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An Exchange Ratio Determination Model1

In any merger that is financed by the issue of stock, the determination of swap ratio (or exchange ratio) is
always very important. As we will see in this chapter, the exchange ratio determines the way the synergy
is distributed between the shareholders of the merged and the merging company. Secondly, the swap ratio
also determines the control that each group of shareholders will have over the combined firm.
Most of the times mergers become controversial because of the inappropriate determination of the
exchange ratio. One can site the example of the TOMCO and the HLL merger.
In this chapter we will see how the exchange ratios are determined, what are the properties of the
exchange ratio, how the synergy gets distributed for a given exchange ratio, and how considerations like
corporate control affect the decision affect the determination of the exchange ratio.

The Model

Suppose A and B are merging. A is the merged company and B is the merging company. A wants to pay
partly in cash and party in stock to the shareholder of B. Lets use the following notation.
A B
No of Shares n1 n2
Earnings per Share E1 E2
Stock Price p1 P2

Suppose A gives “x” shares of A for each 1 shares of B to the shareholders of B. A can give some cash
“C” also to the shareholders of B. We will look at these as two separate cases. Assume that the synergy is
“S”.

Case 1: The entire merger is financed by stock swap only


Here, Shareholders of B swap complete ownership over B for a partial ownership over A+B. The
shareholders of A receive B and swap certain number of shares in return.

Analysis from the point of the shareholders of A:

The shareholders of A will agree to go for the merger only if the stock price of A increases as a result of
the merger. This is given by the following condition:
p1 is less that p1+2.
The price of the merged entity after the merger will be:
p1 * n1 + p 2 * n 2 + S
n1 + x * n 2
Hence shareholders of A will accept the merger if the following condition is satisfied.
p1 * n1 + p 2 * n2 + S
p1 ≤
n1 + x * n 2
⇒ p1 * n1 + p1 * x * n 2 ≤ p1 * n1 + p 2 * n 2 + S
p 2 * n2 + S
⇒x≤
p1 * n2
The above in-equation puts the upper limit for the exchange ratio that will be acceptable to the
shareholders of A. From the above in-equation, we can find one interesting point. When the shareholders
of A perceive no synergy in the merger, (i.e., S=0), the maximum swap ratio that is acceptable to the
shareholders of A is given by p2/p1. As we will see shortly, if there is no synergy in the merger, then the

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© Prof. Pitabas Mohanty
minimum swap ratio that is acceptable to the shareholders of B is also given by p2/p1. Hence in a merger
when there is no synergy, the only exchange ratio that will be acceptable to the shareholders of both the
companies is given by p2/p1.
In the above we only looked at the total wealth of the shareholders of A. It is also possible that the
promoter of A does not want to let his stake fall below a certain level after the merger. If both A and B are
managed by the same promoter this will usually not be a serious problem. If however, B is managed by a
different management, then the promoter of A will also look at considerations other than value while
determining the swap ratio. Let’s see how such considerations affect the predictions of our model.
Let’s use the following notations.
Promoter’s stake in A: α
The minimum stake that the promoter wants in the combined entity: β

(The promoter may want the value of β to be at least 26%, or 51%, or 76%.)

If the promoter wants a stake of at least β after the merger, then the following condition must be satisfied.

α × n1
≥β
n1 + x × n 2
Here, the left hand side of the above equation shows the actual stake of the promoter after the merger for a
given swap ratio “x”. This must be greater than β so that the promoter of A will ok the merger. From the
above we can derive the following value for “x”.

α × n1 ≥ β × n1 + β × x × n2
(α − β ) × n1
⇒x≤
β × n2
Hence if the promoter also puts down a condition of certain minimum stake after the merger, then the
maximum swap ratio that will be acceptable to all the shareholders of A (including the promoter) will be
given by
 (α − β ) × n1 p 2 × n2 + S 
min  , 
 β × n2 p1 × n2 
There are two possibilities in this case. If the maximum swap ratio that is acceptable to the promoter is
lower than the maximum swap ratio that is acceptable to the other shareholders, then it is possible that the
promoter will reject some of the mergers, which are in the interests of most of the shareholders. It is also
possible that the maximum swap ratio acceptable to all the shareholders is less than that is acceptable to
the promoter. As we will discuss later, it is possible that in some cases, the promoter may go ahead with
such mergers.

