CH13 – Pricing issues and

F3 – Financial Strategy
post-transaction issues

Chapter 13
Pricing issues and post-
transaction issues

Chapter learning objectives:

Lead Component Indicative syllabus content

D.3 Analyse pricing Analyse: • Forms of consideration

and bid issues. (a) Pricing issues • Terms of acquisition
(b) Bid issues • Target entity debt
• Methods of financing cash offer and
refinancing target entity debt
• Bid negotiation

D4 Discuss post- Discuss: • Post-transaction value incorporating effect

transaction issues. (a) Post-transaction of intended synergies
value • M&A integration and synergy benefit
(b) Benefit realisation realisation
• Exit strategies

Page 1
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

1. Defence against hostile takeover bids

• Any listed company needs to be aware that a bid might be received at any time.
• The directors of a company subject to a hostile takeover bid should act in the best
interests of their stakeholders.
Defences against hostile takeover:

Pre-bid
Defences
Post-bid

Pre-bid defences
• Communicate effectively with shareholders:
- Have a public relations officer specialising in financial matters constantly
liaising with the entity’s stockbrokers.
- Keep analysts fully informed.
- Speak to journalists.
• Revalue non-current assets: non-current assets are revalued to the current
values to ensure that shareholders are aware of the true asset value per share.
• Poison pill:
- The target company takes steps before a bid has
been made to make itself less attractive to a
potential bidder.
- The most common method is for existing
shareholders to be given rights to buy future
bonds or preference shares.
- If a bid is made before the date of exercise of the rights, then the rights will
automatically be converted into full ordinary shares.
• Change the articles of association to require supermajority approval for a
takeover.

Page 2
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

Post-bid defences
• Appeal to their own shareholders:
A well-managed defensive campaign would include:
- Aggressive publicity on behalf of the company, preferably before a bid is received
- Direct communication with shareholders in writing, stressing the financial and
strategic reasons for remaining independent
• Attack the bidder:
Concentrate on the bidder’s:
- Management style
- Overall strategy
- Methods of increasing earnings per share
- Dubious accounting policies
- Lack of capital investment
• White knight strategy:
- The directors of the target company offer themselves to a more friendly outside
interest.
- This tactic should only be adopted in the last resort as it means that the company
will lose its independence.
- This is acceptable provided that any information given to a preferred bidder is also
given to a hostile bidder.
• Counter-bid, i.e. Pacman defense:
This is where the bidding company is
itself the subject of a takeover bid by the target company.
• Competition authorities:
The target entity could seek government intervention by bringing in the competition
authorities. For this to be effective, it would have to be proved that the takeover was
against the public interest.

Page 3
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

2. The form of consideration for a takeover

Forms of consideration:

Cash
• A cash consideration for the purchase of the target shares is beneficial to the target
shareholders as they are guaranteed a certain sum. However, they no longer have an
interest in the entity itself and will also be subject to tax on the disposal of the shares.
• Suitable only for small companies. The predator company is faced with the issue of
raising cash, so it needs to ensure that adequate cash resources are available to
finance the acquisition.

Test Your Understanding 1 – Cash offer

The following information relates to two US-based entities, Omega and Delta:

Omega Delta

Market price per share ($) 55 15

Number of shares 150,000 40,000

Market value ($) 8,250,000 600,000

If Omega intends to pay $1m cash for Delta, what is the cost premium if:
a. The share price does not anticipate the takeover.
b. The share price of Delta includes a speculation element of $2 per share.

Share exchange
• The bidding company issues new shares and then exchanges them with the target
company’s shareholders.
• The target company’s shareholders then end up with shares in the bidding company
and so still have a vested interest in the performance of the business.
• The target company’s shares end up in the possession of the bidding company.
• This removes any liquidity issues from the predator company’s perspective.
• The predator company needs to be aware that, on issue of shares, there will be loss
of ownership once shares are granted to the target company’s shareholders.

