Computation of Impact on EPS

and Market Price

 M&A Effects Capital Structure and
Financial Position
M&A activity obviously has longer-term ramifications for the acquiring company or
the dominant entity in a merger, than it does for the target company in an
acquisition or the firm that is subsumed in a merger.

For the target company, an M&A transaction gives its shareholders the opportunity
to cash out at a significant premium, especially if the transaction is an all-cash
deal. If the acquirer pays partly in cash and partly in its own stock, the target
companys shareholders would hold a stake in the acquirer, and thus have a vested
interest in its long-term success.

For the acquirer, the impact of an M&A transaction depends on the deal size
relative to the companys size. The larger the potential target, the bigger the risk to
the acquirer. A company may be able to withstand the failure of a small-sized
acquisition, but the failure of a huge purchase may severely jeopardize its long-
term success.
Once an M&A transaction has closed, the impact upon the acquirer would typically
be significant (again depending on the deal size). The acquirers capital structure
will change, depending on how the M&A deal was designed. An all-cash deal will
substantially deplete the acquirers cash holdings. But as many companies seldom
have the cash hoard available to make full payment for a target firm in cash, all-
cash deals are often financed through debt. While this additional debt increases a
companys indebtedness, the higher debt load may be justified by the additional
cash flows contributed by the target firm.
 Many M&A transactions are also financed through the acquirers stock. For an
acquirer to use its stock as currency for an acquisition, its shares must often be
premium-priced to begin with, else making purchases would be needlessly
dilutive. As well, management of the target company also has to be convinced
that accepting the acquirers stock rather than hard cash is a good idea.
Support from the target company for such an M&A transaction is much more
likely to be forthcoming if the acquirer is a Fortune 500 company than if it is
ABC Widget Co.
 Strategic Acquisitions Involving
Common Stock
Strategic Acquisition -- Occurs when one company acquires another as part of its
overall business strategy.

When the acquisition is done for common stock, a ratio of

exchange, which denotes the relative weighting of the two
companies with regard to certain key variables, results.
A financial acquisition occurs when a buyout firm is
motivated to purchase the company (usually to sell assets,
cut costs, and manage the remainder more efficiently), but
keeps it as a stand-alone entity.
 Strategic Acquisitions Involving
Common Stock
Example -- Company A will acquire Company B with shares of common stock.

Company A Company B
Present earnings $20,000,000 $5,000,000
Shares outstanding 5,000,000 2,000,000
Earnings per share $4.00 $2.50
Price per share $64.00 $30.00
Price / earnings ratio 16 12
 Strategic Acquisitions Involving
Common Stock
Example -- Company B has agreed on an offer of $35 in common stock of Company A.

Surviving Company A
Total earnings $25,000,000
Shares outstanding* 6,093,750
Earnings per share $4.10

Exchange ratio = $35 / $64 = .546875

* New shares from exchange = .546875 x 2,000,000
= 1,093,750
 Strategic Acquisitions Involving
Common Stock
The shareholders of Company A will experience an
increase in earnings per share because of the
acquisition [$4.10 post-merger EPS versus $4.00
pre-merger EPS].
The shareholders of Company B will experience a
decrease in earnings per share because of the
acquisition [.546875 x $4.10 = $2.24 post-merger
EPS versus $2.50 pre-merger EPS].
 Strategic Acquisitions Involving
Common Stock
Surviving firm EPS will increase any time the P/E
ratio paid for a firm is less than the pre-merger
P/E ratio of the firm doing the acquiring. [Note: P/E
ratio paid for Company B is $35/$2.50 = 14 versus
pre-merger P/E ratio of 16 for Company A.]
 Strategic Acquisitions Involving
Common Stock
Example -- Company B has agreed on an offer of $45 in common stock of Company A.

Surviving Company A
Total earnings $25,000,000
Shares outstanding* 6,406,250
Earnings per share $3.90

Exchange ratio = $45 / $64 = .703125

* New shares from exchange = .703125 x 2,000,000
= 1,406,250
 Strategic Acquisitions Involving
Common Stock
The shareholders of Company A will experience a
decrease in earnings per share because of the
acquisition [$3.90 post-merger EPS versus $4.00
pre-merger EPS].
The shareholders of Company B will experience an
increase in earnings per share because of the
acquisition [.703125 x $4.10 = $2.88 post-merger
EPS versus $2.50 pre-merger EPS].
 Strategic Acquisitions Involving
Common Stock
Surviving firm EPS will decrease any time the P/E
ratio paid for a firm is greater than the pre-merger
P/E ratio of the firm doing the acquiring. [Note: P/E
ratio paid for Company B is $45/$2.50 = 18 versus
pre-merger P/E ratio of 16 for Company A.]
 What About
Earnings Per Share (EPS)?
Merger decisions should
not be made without With the
considering the long-term

Expected EPS ($)

merger
consequences.
The possibility of future Equal
earnings growth may
outweigh the immediate Without the
dilution of earnings. merger
Time in the Future (years)

Initially, EPS is less with the merger.

Eventually, EPS is greater with the merger.
 Market Value Impact
Number of shares offered by
Market price per share
X the acquiring company for each
of the acquiring company
share of the acquired company
Market price per share of the acquired company

The above formula is the ratio of exchange of market price.

If the ratio is less than or nearly equal to 1, the shareholders
of the acquired firm are not likely to have a monetary
incentive to accept the merger offer from the acquiring firm.
 Market Value Impact
Example -- Acquiring Company offers to acquire Bought Company with shares of
common stock at an exchange price of $40.

Acquiring Bought
Company Company
Present earnings $20,000,000 $6,000,000
Shares outstanding 6,000,000 2,000,000
Earnings per share $3.33 $3.00
Price per share $60.00 $30.00
Price / earnings ratio 18 10
 Market Value Impact
Exchange ratio = $40 / $60 = .667
Market price exchange ratio = $60 x .667 / $30 = 1.33

Surviving Company
Total earnings $26,000,000
Shares outstanding* 7,333,333
Earnings per share $3.55
Price / earnings ratio 18
Market price per share $63.90
* New shares from exchange = .666667 x 2,000,000
= 1,333,333
 Market Value Impact
Notice that both earnings per share and market price per
share have risen because of the acquisition. This is known as
bootstrapping.
The market price per share = (P/E) x (Earnings).
Therefore, the increase in the market price per share is a
function of an expected increase in earnings per share and
the P/E ratio NOT declining.
The apparent increase in the market price is driven by the
assumption that the P/E ratio will not change and that each
dollar of earnings from the acquired firm will be priced the
same as the acquiring firm before the acquisition (a P/E ratio
of 18).