Modalities of Payment

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

Documents

Modalities of Payment