Mergers & Acquisitions: Case study involving exchange of common stock in a merger

When an exchange of common stock is involved in an acquisition or merger agreement, two different securities must he valued. In addition, a proper ratio of exchange must be found that reflects the respective values of the shares. Moreover, in most cases, the acquirer has to pay a significant premium (between 15 and 25 percent is the common range) over the objective value of the shares of the acquired company. This premium, of course, will affect the actual ratio of exchange of shares agreed on. While in the end, a numerical solution is applied, the underlying values and the premium will be the result of extensive negotiation and a certain amount of horse trading. As the two stocks are valued, any differences in the quality and breadth of trading in the securities markets can be an important factor. If, for example, a large, well-established company acquires a new and fast-growing company, the markets assessment of the value of the acquirers stock is likely to be more reliable than that of the candidate, whose stock may be thinly traded and unproven. But even if both companies had comparable market exposure, the inherent difference in the nature and performance of the two companies may exhibit itself in, among other indicators, a pronounced difference in price/earnings ratios. In effect, this means the performance of one company is valued less highly in the marketplace than that of the other. This difference will influence valuation of the stocks and the final price negotiated. We will demonstrate just a few of the key calculations needed to arrive at the basis of exchange, using a simplified example. Let us assume that Acquirer Corporation and Candidate, (or Target Corp.), have the following key dimensions and performance data at the time of their merger negotiations: Key Data Current earnings Number of shares (outstanding) Earnings per share (EPS) Current market price (P) Price/earnings ratio (P/E) Acquirer Corporation EUR 50,000,000 10 million EUR 5 EUR 60 12 x Candidate (Target) Corp. EUR 10,000,000 10 million EUR 1 EUR 15 15 x

Negotiations between the management teams have reached a point where, after Candidate had rejected several offers, Acquirer now considers a price premium of about 20 percent over the

File name: C:\.\Corporate finance course\Assignments and examples Spring 01\M & A Case study exchange of stock

current market value of Candidates stock necessary to make a deal. This would call for an exchange ratio of EUR 18/ EUR 60, or 0.3 shares of Acquirer stock for each share of Candidate stock (meaning that 3 million new shares of Acquirer would be issued to the shareholders of Candidates stock). The impact on Acquirer would be as follows, at the combined current levels of earnings (abstracting from possible synergy effects or benefits): Acquirer Corporation (after the merger) Combined earnings (of the two companies) Number or shares (10 mil. old + 3 miI. new) New earnings per share (new EPS combined) Old earnings per snare (pre-merger EPS) Immediate dilution (difference between EPS) EUR 60,000,000 13 million EUR 4.62 EUR 5.00 EUR 0.38

Under these conditions, Acquirer would suffer an immediate dilution of EUR 0.38 per share from the combination (decline in EPS). Yet the fact that the stock of Candidate had a higher price/earnings ratio suggests that smaller company has certain desirable attributes, which may include high growth in earnings, a technologically protected position, and so on. Acquirer must consider two points: first, whether the earnings of Candidate are likely to grow at a rate that will close the gap in earnings per share relatively quickly, aided by any synergistic benefits available now. Second, Acquirer must judge whether the inclusion of Candidate is likely to change the risk/reward characteristics of the combined company so as to improve the price/earnings ratio and thus help overcome the dilution. In our example, the earnings gap to be filled is 13 million shares times EUR 0.38, or almost EUR 5 million in annual earnings, just to return to the current level of Acquirers earnings per share. How much in synergy benefits can be expected? Perhaps the ratio of exchange has to be reconsidered in this light? But would the smaller company even be interested in being acquired at less than a 20 percent premium over the stock market value of its shares, a common inducement? Note that a reversal of the price/earnings ratios in the example (see the table Key data) would dramatically change both the terms of the offer and the reported performance of the combined companies. At 15 times earnings, the price of Acquirer would be EUR 75 per share, while at 12 times earnings Candidate would sell at EUR 12 per share. Given a 20 percent acquisition premium for Candidates stock, the exchange ratio would be EUR 14.40/EUR 75, or 0.192 shares of Acquirer for each share of Candidate. This would call for 1.92 million new

File name: C:\.\Corporate finance course\Assignments and examples Spring 01\M & A Case study exchange of stock

shares of Acquirer (to be issued), and the new earnings per share would amount to EUR 60,000,000 11,920,000, or EUR 5.03 per share, a slight net improvement even before realizing any synergistic benefits. In this changed situation, both parties would be better off immediately, simply because we assumed the price/earnings ratios to be reversed. It is possible, of course, that a company acquired at a premium, which has caused the combined earnings per share to drop initially, may more than offset the gap with higher growth and synergistic benefits later. This would depend on the relative size of the two companies as well as on the value and exchange considerations discussed. This is but one simplified example, and thus only a quick glimpse of the nature of the deliberations involved in exchanges of stock. At the same time, we have attempted to alert the reader to the many issues underlying the valuation process in mergers and acquisitions. Analysis of such transactions always involves careful projections of the separate and combined earnings patterns, the calculation of dilution, and an assessment of the likely risk/reward market response as inputs into the negotiation process.

Portable School Brief Series

(Theory and Applications in Finance)

File name: C:\.\Corporate finance course\Assignments and examples Spring 01\M & A Case study exchange of stock