determining value creation through mergers and acquisitions in the banking industry using accounting study and event study methodology

European Journal of Economics, Finance and Administrative Sciences
ISSN 1450-2887 Issue 19 (2010)
© EuroJournals, Inc. 2010


Determining Value Creation through Mergers and Acquisitions
in the Banking Industry using Accounting Study and Event
Study Methodology


Manu Sharma
Doctor in Finance, SMC University Switzerland
Faculty: University Institute of Applied Management Science
Panjab University, India


Abstract
This research examines mergers and acquisitions in the United States banking industry
involving the formation of mega banks. It uses event study methodology and accounting
performance techniques to determine the valuation affects of structural changes that are the
result of the merger. When a merger is announced, it often causes abnormal stock price
jumps for both the acquirer and Target Company at or around the date of the
announcement. Acquisitions that concentrate on increasing the diversity of the business
earned the highest abnormal returns. However, other types of mergers neither create nor
destroy shareholder value. Stock return alone does not paint the entire picture of the value
created by the merger. This research study will assess the mergers using accounting
performance techniques as well as stock price analysis to understand the likelihood that the
value creation is stable, and not simply reactionary on the part of the shareholders.

Introduction
Creating value is the primary reason for mergers and acquisitions. There are many reasons for wishing

to engage in mergers and acquisitions. In some cases, the company might be a good bargain with future
potential gains. In other cases, one of the companies may be in financial trouble and the merger might
be a way to fix their predicament. Even a company that is in financial disrepair maybe a good bargain
once the problems are fixed.
Sometimes the backing of a larger company is all that the smaller companies need to return to
profitability. In the case of an acquisition, the purchaser is speculating that the company will be of
greater value at some future point in time. There are many financially motivated reasons why a
company may choose to merge or acquire another company.
Large scale mergers eliminate competition and secure a greater market share. In some cases, an
acquisition may take place so that one company can acquire its competition. Regardless of the primary
reason for the merger or acquisition, one can be certain that at least one company will benefit from it.
In many cases, there will be a mutual benefit and the combined company will be more profitable. Some
companies were created to be sold, providing quick cash revenue for their owners, as opposed to the
long-term gains that are the typical reason for starting a business.
Mergers and acquisitions to create the mega banks are quickly changing the structure of the
banking industry in the United States. There are many questions that need to be answered in the
formation of an opinion of whether these changes are good or bad. In order to answer this question
thoroughly, one must consider all of the effects of on the various players involved in the merger or
acquisition. Shareholder value is only one aspect of value creation.
62 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

This study will focus on answering the question of whether mergers and acquisitions create a
value for shareholders of both acquirers and targets in mergers involving major banking corporations.
It will examine how shareholders react to potential losses and gains through stock price manipulation.
This research will attempt to answer the question of whether the creation of a mega bank is a
good situation for shareholders. This study will focus on five primaries cases to make its
determination. It will examine the merger of JP Morgan and Chase Manhattan Corp., JP Morgan Chase
and Bank One, Bank of America and Fleet Boston, Citicorp and Travelers Group Inc. and Pacific
Northwest Bancorp., and Wells Fargo & Co. It will examine the valuation affects that are a result of
these transactions. It will also examine social capital and the effects of these mergers and acquisitions

on the communities in which they are located.


