Question

It is important that we mention that the higher the share price, naturally the better for management. Investors will see their net worth rise as their investment gains in value, while management will be happy in that the high share price will reflect positively on their incentives and the company, plus the fact that a higher share price can be used as cheap currency if management wishes to say buy out another company. With this said, what type of equity leverage do you think a company has when using their own stock to purchase other companies takes place?

Answer 1

In case of mergers, the acquirer can have his fair share of advantages when issuing own stock, rather than paying cash. Of course, when the value of own equity is high, naturally the number of shares to be issued reduce, thereby reducing the quantum of dilution of existing shareholder stake. Other key advantages that a company can expect from such transactions are:

1. Company does not have to invest immediate cash resources, i.e. it retains the cash it has for it own growth and expansion, or even for paying dividends

2. Company need not borrow funds, especially in case the acquisitions are for high risk businesses or entities, the seller becomes a part of the overall risk structure of the combined entity. No borrowing costs further protect the cash flows of the company. Therfore, exchange of stocks facilitate to an extent, sharing of risk of the business between both parties

3. As the seller remains a stakeholder, negotiations often become easier, because very often, sellers are unwilling to completely let go of their businesses and operations in lieu of cash. The fact they remain shareholders often results in smoother negotiations and more openness on part of the sellers to enter into the transaction

4. The seller can also expect tos ane on immediate tax outflows, as generally, gain on sale of stocks is taxed only when stocks are exchanged for cash and not in case of exchange of stocks