Education Course Notes [Session 7 & 8]
ACCA P4
Advanced Financial Management
Education Class 4
Session 7 and 8
Chapter 9
Patrick Lui
Chapter 9 Financing Mergers and Acquisitions
1. Compare the various sources of financing available for a proposed cash-based acquisition.
2. Evaluate the advantages and disadvantages of a financial offer for a given acquisition proposal using pure or mixed mode financing and recommend the most appropriate offer to be made.
3. Assess the impact of a given financial offer on the reported financial position and performance of the acquirer.
1. Methods of Financing Mergers
1.1 Cash offer
(Jun 11, Dec 12, Jun 13, Dec 13)
1.1.1 In a cash offer, the target company shareholders are offered a fixed cash sum per share.
1.1.2 This method is likely to be suitable only for relatively small acquisitions, unless the bidding entity has an accumulation of cash.
1.1.3 Advantages from acquirer’s point of view:
(a) When the bidder has sufficient cash, the takeover can be achieved quickly and at low cost.
(b) It gives a greater chance of success. The alternative methods carry with them some uncertainty about their true worth. Cash has an obvious value and is therefore preferred by vendors, especially when markets are volatile.
(c) The acquirer’s shareholders retain the same level of control over their company. That is, new shareholders from the target have not suddenly taken possession of a proportion of the acquiring firm’s voting rights, as they would if the target shareholders were offered shares in the acquirer.
1.1.4 Advantages from the target shareholders’ point of view:
(a) Target company shareholders have certainty about the bid’s value. i.e. there is less risk compared to accepting shares in the bidding company.
(b) There is increased liquidity to target company shareholders, i.e. accepting cash in a takeover, is a good way of realizing an investment.
1.1.5 Disadvantages from acquirer’s point of view:
(a) With large acquisitions the bidder must often borrow in the capital markets or issue new shares in order to raise the cash. This may have an adverse effect on gearing, and also cost of capital due to the increased financial risk.
1.1.6 Disadvantages from the target shareholders’ point of view:
(a) In some jurisdictions a taxable chargeable gain will arise if shares are sold for cash, but the gain may not be immediately chargeable to tax under a share exchange.
1.1.7 Funding cash offers:
(a) 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.
(b) The proceeds of a debt issue
This 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 price.
(c) 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.
(d) Mezzanine finance
This may be the only route for companies that do not have access to the bond markets in order to issue bonds.
1.2 Share exchange
(Dec 12, Jun 13, Dec 13)
1.2.1 In a share exchange, the bidding company issues some new shares and then exchanges them with the target company shareholders.
1.2.2 Large acquisitions almost always involve an exchange of shares, in whole or in part.
1.2.3 Advantages:
(a) The bidding company does not have to raise cash to make the payment.
(b) The bidding company can ‘boot strap’ earnings per share if it has a higher P/E ratio than the acquired entity.
(c) Shareholder capital is increased – and gearing similarly improved – as the shareholders of the acquired company become shareholders in the post acquisition company.
(d) A share exchange can be used to finance very large acquisitions.
1.2.4 Disadvantages:
(a) The bidding company’s shareholders have to share future gains with the acquired entity, and the current shareholders will have a lower proportionate control and share in profits of the combined entity than before.
(b) Price risk – there is a risk that the market price of the bidding company’s shares will fall during the bidding process, which will result in the bid failing. For example, if a 1 for 2 share exchange is offered based on the fact that the bidding company’s shares are worth approximately double the value of the target company’s shares, the bid might fail if the value of the bidding company’s shares falls before the acceptance date.
1.3 Convertible loan stock
1.3.1 Alternative forms of paper consideration, including debentures, loan stock and preference shares, are not so commonly used, due to:
(a) difficulties in establishing a rate of return that will be attractive to target shareholders
(b) the effects on the gearing level of the acquiring company
(c) the change in the structure of the target shareholders’ portfolios
(d) the securities being potentially less marketable, and possibly lacking voting rights
1.3.2 Issuing convertible loan stock 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.
1.4 Mezzanine finance (夾層融資)
(Dec 09)
1.4.1 Mezzanine debt is one mechanism by which a small, high growth frim can raise debt finance where the risk of default is high and/or there is low level of asset coverage for the loan.
1.4.2 It is a debt that incorporates equity-based options, such as warrants, with a lower-priority debt. Mezzanine debt is actually closer to equity than debt, in that the debt is usually only of importance in the event of bankruptcy. Mezzanine debt is often used to finance acquisitions and buyouts.
1.4.3 The issue of warrants gives the lender the opportunity to participate in the success of the venture but with a reasonable level of coupon assured.
1.4.4 However, the disadvantage for the current equity investors is that the value of their investment will be reduced by the value of the warrants issued.
1.4.5 Characteristics:
(a) short-to-medium term
(b) unsecured
(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 holder the option to exchange the loan for shares after the takeover
1.5 Earn-out management
1.5.1 The purchase consideration is sometimes structured so that there is an initial amount paid at the time of acquisition, and the balanced deferred.
1.5.2 Some of the deferred balance will usually only become payable if the target entity achieves specified performance targets.
