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Stock Swap

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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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Establishing a Value for the Target Company

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An acquiring company may be interested in acquiring entire business or just acquiring individual assets and selling off the rest of the assets. When considering a merger, companies can use capital budgeting techniques to find the value of the company. If the net present value of the relevant cash flows is positive then a merger is considered acceptable.

If the acquiring company is interested in the whole business rather than in just few assets of the target company then post-merger pro forma statements for the target company should be prepared and the cost of capital of the acquiring company must be adjusted to reflect the cost of capital of the target company.

Test yourself:

ABC Company would like to obtain assets of BCD Company. BCD Company is a loss maker, it made losses over the last 4 years. However, it has three assets which ABC needs for its operations which are assets a, b and c. BCD is not willing to sell the assets separately but willing to sell the entire company for $95,000. According to the balance sheet of BCD:

  • asset a is worth $25,000
  • asset b is worth $20,000
  • asset c is worth $50,000
  • BCD also has $5,000 in cash, $12,000 in accounts receivable, and $5,000 in relatively obsolete inventory
  • ABC found out that they can sell accounts receivable and inventory of BCD for $10,000
  • BCD’s liabilities account for $70,000
  • After the merger, three assets of BCD will generate $15,000 in cash inflows over the next 10 years
  • ABC’s cost of capital is 12%

How should ABC establish if it should undertake this investment?

Solution:

BCD requires $95,000. Out of this money, $70,000 will be used to cover liabilities and $25,000 will be going to the owners of the target company. ABC will be able to recover $10,000 from selling accounts receivable and inventory and it will also obtain $5,000 in cash. Therefore, its actual investment is $80,000 ($95,000-10,000-5,000).

Next we need to determine the net present value of the relevant cash flows. Since it is an annuity, we can calculate it very simply. We will use a financial calculator. The calculation is as follows:

PMT: 15,000

N: 10

I: 12

PV: calculate = 84,753

Since investment required is $80,000, we can find the NPV as follows:

84,753 – 80,000 = 4,753

There is another way to calculate NPV using a financial calculator. It is advisable to try them both to make sure that the answer you obtain is correct. The second way is as follows:

CF0: -80,000

CF1: 15,000

Second function Nj: 10

I: 10

Second function NPV: calculate = $4,753

Since both calculations gave us the same answer, we can be confident that the answer is correct.

Since NPV is $4,753 which is higher than zero, a merger with BCD is acceptable.

 

Divestiture (Divestment)

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Divestiture, which is also called divestment, refers to a company selling (divesting) parts of its business or specific assets because it believes that by following such an action the value of the business will be improved. As an example, a company may sell part of its operations which is not a core business so that it can focus its full attention on the core business and invest money obtained from the sale on expansion of the core business.

Sometimes selected operating units or departments are sold to its current management. Such transactions are usually financed via leveraged buyouts (LBOs).

Spin-off is another way to undertake divestment. This occurs when a certain operating unit becomes an independent business.

If a buyer cannot be found for part of the business or specific assets the business no longer would like to keep, then liquidation of the  business or assets is another option in which divestiture can be accomplished. Liquidation is, for obvious reasons, the least attractive option to accomplish divestiture.

It is often the case that an organization’s breakup value is greater than its current value. Breakup value, which is also called private market value (PMV), refers to the sum of values of each part of the business that could have been sold independently. A company with a high breakup value is more attractive acquisition target for acquiring company. This is because the acquirer can keep the valuable parts and sell the parts it does not need at a high price and use the money to pay down the price of the original acquisition.

 

Leveraged Buyouts (LBOs)

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Leveraged buyouts (LBOs) are also called “bootstrap” transactions or highly-leveraged transactions (HLT). It occurs when a lot of debt, which is also referred to as leverage or borrowing, is used to acquire an organization or controlling percentage of shares of the organisation. As much as 90% or more of debt is used to finance a leveraged buyout.

