Reference Point Theory and Pursuit of Deals

Date01 August 2015
Published date01 August 2015
The Financial Review 50 (2015) 275–300
Reference Point Theory and Pursuit
of Deals
Inga Chira
California State University-Northridge
Jeff Madura
Florida Atlantic University
Target and bidder reference points have separate and joint effects on merger deals. A
firm whose stock price is more distant from its 52-week high reference point is less likely to
attract bids but has a greater likelihood of being acquired by its own managers (vs unaffiliated
bidders). Firm propensity to submit a bid increases if its prevailing stock price is closer to its
52-week high. When both parties’ reference points are close to their current stock prices, they
are more willing to complete a deal. Hostile deals result when the bidder’s stock price is closer
to its reference point.
Keywords: target reference point, bidder reference point, probability of acquisition, MBOs,
hostile mergers
JEL Classifications: G02, G34
1. Introduction and motivation
The framing of the problem and the status quo, or reference level, suggest
a psychological aspect of economic decision making. Monroe (2003) asserts that
Corresponding author: Department of Finance, Financial Planning, and Insurance, California State
University-Northridge, 18111 NordhoffStreet, Northridge, CA 91330-8379; Phone: (818) 677-2459; Fax:
(818) 677-6079; E-mail:
We wouldlike to thank Dr. Bonnie Van Ness, the Editor of The Financial Reviewand the two anonymous
referees who provided valuable comments in the process.
C2015 The Eastern Finance Association 275
276 I. Chira and J. Madura/The Financial Review 50 (2015) 275–300
consumers base purchase decisions on the relative price of items compared against a
reference point; Kamins, Dr`
eze and Folkes (2004) find that seller-specified reference
points in auctions result in higher bidding prices from buyers. Reference points also
influence investment decisions, and multiple studies document how perceptions of
a price or valuation relative to a reference point affect choices. In their prospect
theory, Kahneman and Tversky (1979, 1984, 1986) cite reference points as a means
to explain managerial finance decisions. Shefrin and Statman (1984) apply this theory
to explain why so many firms accommodate investors by paying cash dividends; the
same authors (Shefrin and Statman, 1985) also explain why investorshold on to losing
stocks and sell winning stocks too fast by drawing on prospect theory. Odean (1998)
confirms their explanation by empirically testing the behavior of 10,000 investment
accounts in a large brokerage house. Fanto (2001) notes that a company’s board
is in a better legal position when planning to bid for a target if it uses the prices
from recent similar mergers as reference points. While investigating the impact of
psychological biases on capital budgeting decisions, Gervais and Goldstein (2007)
find that managers with access to their firms’ free cash flows overinvest, engage in
more acquisitions, and invest in more new projects.
A common reference point for investors is a stock’shighest price in the previous
year. Barberis and Xiong (2009) show that investors tend to sell their stocks at prices
near the 52-week high, and Grinblatt and Keloharju (2001) and Huddart, Lang and
Yetman (2009) reveal that sales volumes are much higher when the stock reaches its
52-week high. Kaustia (2004) offers similar results for initial public offerings. Baker,
Pan and Wurgler (2012) also show that target shareholders use the 52-week high as
a reference point when negotiating deal prices (because they believe their stock is
capable of reaching its 52-week high again) so they extract higher premiums from
bidders when the reference point is relatively high, compared with the target’scurrent
stock price. The probability of deal completion increases when the bidder offers a
price that is above the target’s 52-week high.
Webuild on these applications of reference point theory in several ways and make
four distinct contributions to prior literature. First, we test whether a firm’s reference
point influences its appeal to bidders, measured by the probability of receiving a bid.
Baker, Pan and Wurgler’s (2012) focus on targets that already received a bid, not
whether a reference point can distinguish between targeted versus untargeted firms.
We argue that targets with current stock prices that are distant from their reference
point expect a natural rebound, which may make them less willing to accept bids and
therefore less likely to be targeted.
Second, we apply reference point theory to the bidder’s perspective; to the best
of our knowledge, this study represents the first consideration of the concept of a
bidder reference point. Just as target stakeholders may consider a reference point
to determine their own valuation when pursued by bidders, bidder managers may
consider their reference point (i.e., bidder’s 52-week stock price high) when deciding
whether to pursue deals. Bidders should be more willing to pursue deals if the current

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