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It is commonly argued that the NPV of a merger depends on the method of payment...

It is commonly argued that the NPV of a merger depends on the method of payment used. Cash offers seem to yield a higher NPV than stock offers. Thus, acquiring firms need to be very careful in setting the exchange ratio in a stock offer deal. Explain in DETAIL why?

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Expert Solution

Selection of Methods of payment with Mergers & Acquisition(M&A), is the key of a successful M&A. Methods of payment includes cash payment, security payment, stock payments, bond payments and leveraged buyout.

CASH PAYMENT is a simple purchasing action, which means the purchasing corporation purchases a certain amount of assets or stocks from the target company by paying a certain amount of cash. It is the most popular payment method with Mergers & Acquisition on Chinese Capital Market.

Firms have to take many factors into consideration( such as the potential presence of other bidders, tax implications etc.)

STOCK PAYMENT, while stock payment, the purchasing companies issues new stocks to buy the stocks or assets of the target companies. Among which the most popular form is stock exchange, which means the purchasing company pays the stock of its company directly to the target company to buy out the stocks or assets of the target companies.

FOR EXAMPLE :

X ltd is considering the proposal to acquire Y ltd. and their assumed financial information is given below:

Particulars X ltd. Y ltd.
No of Equity Shares 10,00,000 6,00,000
Market price per share(Rs.) 30 18
Market Capitalization (Rs.) 3,00,00,000 1,08,00,000

i) Cost of Merger, when Merger is Financed by Cash = (Cash-MVY)+(MVY-PVY)

where, MVY = Market Value of Y ltd. PVY = True/Intrinsic Value of Y ltd.

Then, = (1,40,00,000 - 1,08,00,000) + (1,08,00,000 - 1,08,00,000) = Rs. 32,00,000

If cost of merger becomes negative then shareholders of X ltd. will get benefited by acquiring Y ltd. in terms of market value.

ii) Cost of Merger, when Merger is Financed by Stock :

Cost of Merger = PVXY - PVY

Where, PVXY = Value in X ltd. that Y ltd.'s shareholders get.

Suppose X ltd. agrees to exchange 5,00,000 shares in exchange of shares in Y ltd., instead of payment in cash of Rs.1,40,00,000. Then the cost of merger is calculated as below:

=(5,00,000 x Rs.30)

= Rs.1,08,00,000

= Rs.42,00,000

PVXY = PVX + PVY = 3,00,00,000 + 1,08,00,000 = 4,08,00,000

Proportion that Y ltd's shareholders get in X ltd's Capital Structure will be :

= 5,00,000 / (10,00,000+5,00,000)

= 0.333

True cost of merger = PVXY - PVY

= (0.333 x 4,08,00,000) - 1,08,00,000

= Rs. 28,00,000

As we can see that the values are different in cash merger and stock merger. Thus, acquiring firms need to be very careful in setting the exchange ratio in a stock offer deal.


jeff jeffy answered 2 years ago
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