1.6 The choice between a cash offer and a paper offer
(Dec 12, Jun 13)
1.6.1 The choice between cash and paper offers (or a combination of both) will depend on how the different methods are viewed by the company and its existing shareholders, and on the attitudes of the shareholders of the target company.
1.6.2 The factors that the directors of the bidding company must consider include the following.
Company and its existing shareholdersDilution of EPS / Fall in EPS attributable to existing shareholders may occur if purchase consideration is in equity shares
Cost to the company / Use of loan stock to back cash offer will attract tax relief on interest and have lower cost than equity. Convertible loan stock can have lower coupon rate than ordinary stock
Gearing / Highly geared company may not be able to issue further loan stock to obtain cash for cash offer
Control / Control could change considerably if large number of new shares issued
Authorised share capital increase / May be required if consideration is in form of shares. This will involve calling a general meeting to pass the necessary resolution
Borrowing limits increase / General meeting resolution also required if borrowing limits have to change
Shareholders in target company
Taxation / If consideration is cash, many investors may suffer immediate liability to tax on capital gain
Income / If consideration is not cash, arrangement must mean existing income is maintained, or be compensated by suitable capital gain or reasonable growth expectations
Future investments / Shareholders who want to retain stake in target business may prefer shares
Share price / If consideration is shares, recipients will want to be sure that the shares retain their values
2. Assessing a Given Offer
2.1 The market values of the companies’ shares during a takeover bid
2.1.1 Market share prices can be very important during a takeover bid.
Example 1Suppose that ABC Inc decides to make a takeover bid for the shares of BBC Inc. BBC Inc shares are currently quoted on the market at $2 each. ABC shares are quoted at $4.50 and ABC offers one of its shares for every two shares in BBC, thus making an offer at current market values worth $2.25 per share in BBC. This is only the value of the bid so long as ABC's shares remain valued at $4.50. If their value falls, the bid will become less attractive.
This is why companies that make takeover bids with a share exchange offer are always concerned that the market value of their shares should not fall during the takeover negotiations, before the target company's shareholders have decided whether to accept the bid.
If the market price of the target company's shares rises above the offer price during the course of a takeover bid, the bid price will seem too low, and the takeover is then likely to fail, with shareholders in the target company refusing to sell their shares to the bidder.
2.2 EPS before and after a takeover
2.2.1 If one company acquires another by issuing shares, its EPS will go up or down according to the P/E ratio at which the target company has been bought.
(a) If the target company’s shares are bought at a higher P/E ratio than the predator company’s shares, the predator company’s shareholders will suffer a fall in EPS.
(b) If the target company’s shares are valued at a lower P/E ratio, the predator company’s shareholders will benefit from a rise in EPS.
Example 2X Ltd takes over Y Ltd by offering two shares in X Ltd for one share in Y Ltd. Details about each company are as follows.
X Ltd / Y Ltd
Number of shares / 2,800,000 / 100,000
Market value per share / $4 / -
Annual earnings / $560,000 / $50,000
EPS / 20c / 50c
P/E ratio / 20 / -
By offering two shares in X Ltd worth $4 each for one share in Y Ltd, the valuation placed on each Y Ltd share is $8, and with Y Ltd’s EPS of 50c, this implies that Y Ltd would be acquired on a P/E ratio of 16. This is lower than P/E ratio of X Ltd, which is 20.
If the acquisition produces no synergy, and there is no growth in the earnings of either X Ltd or its new subsidiary Y Ltd, then the EPS of X Ltd would still be higher than before, because Y Ltd was bought on a lower P/E ratio. The combined group’s results would be as follows.
X Group
Number of shares (2,800,000 + 200,000) / 3,000,000
Annual earnings (560,000 + 50,000) / 610,000
EPS / 20.33c
If the P/E ratio is still 20, the market value per share would be $4.07 (20.33 × 20), which is 7c more than the pre-takeover price.
Example 3
X Ltd agrees to acquire the shares of Y Ltd in a share exchange arrangement. The agreed P/E ratio for Y Ltd’s shares is 15.
X Ltd / Y Ltd
Number of shares / 3,000,000 / 100,000
Market value per share / $2 / -
Annual earnings / $600,000 / $120,000
P/E ratio / 10 / -
The EPS of Y Ltd is $1.20, and so the agreed price per share will be $1.2 × 15 = $18. In a share exchange agreement, X Ltd would have to issue nine new shares (valued at $2 each) to acquire each share in Y Ltd, and so a total of 900,000 new shares must be issued to complete the takeover.
After the takeover, the enlarged company would have 3,900,000 shares in issue and, assuming no earnings growth, total earnings of $720,000. This would give an EPS of:
The pre-takeover EPS of X Ltd was 20c, and so the EPS would fall. This is because Y Ltd has been bought on a higher P/E ratio (15 compared with X Ltd’s 10).
The process of buying a company with a lower P/E ratio and looking to boost its P/E ratio to the predator company P/E ratio is known as bootstrapping. Whether the stock market is fooled by this process is debatable. The P/E ratio is likely to fall after the takeover in the absence of synergistic or other gains.
2.3 Buying companies on a higher P/E ratio, but with profit growth