Page 4
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

• There is the possibility of deferring any gains on disposal of the target company’s
shares.
Note: Takeovers involving large companies almost always involve an exchange of shares
in whole or part.
Evaluating a share-for-share exchange:
• Value the predator company as an independent entity and hence calculate the value
per share in that company.
• Repeat the procedure for the victim company.
• Calculate the value of the combined company post-integration. This is calculated as
follows:
Value of the predator company as an independent company x
Value of the victim company as an independent company x
Value of any synergy x
Total value of combined company
• Calculate the number of shares post-integration:
Numbers of shares originally in the predator company x
Number of shares issued to the victim company x
Total shares post-integration
• Calculate the value of a share in the combined company, and use this to assess the
change in the wealth of the shareholders after the takeover.

Test Your Understanding 2 – Entity A

Entity A has 300m shares with a current market value of $4 per share, whereas Company B has
90m shares with a current market value of $2 per share.
Entity A offers Company B 3 new shares for every 5 currently held in B. Entity A has determined
that the present value of synergy will be $20 million.
Calculate the expected value of a share in a combined company, assuming that the given share
prices have not yet moved to anticipate the takeover, and advise the shareholders in Company
B whether the offer should be accepted or not.

Page 5
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

Earn-out
A procedure whereby owners/managers selling an entity may receive a portion of their
consideration linked to the financial performance of the business during a specified
period after sale. The arrangement gives a measure of security to the new owners, who
pass some of the financial risk associated with the purchase of a new entity to the
sellers. (CIMA Official Terminology, 2005)
Explanation:
• Takes place over a three- to five-year period after acquisition
• May involve 10% to 50% of the purchase price being deferred and paid across during
that period
• Popular among private equity investors

Earn-out targets:
• Revenue
• Net income
• EBITDA
• EBIT
Limitations of earn-out:
• Works best when the business is operated and envisioned at the time of transaction
• The buyer may have the ability to block the earn-out targets from being met
• Outside factors may also impact the company’s ability to achieve earn-out targets

CONSIDERATIONS OF DIFFERENT STAKEHOLDERS

Position of the target company’s shareholders

• If the shareholders want to retain their interest in the company, a cash offer is not
appropriate.
• There is a greater certainty of value (share prices do fluctuate).

Position of the bidding company and its shareholders

• If there is share exchange, a bidding company will have to issue new shares <= that
may require the consent of the current shareholders (they may be concerned about
diluting the value of the shares).
• Impact on the bidding’s company’s financial statements: EPS can go down. If cash is
considered, there might be a problem with gearing.

Page 6
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

METHODS OF FINANCING A CASH OFFER

Debt
• Borrow the required cash from the bank
• Issue bonds in the market
• Debt has low service cost (an advantage)
• Debt increases the bidding company’s gearing

Rights issue
• Alternative to debt finance
• Offering shares to existing shareholders
• Funds raised can be used to buy the shares in the company being acquired
• This protects the gearing level
• In this scenario, shareholders have to arrange funds to accept the rights issue shares
offered

BOOTSTRAPPING AND POST-ACQUISITION VALUE

Let’s explain bootstrapping with the help of an example:

Test Your Understanding 3 – Companies A & B

Post-tax profit P/E ratio Pre-acquisition value

Company A $10 million 15 $150m

Company B $2 million 8 $16m

What will be the value of synergy if Company A acquires Company B?

Page 7
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

3. Treatment of target entity debt

A material adverse change clause is often used to make the target entity’s borrowings
repayable if the company is sold.
Therefore, when considering how to fund a takeover, the bidding company will have to
ensure that sufficient funds are available to purchase the shares from the target entity’s
shareholders and to repay the debt in the target entity.

Test Your Understanding 4 – Takeover bid

Company A is considering a takeover bid for Company B.
The $2.5 million borrowings in Company B are repayable if Company B is acquired. Therefore,
Company A is considering one of the following offers.
a) A to pay $4.5 million in cash ($2 million cash to B’s shareholders plus $2.5 million to finance
the repayment of B’s borrowing).
b) Exchange two A $1 ordinary shares for each B ordinary share held plus A to pay B $2.5
million in cash to finance the repayment of B’s borrowing.
Discuss the implications of the above offers.