Event Study and Accounting Study Parameters
An Event study uses transactions data from financial markets to predict the financial gains and losses
associated with newly disseminated information. For example, the announcement of a merger between
two firms can be analyzed to make predictions about the potential merger-related changes to the supply
and the price of the product(s) subject to the merger.
Investors in financial markets bet their dollars on whether a merger will raise or lower prices. A
merger that raises market prices will benefit both the merging parties and their rivals and thus raise the
prices for all their shares. Conversely, the financial community may expect the efficiencies from the
merger to be sufficiently large to drive down prices. In this case, the share values of the merging firms’
rivals fall as the probability of the merger goes up. Thus, evidence from financial markets can be used
to predict market price effects when significant merger-related events have taken place.
The majority of previous M&A studies have measured the short-term stock price reaction to
merger announcements applying event study methodology. Results are consistent with regard to the
value effect on the shareholders of the target firm and on the shareholders of the combined firm. The
shareholders of the bidding firm either lose or slightly benefit from the mergers whereas those of the
target firm receive large abnormal returns for selling their shares. In most cases, the combined
abnormal return is significantly positive.
But the analysis of the M& A should be performed based on the long term implication of the
merger on the shareholders. This necessitates the determination of the period of study which should be
long enough after the merger to study its impact on the market. Further the impact should not be
continuation of the pre merger market change. Hence it is necessary to include the pre merger period
also in analysis so as to avoid any misinterpretation. In our case study we have taken a pre merger
period of 2 years and post merger period of 2 ½ years.
The contradiction in the acceptance of the merger by the shareholders can be attributed to a
number of reasons, such as the recent losses of the acquired bank and the difference in managing style
of the two involved organization. This was the case with JP Morgan Chase in a different way. It recent
failure to cop up with a merger of Chase in 2000 was clearly reflected in the merger of Bank One in

2004. Further as the event study is dependent on individual shareholder and his perspective of the
financial institution acquired may vary which results in contradictions with the event study. Event
studies have become pervasive; there has not been a concomitant refinement in their technique. The
specification of an event study in terms of a system of abnormal returns and, in particular, emphasizes
the possible limitations of using a methodology when misspecification may be present.
But event study generally predicts the shareholder’s present and future mentality on the
acquisition. Further the support of the shareholders for the merger immediately after merger
announcement results in high returns which help in paying higher dividends. This results in greater
support of the shareholders on combined firm in the future. This high support was evident with
Citicorp which resulted in paying higher dividends by it.
63 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

The accounting technique gives a measure of the assets, revenue and liability of the two
involved banks prior to acquisition and the same of the combined firm after the acquisition.
Furthermore, accounting studies employ control firms in order to control for economy.
The accounting techniques help in accessing the firm’s liability and assets for the future. It
gives the total assets available for future investments. It gives a good account of the total returns of the
merged organization in terms of equity and thereby helps in accessing the value created by the merger.
It gives the real account of the company’s fortunes in terms of physical without any consideration for
the market. The company’s future in terms of the revenue available for new investments is accessed
only through accounting techniques. But in modern public organization the shareholder’s support
greatly the company’s future in long term. Hence the accounting technique alone cannot predict the
value created by the merger.
The partial contradictory results of event studies and accounting studies raise an important
question which has remained unanswered until now: Can we freely choose between both approaches
when analyzing the performance of corporate bank mergers? So far, despite the contradictory results,
the two approaches measuring the economic gains of mergers have been employed as substitutes.
In most of previous literatures (Healy, Palepu and Ruback (1992)) they find a great relation
between the two methods. They find a significant positive relationship between the measures of the
two and hence they advocate the use of both as substitutes. Both the studies predict the future of the

organization in different terms, former in terms of shareholders support and the latter in terms of
company’s assets and liabilities.


Methodolgy
A convenience sample of 20 quarterly time points in the event window from 2 year prior to the merger
through to 2½ years after the merger, including the announcement date and the date of completion for
each merger: t = {T1 … T20}. The event study methodology will utilize stock market abnormal price
returns (ASPR) of both the acquiring and target companies to determine if shareholders experienced an
abnormal change in stock value, as well as examine the Sharpe Ratio. The accounting performance
technique will utilize operating cash flows, absolute cash flows as well as returns on equity for both
pre- and post-merger periods.

Event Study Methodology
Measures for the event study methodology will include computations of abnormal stock price returns
(ASPR) and cumulative abnormal stock price returns (CASPR) and the Sharpe Ratio (SR).

