Risk dynamics, growth options, and financial leverage

In essay I, I empirically examine theoretical inferences of real options models regarding the effects of business risk on the pricing of firms engaged in corporate control transactions. This study shows that the risk differential between the merging firms has a significant effect on the risk dynamic of bidding firms around control transactions and that the at-announcement risk dynamic is negatively related to that in the preannouncement period. In addition, the relative size of the target, the volatility of bidder cash flows, and the relative growth rate of the bidder have significant explanatory power in the cross-section of announcement returns to bidding firm shareholders as does the change in the cost of capital resulting from the transaction. Essay II provides an empirical analysis of a second set of real options models that theoretically examine the dynamics of financial risk around control transactions as well as the link between financial leverage and the probability of acquisition. In addition, I present a comparison of the financial risk dynamics of firms that choose an external growth strategy, through acquisition, and those that pursue an internal growth strategy through capital expenditures that are unrelated to acquisition.