Exchange Ratio
What Is the Exchange Ratio?
The exchange ratio is the relative number of new shares that will be given to existing shareholders of a company that has been acquired or that has merged with another. After the old company shares have been delivered, the exchange ratio is utilized to give shareholders similar relative value in new shares of the merged entity.
Figuring out the Exchange Ratio
An exchange ratio is intended to provide shareholders with the amount of stock in an acquirer company that keeps up with the equivalent relative value of the stock the shareholder held in the target, or acquired company. The target company share price is commonly increased by the amount of a "takeover premium," or an extra amount of money an acquirer pays for the right to buy 100% of the company's outstanding shares and have a 100% controlling interest in the company.
Relative value doesn't mean, in any case, that the shareholder receives similar number of shares or same dollar value in view of current prices. All things considered, the intrinsic value of the shares and the underlying value of the company are thought about while thinking of an exchange ratio.
Computing the Exchange Ratio
The exchange ratio just exists in deals that are paid for in stock or a mix of stock and cash rather than just cash. The calculation for the exchange ratio is:
The target share price is the price offered for the target shares. Since both share prices can change from the time the initial numbers are drafted to when the deal shuts, the exchange ratio is typically structured as a fixed exchange ratio or a floating exchange ratio.
A fixed exchange ratio is fixed until the deal closes. The number of issued shares is known yet the value of the deal is obscure. The obtaining company favors this method as the number of shares is known consequently the percentage of control is known.
A floating exchange ratio is where the ratio drifts with the goal that the target company receives a fixed value regardless of the changes in price shares. In a floating exchange ratio, the shares are obscure yet the value of the deal is known. The target company, or seller, favors this method as they probably are aware the specific value they will receive.
Illustration of the Exchange Ratio
Envision that the buyer of a company offers the seller two shares of the buyer's company in exchange for one share of the seller's company. Prior to the announcement of the deal, the buyer's or alternately acquirer's shares might be trading at $10, while the seller's or alternately target's shares trade at $15. Due to the 2 to 1 exchange ratio, the buyer is successfully offering $20 for a seller share that is trading at $15.
Fixed exchange ratios are typically limited by covers and floors to reflect extreme changes in stock prices. Covers and floors keep the seller from getting essentially less consideration than anticipated, and they in like manner keep the buyer from surrendering fundamentally more consideration than anticipated.
Post announcement of a deal, there is normally a gap in valuation between the seller's and buyer's shares to mirror the time value of money and risks. A portion of these risks incorporate the deal being blocked by the government, shareholder dissatisfaction, or extreme changes in markets or economies.
Exploiting the gap, accepting that the deal will go through, is alluded to as merger arbitrage and is rehearsed by hedge funds and different investors. Utilizing the model above, expect that the buyer's shares stay at $10 and the seller's shares leap to $18. There will be a $2 gap that investors can secure by buying one seller share for $18 and shorting two buyer shares for $20.
Assuming that the deal closes, investors will receive two buyer shares in exchange for one seller share, closing out the short position and leaving investors with $20 in cash. Minus the initial outlay of $18, investors will net $2.
Features
- The exchange ratio works out the number of shares an obtaining that company needs to issue for each share an investor possesses in a target company to offer a similar relative benefit to the investor.
- There are two types of exchange ratios: a fixed exchange ratio and a floating exchange ratio.
- The intrinsic value of the shares and the underlying value of the company are thought about while concocting an exchange ratio.
- The target company purchase price frequently incorporates a price premium paid by the acquirer due to buying 100% control of the target company.