Abnormal Stock Prices Returns
Abnormal returns (ASPR) are the differences between a single stock or portfolio's performance in
regard to the average market performance over a set period of time.
For example if a stock increased by 5%, but the average market only increased by 3%, then the
abnormal return was 2% (5% - 3% = 2%). If the market average performs better than the individual
stock then the abnormal return will be negative. The ASPR’s will be computed for each time period in
the event window. The cumulative abnormal returns (CASPR) will be calculated over the whole event
window of the study for the acquiring banks pre- and post merger, and for the period prior to the
merger for the target banks.

The Sharpe Ratio
The Sharpe Ratio, or Sharpe Index, measures the mean excess return per unit of risk in an investment
asset or a trading strategy. The Sharpe Ratio is defined as:

64 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

][
][][
f
ff
RRVar
RRERRE
S
−
−
=
−
=
σ

where R is the asset return, R
f
is the return on a benchmark asset, such as the risk free rate of return,
E[R − R
f
] is the expected value of the excess of the asset return over the benchmark return, and σ is the
standard deviation of the excess return (Sharpe 1994). The Sharpe Ratio is used to characterize how
well the return of an asset compensates the investor for the risk taken. When comparing two assets
each with the expected return E[R] against the same benchmark with return R
f
, the asset with the higher
Sharpe Ratio gives more return for the same risk. The Sharpe ratios for this study will be computed at 2
year prior to the merger, the beginning of the event window; at the announcement and 2½ years after
the merger, the end of the event window.

Accounting Performance Techniques
The accounting performance techniques will utilize a return on equity (ROE) as the means to measure
profit; as well as operating cash flow (OCF) and absolute cash flow (ACF). This method will examine
the performance data of the acquirer and the target before the final merger date, which will then be
aggregated into a pre-merger measure of the combined firms. A comparison of post-merger
performance of the acquirers with the pre-merger measure will provide an idea of whether the
performance of the firms is in alignment with what could be expected (Bild, et al., 2002).

Return on Equity
Return on Equity (return on average common equity, return on net worth) measures the rate of return
on the ownership interest (shareholders' equity) of the common stock owners. ROE is viewed as one of
the most important financial ratios. It measures a firm's efficiency at generating profits from every
dollar of net assets, and shows how well a company uses investment dollars to generate earnings
growth. ROE is equal to a fiscal year's net income (after preferred stock dividends but before common
stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.
sEquityckholderAverageSto
IncomeNet
ROE
'
=

ROE is best used to compare companies in the same industry, in this case, banking.

Operating Cash Flows
In financial accounting, operating cash flow (OCF), cash flow provided by operations or cash flow
from operating activities refers to the amount of cash a company generates from the revenues it brings
in, excluding costs associated with long-term investment on capital items or investment in securities.
OCF = [EBITDA] - Taxes
[Earnings before Interest Taxes Depreciation and Amortization].

Absolute Cash Flows
For the purposes of this study, the absolute cash flows will be computed by summing the cash flow
from operations, investments and financing measures. This will provide a measure of the net cash
in/out for all the time periods in the event window for both the acquiring and target banks pre- and
post- merger.

Data Analysis
A convenience sample of 20 quarterly time points in the event window from 2 year prior to the merger
through to 2½ years after the merger, including the announcement date and the date of completion for
each merger: t = {T1 … T20}. The event study methodology will utilize stock market abnormal price
returns (ASPR) of both the acquiring and target companies to determine if shareholders experienced an
65 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

abnormal change in stock value, as well as examine the Sharpe Ratio. The accounting performance
technique will utilize operating cash flows, absolute cash flows as well as returns on equity for both
pre- and post-merger periods.

Descriptive Statistics
The following descriptive statistics are based on the historical data retrieved and computed for the
study cases. The measures shown in Table 1 are the means and cumulative measures for abnormal
stock price returns; and Sharpe ratios computed at time periods T1 (2 year prior to the mergers) and T9
(taken at the date of the announcement of the proposed mergers). The Table 2 shows measures for the
variable for Event Study Methodology after the merger. The Table 3 shows Buyer and Target average
measures for the variable for Accounting Performance Techniques before the mergers. The Table
shows average measures for the variable for Accounting Performance Techniques after the mergers.

