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Key25 Mergers for stock: know how much you are paying

When one company acquires another, it can pay cash or stock. In a cash deal, the acquiring company buys all of the target company’s common shares for cash. In a stock deal, the acquiring company issues new shares and exchanges them for the target company’s shares. In the latter case, the target company’s former shareholders become shareholders in the combined company.

The calculation of the merger N.P.V. is conceptually straightforward in a cash deal. If Company A buys company B, the gain, or “synergy,” from the acquisition is equal to the market value of the combined company minus the sum of their premerger market values. The acquisition’s cost is the amount paid in cash for Company B minus the previous market value of B. This represents the amount of the merger gain that is shared with B’s original shareholders. The net present value is the difference between the gain and cost. Suppose, for example, that A and B each have a total market value of $100 million prior to any merger announcement. If the combined company is worth $250 million, the merger has produced a gain in value of $50 million. If A agrees to pay $115 million in cash to acquire B, the merger’s cost is $115-$100=$15 million, and the N.P.V. is $50 million-$15 million=$35 million.

When the merging companies exchange shares, on the other hand, the acquiring company gives an ownership share in the combined company to the target company’s shareholders. The acquisition’s true cost thus depends on the combined company’s market value. Suppose that the same two companies from our previous example merge for stock. Specifically, let each company have 1 million shares outstanding originally and let A exchange one A share for each B share currently outstanding. Because the companies exchange shares in a one-to-one ratio, the former B shareholders wind up with a 50 percent ownership share in the combined company. Because half the combined company is worth $125 million, the merger’s cost in the case of the share exchange is $125 million-$100 million=$25 million, so the merger’s N.P.V. is $50 million-$25 million=$25 million. Under the terms described here, A’s shareholders have given a bigger piece of the merger gain to B’s shareholders in the share exchange deal than in the cash deal.

However, if the combined company turns out to be worth less than originally expected, the cost of the stock deal adjusts, whereas that of the cash deal does not. If the combined company turns out to be worth only $210 million, the gain falls to $10 million. The cost of the cash deal is still $15 million, so the deal will now be seen in retrospect to have been bad for A’s shareholders. In the stock deal, on the other hand, the value of a 50 percent ownership share is now only $105 million, so the merger has cost only $5 million, and the merger N.P.V. is still $10 million-$5 million=$5 million.

The essential point in these examples is that a merger’s N.P.V. depends on the value of the consideration paid to the acquired company. If payment is in cash, the value of the consideration is fixed. If payment is in stock, the value of the consideration depends on the market value of the combined company.