The Fundamentals of Exchange Ratios
The exchange ratio represents the relative number of new shares that will be allocated to existing shareholders of a company that has either been acquired or merged with another company. This ratio is meant to offer shareholders the same relative value in new shares post-merger or acquisition.
Key Takeaways
- Calculation Basis: The exchange ratio determines how many shares an acquiring company needs to provide for each share an investor owns in the target company, ensuring the investor receives equivalent relative value.
- Purchase Premium: Oftentimes, the target company’s purchase price includes a premium, reflecting the value of acquiring 100% control of the target company.
- Intrinsic Value Considerations: While calculating the exchange ratio, the intrinsic value of the shares and the underlying value of the companies involved are crucial factors.
- Types of Exchange Ratios: There are two primary types of exchange ratios - fixed and floating.
Understanding the Exchange Ratio
An exchange ratio is engineered to provide shareholders of the target company with stock in the acquiring company that maintains the same relative value as their former stocks. This does not necessarily mean they will get the same number of shares or the same dollar value based on current prices. Instead, the ratio is determined by the intrinsic value of the shares and the intrinsic worth of the company.
Calculating the Exchange Ratio
The exchange ratio is relevant in deals settled with stock or a combination of stock and cash, rather than purely cash transactions. The formula for the exchange ratio is:
1Exchange Ratio = Target Share Price / Acquirer Share Price
Share prices can fluctuate from the time the deal is proposed to when it closes. As a result, the exchange ratio can be structured as either a fixed or a floating ratio.
Fixed Exchange Ratio
A fixed exchange ratio sets a static number of new shares to be issued until the deal concludes. Although the exact value of the deal remains unknown, the acquiring firm can predict the exact number of shares it will issue, maintaining clarity on the percentage of control received.
Floating Exchange Ratio
A floating exchange ratio assures the target company a fixed value regardless of share price variations. Here, the precise number of shares to be issued is unknown, but the monetary value of the deal is certain, providing predictability for the target company.
Example of the Exchange Ratio in Action
Consider a scenario where a company, ‘Acquirer Co.’, offers to exchange two of its shares for every one share of ‘Target Co.’. Assume Acquirer Co.’s shares are priced at $10 each, while Target Co.’s shares trade at $15. By offering a 2:1 ratio, Acquirer Co. is essentially offering $20 for each share of Target Co., which is currently worth $15.
Addressing Fluctuations: Caps and Floors
Fixed exchange ratios often deploy caps and floors to buffer against extreme stock price changes. These mechanisms prevent the seller from gaining substantially less or the buyer from surrendering significantly more value than anticipated.
Merger Arbitrage Opportunities
Upon announcing the deal, a gap often arises between the buyer’s and seller’s stock valuations, attributed to the time value of money and risk factors such as potential government intervention, shareholder disapproval, or economic changes. This creates an opportunity for merger arbitrage. For instance, if Acquirer Co.’s shares drop to $10 while Target Co.’s shares rise to $18, investors can exploit this by purchasing Target Co. shares and shorting Acquirer Co. shares, netting a profit if the deal proceeds as expected.
Related Terms: intrinsic value, target company, acquirer, merger arbitrage, hedge funds, share price, time value of money