Analysis from the point of shareholders of B:


The shareholders of B are actually getting “x” number of shares of A for each share of B that they have.
The shareholders of B will accept the merger if the value of the “x” number of shares of A that they are
getting is higher than the value of each share of B. This will happen if the following condition is satisfied.
 p1 * n1 + p 2 * n 2 + S 
p2 ≤  * x
 n1 + x * n 2 
⇒ p 2 * n1 + p 2 * n 2 * x ≤ p1 * n1 * x + p 2 * n 2 * x + S * x
⇒ p 2 * n1 ≤ ( p1 * n1 + S ) * x
p 2 * n1
⇒x≥
p1 * n1 + S
The above in-equation gives us the minimum exchange ratio that will be acceptable for a given level of
synergy. You can see from the above in-equation that when synergy is zero, the shareholders of B will
demand an exchange ratio of at least p2/p1.
We can plot the above two in-equations graphically.

E
x
c
h
a Zone 2
n
g
e Zone 1
Zone 3
R
a
t Zone 4
i
o

Synergy

If a promoter different from the promoter of A is managing B, then the promoter of B may put a different
constraint for the merger. The promoter of B may also demand that its stake does not fall below certain
key percentage.
Let’s see how this affects our model.
Let’s assume that the promoter of B has a stake in B given by δ. Suppose, also that the promoter of B
wants its stake to be at least λ after the merger. Then the promoter of B will accept the merger only if the
following condition gets satisfied.

δ * n2 * x
≥λ
n1 + n 2 * x
Here, the left hand side tells us what is the stake of the promoter of B in the combined entity for different
values of “x”. The above in-equation can be further reduced to

δ * n2 * x ≥ λ * n1 + λ * n2 * x
⇒ x(δ * n2 − λ * n1) ≥ λ * n1
λ * n1
⇒x≥
(δ * n2 − λ * n1)
Hence the promoter of B will accept the merger only if the actual exchange ratio is greater than or equal
to the term on the right side of the above equation.
We can combine the constraints given in the above two in-equations as follows. The shareholders and the
promoter of B will accept the merger only if the exchange ratio is given by
 λ * n1 p 2 * n1 
max  , 
δ * n 2 − λ * n1 p1 * n1 + S 
There are two possibilities. Either the first term in the bracket is lower than or equal to the second term, or
it is higher than the second term. If the first term is higher than the second term, then it is possible that a
merger which is beneficial to the shareholders of B (on considerations of value) will not be acceptable to
the promoter and hence will not take place at all.
The above analysis clearly shows that if the promoters are worried about their control in a company, then
they will reject some of the value-maximizing mergers.

Case 2: Merger is being financed by a mix of cash and stock swap

Here, we will assume that A is financing the acquisition through an issue of stock and part payment of
cash. The share price of the merged entity after the merger will be equal to
n1 * p1 + n2 * p 2 − n2 * C + S
n1 + x * n2
Here, the numerator stands for the total value of equity after the merger. The first two terms, namely,
n1*p1+n2*p2 stand for the sum total of the value of the two companies. Since A is making a cash payment
of C for each share of B, the value of the merged entity is going to come down after the merger by an
amount equal to n2*C. Finally, since the management is expecting a synergy of S from the merger, the
value of the combined entity will increase by an amount equal to S.2
The numerator tells us that after the merger there will be n1+x*n2 shares outstanding in the merged
company. Initially, there are n1 number of shares in A and consequent to the terms of agreements of the
merger A has to issue “x” shares of A for each share of A to the shareholders of B.