Table 1:

Note: Abnormal returns (ASPR) are computed from the average differences between a single stock or portfolio's
performance in regard to the average market performance over a set period of time. If the market average performs
better than the individual stock then the abnormal return will be negative. The cumulative abnormal returns (CASPR)
will be calculated over the whole event window of the study prior to the mergers.
Note: The Sharpe Ratio is used to characterize how well the return of an asset compensates the investor for the risk taken.
When comparing two assets each with the expected return E[R] against the same benchmark with return R
f
, the asset
with the higher Sharpe Ratio gives more return for the same risk.
66 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

Table 2: Merger/Acquisition Measures for the variable for Event Study Methodology after the merger

Buyer Merged Banks Mean ASPR CASPR
Sharpe Ratio
(T10)
Sharpe Ratio
(T20)
Bank Ind.
Mean ASPR
Bank Ind. Sharpe
Ratio (T10)
Bank Ind. Sharpe
Ratio (T20)
1B: Citi Group
-1.32% 12.70% -15.8236 -3.4995 5.83% 0.4114 0.4800
2B: Wells Fargo & Co.
-0.25% -0.99% 5.2664 0.1552 3.08% 0.5372 0.4370
3B: JP Morgan Chase
1.83% 1.20% -4.6476 21.4012 9.46% 2.7031 0.5250

4B: Bank of America
-3.52% -51.77% 7.4924 11.4298 3.66% 0.4739 2.4241
5B: JP Morgan Chase & Co. (Bank One)
0.03% -1.01% -3.4121 1.5396 3.90% 0.4488 0.3731


Table 3: Buyer and Target average measures for the variable for Accounting Performance Techniques before
the mergers

B‐Buyer,
T‐Target
Banks MeanROE MeanOCF MeanACF
Bank
Industry
MeanROE
1B: CitiCorp 7.40% 3835 1004 6.00%
2B: WellsFargo&Co. 6.39% ‐4031 ‐1197 5.84%
3B: ChaseManhattan 8.01% 195 472 6.09%
4B: BankofAmerica 9.41% 3510 ‐1679 7.25%
5B: JPMorganChase&Co.(Bank 4.26% 223 ‐388 6.22%
1T: TravelersGroup 7.32% ‐796 1610 6.00%
2T: PacificNorthwestBancorp 6.34% 19 ‐5 5.84%
3T: JPMorgan NoData NoData NoData 6.09%
4T: FleetBostonFinancial 4.73% 3081 ‐1526 7.25%
5T: BankOne 6.25% 1305 2474 6.22%

Note: Return on Equity (return on average common equity, return on net worth) measures the rate of return on the
ownership interest (shareholders' equity) of the common stock owners.
Note: In financial accounting, operating cash flow (OCF), cash flow provided by operations or cash flow from operating
activities refers to the amount of cash a company generates from the revenues it brings in, excluding costs associated

with long-term investment on capital items or investment in securities.
Note: The Absolute cash flows (ACF) will be computed by summing the cash flow from operations, investments and
financing measures. This will provide a measure of the net cash in/out for the time periods in the even window
67 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

Table 4: Merger/Acquisition average measures for the variable for Accounting Performance Techniques after
the mergers

Buyer MergedBanks MeanROE MeanOCF MeanACF
BankIndustry
MeanROE
1B: CitiGroup 8.26% 2804 ‐490
6.59%
2B: WellsFargo&Co. 8.57% 94 62 ‐938
6.36%
3B: JPMorganChase&Co. 3.50% ‐11077 ‐143
6.39%
4B: BankofAmerica 7.20% ‐3965 1102
6.06%
5B: JPMorganChase&Co.(BankOne) 4.04% ‐35013 2201
6.01%


The figure 1, figure 2, figure 3, figure 4 and figure 5 shows ASPRs’ values, Sharpe’s ratio
values, ROE Values, OCF Values and ACF values on quarterly basis for Acquirers before and after the
Merger. The figure 6, figure 7, figure 8, figure 9 and figure 10 shows ASPRs’ values, Sharpe’s ratio
values, ROE Values, OCF Values and ACF values on quarterly basis for banking industry on quarterly
basis for the same time period before and after the Merger.

