Effects of Price and Payment Method in M&A Transactions

The form of payment and the price in a merger determine the distribution of benefits and risk. Acquiring managers will prefer to pay with cash if they are confident that estimated synergies will be realized. However, the target management will want to receive stock, and the more of the acquirer’s stock is used, the more the risk and benefits will be transferred to the target shareholders. If the expected synergies reduce, the acquirer’s gain will reduce or be completely eroded, but the target’s premium will be unchanged.

Target companies become part owners of the acquiring company in the case of cash offerings. Since the target is a part-owner, they contribute to any deviations of synergies of the pre-merger estimates; thus, if the estimated synergies reduce, the acquirer’s gain and the target’s gain both reduce.

The more confident managers are in the estimates of the target company’s value, the more the acquirer would prefer cash and the more the target would prefer stock. Hence, the counterparties’ confidence in the companies’ relative value affects the method of payment decision. From empirical research in the short run, merger transactions create value for the target shareholders. Both acquirer and target see high stock return with cash offers than stock offers.

The winning bidder is likely to be the bidder who overestimates the value of the target, effectively paying higher premiums for the target. These high premiums paid to target shareholders are attributed to the winner’s curse. Over a long period, the comparable companies seem to outperform the acquirer three years after the merger, implying that post-merger synergies were not attained. Analysts must therefore strive to identify the mergers that create value and those that do not. 

Question

The synergy estimates for a combined company fall after the merger and acquisition is made. If this was a cash-only offer, what is the most likely result for the target company?

1. The value of the target will decrease.
2. The premium paid to the target will remain unchanged.
3. The value of the target will increase.

Solution

The correct answer is B.

For cash offers, the change in the estimated synergies does not affect the premium paid to the target.

A is incorrect.  This happens in a stock offering.

C is incorrect. This will occur in a stock offering, and the estimated synergies have increased.

Reading 18: Mergers and Acquisition

LOS 18 (i) Explain how price and payment methods affect the distribution of risks and benefits in M&A transactions.