Once the target firm has been identified and valued, the acquisition moves forward into the structuring phase. There are three interrelated steps in this phase. The first is the decision on how much to pay for the target firm, given that we have valued it, with synergy and control built into the valuation. The second is the determination of how to pay for the deal, i.e., whether to use stock, cash or some combination of the two, and whether to borrow any of the funds needed.

The final step is the choice of the accounting treatment of the deal because it can affect both taxes paid by stockholders in the target firm and how the purchase is accounted for in the acquiring firm’s income statement and balance sheets

Deciding on an Acquisition Price

In the last section, we explained how to value a target firm, with control and synergy considerations built into the value. This value represents a ceiling on the price that the acquirer can pay on the acquisition rather than a floor. If the acquirer pays the full value, there is no surplus value to claim for the acquirer’s stockholders and the target firm’s stockholders get the entire value of the synergy and control premiums.

This division of value is unfair, if the acquiring firm plays an indispensable role in creating the synergy and control premiums. Consequently, the acquiring firm should try to keep as much of the premium as it can for its stockholders. Several factors, however, will act as constraints. They include

1. The market price of the target firm, if it is publicly traded, prior to the acquisition: Since acquisitions have to based on the current market price, the greater the current market value of equity, the lower the potential for gain to the acquiring firm’s stockholders. For instance, if the market price of a poorly managed firm already reflects a high probability that the management of the firm will be changed, there is likely to be little or no value gained from control.

2. The relative scarcity of the specialized resources that the target and the acquiring firm bring to the merger: Since the bidding firm and the target firm are both contributors to the creation of synergy, the sharing of the benefits of synergy among the two parties will depend in large part on whether the bidding firm's contribution to the creation of the synergy is unique or easily replaced. If it can be easily replaced, the bulk of the synergy benefits will accrue to the target firm. If it is unique, the benefits will be shared much more equitably. Thus, when a firm with cash slack acquires a firm with many highreturn projects, value is created. If there are a large number of firms with cash slack, and relatively few firms with high-return projects, the bulk of the value of the synergy will accrue to the latter.

3. The presence of other bidders for the target firm: When there is more than one bidder for a firm, the odds are likely to favor the target firm’s stockholders. Bradley, Desai, and Kim (1988) examined an extensive sample of 236 tender offers made between 1963 and 1984 and concluded that the benefits of synergy accrue primarily to the target firms when multiple bidders are involved in the takeover. They estimated the market-adjusted stock returns around the announcement of the takeover for the successful bidder to be 2% in single bidder takeovers, and -1.33% in contested takeovers.

Payment for the Target Firm

Once a firm has decided to pay a given price for a target firm, it has to follow up by deciding how it is going to pay for this acquisition. In particular, a decision has to be made about the following aspects of the deal:

1. Debt versus Equity: A firm can raise the funds for an acquisition from either debt or equity. The mix will generally depend upon both the excess debt capacities of the acquiring and the target firm. Thus, the acquisition of a target firm that is significantly under levered may be carried out with a larger proportion of debt than the acquisition of one that is already at its optimal debt ratio. This, of course, is reflected in the value of the firm through the cost of capital.

It is also possible that the acquiring firm has excess debt capacity and that it uses its ability to borrow money to carry out the acquisition. Although the mechanics of raising the money may look the same in this case, it is important that the value of the target firm not reflect this additional debt. As we noted in the last section, the cost of capital used in valuing the acquisition should not reflect this debt raised. The additional debt has nothing to do with the target firm, and building it into the value will only result in the acquiring firm is paying a premium for a value enhancement that rightfully belongs to its own stockholders.

2. Cash versus Stock: There are three ways in which a firm can use equity in a transaction. The first is to use cash balances that have been built up over time to finance the acquisition. The second is to issue stock to the public, raise cash and use the cash to pay for the acquisition. The third is to offer stock as payment for the target firm, where the payment is structured in terms of a stock swap – shares in the acquiring firm in exchange for shares in the target firm. The question of which of these approaches is best utilized by a firm cannot be answered without looking at the following factors:

· The availability of cash on hand: Clearly, the option of using cash on hand is available only to those firms that have accumulated substantial amounts of cash.

· The perceived value of the stock: When stock is issued to the public to raise new funds or when it is offered as payment on acquisitions, the acquiring firm’s managers are making a judgment about what the perceived value of the stock is. In other words, managers who believe that their stock is trading at a price significantly below value should not use stock as currency on acquisitions, since what they gain on the acquisitions can be more than lost in the stock issue. On the other hand, firms that believe their stocks are overvalued are much more likely to use stock as currency in transactions. The stockholders in the target firm are also aware of this, and may demand a larger premium when the payment is made entirely in the form of the acquiring firm’s stock.

· Tax factors; When an acquisition is a stock swap, the stockholders in the target firm may be able to defer capital gains taxes on the exchanged shares. Since this benefit can be significant in an acquisition, the potential tax gains from a stock swap may be large enough to offset any perceived disadvantages. The final aspect of a stock swap is the setting of the terms of the stock swap, i.e., the number of shares of the acquired firm that will be offered per share of the acquiring firm. While this amount is generally based upon the market price at the time of the acquisition, the ratio that results may be skewed by the relative mispricing of the two firm’s securities, with the more overpriced firm gaining at the expense of the more underpriced (or at least, less overpriced) firm. A fairer ratio would be based upon the relative values of the two firm’s shares. This can be seen quite clearly in the illustration below.

In Practice 26.6: Setting the Exchange Ratio

We will begin by reviewing our valuation for Digital in Figure 26.5. The value of Digital with the synergy and control components is $6,964 million. Digital also has $1,006 million in debt, and 146.789 million shares outstanding. The maximum value per share for Digital can then be estimated as follows: Maximum value per share for Digital =(Firm Value – Debt)/ Number of shares outstanding = ($6,964 - $1,006)/146.789 = $40.59

The estimated value per share for Compaq is $27, based upon the total value of the firm of $38,546.91 million, the debt outstanding of $ 3.2 billion and 1,305.76 million shares.

Value per share for Compaq = (38,546.91-3,200)/1,305.76 = $ 27.07

The appropriate exchange ratio, based upon value per share, can be estimated: Exchange ratioCompaq, Digital = Value per shareDigital/ Value per shareCompaq = $40.59/$27.07 = 1.50 Compaq shares/Digital share

If the exchange ratio is set above this number, Compaq stockholders will lose at the expense of Digital stockholders. If it is set below, Digital stockholders will lose at the expense of Compaq stockholders. In fact, Compaq paid $ 30 in cash and offered 0.945 shares of Compaq stock for every Digital share. Assessing the value of this offer,

Value per Digital share (Compaq offer) = $ 30 + 0.945 ($27.07) = $55.58

Value per Digital share (Assessed value) = $40.59

Over payment by Compaq = $14.99

Based on our assessments of value and control, Compaq over paid on this acquisition for Digital.

--> exchratio.xls: This spreadsheet allows you to estimate the exchange ratio on an acquisition, given the value of control and synergy.

Figure 26.5: Valuing Compaq for Digital

Prof. Aswath Damodaran

Next: Accounting Considerations

Summary: Index