SWAP RATIO
PRANTIK RAY
XLRI
An Exchange Ratio Determination
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
Analysis from the point of the
shareholders of A
• Hence shareholders of A will accept the
merger if the following condition is
satisfied.
p1 * n1 p 2 * n 2 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 * n 2
• The above in-equation puts the upper limit
for the exchange ratio that will be
acceptable to the shareholders of A.
Analysis from the point of the
shareholders of A
p1 * n1 p 2 * n 2 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 * n 2
• 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 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.
Promoter’s Constraint
• Let’s use the following notations:
• Promoter’s stake in A:
• The minimum stake that the promoter
wants in the combined entity:
(The promoter may want the value of to
be at least 26%, or 51%, or 76%.)
• If the promoter wants a stake of at least
after the merger, then the following
condition must be satisfied:
n1
n1 x n 2
Swap Ratio
• Here, the LHS the above equation shows
the actual stake of the promoter after the
merger for a given swap ratio “x”. This
must be greater than so that the
promoter of A will ok the merger.
• From the above we can derive the
following value for “x”.
n1 n1 x n 2
( ) n1
x
n 2
Constrained Optimization
• 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
( ) n1 p 2 n 2 S
min ,
n 2 p1 n 2
Issues in Corporate Governance
• 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.
• 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
p 2 *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
When synergy is zero, the shareholders of B will demand an
exchange ratio of at least p2/p1.
B’s Promoter
• 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 assume that the promoter of B has a stake
in B given by . Suppose, also that the promoter
of B wants its stake to be at least after the
merger. Then the promoter of B will accept the
merger only if the following condition gets
satisfied:
* n2 * x
n1 n 2 * x
Swap Ratio
• 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
* n 2 * x * n1 * n 2 * x
x( * n 2 * n1) * n1
*n 1
x
( * n 2 * 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.
Optimization
• 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
* n1 p 2 * n1
max ,
* n 2 * n1 p1 * n1 S
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
Case 2: Merger is being financed
by a mix of cash and stock swap
n1 * p1 n2 * p 2 n2 * C S
n1 x * n2
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 n 2 * p 2 n 2 * C S
p1
n1 x * n 2
p1 * n1 p1 * x * n 2 n1 * p1 n 2 * p 2 n 2 * C S
n2 * ( p 2 C ) S
x
p1 * n 2
• 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. n1 * p1 n 2 * p 2 n 2 * C S
p1
• As “C” increases, the value of n1 x * n 2
“x” comes down. This quite p1 * n1 p1 * x * n 2 n1 * p1 n 2 * p 2 n 2 * C S
easy to understand. If A is n2 * ( p 2 C ) S
paying a large sum to the x
p1 * n 2
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:
S
x
p1 * n 2
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.
“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
p 2 *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
Analysis from the point of view
of the shareholders of B
n1 * p1 n 2 * p 2 n 2 * C S
p 2 *x C
n1 x * n 2
• 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.
• If there is higher synergy, then the shareholders of B will not mind
LARSON-GONEDES EXCHANGE
RATIO DETERMINATION MODEL