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8/7/2019 Modalities of Payment
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Modalities of Payment
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Concept
Could be:
Cash: need to find sources of generating cash
Stock: estimate valuation and exchange ratio
Affects returns of shareholders
Issues:
Tactical: to get the deal done
Strategic : operational issues
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Cash Consideration
Advantages:
Speed of getting transaction done
Liquidity: sellers usually prefer cash
Disadvantages: Difficulty in arranging it from buyers viewpoint
From sellers viewpoint:
capital gains tax is not deferred
no continuing equity interest in combined firm
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Sources of Acquisition ofCash
Commercial banks:
Terms depend on creditworthiness of borrower/ transactionstructure
Are senior, and secured
May have fixed or floating interest rates Restrictive covenants
Private placement market: emergence of junk bonds financing
Investment banks:
may provide bridge loans: however, may be risky
Mostly syndicate funding Private Equity Funds
Internal accruals or raise public equity
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Common Stock
Procedure for issue is more time consuming
Relative P/E ratios of buyer and seller companies
are to be considered
Apportionment of merger gains amongstshareholders of bidder and target firm
Convertible Preferred Stock: currently CCPS is a
more common mode of issuance in PE transactions
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Deferred PaySecurities
No return is paid to the lender for initial few
years, after which servicing payments start
Helps to: Reduce debt service burden on acquirer in early
years
Assists acquirer in raising more senior funds from
other lenders
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Contingency Payments
Some payment is made initially
More future payments are linked to target achievingsome financial milestones
Advantages: Helps sort out differences of opinion about future
financial prospects of target firm and hence ofpurchase consideration
Thus enables sharing of risks by both parties
Places golden handcuffs on owner-manager of target
firm Are of various types, a common one is base-period
earnout where no. of additional shares to be issued =(excess earnings * P/E ratio)/ MPS of acquirer
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Theories of Effect of Method of Payment
on Abnormal Returns Taxes:
cash payment does not allow tax deferment by target firmshareholders, thus extra premium may have to be paid oncash offers
However allows assets to be carried to books of acquireron stepped up basis, thus giving it higher depreciationbenefit, and lower capital gains at the time of sale
Information Effects and Signaling: stock payment may signify that bidders equity is
overvalued
cash payment normally sends more positive signals thanstock payment
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Other Theories
Managerial Ownership Proposition: stock offer is preferred bytarget to ensure its continuing control on management ofcombined firm; acquirer may prefer cash payment for similarreasons
Growth Opportunity Proposition: acquirer would avoid cashpayment, if it has other investment opportunities to invest into
Relative Size Proposition: bigger size of target may motivateshare financing by acquirer
Business Cycle Proposition: good stock market performanceleads to share financing
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Junk Bonds
Emerged in the fourth merger wave
Studies showed that risky bonds yielded more thanenough to compensate for risk factor
Risk of default and liquidity High risk, high return bonds
Widened investor participation base due toavailability of large amounts of capital thru junk
bonds Made even large firms vulnerable to takeovers by
smaller firms
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Accounting for Mergers and
Acquisitions Falls under the purview of Companies Act,
1956
Types:
Amalgamation in the nature of merger
Amalgamation in the nature of purchase
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Amalgamation in the Nature of Merger:
Basic Conditions All assets and liabilities of transferor are transferred
to transferee company
Shareholders with > 90% equity value of transferorbecome shareholders of transferee company
Consideration is paid by issue of equity shares Business of transferor is intended to be carried on
by the transferee company
No adjustment is made in book values of assets,
liabilities of transferor, in the books of transfereecompany
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Accounting Methods
Pooling of interest method: Used in case of amalgamation in the nature of merger
All reserves, assets, liabilities carried at book values to combined entitys B/S
Thus no creation of goodwill account
Purchase method:
Used in case of amalgamation in the nature of purchase Assets/ liabilities carried at their fair values; purchase amount is
proportionately allocated to them
Thus extra amount paid over value of assets, is transferred to goodwillaccount
All reserves (except statutory reserves) are clubbed in the equity capital, andlose their identity in the combined B/S
Amalgamation adjustment A/c is created to transfer the amount of statutoryreserves
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Tax Implications
Taxable transaction
Payment by cash/ nonequity form
Acquiring firm:
Assets are allowed to becarried at stepped up basis,thus higher depreciationamount claimed and lowercapital gains shown on sale
Loss of net operating loss setoff and tax credits
Acquired firmsshareholders payimmediate tax, hence maydemand a premium tocompensate this
Tax free transactions
Payment thru exchange ofstock
Acquiring firm:
Assets carried at bookvalues, not stepped upbasis
Benefits of net operatingloss set off, tax creditcarryovers, are allowed
Acquired firmsshareholders benefit by taxdeferment
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Purchase Consideration
Lump sum method
Net Asset Method: assets (except fictitious
assets) at agreed values liabilities at
agreed values
Net payment method: sum of payments made
to equity, debt holders
Intrinsic value method
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