Financial engineering : Question 4
What are the different types of financing that can be used during a merger or an acquisition? How is arbitrage between these different types of financing possible? What is the most frequently used today?

When mergers happen, the issue of financing does not arise. By definition, consideration is in the form of shares since one of the companies (the acquiring company) takes over the other (the target company) and offers shareholders of the target company shares in the acquiring company in exchange for their shares in the target company, at a ratio known as the exchange ratio. For more information, see chapter 43 of the Vernimmen.

For acquisitions however, financing is an issue. The acquiring company may use ready cash that the group has available (unusual except when the target is very small), or raise financing through a capital increase (i.e. increasing shareholder equity) or by borrowing (bank loan or bond issue) or a mix of the two.

Choosing between equity and debt when financing an acquisition is no different from choosing between equity and debt for financing an investment. All will depend on the shareholders’ risk aversion (if they’re not keen on risk, they’ll use equity to finance the acquisition, otherwise they’ll use debt), on the market situation (it may sometimes be impossible to carry out capital increases when the stock markets are declining as in 2002, on whether shareholders wish to see their power diluted in the event of a capita increase, etc.

The cost of financing does not play a major role, as focusing too much on this factor will result in the risk dimension being overlooked – even though debt is always cheaper than equity, it is also always more risky. For more information, see chapter 43 of the Vernimmen.