Figure 1: ASPRs’ values for Acquirers before and after the Merger

‐60%
‐40%
‐20%
0%
20%
40%
60%
1 2 3 4 5 6 7 8 9 1011121314151617181920
A
S
P
R
EventWindow
Citi
WFC
JPMorgan
BOA
JPM

68 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

Figure 2: Sharpe Ratios’ values for Acquirers before and after the Merger



Figure 3: Mean ROE values for acquiring Banks before and after the merger

‐5.00%
0.00%

5.00%
10.00%
15.00%
20.00%
25.00%
1234567891011121314151617181920
R
O
E
EventWindow
Citi
WFC
JPMorgan
BOA
JPMBank


69 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

Figure 4: OCF values for acquiring Banks before and after the merger


(60,000)
(40,000)
(20,000)
0
20,000
40,000
60,000
1234567891011121314151617181920

O
C
F
EventWindow
Citi
WFC
JPMorgan
BOA
JPMBankOne


Figure 5: ACF values for acquiring Banks before and after the merger


(10,000)
(5,000)
0
5,000
10,000
15,000
20,000
1 2 3 4 5 6 7 8 9 1011121314151617181920
A
C
F
EventWindow
Citi
WFC
JPMorgan
BOA

JPMBank
One


70 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

Figure 6: ASPR values for Banking Industry for comparable period of Acquirers.


‐20.00%
‐15.00%
‐10.00%
‐5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
1234567891011121314151617181920
ASPR
EventWindow
BankingIndustryASPRforCom parableperiodof
Acqur ier s
BankInd.CitiGroup
BankInd.WellsFargo
BankInd.JP Morgan
BankInd.BOA
BankInd.JPM‐Bank One

Figure 7: Sharpe Ratio values for Banking Industry for comparable period of Acquirers.


0.0000
0.5000
1.0000
1.5000
2.0000
2.5000
3.0000
3.5000
1 2 3 4 5 6 7 8 9 10 11 12 13 1 4 15 16 1 7 18 19 20
SharpeRatio
EventWindow
BankingIndustrySharpeRatiofor
ComparableperiodofA cquriers
BankInd.CitiGroup
BankInd.WellsFargo
BankInd.JP Morgan
BankInd.BOA
BankInd.JPM‐Bank One

71 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

Figure 8: Return on Equity values for Banking Industry for comparable period of Acquirers.


0.00%

2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
1 2 3 4 5 6 7 8 9 1011121314151617181920
ReturnonEquity
EventWindow
BankingIndustryROEforComparablePeriodof 
Acquirers
BankInd.CitiGroup
BankInd.WellsFargo
BankInd.JP Morgan
BankInd.BOA
BankInd.JPM‐Bank One



Conclusion
In this research we have studied the cases of five mega mergers. Our objective is to analyze whether
these acquisitions pronounced success. We have made an effort to judge the justifiability of merger on
the ground of value creation. In this purpose we have used the two techniques. The first is the event
study methodology, for which the target variables are abnormal stock price return (ASRP), cumulative
abnormal stock price return (CASRP) and the Sharpe ratio. The second method is the accounting
performance techniques, in which the target variables are return on equity (ROE), an indicator of
profit, and the cash flow variables such as operating cash flow (OCF) and absolute cash flow (ACF).

The definitions of the aforesaid variables are given in the research methodology.
Findings from the results of accounting study methodology (deferential statistics) show that the
for the sample of mergers and acquisitions of the five mega-banks analyzed in this study, significant
value was created for Citigroup, Wells Fargo and BOA where as no significant value was created in
both the JP Morgan Chase mergers including JP Morgan and Bank One.
Here the event study methodology tend to differ from accounting study methodology as event
study has shown that value creation didn’t happen for any of the mergers where as accounting study
has shown that the value creation did happen for three out of the five mergers studied.
72 European Journal of Economics, Finance And Administrative Sciences - Issue 19 (2010)

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