[Session 7 & 8]
June 2016
Education Course Notes
ACCA P4
Advanced Financial Management
Session 7 and 8
Chapter 9
Patrick Lui
[email protected]
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ACCA
Education Class 4
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Education Course Notes
[Session 7 & 8]
Chapter 9 Financing Mergers and Acquisitions
LEARNING OBJECTIVES
1.
2.
3.
Compare the various sources of financing available for a proposed cash-based
acquisition.
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.
Assess the impact of a given financial offer on the reported financial position and
performance of the acquirer.
Financing Mergers
and
Acquisitions
Methods of
Financing Mergers
Assessing a
Given Offer
Cash offer
Market Values
During a
Takeover Bid
Share Exchange
EPS before &
after a Takeover
Convertible
Loan Stock
Buying on a higher
P/E ratio with
Profit Growth
Mezzanine
Finance
Evaluating a Share
for Share Exchange
Effect of an Offer
On Financial
Position &
Performance
Effects on
Earnings
Earn-out
Management
Choice between
Cash & Paper
Offer
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[Session 7 & 8]
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
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approach that is normally taken, because the act of issuing bonds will alert
(c)
(d)
1.2
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.
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.
Mezzanine finance
This may be the only route for companies that do not have access to the bond
markets in order to issue bonds.
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.
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1.3
[Session 7 & 8]
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)
(d)
because they are unsecured, attract a much higher rate of interest than secured
debt (typically 4% or 5% above LIBOR)
often, give the holder the option to exchange the loan for shares after the
takeover
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1.5
[Session 7 & 8]
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 shareholders
Dilution 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
increase
share
capital 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
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General meeting resolution also required if borrowing limits
have to change
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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 1
Suppose 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.
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2.2
[Session 7 & 8]
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)
(b)
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.
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 2
X 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.
Number of shares
Market value per share
Annual earnings
EPS
P/E ratio
X Ltd
2,800,000
$4
$560,000
20c
20
Y Ltd
100,000
$50,000
50c
-
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
3,000,000
610,000
20.33c
Number of shares (2,800,000 + 200,000)
Annual earnings (560,000 + 50,000)
EPS
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.
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[Session 7 & 8]
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.
Number of shares
Market value per share
Annual earnings
P/E ratio
X Ltd
3,000,000
$2
$600,000
10
Y Ltd
100,000
$120,000
-
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:
$720,000
 18.2c
3,900,000
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.
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2.3
[Session 7 & 8]
Buying companies on a higher P/E ratio, but with profit growth
2.3.1 Buying companies with a higher P/E ratio will result in a fall in EPS unless there is
profit growth to offset this fall.
Example 4
Suppose that X Ltd acquires Y Ltd by offering two shares in X Ltd for three shares in Y Ltd.
Details of each company are as follows:
Number of shares
X Ltd
5,000,000
Y Ltd
3,000,000
Value per share
Annual earnings
Current
$6
$4
$2,000,000
$600,000
Next year
EPS
P/E ratio
$2,200,000
40c
15
$950,000
20c
20
X Ltd is acquiring Y Ltd on a higher P/E ratio, and it is only the profit growth in the
acquired subsidiary that gives the enlarged X Ltd its growth in EPS.
Number of shares (5,000,000 + 3,000,000 × 2/3)
X Group
7,000,000
Earnings
If no profit growth (2,000,000 + 600,000) $2,600,000
With profit growth (2,200,000 + 950,000) $3,150,000
EPS would have been 37.14c
EPS will be 45c
If an acquisition strategy involves buying companies on a higher P/E ratio, it is therefore
essential for continuing EPS growth that the acquired companies offer prospects of strong
profit growth.
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2.4
[Session 7 & 8]
Evaluating a share for share exchange
2.4.1 One popular question is to comment on the likely acceptance of a share for share offer.
The procedure is as follows:
(a)
Value the acquiring company as an independent entity and hence calculate the
value of a share in that company.
(b)
Repeat the procedure for the acquired company.
(c)
Calculate the value of the combined company post integration. This is
calculated as:
(d)
(e)
Value of acquiring company as independent company
X
Value of acquired company as independent company
Value of any synergy
X
X
Total value of combined company
X
Calculate the number of shares post integration:
Number of shares originally in the acquiring company
Number of shares issued to acquired company
X
X
Total shares post integration
X
Calculate the value of a share in the combined company, and use this to assess
the change in wealth of the shareholders after the takeover.
Example 5
Company A has 200m shares with a current market value of $4 per share. Company B has
90m shares with a current market value of $2 per share.
Company A makes an offer of 3 new shares for every 5 currently held in Company B.
Company A has worked out that the present value of synergies will be $40m.
Required:
Calculate the expected value of a share in the combined company (assuming that the
given share prices have not yet moved to anticipate the takeover), and advise the
shareholders in Company B whether the offer should be accepted.
