AFMP4
Syllabus C. Acquisitions And Mergers C4. Financing acquisitions and mergers

C4ac. Forms of consideration 1 / 5

Syllabus C4ac)

a) Compare the various sources of financing available for a proposed cash-based acquisition.

c) Assess the impact of a given financial offer on the reported financial position and performance of the acquirer.

Payment methods - how an acquisition can be financed

Methods of payment

The takeover will involve a purchase of the shares of the target company for

  1. cash

    If the purchase consideration is in cash, the shareholders of the target company will simply be bought out.

  2. 'paper' (shares, or possibly convertible bonds)

    A purchase of a target company's shares with shares of the predator company is referred to as a share exchange.

  3. Those choice will depend on:

    - available cash, 
    - desired level of gearing, 
    - shareholders' taxation position and 
    - change in control.

An Illustration: Cash purchases

Suppose that there are two companies

Cow Calf
Net assets (book value) $2,000 $300
Number of shares 100 10
Earnings $3,000 $90

Cow negotiates a takeover of Calf for $600 in cash.

As a result, Cow will end up with:

  • Net assets (book value) of:
    $2,000 + $300- $600 cash = $1,700

  • 100 shares (no change)

  • Expected earnings of $3,090 minus the loss of interest (net of tax) which would have been obtained from the investment of the $600 in cash which was given up to acquire Calf

A cash offer can be financed from:

  • Cash retained from earnings 

    This is a common way when the firm to be acquired is small compared to the acquiring firm, but not very common if the target firm is large relative to the acquiring firm.

  • The proceeds of a debt issue

    That is the company may raise money by issuing bonds. 

    This is not an approach that is normally taken, because the act of issuing bonds will alert the markets to the intentions of the company to bid for another company and it may lead investors to buy the shares of potential targets, raising their prices.

  • A loan facility from a bank

    This can be done as a short term funding strategy, until the bid is accepted and then the company is free to make a bond issue.

  • Mezzanine finance

    This may be the only route for companies that do not have access to the bond markets in order to issue bonds.

    Mezzanine financing is a hybrid of debt and equity financing that gives the lender the rights to convert to an equity interest in the company in case of default, after venture capital companies and other senior lenders are paid.

Purchases by share exchange

One company can acquire another company by issuing shares to pay for the acquisition. 

The new shares might be issued:

  • In exchange for shares in the target company. 

    Thus, if A acquires B, A might issue shares which it gives to B's shareholders in exchange for their shares. 

    The B shareholders therefore become new shareholders of A. 

    This is a takeover for a paper consideration. 

    Paper offers will often be accompanied by a cash alternative.

  • To raise cash on the stock market, which will then be used to buy the target company's shares. 

    To the target company shareholders, this is a cash bid.

Sometimes, a company might acquire another in a share exchange, but the shares are then sold immediately on a stock market to raise cash for the seller.

An Illustration: Share consideration

Cow has agreed to acquire all the ordinary shares in Calf and has also agreed a share-for-share exchange as the form of consideration. 

The following information is available.

Cow - $m Calf -$m
Net profit after taxation 100 30
Share capital - $0.50 ordinary shares £25m £5m
Price/earnings ratio 11 14

The agreed share price for Calf will result in its shareholders receiving a premium of 25% on the current share price.

How many new shares must Cow issue to purchase the shares in Calf?

Solution

Market value Cow (11 x $100m) = $1,100m
Value per share ($1,100m/50m) = $22 per share
Market value Calf (14 x $30m) = $420m
Value of bid ($420m x 1.25) = $525m
Number of shares issued ($525m/$22) = 24 million shares

Use of bonds

Alternative forms of paper consideration, including debentures, loan notes and preference shares, are not so commonly used, due to:

  • Difficulties in establishing a rate of return that is attractive to target shareholders

  • The effects on the gearing levels of the acquiring company

  • The change in the structure of the target shareholders' portfolios

  • The securities being potentially less marketable, and lacking voting rights

Issuing convertible bonds will overcome some of these drawbacks, by offering the target shareholders the option of partaking in the future profits of the company if they wish.

An Illustration: Loan consideration

Cow offers to buy 100% of the equity shares of Calf.

The purchase price will be  $3 million in 10% bonds. 

The annual profits before tax of Calf have been $2 millions.

Assuming no synergy as the result of the acquisition, by how much will the earnings of Cow be expected to increase next year when the profits of Calf are taken into account? 

Company tax is 30%.

Solution
$'000 $'000
Calf profit before tax 2,000
Less: tax (30%) (600)
1,400
Interest on bonds 300
Less: tax reduction (90)
Net increase in interest 210
Increase in profit after tax for Cow 1,190