Financial engineering : Question 9
What is the basis used for calculating the exchange ratio of two shares during a public exchange offer? When the target company is bigger than the acquiring company, are there any problems (theoretical or practical) that arise? What sort of calculations need to be made to determine dilutive or accretive mechanisms?

In practice, a public exchange offer or non-cash merger requires first that the shares of the target company (A) be valued. Then the acquiring company (B) must be valued, since it must issue new shares to the target’s shareholders. Shares are then exchanged (x shares in Company A for y shares in Company B), on the basis of the exchange ratio set out in a valuation report on the shares of the two companies.

The difficulty is not so much in determining the per-share value of the companies as in establishing the relationship that will serve as the basis for the exchange. We’re not interested in calculating absolute values, but relative values. There is thus a direct link between the exchange ratio and the relative financial values that result from the relationship between the two companies. The relative size of the two companies is in itself not an issue.

In order to determine this relative value, a full valuation of the two companies must be made (see discounted cash flows and comparable methods described in chapter 40 of the Vernimmen). It is customary in the mergers and acquisitions business to examine the impact of the exchange ratio on the performance metrics generally monitored by the market, in order to analyse the mechanical impact of the merger on these criteria on which investors keep a very close watch. The most frequently used reference metrics are net income, cash flow, dividends, market capitalisation and shareholders’ equity.

When a share exchange takes place, if the relative value for a given reference metric of one company is greater than the relative value calculated, the shareholders of that company will benefit. The inverse is also true – if the relative value for a given reference metric of one companies is lower than that of value arrived at by comparing the reference metrics, the value on this reference metric will be diluted.

For more information, see chapter 43 of the Vernimmen.