CORPORATE MERGERS AND THE CO‐INSURANCE OF CORPORATE DEBT

WHILE NUMEROUS STUDIES have been devoted to examining the returns to the stockholders of merging firms, the same detailed analysis has not been extended to another group of emminently interested security owners-namely the bondholders of these same firms. Indeed, there exists a fundamental unresolved controversy concerning the impact of corporate merger on the value of the merging firms' bonds, and, by implication, the value of their common stock. The controversy revolves around the notion of a "co-insurance" effect for corporate debt and the wealth-transfers thereby engendered. The idea of a co-insurance effect for corporate debt was first advanced by Lewellen (11). He argued that the joining-together of two or more firms whose earnings streams were less-than-perfectly correlated would reduce the risk of default of the merged firms (i.e., the co-insurance effect) and thereby increase the "debt capacity" or "borrowing ability" of the combined enterprise. He concluded that the increased total borrowing capacity of the resulting firm, in combination with the well-known effect of tax-deductible interest payments, provided an economic incentive for shareholder-wealth-maximizing firms to engage in merger. However, Lewellen's thesis was incomplete because he failed to examine carefully the impact of the co-insurance effect on the value of the merging firm's already outstanding debt. Higgins and Schall (6) and Galai and Masulis (5) extended the analysis to show that the co-insurance effect would lead to an increase in the market value of the merging firms' debt and a concomitant decline in the market value of their equity. Thus, the net financial result of non-synergistic mergers would be a wealth-transfer from stockholders to debtholders. They concluded that unless firms can neutralize this wealth-transfer they should not engage in merger. However, if firms are either controlled by stockholders or if managers at least seek to maintain shareholders' wealth-let us define these more generally as shareholder-wealth-protecting firmswe would expect to observe that merging firms do take steps to neutralize this wealth-transfer. This paper is a theoretical and empirical examination of corporate merger and the co-insurance of corporate debt. The theoretical section uses a cash-flow analysis to re-examine the co-insurance effect. The comparative advantages of the theoretical framework used here is that the valuation consequences of the coinsurance effect are provided with no distributional assumptions and without