Leverage changes and growth options in mergers and acquisitions

We develop and empirically test a trade-off model for the analysis of leverage changes in mergers and acquisitions. Our study extends prior findings of a post-merger increase in leverage for the acquiring firm, by linking this leverage increase to merging firms that are less correlated, create significantly larger growth options, and have lower bankruptcy costs and lower volatility. Specifically, we show that acquiring firms are more likely to finance diversifying acquisitions with debt as equity holders exploit the increased debt capacity with higher leverage resulting in total merger gains that are positively associated with financial synergies. We also provide evidence of a U-shaped relationship between growth options and leverage changes theoretically and empirically in the context of mergers.