Mergers, Debt Capacity, And Stockholder-Bondholder Wealth Transfers

This study presents a framework for determining whether post merger actual debt of a merged firm is higher than its potential debt capacity. Our results show that on the average, actual debt of the merged firm is significantly higher than its potential debt capacity, and that the proportion of firms with actual debt higher than potential debt capacity is higher than expected. This evidence is consistent with the argument that the co-insurance wealth transfer from shareholders to bondholders is negated by increased leverage post merger. The results on abnormal returns to bondholders for the two subgroups with actual debt higher/lower than the potential debt capacity support the neutralization of wealth transfers. Forty-nine industrial mergers during 1970-1984 and the associated debentures comprise the sample. We measure the potential debt capacity after the merger based on a theoretical model using pre-merger correlation of the cash flows of the merging firms and their debt ratios. Our results indicate that post merger actual debt ratios are significantly higher than the potential theoretical ratios providing support for the increased debt capacity as motive for merger. We also find evidence for leverage induced neutralization of wealth transfers to bondholders