Analysis from the point of view of the shareholders of A

The proposed merger will be acceptable to the shareholders only if the stock price of the merged entity
after the merger is greater than the pre-merger stock price. That is, the following condition needs to be
satisfied if the shareholders of A will accept the merger.

n1 * p1 + n2 * p 2 − n2 * C + S
p1 ≤
n1 + x * n2
⇒ p1 * n1 + p1 * x * n2 ≤ n1 * p1 + n 2 * p 2 − n2 * C + S
n2 * ( p 2 − C ) + S
⇒x≤
p1 * n2
The above in-equation tells us that if the proposed exchange ratio is greater than the right hand side of the
above equation, then the shareholders of A will not accept the merger. We can see from the above in-
equation that as “C” increases, the value of “x” comes down. This quite easy to understand. If A is paying
a large sum to the shareholders of B in the form of cash, then the exchange ratio cannot be large. In the
extreme case, when “C” is set equal to p2, we obtain:

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It is possible that the actual synergy will be less than what the management expects. However, we are going to ignore these
issues in this Chapter.
S
x≤
p1 * n 2
This tells us that if there is some synergy in the proposed merger, then the shareholders of A will not mind
swapping some shares for the shares of B even when “C” is set equal to the pre-merger price of B.
A second interesting observation that we can find from the above in-equation is that “x” is a positive
function of the synergy, i.e., “S”. This is again easy to understand. If the shareholders of A perceive a
large amount of synergy from the merger, then they will not mind exchanging a larger number of shares
of A for every share of B.

Analysis from the point of view of the shareholders of B

The shareholders of B are exchanging their ownership over B for a partial ownership over the new
merged company and a part payment of cash. The shareholders of B will accept this merger only if the
following condition is satisfied:
 n1 * p1 + n 2 * p 2 − n 2 * C + S 
p2 ≤  * x + C
 n1 + x * n 2 
Here, each share of B is being exchanged for “x” number of shares of A and a cash payment of “C”. The
above in-equation further reduces to:
( p 2 − C ) * n1 + ( p 2 − C ) * x * n 2 ≤ (n1 * p1 + n 2 * p 2 − n 2 * C + S ) * x
⇒ ( p 2 − C ) * n1 ≤ x * (n1 * p1 + n 2 * p 2 − n 2 * C + S − n 2 * p 2 + n 2 * C )
⇒ ( p 2 − C ) * n1 ≤ x * (n1 * p1 + S )
( p 2 − C ) * n1
⇒x≥
n1 * p1 + S
The right hand side of the above in-equation gives the minimum exchange ratio that is acceptable to the
shareholders of B. We can see certain interesting points from the above in-equation.
The value of “x” is negatively related to the cash payment made (i.e., C). This means that if the
shareholders of B receive a large cash payment, then they will not minding receiving a lower exchange
ratio in the merger. In the extreme case, if we set “C” equal to p2, then any exchange ratio will be
acceptable to the shareholders of B.
Secondly, there is also a negative relationship between “x” and the synergy. This is again very easy to
understand. If there is higher synergy, then the shareholders of B will not mind receiving a lower
exchange ratio.

Determination of Exchange Ratio in Consolidations


Let’s use the following notation.
Company A Company B
No of shares n1 n2
Stock price p1 p2
Exchange Ratio x1 x2

Suppose the synergy in consolidation is S.


Shareholders of A will accept this merger if the following condition is satisfied.
p12 ≥p1
This can be written as follows:
 p1 * n1 + p 2 * n2 + S 
x1 *   ≥ p1
 n1 * x1 + n2 * x 2 
⇒ x1 * p1 * n1 + x1 * p 2 * n2 + x1 * S ≥ p1 * n1 * x1 + p1 * n2 * x 2
p1 * n 2 * x 2
⇒ x1 ≥
p 2 * n2 + S
Here, we can see that

∂x1
≥ 0,
∂x 2
∂x1
≤ 0.
∂S

We can similarly derive the following condition for the shareholders of B.

p 2 * n1 * x1
x2 ≥
p1 * n1 + S
We can rewrite the above two in-equations in the following fashion:

x1 p1 * n1 + S

x2 p 2 * n1
for the shareholders of the first company, and

x1 p1 * n 2

x 2 p 2 * n2 + S

for the shareholders of the second company.


We can see both the curves intersect at the point p1/p2.

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