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