Financing mergers and acquisitions

Methods of payment
• The terms of a takeover will involve a purchase of the shares of the
target company for cash or for ‘paper’ (shares, or possibly loan
stock). A purchase of a target company's shares with shares of the
predator company is referred to as a share exchange.
Funding cash offers
• A cash offer can be financed from:
I. Cash retained from earnings. A company may occasionally divest of
some of its own assets to accumulate cash prior to bidding for another
company.
II. 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.
III. A loan facility from a bank.
IV. Mezzanine finance.
Purchases by share exchange
• One company can acquire another company by issuing shares to pay
for the acquisition. The new shares might be issued:
a) In exchange for shares in the target company. Thus, if A Inc
acquires B Co, A Inc might issue shares which it gives to B Co's
shareholders in exchange for their shares. The B Co shareholders
therefore become new shareholders of A Inc. This is a takeover for a
'paper' consideration. Paper offers will often be accompanied by a
cash alternative.
b) 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.
Convertible loan stock
• Convertible loan stock is a loan which gives the holder the right to
convert to other securities, normally ordinary shares, at a
predetermined price/rate and time.
• Convertible loan stock can have lower coupon rate than ordinary
stock
Mezzanine finance
• However, there have been many takeover bids, with a cash purchase
option for the target company's shareholders, where the bidding
company has arranged loans that:
a) Are short to medium term
b) Are unsecured (that is, 'junior' debt, low in the priority list for
repayment in the event of liquidation of the borrower)
c) Because they are unsecured, attract a much higher rate of interest
than secured debt (typically 4% or 5% above LIBOR)
d) Often give the lender the option to exchange the loan for shares
after the takeover
• This type of borrowing is called mezzanine finance (because it lies
between equity and debt financing) – a form of finance which is also
often used in management buy-outs
Factors - influence the offer

COMPANY AND ITS EXISTING SHAREHOLDERS

Fall in EPS attributable to existing shareholders may occur

Dilution of EPS
if purchase consideration is in equity shares

Use of loan stock to back cash offer will attract tax relief
Cost to the
on interest and have lower cost than equity. Convertible
company
loan stock can have lower coupon rate than ordinary stock

Highly geared company may not be able to issue further

Gearing
loan stock to obtains cash for cash offer
Control could change considerably if large number of new
Control
shares issued
 SHAREHOLDERS IN TARGET COMPANY

If consideration is cash, many investors may suffer

Taxation
immediate liability to tax on capital gain

If consideration is not cash, arrangement must

mean existing income is maintained, or be
Income
compensated by suitable capital gain or reasonable
growth expectations
Future Shareholders who want to retain stake in target
investment business may prefer shares
If consideration is share, recipients will want to be
Share price
sure that the shares retain their values
 201312 Q3
Makonis Co has offered to acquire Nuvola Co through a mixed offer of
one of its shares for two Nuvola Co shares plus a cash payment, such
that a 30% premium is paid for the acquisition. Nuvola Co’s equity holders
feel that a 50% premium would be more acceptable. Makonis Co has
sufficient cash reserves if the premium is 30%, but not if it is 50%.
The following financial information is provided for the two companies:
Makonis Co Nuvola Co
Current share price $5·80 $2·40
Number of issued shares 210 million 200 million
Required:
Estimate the additional funds required if a premium of 50% is paid instead
of 30% and discuss how this premium could be financed. (7 marks)
Answer
The amount of cash required will increase substantially, by
about $96 million, if Makonis Co agrees to the demands
made by Nuvola Co’s equity holders and pays the 50%
premium.
Makonis Co needs to determine how it is going to acquire
the additional funds and the implications from this.
For example, it could borrow the money required for the
additional funds, but taking on more debt may affect the cost
of capital and therefore the value of the company.
It could raise the funds by issuing more equity shares, but this
may not be viewed in a positive light by the current equity
holders.
Makonis Co may decide to offer a higher proportion of
its shares in the share-for-share exchange instead of
paying cash for the additional premium.
However, this will affect its equity holders and dilute
their equity holding further. Even the current proposal
to issue 100 million new shares will mean that Nuvola
Co’s equity holders will own just under 1/3 of the
combined company and Makonis Co’s shareholders
would own just over 2/3 of the combined company.
Makonis Co should also consider what Nuvola Co’s
equity holders would prefer. They may prefer less cash
and more equity due to their personal tax circumstances,
but, in most cases, cash is preferred by the target firm’s
equity holders.
 Financing - 201306Q2
Assume Strand Co, current value per share is $4·76 per share
Hav Co has proposed to pay for the acquisition using one of the following three methods:
I. A cash offer of $5·72 for each Strand Co share; or
II. A cash offer of $1·33 for each Strand Co share plus one Hav Co share
for every two Strand Co shares; Hav Co share price = $9·24 or
III. A cash offer of $1·25 for each Strand Co share plus one $100 3%
convertible bond for every $5 nominal value of Strand Co shares. In
six years, the bond can be converted into 12 Hav Co shares or
redeemed at par.【 Share capital (25c/share) 】
• Required: Calculate the percentage premium per share that Strand
Co’s shareholders will receive under each acquisition payment method
and justify, with explanations, which payment method would be
most acceptable to them. (10 marks)
 Answer
Cash offer: premium (%)
($5·72 – $4·76)/$4·76 × 100% = 20·2%

Cash and share offer: premium (%)

1 Hav Co share for 2 Strand Co shares
Hav Co share price = $9·24
Per Strand Co share = $4·62
Cash payment per share= $1·33
Total return = $1·33 + $4·62 = $5·95
Premium percentage = ($5·95 – $4·76)/$4·76 × 100% = 25·0%
Cash and bond offer: premium (%)
Each share has a nominal value of $0·25, therefore $5 is $5/$0·25
= 20 shares
Bond value = $100/20 shares = $5 per share
Cash payment = $1·25 per share
Total = $6·25 per share
Premium percentage = ($6·25 – $4·76)/$4·76 = 31·3%
On the basis of the calculations, the cash together with bond offer
yields the highest return; in addition to the value calculated above,
the bonds can be converted to 12 Hav Co shares, giving them a
price per share of $8·33 ($100/12). This price is below Hav Co’s
current share price of $9·24, and therefore the conversion option is
already in-the-money. It is probable that the share price will
increase in the 10-year period and therefore the value of the
convertible bond should increase. A bond also earns a small
coupon interest of $3 per $100 a year.
However, with this option Strand Co shareholders only
receive an initial cash payment of $1·25 per share compared to
$1·33 per share and $5·72 per share for the other methods.
This may make it the more attractive option for the Hav Co
shareholders as well, and although their shareholding will be
diluted most under this option, it will not happen for some
time.
The cash and share offer gives a return in between the pure
cash and the cash and bonds offers. Although the return is
lower, Strand Co’s shareholders become owners of Hav Co
and have the option to sell their equity immediately.
However, the share price may fall between now and when the
payment for the acquisition is made. If this happens, then the
return to Strand Co’s shareholders will be lower.
The pure cash offer gives an immediate and definite return to
Strand Co’s shareholders, but is also the lowest offer and may
also put a significant burden on Hav Co having to fund so
much cash, possibly through increased debt.
It is likely that Strand Co’s shareholder/managers, who
will continue to work within Hav Co, will accept the
mixed cash and bond offer.
They, therefore, get to maximise their current return and
also potentially gain when the bonds are converted into
shares.
Different impacts on shareholders’ personal taxation
situations due to the different payment methods might
also influence the choice of method.