in the market for corporate control. 22 Lehn and Poulsen (1988), table 6, p. 54. The measure of cash flow used in their empirical analysis, however, does not control for the firm’s growth prospects and so only crudely captures the firm’s “free cash flow.” But in a subsequent analysis, Lehn and Poulsen (1989), using un- distributed cash flow (that is, the firm’s after-tax cash flow net of interest and dividend payments) and attempting to control for the firm’s growth prospects, get similar results for LBOs between 1984 and 1987 (table V, p. 782). Also, Lehn and Poulsen (1989), table Ill, p. 778, find that firms going private have a significantly higher flow of un - distributed cash flow as a fraction of their equity value and possibly lower growth prospects than a control group of firms. Recently, Mitchell and Lehn (1988), who attempt to iden- tify the source of gains to shareholders in takeover activi - ty, present some preliminary evidence to support the hypothesis that the growth in productive takeover activity is partly an attempt to prevent the target firm from using free cash flow in an unprofitable way or to reverse the earlier unprofitable takeover activity due to the free cash flow problems. “Lehn and Poulsen (1988, 1989). Lehn and Poulsen (1988), table 9, p. 60, divide their sample into two equal sub- samples according to the magnitude of the firm’s tax liability as a fraction of the market value of the firm’s outstanding equity before the transaction. They find that the mean market-valued premium for those firms with the higher tax liability measure was 47.7 percent, whereas that for firms with the lower measure of tax liability was 32.1 percent. The difference in the premiums for the two sub- samples cannot be due to chance alone. (See footnote 11 for their definition of the market-valued premium.) However, the firm’s tax liability does not explain variation in the premium not already explained by variation in the firm’s undistributed cash flow. See Lehn and Poulsen (1989), table V, p. 782. Also, they do not find a significant difference between the mean tax liability for firms that went private and that for a control group of firms (table Ill, p. 778). SEPTEMBER/OCTOBER 1989
30 market value of the firm’s outstanding debt. 2~ The value of debt allegedly falls because the target firm’s increased leveraged position, typically in the form of low-quality, high- yielding (junk) bonds, increases the probability that its future revenues will be insufficient to cover its higher interest payments. That is, the value of the firm’s bonds outstanding before the announcement of the LBO drops because market participants believe that the probability of default has increased as a result of the LBO transaction.’ 5 Even if LBOs were to redistribute wealth in this way, however, whether or not public policy should aim to discourage LEO activity is not ob - vious.’° Economics has nothing meaningful to say about the “fairness” of wealth redistribu - tions that leave social wealth unchanged. The key economic issue is whether LBOs reduce the market value of the
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