Introduction to Corporate Finance

ONLINE CHAPTERS

even more) to the target shareholders. In many cases, therefore, bidders appear to pay too large an

acquisition premium on average, paying up front for any gains the market expects the merger to produce.

Why might bidders do this? One reason is that few companies seek to be taken over, so it is necessary to

pay a control premium in order to buy out target shareholders. A related explanation is that if a bidding

war occurs, with two companies both bidding for the same target, then ‘in the heat of the moment’ bidders

have a tendency to offer aggressive prices for the target. This phenomenon is sometimes called the winner’s

curse, in reference to the possibility that when multiple bidders are attempting to buy an asset with an

uncertain value, the ultimate winner may well pay a price that is greater than the asset’s true value. A third

explanation, described in the next section, relates to the frequent use by acquirers of their ordinary shares as

acquisition currency. To put these results in context, it is important to remember that Table 21.2 presents

two-day returns, so it is possible that bidder shareholders eventually earn their reward in the long run

(though currently, the market does not expect them to do so – if the market expected long-run gains, they

would be reflected in the two-day return).

While acquiring companies may experience negative abnormal returns around the time of the merger

announcement^18 this does not mean that the merger does not create any value. To determine whether the

merger creates value, we need to consider the combined bidder and target returns. For example, if a $9

billion company bidder earns a 0% return when it takes over a $1 billion target which itself earns a 10%

abnormal return, then the overall merger created a 1% abnormal return (= ($9 billion *0% + $1 billion

*10%) ÷ $10 billion). Table 21.2 shows that on average, mergers do create value (but most of this value gain

flows to target shareholders on average). This modest value creation is consistent with research by Andrade,

Mitchell and Stafford (2001), who show that, on average, there is a 1% improvement in abnormal operating

performance (measured by an increase in return on assets) in the year after an acquisition is completed.

21-3c METHOD OF PAYMENT

Just like any other type of investment, a merger must be financed with capital – such as debt, accumulated

profits (that is, cash on hand) or newly issued ordinary equity. These components make up the consideration

offered in a transaction, and sum to the transaction value: the dollar value of all forms of payment offered

to the target for control of the company. Cash on hand from retained earnings and/or generated from a

debt issuance is used in financing a cash-only deal, where the target’s shareholders receive only cash for

their shares in a public company or where the target’s owner(s) receives cash for the private enterprise.

More rarely, the target receives a new issue of debt in exchange for control in a debt-only transaction.

The bidding company’s shares are the only mode of payment in a share-swap merger, or pure share

exchange merger (these takeover bids are also known as scrip bids). The most ordinary share-swap merger

involves the issuance of new shares of the bidder’s ordinary equity in exchange for the target’s ordinary

shares, but payment may come in the form of either preferred shares or subsidiary tracking shares.

The number of shares of the surviving company that target shareholders receive is determined by the

exchange ratio. For instance, if an acquirer sets an exchange ratio of 0.75 for a target with 100 million

shares outstanding, the acquirer will issue 75 million new shares (0.75 × 100 million) in exchange for

the target’s shares. If the acquirer’s current share price is $20 and the target’s share price is $12, the

transaction value of this merger would be $1.5 billion ($20 × 75 million). An investor who owns 100

shares of the target ($1,200) would receive acquirer shares worth $1,500 ($20 × 75 shares), a 25%

control premium.^19 One advantage of this approach is that if a share deal is structured properly, a share

18 Negative bidder price pressure can be associated with arbitrageurs shorting the bidder’s shares and going long the target’s shares.

19 We assume in this example that the bidder share price does not change from $20 when the merger is announced.

pure share exchange

merger

A merger in which shares are

the only mode of payment –

such acquisition bids are also

known as scrip bids

thinking cap

question

When should an acquirer pay

for an acquisition with equity?

When should an acquirer

finance an acquisition with

debt?