Takeover Attempts, Economic Welfare, and the Role of Outside Directors

Jean A. Crockett

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: The implications for takeover activity of certain types of capital market imperfections are examined. Management, "knowledgeable outsiders" and "uninformed investors" are assumed to differ in the extent to which they have access to the total information potentially available at a given point in time. More information means less dispersion in the subjective probability distribution of future cash flows and a lower required risk premium.

Stockholders also differ with respect to their investment horizons and tend to be myopic beyond their own horizon. While they may estimate the expected value of earnings and dividends within their horizon quite accurately (relative to the full-information estimate), they have little information regarding events beyond that horizon and may tend to underestimate the long--term trend in periods when this is steeper than the trend within the relevant horizon. This tendency, in conjunction with the inverse relationship of the required risk premium to information access, implies that in such periods market participants will generally underprice stock relative to its fundamental value as defined in terms of an infinite horizon and maximum information. Unless those with the most information and the longest horizons dominate trading, stocks will be undervalued in the market.

If market price remains below fundamental value for any significant period, a profit opportunity is created for any "knowledgeable outsider" with sufficient information to perceive the discrepancy. The welfare implications of takeover bids motivated solely by such a discrepancy are investigated. Also investigated is the dilemma of outside directors when faced with a takeover bid above market price but below what they perceive as long-term value. Acceptance of these terms may well benefit stockholders with short horizons, while damaging those with longer horizons.

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