The assets of the target company are typically used as collateral to finance the merger. Leveraged buyouts often involve situations when a public company is taken private. LBOs are examples of financial mergers.

Due to the nature of the acquisition, certain organizations are especially attractive candidates for leveraged buyouts. Such characteristics include under priced stock, healthy liquidity position, low debt level, inefficient current management of the organization which can be rectified by the new owners, consistent stable earnings of the target company, strong cash flow or the possibility of stronger cash-flows and a good position within the industry and availability of assets to account for sufficient collateral.

Repurchase of stock is sometimes undertaken by companies to decrease attractiveness of the company as a leveraged buyout target. Takeovers can be attractive due to a company’s liquidity position. If a company has a lot of cash, it can be used to cover all or part of the debt undertaken to finance the acquisition. By using available cash to repurchase stock, a firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes takeover more expensive.

Another strategy that management of the target company may use to protect itself against hostile takeover via leveraged buyout is defensive acquisition. The purpose of such an action is for the target company to make itself less attractive to the acquiring company. In such situations, the target company will acquire another company as a defensive acquisition and finance such an acquisition through debt. Due to increased debt of the target company, the acquiring company, which previously planned the hostile takeover, may lose interest in acquiring a highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than a merger with acquiring company which pursues hostile takeover.

The nature of leveraged buyouts changed over the last 30 years. Whereas before, LBOs were mostly used to finance hostile takeovers, currently leveraged buyouts are predominantly used to finance management buyouts.

 

Types of mergers

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There are four types of mergers, which are presented below:

Conglomerate merger – acquisition of businesses in different lines of business to diversify risk.

Congeneric merger – acquisition of company in the same general industry to cross-sell products and services. It can be further subdivided into:

a. Market-extension merger – which refers to acquisition of company which operates in different market.

b. Product-extension merger – which involves acquisition of company that operate within same market but which product and service mix is different but related to that of the acquiring company.

Horizontal merger – acquisition of company in the same line of business which operates in the same market. This refers to acquisition of the direct competitor.

Vertical merger – acquisition of a supplier or customer.

 

8 Specific Motives for Mergers and Acquisitions

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Mergers are undertaken if it is believed two or more companies which are merging will be greater together than sum of its parts. The math of a merger is “1+1=3” or “2+2=5”. Specific motives for mergers for strategic and financial reasons include the following:

Tax advantages – Tax advantages in mergers will differ from one location to another. In US it can be utilized if the acquiring firm or target company has a tax loss carry-forward. Tax loss carry-forward refers to the ability to deduct past losses from the taxable income. This advantage is available in mergers but not for holding companies. To decrease the attractiveness of this motive, the US and many other countries limit the amount of tax loss carry-forward that can be deducted annually from the taxable income of merged companies.

For example, assume the acquiring company is a profitable company and the target company is a loss maker which incurred losses in the past two years. When the merger is completed, the operating results of a merged company, which probably will have the identity of the acquiring company, will be reported on a consolidated basis.

This means the acquiring company will be able to deduct past losses of the target company from the consolidated taxable income, within limits. Merged firms will continue deducting the tax loss carry-forward (within limits) until it is recovered completely over a duration of up to 20 years.

Increases liquidity for owners – If the acquiring firm is a large company and target company is a small organization then the target company’s shareholders may find it very appealing that after merger their shares’ liquidity and marketability will likely be considerably better.

Gaining access to funds – The acquiring company may have high financial leverage (a lot of debt) thereby making access to additional external debt financing very limited. Therefore, one of the motives of the acquiring company to undertake the merger is to merge with a company which has a healthy liquidity position with low or non-existent financial leverage (very little or no debt).

Growth – This is one of the most common motives for mergers. It may be cheaper and less risky for the acquiring company to merge with another provider in a similar line of business than to expand operations internally. It is also much faster to grow by acquisition.

