modalities of payment detailed

1. Modalities of Payment

2. 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

3. Cash Consideration
 Advantages:
 Speed of getting transaction done
 Liquidity: sellers usually prefer cash
 Disadvantages:
 Difficulty in arranging it from buyer’s viewpoint
 From seller’s viewpoint:
 capital gains tax is not deferred
 no continuing equity interest in combined firm

4. Sources of Acquisition of Cash
 Commercial banks:
 Terms depend on creditworthiness of borrower/ transaction
structure
 Are senior, and secured
 May have fixed or floating interest rates
 Restrictive covenants
 Investment banks:
 may provide bridge loans: however, may be risky
 Mostly syndicate funding
 Private Equity Funds
 Internal accruals or raise public equity

5. 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 amongst
shareholders of bidder and target firm
 Convertible Preferred Stock: currently CCPS is a
more common mode of issuance in PE transactions

6. Deferred Pay Securities
 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

7. Contingency Payments
 Some payment is made initially
 More future payments are linked to target achieving
some financial milestones
 Advantages:
 Helps sort out differences of opinion about future
financial prospects of target firm and hence of
purchase 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

8. Theories of Effect of Method of Payment
on Abnormal Returns
 Taxes:
 cash payment does not allow tax deferment by target firm
shareholders, thus extra premium may have to be paid on
cash offers
 However allows assets to be carried to books of acquirer
on stepped up basis, thus giving it higher depreciation
benefit, and lower capital gains at the time of sale
 Information Effects and Signaling:
 stock payment may signify that bidder’s equity is
overvalued
 cash payment normally sends more positive signals than
stock payment

9. Other Theories
 Managerial Ownership Proposition: stock offer is preferred by
target to ensure its continuing control on management of
combined firm; acquirer may prefer cash payment for similar
reasons
 Growth Opportunity Proposition: acquirer would avoid cash
payment, if it has other investment opportunities to invest into
 Relative Size Proposition: bigger size of target may motivate
share financing by acquirer
 Business Cycle Proposition: good stock market performance
leads to share financing

10. 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

11. 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 transferor
become 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 transferee
company

12. 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 entity’s 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 goodwill
account
 All reserves (except statutory reserves) are clubbed in the equity capital, and
lose their identity in the combined B/S
 Amalgamation adjustment A/c is created to transfer the amount of statutory
reserves

13. Tax Implications
Taxable transaction
 Payment by cash/ non
equity form
 Acquiring firm:
 Assets are allowed to be
carried at stepped up basis,
thus higher depreciation
amount claimed and lower
capital gains shown on sale
 Loss of net operating loss set
off and tax credits
 Acquired firm’s
shareholders pay
immediate tax, hence may
demand a premium to
compensate this
Tax free transactions
 Payment through exchange
of stock
 Acquiring firm:
 Assets carried at book
values, not stepped up
basis
 Benefits of net operating
loss set off, tax credit
carryovers, are allowed
 Acquired firm’s
shareholders benefit by tax
deferment

14. 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