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Solution:
Market value of Company A = $800m
Market value of Company B = $180m
PV of synergies = $40m
Total = $1,020m
No. of new shares = 200m + 3/5 × 90m = 254m
New share price = $1,020m ÷ 254m = $4.02
A
Shares
200m
Market value
$804m
Old wealth
$800m
Change
$4m
B
3/5 × 90m = 54m
54m × $4 = $216m
$180m
$36m
The wealth of the shareholders in Company B will increase by $36m as a consequence of
the takeover. This is a (36/180) 20% increase in wealth.
Company B’s shareholders should be advised to accept the 3 for 5 share for share offer.
Example 6
Mavers Co and Power Co are listed on the Stock Exchange.
Relevant information is as follows:
Share price today
Shares in issue
Mavers Co
$3.05
48 million
Power Co
$6.80
13 million
Mavers Co wants to acquire 100% of the shares of Power Co.
The directors are considering offering 2 new Mavers Co shares for every 1 Power Co share.
Required:
Evaluate whether the 2 for 1 share for share exchange will be likely to succeed.
It necessary, recommend revised terms for the offer which would be likely to succeed.
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[Session 7 & 8]
Solution:
Value of Mavers Co = $3.05 × 48m shares = $146.4m
Value of Power Co = $6.80 × 13m shares = $88.4m
Total value (assuming no synergistic gains) = $146.4m + $88.4m = $234.8m
No. of shares of post-integration = 48m + (2 × 13m) = 74m
So the post-integration share price = $234.8m ÷ 74m = $3.173
Mavers
Power
Shares
48m
2 × 13m = 26m
Market value
$152.3m
26m × $3.173 = $82.5m
Old wealth
$146.4m
$88.4m
Change
$5.9m
–$5.9m
Advice
The Power Co shareholders will not accept a 2 for 1 share for share exchange since it causes
their wealth to reduce.
Recommendation
In order for the Power Co shareholders to be encouraged to accept the offer, it must offer
them a gain in wealth.
To make sure that Mavers Co is valuing Power Co at its current market value, the value of
the offer needs to be at least $88.4m in total.
Given the current Mavers Co share of $3.05, this amounts to $88.4m/$3.05 = 28.98m shares
in Mavers Co.
An exchange of 28.98m Mavers Co shares for the 13m Power Co shares represents a ratio
of 28.98m to 13m or 2.23 to 1.
However, if the terms of the offer were to be exactly 2.23 Mavers Co shares for every 1
share in Power Co, there would be no incentive for the Power Co shareholders to sell. In
order to encourage Power Co’s shareholders to sell, a premium would have to be offered.
Hence, an offer of (say) 2.5 Mavers Co shares for every 1 share in Power Co would
probably be needed to encourage the Power Co shareholders to sell.
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Education Course Notes
[Session 7 & 8]
Position of Mavers Co shareholders
In this situation, where no synergistic gains are included in the calculations, a gain to Power
Co’s shareholders will result in a corresponding loss to the Mavers Co shareholders. Clearly
Mavers Co would not want to proceed with the takeover in these circumstances.
Unless some synergies can be generated, to improve the wealth of the overall company after
the acquisition, there is no way of structuring the deal so that both sets of shareholders will
be satisfied.
3.
Effect of an Offer on Financial Position and Performance
3.1
Effects on earnings
3.1.1 Failures of takeovers often result from inadequate integration of the companies after
the takeover has taken place. There is a tendency for senior management to devote
their energies to the next acquisition rather than to the newly-acquired firm. The
particular approach adopted will depend upon the culture of the organisation as well
as the nature of the company acquired and how it fits into the amalgamated
organisation (eg horizontally, vertically, or as part of a diversified conglomerate).
3.1.2 One obvious place to start is to assess how the merger will affect earnings. P/E ratios
can be used as a rough indicator for assessing the impact on earnings. The higher the
P/E Ratio of the acquiring firm compared to the target company, the greater the
increase in Earnings per Share (EPS) to the acquiring firm.
3.1.3 Dilution of EPS occurs when the P/E ratio paid for the target exceeds the P/E ratio of
the acquiring company. The size of the target's earnings is also important; the larger
the target's earnings are relative to the acquirer, the greater the increase to EPS for the
combined company. The following examples will illustrate these points.
Example 7
X Co has plans to acquire Y Co by exchanging shares. X Ltd will issue 1.5 shares of its
share for each share of Y Ltd. Financial information for the two companies is as follows:
Net income
Shares outstanding
EPS
Market price per share
Prepared by Patrick Lui
X Co
$400,000
200,000
$2.00
$40.00
P. 232
Y Co
$100,000
25,000
$4.00
$48.00
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[Session 7 & 8]
X Ltd expects the P/E ratio for the combined company to be 15. What is the expected share
price after the acquisition?
Solution:
Combined earnings = $400,000 + $100,000 = $500,000
Combined shares = 200,000 shares + (25,000 × 1.5) = 237,500
Combined EPS = $500,000 / 237,500 = $2.11
Expected price of share = expected P/E ratio × combined EPS = 15 × $2.11 = $31.65
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