4. The post-merger or post-acquisition integration process

Druker’s Golden Rule

P.F Druker (1981) identified five Golden Rules to apply to post-acquisition integration.
1) Ensure a common core is shared by the acquired entity and acquirer. Shared
technology or markets are an essential element.
2) The acquirer should not just think, “What is in it for us?” but also “What can we
offer them?”
3) The acquirer must treat the products, markets and customers of the acquired entity
with respect.
4) Within 1 year, the acquirer should provide appropriately skilled top management
for the acquired company.
5) Within 1 year, the acquirer should make several cross-entity promotions of staff.

Page 8
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

Jones’ 5-step integration sequence

1) Reporting relationships – these should be established quickly to avoid
uncertainty
2) Control of key factors – especially over capital expenditures and borrowing, to
avoid imposing too many new controls too quickly
3) Resource audit – looking for unexpected strengths or weaknesses
4) Corporate objectives – targets for synergies, communicate benefits to customers
and staff, corporate objectives aligned to the parental company
5) Revising the organisation structure – a good opportunity for review and change

Post-audit
• This should examine whether the acquisition achieved its aims (if synergies were
achieved).
• It should be independent.
• The organisation should learn from its mistakes.
• The existence of a post-auditing process should ensure that the original synergies
forecast are not overly optimistic.

5. Solutions to Test Your Understanding

Test Your Understanding 1 – Cash offer

a. The share price accurately reflects the true value of the entity:
The cost of bidder = $1,000,000 - $600,000
The cost of bidder = $400,000
Omega is paying $400,000 for the identified benefits of the takeover
b. The cost is $400,000 + (40,000 × $2 per share)
The cost = $400,000 + $80,000
The cost = $480,000

Page 9
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

Test Your Understanding 2 – Entity A

MV of Entity A = $1,200m (3m shares x $4 a share)
MV of Company B = $180m
PV of synergy = $20m
Total = $1,400
No. of new shares = 300m + (90 × 3/5) = 354m
New share price = $1,400/354 = $3.95 per share

Current B share value $2

New B share value = (3 x 3.95) / 5 = $2.37 per B share

The share price of Company B has increased by $0.37 per share as a consequence of the takeover.
Therefore, Company B’s shareholders should be advised to accept the 3 for 5 share offer.

Test Your Understanding 3 – Companies A & B

If Company A takes over Company B, the post-acquisition value of the combined company can be
estimated by applying Company C’s P/E ratio to the combined post-tax profit.
This is known as bootstrapping and it is based on the assumption that the market will assume that
the management of the larger company will be able to apply a common approach to both
companies after the takeover, thus improving the performance of the acquired company by using
the methods they have been using on their own company before takeover.
Value of (A+B) post-acquisition reserves = 15*($10m + $2m) = $180m
Thus, the value of synergy is this combined value less the values of the individual companies pre-
acquisition, i.e.
$180m - $150 - $16 = $14m

Test Your Understanding 4 – Takeover bid

Note that the bids look very similar to those seen earlier in the chapter, but they now contain a
reference to the extra payment required to pay the debt.
We need to be careful with business valuation here.
• Apply an appropriate P/E ratio to the company’s earnings or discounting forecast cash flows
to the equity using cost of equity gives the value of equity, whereas:
• Discounting forecast cash flows to all investors using WACC gives the value of the whole entity
(equity + debt).

Page 10
 CH13 – Pricing issues and
F3 – Financial Strategy
post-transaction issues

• An asset valuation could either be an EQUITY valuation or an ENTITY valuation, depending on

what is included in the valuation.
• Therefore, when deciding what size of offer should be made, it is critical to assess whether
the valuation figure already includes the value of both debt and equity or whether it is just an
equity valuation.
• Note that in the circumstances described in the offer above, A would need to consider how to
finance the cash offer of $4.5 million, but it would also have to consider the possibility of
borrowing under the share-for-share exchange offer.

6. Chapter summary

Page 11