Co A Co B

Share exchange ratio determination in case of merger Co A Co B

Current earnings 100, 00,000 25, 00,000

Shares 25,00,000 10,00,000

EPS 4.00 2.50

Price of stock 80 37.50

PE Ratio 20 15

Suppose both companies merge.

Earnings------------Rs 125,00,000

Shares--------------30,00,000(Co B gets one share for 2 held)

EPS===========4.17.

****Shareholders of Company A will benefit as their EPS

will go up by 0.17.

*****Shareholders of Co B will loose as their EPS will go down,

4.17/0.5=2.08. Earlier they were getting 2.50 per share held.

Change in EPS is a function of 2 variables.

1. Difference in PE Ratio.

2..Relative size of 2 Companies as measured by total earnings.

Market ValueThe ratio of exchange of market price is

Mkt price of the acquiring co. * No of shares offered by the acquiring

co. to each share of the acquired co.

Market price per share of the acquired co.

Assume

Market price per share of the acquiring co. is===Rs 50 per share.

Market price of the acquired co. is Rs 25 per shareCo a offers one half share of Co B

=====50*.05/25========1.00

But this ratio will not entice the stock holders of the co. being acquired.

Suppose B is offered 0.60 share of A i.e. =Rs 30.00, which is higher

Than the present price of B i.e. Rs 25.00.

Co A Co B

CURRENT EARNINGS 100, 00,000 30, 00,000No Of Shares 30, 00,000 10,00,000

EPS 3.33 3.00

Market price per share 50 25

PE Ratio 15.02 8.33

With an offer of 0.60 shares of company A for each share of Co B,

The exchange ratio will be 50*0.6/25, equals to 1.20

Combined earnings will be 130,00,0000

No of shares 36, 00,000

EPS will 3.61

Market price per share will be 54.22 if PE of Co A (15.02) is maintained,

which will ultimately be also beneficial to the shareholders of Co A, so when a high PE company is taking over the low PE company, it may be beneficial to it to take over low PE company but the determinant will be after merger PE Ratio.However, in real world, it is doubtful if the PE ratio of a company that cannot demonstrate growth potential itself and can show such a growth only by acquiring co. will cover PE ratio will be held constant in the market place.

In perfect market conditions, and in situation where acquisition is not going to produce synergic benefits, it may be expected that PE of the surviving company would represent weighted average of previous PE ratio of the companies.

Despite the fact that market value is a major factor in most mergers, it is highly volatile which fluctuates violently, so it is difficult to ascertain the appropriate market price of a company.

As such, exchange ratio based on mkt. price may not be very rational.

Merger gain=====Pvxy-(Pvx+Pvy)

Determine the cost of acquiring firm Y.

If the payment is made in cash, the cost of acquiring Y, is equal to the cash payment minus Y as a separate entity.

Cost=Cash- Pvy

NPV=Gain Cash.

If the difference is positive, it is advisable to go ahead with the merger.

X=value=400 Crores.

Y=value=100Crores.

Cost saving by merger=50 Crores.

Gain=50 Crores.

Pvxy=550 Crores.

Suppose Y is bought for cash of say 130 Crores,

Cost of merger =cash payment Pvy

130-100=30 Crores.

Y owners will have a gain of 30 Crores which is a loss of X.

Firm A gain is 50-30 =Rs 20 Crores.

So merger is advisable.----------------------------------------------------------------------------------------------------------------------When the merger is financed by Stocks

X Y

Market price per share 100 40

Number of shares 50,000 2,50,000

Market value of the firm Rs 50 Lakhs Rs 10 Lakhs

The merger deal is expected to bring gains , which have a present value of Rs 10 Lakhs,

Firm X offers 125,000 shares in exchange for 2,50,000 shares to the shareholders of of Y.

Apparent cost of acquiring firm Y is

125,000*100-100,000=25,00,000

However, the the apparent cost may not be a true cost, Price of the stock X is 100 but may go up after merger. Leveraged Buy Outs

An acquisition that is largely financed by debt. LBO are financed normally disproportionately with debt.The high level of leverage is justified in following ways

1..If the target firm initially has too little debt relative to its optimal debt equity ratio.

2The increase in the debt can be explained partially by increase in value that moving to the optimal rate process.

Some of the debt will have to be paid quickly in order firm to reduce its cost of capital and its default risk.

3.. Michael James That managers cannot be trusted to invest free cash flows wisely for the shareholders, they need to discipline the debt payment to manage cash flows on project and firm value.

4That the high debt ratio is temporary and will disappear once the firm liquidates unnecessary assets and pays off a significant portion of Debt.