Although it is well documented that target firms' shareholders earn large positive abnormal returns from mergers and tender offers, sources of such returns are not well understood. We show that the stock market liquidity of target firms is typically much poorer than that of acquirers, and the liquidity of target firms improves significantly and permanently after a successful merger or tender offer. Our results show that abnormal returns to target firms' shareholders are significantly and positively related to the difference in liquidity between acquirers and targets as well as the magnitude of target firms' liquidity improvement. Our results indicate that at least part (about 4%) of the abnormal returns to target shareholders can be attributed to the liquidity improvement for target shares after a merger or tender offer.
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