This paper considers the impact of takeover (or acquisition) likelihood on firm valuation. If firms are more likely to acquire during times when they have free cash and/or when the required rate of return is low, takeover targets become more sensitive to shocks to aggregate cash flows and/or to the price of risk. Thus, ceteris paribus, firms that are exposed to takeovers will have a different rate of return from firms that are protected from takeovers. Using estimates of the likelihood that a firm will be acquired, we create a takeover-spread portfolio that buys firms with a high likelihood of being acquired and shorts firms with low likelihood of being acquired. Relative to the Fama-French model, the takeover-spread portfolio generates annualized abnormal returns of up to 12% between 1980 and 2004. Further, the takeover-spread portfolio is shown to be important in explaining cross-sectional differences in equity returns. Additionally, using a two-beta model that distinguishes cash flow shocks from discount rate shocks, we show that firms more likely to be taken over have higher betas on the aggregate cash factor. Finally, we provide an explanation for the existence of abnormal returns associated with governancespread portfolios (Gompers, Ishii and Metrick, 2003 and Cremers and Nair, 2005), and relate the takeover-spread portfolio returns to takeover activity in the economy.
