Ishan Goyal/Jashan Deep Singh 1

METHODS OF PAYMENT
28/08/2017 Submitted By:- Ishan Goyal/Jashan Deep Singh
 Contents
2

Introduction
Considerations while choosing method of payment
Choices of methods of payment
Theories and studies
Asset vs Stock purchases: Advantages and
disadvantages
Conclusion
questions
References

Ishan Goyal/Jashan Deep Singh 11/6/2017

 Introduction
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Mergers & Acquisitions(M&A) are part of the life cycle of any

business. They can help businesses expand, acquire new
knowledge, move into new areas, or improve their output with
one simple transaction.

But along with these benefits and opportunities comes great

expense for both parties. A standard M&A deal will usually
involve lawyers, administrators, and investment banks.

Theres no doubt about it mergers and acquisitions are

expensive, and without huge amounts of spare cash on hand,
companies will have to seek out alternative financing options in
order to pay for their transactions.

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There are a number of different methods for financing

mergers and acquisitions, and the chosen method will
depend not only on the state of the company, but also
on overall activity in M&A and finance at the time of
the transaction.

The two most common currencies for payments in

corporate mergers and acquisitions are cash and stock.
Some mergers involve all cash and some all stock, but a
mixture of both currencies is also widely observed.
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 Considerations while choosing method
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of payment
Managerial ownership and ownership structure

Managerial ownership refers to the percentage of equity held by the

firms management who are the insiders of the firm

Stulz (1988) investigates the association between target managerial

ownership and payment methods in M&As

His finding suggests that the larger the fraction of ownership held by
target management, the more likely the transaction will be financed by
cash

Consistent with result of Stulzs (1988), Grullon, Michaely and Swary

(1997) find that cash offer is a positive function of target managerial
ownership

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Free cash flows and tax considerations

There are generally two ways for a firm to distribute cash to its shareholders one is paying cash
dividends and the other is repurchasing shares from the stock market.

Cash dividend payouts are liable to immediate tax, Two implications arise consequently. First,
paying dividends may not be desirable in the interest of shareholders as well as management. An
alternative way to use generated cash is to engage in acquisition activities, Second, as suggested
by Wansley, Lane, and Yang (1983), acquirers may be prepared to pay a higher premium for
target shareholders in order to compensate for their additional tax payment when cash offer is
employed.

However, even if cash offer requires the acquirer to pay a higher premium under the tax
consideration, share exchange remains unfavorable for a number of reasons. Cash offer generally
takes a shorter time to complete the deal compared with share exchange and share exchange
inevitably increase the number of outstanding shares, and therefore dilute the reported earnings
after the deal is completed.

Therefore, it is the amount of free cash in hand and its tax implications, but not tax itself, that
influence the choice of payment methods
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Corporation performance and growth opportunities

The choice of payment methods in M&As may also be linked to

the pre-acquisition performance of both acquirers and targets

A firm with bad performance is liable to be attacked, thereby

being an acquisition target. In contrast, when a firm performs well
and given it has ambitions to expand its business, it is prone to be
an acquirer

There are several proxies to measure the performance of a firm:

market value to book value, Tobins Q, dividend yields, and return
on equity, with different perspectives

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In a sense, Tobins Q and market value or the market to book ratio share
the same insight about corporate performance with reference to firm
growth. While return on equity and dividend yields focus on return to
shareholders

Martin (1996) finds that acquiring firms with greater growth

opportunities, i.e., higher Tobins Q values, are more likely to employ the
share exchange method. The reason behind this phenomenon is that
excess cash can be reversely proportional to growth

Bad performance of a firm means it is poorly managed, which can be

characterized by a low level of return on equity. Under such
circumstances, the well-performed firm (acquirer) is likely to acquire its
less-performed rival (target) and prefers using cash offer in the
transaction. By doing so, the acquirer can totally eliminate the inefficient
management team of the target firm
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Stock market performance and business cycles

Stock market performance may be strongly related to the choice
of payment methods in corporate M&As. In fact, the merger wave
has, globally and historically, coincided with stock market booms

Moore (1980) documents that share exchange is more frequently

employed than cash offer in the expansionary phase of business
cycles. Martin (1996) claims that share exchange in acquisitions is
positively associated with the performance of the stock market

A booming stock market means buoyant profitability for firms.

Under such circumstances, the shares of potential acquirers seem
to be more attractive than cash when offered for consideration

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Relative size

Martin (1996), Grullon, Michaely and Swary (1997), and

Ghosh and Ruland (1998) have linked the choice of
payment methods to the relative size of the target to the
acquirer

However, their empirical results are mixed. Martins (1996)

descriptive statistics show that the relative size is an
important factor in determining payment methods, while his
multinomial logistic model does not yield the same result as
his descriptive statistic analysis
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By examining US bank mergers, Grullon, Michaely and Swary (1997)

document the results contrary to Martins (1996). They use the similar
multinomial logistic model in the study and find that the relative size of
target banks to acquiring banks is one of the most important
determinants in choosing payment methods. Their results indicate that the
bigger the relative size of the target to the acquirer, the more probably
the merger is financed by share exchange rather than cash offer.

When examining the effects of the relative size on the choice of

payment methods, Ghosh and Ruland (1998) find that the results from
both descriptive statistics and multinomial logistic model show no
significant difference in the three payment methods with regard to the
relative size variable. Accordingly, they conclude that there is no direct
association between the choice of payment methods and the relative
size of the target to the acquirer.