Sometimes an organization may have a window of opportunity that will be closing fast and the only way the organization can take advantage of this opportunity is by acquiring a company with competencies and resources necessary to take advantage of the opportunity. Additional benefits of growth motivated mergers are that a competitor or potential future competitor is eliminated.

Diversification – Diversification is an external growth strategy and sometimes serves as a motive for a merger. For example, if an organization operates in a volatile industry, it may decide to undertake a merger to hedge itself against fluctuations in its own market. Another example can be when an acquiring company pursues a target company which is located in different state or country. This is called a geographical diversification.

Related diversification seems to have a better track record. It refers to expanding in the current market or entering new markets and adding related new products and services to the product or service line of the acquiring company.

Diversification usually does not deliver value to the shareholders because they can diversify their portfolio on their own at much lower cost. Therefore, diversification on its own is unlikely to be sufficient motive for a merger.

Synergistic benefits – Synergy occurs when the whole is greater than sum of its parts. For example, in terms of math it could be represented as “1+1=3” or as “2+2=5”. Within the context of mergers, synergy means the performance of firms after a merger (in certain areas and overall) will be better than the sum of their performances before the merger. For example, a larger merged company may be able to order larger quantities from suppliers and obtain greater discounts due to the size of the order.

In the context of mergers, there can be two types of synergy. The first type of synergy results in economies of scale, which refers to decreased costs. Another type of synergyresults in increased revenues such as cross-selling.

As per the above, economies of scale are derived from synergy. For example, merging businesses in the same business line will allow elimination of some of the duplicated overhead costs. A new business will not need two human resources and public relations departments. Instead, the best employees will be kept and the rest of personnel and unused office space will be reallocated or no longer used.

Cross-selling is another benefit derived from synergy. If some of the products and services of merged companies differ then cross-selling those products and services to the other firm’s customer base can be a cost effective way to increase sales. Being able to effectively meet more of the customers’ needs may also increase customer loyalty due to higher customer satisfaction which can occur by effectively providing customers with a broader spectrum of products and services which meet customers’ needs.

Synergy benefits with regard to an increase in revenue are usually more difficult to achieve than synergy benefits with regard to decreasing costs. Management also needs to be careful to ensure that potential synergy benefits are not overestimated as this may result in overpayment for the target company.

Protection against a hostile takeover – Defensive acquisition is one of the hostile takeover defense strategies that may be undertaken by target of the hostile takeover to make itself less attractive to the acquiring company. In such a situation, the target company will acquire another company as a defensive acquisition and finance such an acquisition through adding substantial debt. Due to the increased debt of the target company, the acquiring company, which planned the hostile takeover, will likely lose interest in acquiring the now highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than a merger with the acquiring company which started off the whole process by proposing a hostile takeover.

Acquisition of required managerial skills, assets or technology – The target company may have managerial skills, assets and/or technology that the acquiring company needs to improve its performance, profits, revenue, cut costs, reduce productivity etc. This can become a motive for merger.

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Types of Corporate Restructuring

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Mergers and Consolidations

Consolidation is a type of corporate restructuring and occurs when two or more organizations come together to form a completely new corporation. This new corporation typically include all assets and liabilities of the combined separate companies. Consolidations usually occur between organizations of similar size.

Merger is also a type of corporate restructuring and occurs when two or more organizations merge into one. Organizations that merged into one usually maintain the identity of most important organization.

Merger often involves one or more smaller organizations merging into a larger organization and becoming part of that larger organization. Merging involves absorption of assets and liabilities of all firms merged. Mergers also can be called acquisitions, buyouts or takeovers.

Within a merger, the acquiring company (generally larger and more important company) usually will approach a target company (smaller and less important company) to arrange a merger.

Sometimes, however, the target company may approach acquiring company. The key outcome that the acquiring company seeks from a merger is synergy, leverage, key staff, technology or even preventing a competitor from acquiring a particular company.

