Stock swap transactions are one of the popular ways in which mergers can be financed. Stock swap refers to the situation when an acquiring company exchanges its common stock shares for common stock shares of the target company at the agreed upon ratio.

The ratio, which is called ratio of exchange, is determined during merger negotiations. The acquiring company often needs to repurchase shares in the market place to obtain an adequate amount of shares to be able to complete the stock swap transaction.

To find the ratio of exchange, the dollar amount required to be paid per share of the target company must be divided by the market value of the shares of the acquiring company.

Ratio of exchange = amount required to be paid per share of the target company/market value of the shares of the acquiring company

Test yourself:

ABC Company would like to acquire company BCD by using a stock swap transaction to finance the merger. ABC’s shares currently trade for $60 per share. BCD’s shares are traded for $55. However, in merger negotiations, it was agreed that BCD’s shares should be valued at $90 per share. What is the ratio of exchange in this merger stock swap transaction?

Solution:

The ratio of exchange is 1.5 (90/60). ABC will need to exchange 1.5 shares of common stock to obtain 1 common stock share of BCD.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction where it will exchange 1.5 shares of common stock for each common stock share of BCD. ABC’s shares trade at $60 per share. It was agreed during merger negotiations that BCD’s shares will be valued at $90 each. The real market price of BCD’s shares is $55 per share. Find out how many shares does ABC need to exchange in the stock swap transaction if BCD needs to obtain 15,000 shares?

Solution:

ABC needs 22,500 (15,000*1.5) to complete stock swap transaction with BCD at a ratio of exchange of 1.5:1.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s earnings before the merger were $400,000 per year and it has 110,000 of shares of common stock outstanding. ABC will have to issue 22,500 shares of additional common stock to complete the stock swap transaction with BCD. BCD’s earnings before the merger are $65,000 and it has 15,000 shares of common stock outstanding. The ratio of exchange is 1.5 of ABC’s shares for 1 share of BCD.

What are current earnings per share (EPS) of ABC and BCD and what will be the initial earnings per share of ABC after the merger, if earnings are assumed to stay unchanged?

Solution:

Current (before the merger) earnings per share (EPS) of ABC is $3.6 (400,000/110,000).

Current (before the merger) earnings per share (EPS) of BCD is $4.3 (65,000/15,000).

Initial earnings per share of ABC after the merger is:

= ((400,000+65,000)/(110,000+22,500))

=485,000/132,500

= $3.5

It is common for earnings per share of acquiring company to initially decrease. This happens because acquiring company pays a large premium above the target company’s market price. In the long run, however, earning per share will likely be higher than it would be without the merger.

If the price/earnings ratio (P/E ratio) paid for the target firm by the acquiring firm is greater than the P/E of acquiring firm then, the EPS of the acquiring firm will initially decrease and vice versa. However, in the long term, the EPS of acquiring firm should increase. The P/E Ratio is found by dividing the market price per share by earnings per share (EPS).

Test yourself:

ABC (acquiring company) is acquiring BCD (Target Company) with the use of a stock swap transaction. ABC’s market price is $60 and its earnings per share are $3.6. BCD’s market price is $55 and its earnings per share are $4.3. However, during merger negotiations ABC agreed to a 1.5 ratio of exchange where it value BCD’s shares at $90.

A. Explain how ratio of exchange was determined.

B. Calculate the P/E ratio for ABC and BCD before the merger at market prices per share.

C. Calculate the P/E ratio of BCD at the agreed upon price per share for the merger.

Solution:

A.

The ratio of exchange of 1.5 is calculated by dividing $90 (the agreed upon price of BCD’s share) by $60 (the market price of ABC’s share). ABC will need to exchange 1.5 shares of common stock to obtain 1 common stock share of BCD.

B.

P/E ratio of ABC before the merger is $60/$3.6=16.6

P/E ratio of BCD before the merger is $55/$4.3=12.7

C.

The P/E ratio of BCD at the agreed upon price per share for the merger is:

$90/$4.3=20.9

The P/E ratio paid by ABC for target company (BCD) was larger than the P/E ratio of ABC. This was due to an agreed upon price for BCD common stock shares which was $35 ($90-55) or 63.6% (35/(55/100)) above the  target company’s market price. It is common for an acquiring firm to pay approximately 50% above the target company’s market price. Consequently, in such situations the P/E ratio paid is often higher than the acquirers P/E ratio. This results in the initial earnings per share to be lower after the merger.

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