Finding the Market Price Ratio of Exchange

When the acquiring company knows the ratio of exchange, it can be used to find the market price ratio of exchange. The market price rate of exchange is found as follows:

(MP of acquiring company * ratio of exchange)/ MP of the target company

Where: MP refers to the market price per share.

The market price ratio of exchange indicates how much of market price per share of the acquiring firm is exchanged for every $1.00 of the market price per share of the target company.

It is normal for the market price ratio of exchange to be above 1. This is an indication that the acquiring company pays a premium above the market price to acquire a target company.

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 BCD’s market price is $55. However, during merger negotiations, ABC agreed to a 1.5 ratio of exchange where it valued BCD’s shares at $90.

Find the market price per share in the ABC/BCD merger.

Solution:

(60*1.5)/55=1.6

This means that ABC gives $1.6 of its market price in exchange for every dollar of the BCD’s market price.

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Types of Corporate Restructuring

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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Finding the after-tax cost of preferred stock (rp)

After discussing the cost of long-term debt, we must now find the cost of preferred stock (after-tax). Preferred stock, which is also called preferred shares or preference shares, refers to the category of ownership that has preferential claim on earnings and assets of the firm, compared to common stock ownership.

The preferential claim is generally manifested in the fact that dividends cannot be distributed to common stockholders until it is distributed to holders of preferred stock first. Further, in case of liquidation, holders of the preferred stock also have preferential claim on assets of the firm, compared to the holders of common stock.

Preferred stock is a hybrid instrument as it has characteristics of both debt and equity. The drawback of preferred shares, compared to the common stock, is lower potential for appreciation of shares as well as absence of voting rights.

Calculating the cost of preferred stock


To calculate the specific after-tax cost-of-preferred-stock all we need to do is to take the preferred stock dividend and divide it by the net proceeds from the sale of the preferred stock (funds received minus flotation cost).

Cost-of-preferred-stock (rp) = Preferred stock dividend/(Funds received – Flotation costs)

Because preferred stock is paid out of the after-tax earnings, the cost-of-preferred-stock is already after-tax.

EXAMPLE:

If Company A issued 9% preferred stock at $100 and the flotation cost is $8, then the calculation will be as follows:

rp = 100*9%/100-8

rp =9/92

rp =9.8%

Test yourself


A corporation is issuing 10% preferred stock that should be sold for $15 each. The business will incur flotation costs of $2 per share.

REQUIRED: What is the cost-of-preferred-stock?

SOLUTION:

10%*15/15-2

1.5/13

The answer is 11.54%

Note: If you struggle with a calculation, read using a financial calculator article for some simple tips on using a financial calculator.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

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Cost of long term debt

The first long term source of finance that we consider is the cost of long term debt, which is usually the cheapest of the long-term sources of finance. The majority of long term debt of large corporations is the result of issuing bonds.

Flotation cost


Companies that issue bonds have to take into account the flotation cost, which is the complete cost the company has to incur to issue and sell a security, such as common stock, preferred stock and bonds. This cost reduces the company’s net proceeds from issuing security.

Flotation cost consists of underwriting and administrative costs. Underwriting costs are payment to investment bankers for their services and administrative costs are costs other than the underwriting costs of issuing bonds.

Finding the before-tax cost of long-term debt (rd)


To find the after-tax cost of long term debt, we first need to find the before-tax cost of long term debt (rd). As mentioned above, the majority of long term debts of large corporations are the result of issuing bonds. By using a financial calculator, we can find the before tax cost of a bond (cost of long-term debt).

THE CALCULATION FOLLOWS:

FV – (future value of the bond which refers to its par value, which is also called the face value, and is usually $1,000)

PV – the value of the bond today at which it is sold (after deducting the flotation cost)

PMT – payment on the bond (for example, at 8% coupon interest rate a bond issuer will have to make annual payments of $80 if the par value is $1,000). Payments can also be made more frequently, such as semi-annually or even monthly, but in such a case we need to adjust the amount of payment and number of periods.

For example, if payment is made semi-annually, we will need to divide $80 by 2 and we will need to multiply number of periods by 2.

N – Number of periods

Calculate I – the cost of the bond (for the bond’s issuer it is the cost to maturity of the cash flows, for the bond’s holders it is the return they earn on buying and holding this bond to maturity). Within the context of our discussion, it is also the before-tax cost of long-term debt.

Note that if the net proceeds from the sale of the bond is the same as the face value of the bond than the before-tax cost of long-term debt will be equal to the coupon interest rate. For example, at 8% coupon interest rate, the par value of $1,000 and net proceeds of $1,000 (no flotation costs), the before-tax cost of long-term debt will equal 8%.

Finding the after-tax cost of long-term debt


After we found the before-tax cost of long term debt, we need to find the after-tax cost of long term debt. To do so all we need to do is to multiply the before-tax cost of long-term debt by (1-T), where T stands for the tax rate.

THEREFORE:

ri = rd * (1-T)

EXAMPLE:

If the before-tax cost of long term debt is 10% and tax rate is 28% then the calculation will be as follows:

Ri =10% * (1-.28)

Ri =10% * .72

Ri = 7.2%

Test yourself


You need to calculate the after-tax cost of a 30-year bond. The coupon interest rate is 10%, the par value is $1,000 and the bond is currently selling at $950.

SOLUTION:

PV: -950

FV: 1,000

PMT: 100

N: 30

I: 10.56%

Note: If you struggle with a calculation, read using a financial calculator article for some simple tips on using a financial calculator.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

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