Government and mergers

Governments regulate mergers. The main concern of the government is to ensure that competition is not eliminated. This concern is especially relevant if one direct competitor attempts to acquire another direct competitor. Such a merger could result in higher prices for consumers and lower output of combined organizations (fewer product or service options or inferior customer service). If such a situation occurs then population may end up worse off than it was before the merger.

Mergers, of course, also may provide social benefits. Such benefits include economies of scale and scope, better utilization of resources, higher output and improved quality.

Therefore, government usually prohibits only those mergers in which anticompetitive disadvantages outweigh social benefits.

Hostile and Friendly mergers (takeovers)

Hostile merger (hostile takeover) usually occurs when the acquiring company approaches target company but management of the target company or the board of directors of the target company do not support the proposal for acquisition. In such a situation, the target company may take actions to make it harder or impossible for the hostile merger to take place by executing hostile merger defence strategies.

Acquiring company then attempts to obtain the required amount of shares in the market place via tender offers. Tender offers refer to formal offers made to the shareholders in the market place to obtain a certain amount of shares at a given price which is above the current market price.

The acquiring company may also undertake a creeping tender offer by silently purchasing enough shares in the market place before making their intentions known.

Hostile mergers (hostile takeover) also occurs if the acquiring company approached shareholders directly without firstly approaching the management and board of directors of the target company.

Another way a hostile merger can occur is if the acquiring company engages in a proxy fight by trying to obtain support of enough shareholders to replace management with new management which will endorse the takeover.

Certainly hostile mergers are more difficult to undertake. The acquiring company may struggle to obtain a loan if it needs to borrow to finance a hostile takeover as banks usually are not supportive of hostile takeovers.

The acquiring company is also at greater risk under a hostile takeover because it cannot undertake an in depth due diligence of the target company and will have to rely completely on the publicly available information to make a decision to acquire a target company. Nevertheless, hostile takeovers also take place.

Friendly merger (friendly takeover) involves a situation where the acquiring company approaches the management of the target company with the proposal for acquisition. If management supports such an acquisition and if the board of directors sees a merger to be in best interests of shareholders, then the board makes such a recommendation to the shareholders. If shareholders approval is obtained then a friendly merger occurs and it is completed by the acquiring company obtaining shares in the target company.

Motives for mergers

Any action undertaken by business must be based on achieving the main objective of the enterprise which is the wealth maximization of the owners of the enterprise.

The main objective of a merger should be the same as the main objective of the firm. Namely, the maximization of the owners’ wealth by improving the share value.

There are two driving forces for mergers, which should be consistent with the main objective. They include strategic and financial reasons.

Under a strategic merger the performance of firms after the merger is higher than performance of firms before merger. The strategic merger involves economies of scale due to combining two or more firms to achieve greater productivity and profitability.

Financial mergers are conducted due to a perception by the acquiring company that the target company can be managed and structured better after acquisition. In this way the acquiring company anticipates to unlock unrealized value from the target company. Such mergers rely significantly on debt to finance acquisition. A leveraged buyout (LBOs) is an example of financial mergers. Strategic mergers are more prevalent than financial mergers.

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Corporate Restructuring

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Corporate restructuring is the process of reorganizing the ownership, legal, operating or any other structures of the company. It may involve expansion or contraction of the operations of the business.

There are various types of corporate restructuring such as mergers, consolidations and leveraged buyouts (LBOs). Successfully restructured organization should result in an increase of the owners’ wealth and more effective operations.

Restructuring can be necessary in various situations. Some of the reasons are as follows.

