The problem of overvaluation
When a company acquires another company, it always pays above its current market value.
Mergers enhance shareholders' value if there are:
Significant improvements in the management of the assets of the target company that could be realised by an acquisition
The larger the agency problem within the acquiring company, the larger the premium the acquiring company will be willing to pay.
During an acquisition, there is normally a fall in the price of the bidder and an increase in the price of the target.
The overvaluation problem may arise as a miscalculation of the potential synergies or the overestimation of the ability of the acquiring firm's management to improve performance.
Both errors will lead to a higher price being paid as compared to the current market price.