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Methods of payment consideration
By issue of equity shares of the acquirer company
By issue of preference shares of the acquirer
company
By issue of secured debt instruments of the acquirer
company
By payment in cash
By any combination of the above
Issue of equity shares
In this method an acquirer company issues its shares
to the shareholders of the target company in
exchange of the shares of the target company in a
specified ratio known as swap ratio.
Swap ratio or exchange ratio is simply the ratio of
the price offered for acquiring of one equity share
of the target company divided by the valuation of
one equity share of the acquirer company.
Issue of preference shares of the
acquirer company
When negotiated block deal enters into by the
acquire company with the existing promoters or
institutional shareholders prior to the open offer
Regulated by SEBI
Generally not allowed by the regulatory
Issue of secured debt instruments of the
acquire company
When debt instruments are listed on a stock
exchange with national trading providing liquidity
Chances of acceptance of such instruments instead
of cash would be better if the company resorts to
differential pricing
Payment in cash
Most favoured method
Clean and transparent
In cash transactions the acquiring shareholders thae
on the entire risk of the expected synergy value
embedded in the acquisition premium not
materialising.
 Theories and studies
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Theory of asymmetric information: the asymmetric

information theory hypothesizes that due to
information asymmetry between managers and
investors, shares could be over or under-valued.

The managers, acting in the interests of existing

shareholders have an incentive to issue shares if they
are overvalued. If this theory were right, we would
expect managers to pay in stock rather than cash in
context of acauisitions.

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 Theories and studies
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Theory of Myers and Majluf (1984) argues that

when the firm sells common stock to finance a new
project, it is because the managers judge the
common stock to be overvalued. When the firm uses
debt to finance a new investment, this implies that
management judges its common stock to be
undervalued.

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 Basic Structures
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Asset purchases Stock purchases Mergers

Taxable Taxable Statutory mergers

Non taxable Non taxable Stock for stock
buyouts Roll Stock for assets
Spin offs ups/Consolidations Reverse
buyouts mortagages

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 Asset vs Share purchases
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Directly influenced by the tax structure

Share added value (SAV)
Net operating losses (NOLs)

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 Stock purchase
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Buyers perspective Advantages

Tax attributes carryover to buyer (eg NOL)
Avoids many of the restrictions imposed on sales of
assets in loan agreements and potential sales tax
Preserves he right of the buyer to use sellers name,
licenses and permits
No changes in corporations liability,
unemployement
Nontransferable rights or assets

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The sellers perspectives: advantages

Taxed only on the sale of stock
All obligations and non transferable rights can be
transferred to the buyer
Gain/loss is usually capital in nature
If stock held by individuals in IRC Section 1244 stock and is
sold at a loss, the loss is generally treated as ordinary
May permit sellers to report gains from sale of stock on the
installment basis
Does not leave the seller with the problem of disposing of
assets which are not bought by the purchaser
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The buyers perspective: disadvantages

Less flexibility to cherry pick key assets of the seller
The buyer may be liable for unknown, undisclosed
or contingent liabilities
Normally does not terminate labor union collective
bargaining agreements

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The sellers perspective: disadvantages

Offer and sale of the companys securities may
need to be registered under certain circumstances
Seller cannot pick and choose assets to be retained
May not use the corporations net operating loss
and credit carry forwards to offset gain on sale

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 Asset purchases
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The buyers perspective: advantages

The buyer can be selective as to which assets of the
target will be purchase
The buyer is generally not liable for the sellers
liablities
Buyers are generally free of any undisclosed or
contingent liablities
Buyers may elect new accounting methods

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The sellers perspective: advantages

Sellers maintain corporate existence
Ownership of nontransferable assets or rights
Corporate name and goodwill can generally be
maintained
Corporations tax attributes( NOL CCf)

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The buyers perspective: disadvantages

No carry over of seller corporations tax attributes
Non transferrable rights or assets cannot be
transferred to buyers
Transaction is more complex and costly
Lenders consent may be required to resume liability

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The sellers perspective: disadvantages

Double taxation if the corporation also liquidates
Transaction is more coplex and costly
A variety of third party consents will typically be
required

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 conclusion
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It is the internal as well as the external factors of

the firm that effects the choice of method of
payment. The ultimate target is to remain on a gain
side of the deal with past, present and future
perspectives. Thus it is not feasible to put the firm
strictly into predefined strategies rather than
building a new one.

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 Questions
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What are the determinants of methods of payment?

What are advantages and disadvantages of asset
purchase?
What are statutory mergers?
What is theory of asymmetric information?

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 References
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Franks, J., Harris, R., and Mayer, C., 1988. Means of Payment in Takeovers:
Results for the United Kingdom and the United States, in Alan J. Auerbach
(ed.), Corporate Takeovers: Causes and Consequences, University of
Chicago Press, 221-258

Ghosh, A., and Ruland, W., 1998. Managerial Ownership, the Method of
Payment for Acquisitions, and Executive Job Retention, Journal of Finance
53, 785-798.

Grullon, G., Michaely, R. and Swary, I., 1997. Capital Adequacy, Bank
Mergers and the Medium of Payment, Journal of Business Finance &
Accounting 24, 97-124.

https://www.idealsvdr.com/blog/methods-of-financing-mergers-and-
acquisitions/

Ishan Goyal/Jashan Deep Singh 11/6/2017