  • If company was the target of a leveraged buyout than it is likely to be restructured by the new owner and sold for a profit after the restructuring is successfully completed.
  • Restructuring can also be necessary in situations when the organization became too large, to the point that the structure established for the organization earlier can no longer support the operations of the organization.
  • If an organization grows to be too large for its current structure, restructuring may allow the organization to make its operations more efficient. For example, some parts of the organization can be converted into subsidiaries to obtain tax advantages and to ensure more effective management of the operations.
  • Another situation which may require restructuring is an organization struggling to survive. Such a situation can occur for various reasons such as the downturn in the economy, market entry of an unexpectedly strong competitor or revolutionary changes in technology which make some of the business’s product offerings obsolete. Contraction of the operations of such an organization may be necessary to ensure that the business can continue its existence and start rebuilding itself from the size it can currently sustain.

There are of course many more reasons why an organisation can be restructured. In general, restructuring implies the organization will continue its operations in one way or another.

 

 

Purchase versus Lease Decision

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When deciding on whether to purchase or lease an asset, a firm should compare after-tax cash outflows associated with each option. The option with the lowest present value of after-tax cash outflows should be selected.

To make a decision between purchase and lease alternatives, we need to do the following:

  • Determine after-tax cash outflows for lease alternatives.
  • Determine after-tax cash outflows for purchase alternatives.
  • When completing steps 1 and 2,  the purchase option at the end of the lease should be incorporated into analysis in step 1 and sale of purchased asset at the end of the term (equivalent to the lease term) should be incorporated in analysis in step 2. This will ensure that we compare assets of equal lives.
  • Find the present value of the cash outflows under lease and purchase. The after-tax cost of debt should be used as a discount rate. One can use a financial calculator to find present value of the mixed stream of outflows or find the present value of the annuity.
  • Select an option with the lowest present value.

It is also important to remember that financial manager must always attempt to find options with the lowest cost of capital to ensure maximization of the owners’ wealth.

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Financial Lease (Capital Lease)

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Finance lease (also called financial lease or capital lease) refers to the lease of the asset where the useful life is closely aligned to the term of the lease. The lease term is longer than operating lease. Finance leases are usually leases for an asset which does not become technologically obsolete. Under a capital lease, the lessee is usually responsible for all maintenance and other costs. Comparatively, under an operational lease, lessor is usually responsible for such costs.

A lessor purchases an asset selected by the lessee. The lessee will be able to use the asset during the duration of the lease agreement as long as contractual, periodic and timely payments are made by lessee to the lessor.

At the end of the term, the lessee may have a purchase option which allows the lessee to acquire an ownership of the asset. The lessee is not allowed to cancel the lease which makes a financial lease similar to long-term debt. If a lessee misses contractual or periodic payments, the lessee may be forced into bankruptcy.

Because under a finance lease, the lessee may have some ownership of the asset with some risks and benefits that comes with ownership, a finance lease must be recorded as a capitalized lease. This refers to recording the present value of all contractual payments and assets and corresponding liabilities on the balance sheet.

Under a finance lease, the firm benefits from the tax-deductibility of the interest paid on the leased asset as well as from depreciation of the leased asset which is recorded as an expense on the firm’s income statement.

This leads to increases in the debt/equity ratio and therefore an increase in financial leverage compared to an operational lease. It also leads to a decrease in working capital due to an increase in current liabilities.

Moreover, part of the payments due to a financial lease are recorded as a reduction in lease liability under operating cash flows and part is recorded as lease interest payments under financing cash flows. This leads to an increase in operating cash flow compared to records under operating lease where only operating cash flow is affected.

Because firms have an incentive to report leases as operational leases, certain regulatory rules were established by Financial Accounting Standards Board (FASB) which specify which assets can qualify for operational leases. The following is a list of characteristics of financial leases. If even one of such characteristic is met than an asset should be recorded as financial lease.

  • A lease term is 75% or more of the useable life of the asset.
  • At the commencement of the lease agreement, the present value of the lease payments is equal to 90% or more of the fair market value of the leased asset.
  • Ownership of the asset is transferred to the lessee at the maturity of the lease agreement.
  • A lease agreement contains an option to purchase the asset at the “bargain price” which must be the fair market value.

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