determined using either the fixed ratio or the fixed value method. We illus-
trate the transaction terms with an example.
Bidder B pays for target T, 70 percent in stock, 30 percent in cash. The
share exchange ratio is 0.5; that is, 1/2 a share of B for one share of T. Cash
amount paid for the remaining 30 percent is $20. Based on the preceding
specification, let us now compute the exchange on a per target stock basis.
Share amount: share percentage ×ratio = 0.7 ×0.5 = .35
Cash amount: cash percentage ×cash value = 0.3 ×$20 = $6.0
Thus, for each share of the target the holder of record would receive 0.35
share of the bidder and $6 in cash.
Note that while these sets of transaction terms reduce the dependence of
the exchange ratio on the price of the bidder stock, paying partly in cash re-
duces the amount of equity issued and has an effect on the capital structure
of the new entity.
Collars
An explicit attempt to reduce the dependence of the exchange ratio to the
volatility of the bidder stock without resorting to cash payments can be seen
in the case of collars. Collarsare transaction terms that are contingent on the
price of the bidder. They come primarily in two flavors, the fixed exchange
collar and the fixed value collar.
In a fixed exchange collar, a constant exchange ratio is specified over a
range of the Bidder’s stock price. This ratio is subject to adjustment; that is,
to a maximum or minimum value if the bidder’s stock price falls out of the
range. In a fixed value collar, a constant dollar value is set for each share of
the target stock. The ratio is then determined using the pricing period ap-
proach. However, the terms would be adjusted to a maximum or minimum
exchange ratio if the bidder’s stock price falls out of the range.
Also included in some cases is a walk awayright, which grants the tar-
get company an option to terminate the deal in case the price of the bidder
falls below a specified level. In other cases, the bidder is also granted a ter-
mination option if the stock price of the target experiences a very steep in-
crease after announcement.
The Deal Spread
The transaction terms in a merger or exchange offer create a strict parity re-
lationship between the bidder and target stocks. Violations of this parity
relationship can be measured based on the stock prices of both the stocks
and is called the spread. To see how the spread is calculated, consider the
Risk Arbitrage Mechanics 145