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Frequently Asked Questions: Financial engineering

Question 1: Could you explain the procedures involved in a merger?

Question 2: How are mandatory convertible bonds treated during merger operations?

Question 3: What are the advantages and drawbacks of securitisation and defeasance, in terms of risk and valuation?

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?

Question 5: What is the difference between a capital increase and the par value of new shares issued?

Question 6: How then do you calculate the capital increase and the share premium for the company benefiting from the transfer? What happens if the value of the shares of the company benefiting from the transfer is worth less than their par value (e.g. par value = 100 and market value = 20)?

Question 7: What are the precise reasons why a share buyback results in an increase in EPS when inverse P/E is higher than the cost of debt after tax?

Question 8: What is the average control premium paid in takeovers, and what are the factors that determine this premium?

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?

Question 10: What are the financial, tax and legal constraints involved in a merger between the target company and the acquirer’s holding company in LBOs?

Question 11: What advantages are there for a group in spinning off its divisions into subsidiaries?
Can this be considered to be a defence against a takeover?

Question 12: What are the respective advantages of a public purchase offer and a public exchange offer? Which would be better for the target company and which for the initiator of the takeover?

Question 13: What are the advantages of UCITS over direct investments, and how do they work?

Back to Questions and answers

Question 1:

Could you explain the procedures involved in a merger?

Réponse:

A merger generally involves the following three steps:

1. Negotiation of the exchange ratio which will determine the share of each shareholder group in the new entity. The ratio is expressed as a given number of shares in Company A for a given number of shares in Company B.

2. Legal implementation of the link-up – drafting of merger agreement, report by special mergers auditor on the fairness of the exchange ratio, holding of EGMs by the shareholders of both companies which must approve the operation by a majority, in France, Russia or Denmark of 66.7% of votes; in the UK, Germany or Belgium of 75% of votes.

3. Implementation of the merger by combining the operations and human resources of the two entities which have now become a single entity.
For more details, see chapter 43 of the Vernimmen.

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Question 2:

How are mandatory convertible bonds treated during merger operations?

Réponse:

After a merger, the yield on mandatory convertible bonds remains the same and there is no reason to change it, unless the parties (the issuer and holders of mandatory convertible bonds) decide otherwise, since the yield on a mandatory convertible bond is an interest rate that is independent from the dividend.


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Question 3:

What are the advantages and drawbacks of securitisation and defeasance, in terms of risk and valuation?

Réponse:

The securitisation of assets provides a financial institution or a company with ready cash, and, if applicable, enables it to remove it from its balance sheet. Accordingly, securitisation enables a company to reduce the total balance sheet and improve the weighted debt / equity ratio, one of the ratios that banks keep a very close eye on. This said, the cost of these arrangements is higher than that of straight debt, especially for a high-quality borrower.


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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?

Réponse:

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 focussing 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 47 of the Vernimmen.

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Question 5:

What is the difference between a capital increase and the par value of new shares issued?

Réponse:

You have to understand that behind the term capital increase, there are two ideas that should not be confused:
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Question 6:

How then do you calculate the capital increase and the share premium for the company benefiting from the transfer? What happens if the value of the shares of the company benefiting from the transfer is worth less than their par value (e.g. par value = 100 and market value = 20)?

Réponse:

Be careful not to confuse the estimated market value of the transferred assets, with the book value at which the assets are transferred, from a legal and accounting standpoint. These are two different things.

Once the financial value of the transferred assets is determined, you only have to divide this value by the unit value of the shares of the company benefiting from the transfer, in order to determine the number of shares that will be issued as consideration for the transfer, let’s say a million.

Next, you choose a transfer value which will be the legal and accounting value which will appear on the books of the company benefiting from the transfer. This can be the book value of the assets, their estimated market value or an intermediate value. Let’s say 100 million. Each newly created share will then have a book value of 100/1 = €100, which will be split into €10 of share capital (if the par value of the company receiving the transfer is €10, for example) and €90 of share premium. However, in finance, the 10 / 90 split is not important. The only thing that counts in finance is the number of shares issued.

If the market value of the shares of the company receiving the transfer is less than their par value, this is most likely because the company was making losses and there are loss-carryforwards. In such cases, these losses must first be set off against the amount of the share capital, which results in a reduction of the par value of the shares, and thus solves the problem.

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Question 7:

What are the precise reasons why a share buyback results in an increase in EPS when inverse P/E is higher than the cost of debt after tax?

Réponse:

P/E is equal to the value of shares divided by net profits. Inverse P/E corresponds to an instantaneous book return on an investment. If a company is worth 100 with net profits of 5, its P/E is 20. The inverse of 20 is 5%, which is the dividen return you get when you pay 100 per share, while the net profit for the shareholder is 5.


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Question 8:

What is the average control premium paid in takeovers, and what are the factors that determine this premium?

Réponse:

The average premium paid in takeovers is around 25 to 30%. This is obviously just an average, and premiums can be much larger or smaller.

The theoretical basis for this control premium is the present value of synergies (increase in sales, reduction in costs, etc.) that the link-up should generate. The acquiring company is thus prepared to pay a premium, as it will manage the target is such a way as to ensure that the profits made by the business combination of the target and the acquiring company will be higher after the link-up than they are today.

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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?

Réponse:

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.


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Question 10:

What are the financial, tax and legal constraints involved in a merger between the target company and the acquirer’s holding company in LBOs?

Réponse:

Financial constraints: if there are minority shareholders in the target company, a merger will dilute the stake of the holding company’s shareholders significantly. This is because the holding company’s debt has made the value of their shareholding small compared with the value of the target company;


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Question 11:

What advantages are there for a group in spinning off its divisions into subsidiaries?
Can this be considered to be a defence against a takeover?

Réponse:

Firstly, if a division is spun off into a subsidiary, its real earnings, which are otherwise drowned in the sea of the parent company’s results, become clearly visible. This makes it easier to get the managers of the division to take more responsibility and to involve them financially in the company, through a share in the capital, stock options, etc., which sooner or later will be bought back by the parent company, unless the spun off division goes public. The key advantages here are management control and staff motivation.


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Question 12:

What are the respective advantages of a public purchase offer and a public exchange offer? Which would be better for the target company and which for the initiator of the takeover?

Réponse:

Briefly, a share exchange offer is generally a more friendly way of linking up than a takeover through the purchase of the target's shares, but this is not always the case (Vodafone/Manesmann, Sanofi/Aventis). The acquirer does not have to pay out cash and take out debt simultaneously, and in most countries, the shareholder of a target that accepts the offer, does not have to pay capital gains tax.

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Question 13:

What are the advantages of UCITS over direct investments, and how do they work?

Réponse:

UCITS (unit trusts or mutual funds) have two advantages over a direct investment.

1. They make it easier to diversify risks – when you’ve only got 1,000 euros, it may be difficult to put together a very diversified portfolio which reduces risk without sacrificing earnings, but this is not a problem when you own a share in a UCITS, as you hold 0.000001% of a highly diversified portfolio
2. UCITS are managed by professionals who have a better understanding of financial mechanisms than the ordinary retail investor (usually, there may be exceptional cases!), and have access to more information more quickly. Logically, they should perform better than any investment made by an ordinary retail investor, which justifies the fee charged to holders of shares in UCITS.

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