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MERGERS FINANCED BY STOCK

What if Cislunar wants to conserve its cash for other investments, and therefore decides to pay for the Targetco acquisition with new Cislunar shares? The deal calls for Targetco shareholders to receive one Cislunar share in exchange for every three Targetco shares. It`s the same merger, but the financing is different. The right column of Table 6.4 works out the consequences. Again, start at the bottom of the column. Note that the market value of Cislunar`s shares after the merger is $540 million, $47.5 million higher than in the cash deal, because that cash is kept rather than paid out to Targetco shareholders.

On the other hand, there are more shares outstanding, since 833,333 new shares have to be issued in exchange for the 2.5 million Targetco shares (a 1 to 3 ratio). Therefore, the price per share is 540/10.833 = $49.85, which is 60 cents higher than in the cash offer.

Why do Cislunar stockholders do better from the share exchange? The economic gain from the merger is the same, but the Targetco stockholders capture less of it. They get 833,333 shares at $49.85, or $41.5 million, a premium of only $1.5 million over Targetco`s prior market value.

Cost = value of shares issued Ј Targetco value = $41.5 Ј 40 = $1.5 million

The merger`s NPV to Cislunar`s original shareholders is

NPV = economic gain Ј cost = 20 Ј 1.5 = $18.5 million

Note that Cislunar stock rises by $1.85 from its prior value. The total increase in value for Cislunar`s original shareholders, who retain 10 million shares, is $18.5 million.

Evaluating the terms of a merger can be tricky when there is an exchange of shares. The target company`s shareholders will retain a stake in the merged firms, so you have to figure out what the firm`s shares will be worth after the merger is announced and its benefits appreciated by investors. Notice that we started with the total market value of

Cislunar and Targetco postmerger, took account of the merger terms (833,333 new shares issued), and worked back to the postmerger share price. Only then could we work out the division of the merger gains between the two companies.

There is a key distinction between cash and stock for financing mergers. If cash is offered, the cost of the merger is not affected by the size of the merger gains. If stock is offered, the cost depends on the gains because the gains show up in the post-merger share price, and these shares are used to pay for the acquired firm. The nearby box illustrates how complex a stock offer can be. When Gillette offered to buy Duracell, giving

Duracell shareholders about a 20 percent stake in the merged firm, the attractiveness of the deal depended on the stock market`s valuation of both firms.

Stock financing also mitigates the effects of over- or undervaluation of either firm. Suppose, for example, that A overestimates B`s value as a separate entity, perhaps because it has overlooked some hidden liability. Thus A makes too generous an offer. Other things equal, A`s stockholders are better off if it is a stock rather than a cash offer. With a stock offer, the inevitable bad news about B`s value will fall partly on B`s former stockholders.

A WARNING

The cost of a merger is the premium the acquirer pays for the target firm over its value as a separate company. If the target is a public company, you can measure its separate value by multiplying its stock price by the number of outstanding shares. Watch out, though: if investors expect the target to be acquired, its stock price may overstate the company`s separate value. The target company`s stock price may already have risen in anticipation of a premium to be paid by an acquiring firm.

ANOTHER WARNING

Some companies begin their merger analyses with a forecast of the target firm`s future cash flows. Any revenue increases or cost reductions attributable to the merger are included in the forecasts, which are then discounted back to the present and compared with the purchase price:

Estimated net gain = DCF valuation of target including merger benefits Ј cash required for acquisition

This is a dangerous procedure. Even the brightest and best-trained analyst can make large errors in valuing a business. The estimated net gain may come up positive not because the merger makes sense, but simply because the analyst`s cash-flow forecasts are too optimistic. On the other hand, a good merger may not be pursued if the analyst fails to recognize the target`s potential as a stand-alone business. edge that other firms can`t match and that the target firm`s managers can`t achieve on their own.

It makes sense to keep an eye on the value that investors place on the gains from merging. If A`s stock price falls when the deal is announced, investors are sending a message that the merger benefits are doubtful or that A is paying too much for these benefits.