acquisitions involving higher levered targets are associated with greater values of total gains.
Authors use SDC data on mergers and acquisitions for the time period 1981 – 1995 for this study. They use OLS regression, probit regression and weighted least square regression methods to explain the relationship between debt and time taken for takeover negotiations, target debt and multiple bidders and changes in offer price and takeover complexity and acquisition synergies.


I conclude this review by summarizing that despite the tax advantage associated with it, debt as a financing option comes with a multitude of caveats in terms of agency issues, bankruptcy costs etc. The studies indicate that beyond a certain level, debt will not support any increase in the value of the firm. However, studies indicate that debt is often used as a defensive tool by a target firm in case of an impending takeover. Even in case the target is not able to prevent itself from being taken over, higher debt helps in receiving higher acquisition premium by concentration of voting power in the hands of the incumbent management. Another study relates the increase in operating performance and value of the former target firm, post a successful attempt at preventing an acquisition, to increase in debt. Last, studies also indicate that if firms are protected by anti takeover laws, they would reduce the extent of leverage that they would probably use as a defensive tool to prevent a takeover.


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