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 Value
The 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 share
Co 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, 00,000
No 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.