A bidder has agreed a price. Now it must decide how to pay: with its own shares, with cash raised from borrowing, with loan stock, or with a mix. The same headline price can leave the bidder’s shareholders better or worse off depending on the answer. Paying in shares shares the gains and risks with the target’s owners.
Paying in cash financed by debt keeps the gains but adds gearing and gives tax relief on the interest.
This topic covers the purchase consideration, all-share offers and their effect on earnings per share and value (with and without synergy), cash and debt consideration and the tax shield, and why hostile bids usually need cash. The previous topic covered valuation for mergers and acquisitions. The next covers capital reconstructions. The May 2014 Pathfinder paper tested a share exchange calculation.
In 30 seconds
The purchase consideration can be shares, cash (from reserves, a share issue or borrowing), debt securities or a mix. Shares to issue = offer value ÷ bidder’s share price. An all-share deal moves value between the two sets of shareholders.
If the price paid is on a higher P/E than the bidder’s and there is no growth in combined profit, the bidder’s shareholders lose and the target’s gain. Synergy (higher combined earnings) can make both gain. Cash or debt consideration keeps all gains with the bidder’s shareholders and brings tax relief on interest, but raises gearing, so the P/E may change.
In a hostile bid, an all-cash offer is more likely to succeed because target holders may not want shares in the bidder.
Key terms in plain English
| Term | What it means |
|---|---|
| Purchase consideration | What the bidder gives the target’s shareholders: shares, cash or debt |
| Share exchange ratio | New bidder shares offered for each target share |
| All-share offer | A deal paid wholly in the bidder’s new shares |
| Earnings per share (EPS) | Profit attributable to each ordinary share |
| Tax shield on interest | The tax saved because interest is deductible |
Syllabus check
This topic is in syllabus area D (mergers and acquisitions, organic growth and reconstruction). It covers:
- methods of financing mergers and takeovers;
- the benefits of mergers and acquisitions to shareholders.
CAMA 2020 and acquisition finance
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 149 | The board may allot shares only with express authority from the company in general meeting or under the articles | Issuing shares as the purchase consideration |
| s. 142 | Existing shareholders of a private company must first be offered new shares in proportion to their holdings, and have 21 days to accept | Share consideration in a private company |
| s. 154(1) | A company limited by shares must file a return of allotment with the CAC within 15 days | After the new shares are issued |
| s. 127 | A company may increase its issued share capital by allotting new shares | Funding a deal with a share issue |
The purchase consideration
A takeover can be paid for by issuing new shares to the target’s holders, from cash (existing resources, a new share issue or borrowing), or by debt securities, or a mix. ICAN’s example: X offers 3 new shares for every 2 in Y, which has 500,000 shares. X issues 750,000 shares. At ₦4 each, the price is ₦3,000,000. X could instead pay ₦2m in cash and give loan stock for the rest.
The total price and the form of payment are negotiated in a friendly bid, and the target’s directors recommend the terms. In a hostile bid, an all-cash offer is more likely to win, because the target’s shareholders may not want to keep an investment in the bidder.
All-share consideration
When shares are the consideration, one set of shareholders gains value at the expense of the other. A takeover destroys value for the bidder’s shareholders when all these hold:
- the consideration is all shares
- the price is on a higher P/E than the bidder’s
- combined profit does not rise
ICAN’s example. A earns ₦800,000 with 1m shares (EPS ₦0.80) at a P/E of 10, so its shares are ₦8. B earns ₦400,000 with 1m shares at a P/E of 9 (₦3.60). A offers ₦4.40 a share (₦4.4m, a P/E of 11) in A shares.
- New shares.
4.4m ÷ 8 = 550,000 (11 new A shares for 20 B shares).
A then has 1,550,000 shares. - Combined profit ₦1.2m at a P/E of 10 = ₦12m, or ₦7.74 a share.
- A’s original holders.
1,000,000 × 7.74 = ₦7.74m against ₦8.00m, a loss of ₦0.26m.
B’s former holders: 550,000 × 7.74 = ₦4.26m against ₦3.60m, a gain of ₦0.66m.
With synergy: if earnings rise by ₦200,000 to ₦1.4m at a P/E of 10, value = ₦14m, or ₦9.03 a share. A’s holders gain ₦1.03m (9.03m against 8.00m) and B’s holders gain ₦1.37m (4.97m against 3.60m). Both gain because earnings grow.
Cash or debt consideration
Paying in cash raised by borrowing, or in debt securities, gives tax relief on interest. Target holders may want cash. ICAN’s example: the same ₦4.4m is paid in cash from an 8% loan. Tax is 25%, no synergy, P/E stays at 10.
- Combined profit.
800,000 + 400,000 = ₦1,200,000. - Interest = 4.4m × 8% = ₦352,000
tax relief at 25% = ₦88,000
net cost = ₦264,000. - Earnings = ₦936,000, value = 936,000 × 10 = ₦9,360,000 against ₦8,000,000, a gain of ₦1,360,000 for A’s shareholders, who still own 1m shares.
The company is now geared, so its cost of capital and P/E may change. Even so, debt-financed takeovers can add wealth through the interest tax relief.
Choosing the consideration
- Shares: no cash outflow and no extra gearing; target holders share in synergy and risk; dilutes the bidder’s holders and may lose value if the price is on a high P/E.
- Cash from borrowing: bidder’s holders keep all the gain; tax relief on interest; more financial risk and a possible fall in the P/E; the bidder must be able to raise the debt.
- Cash from a share issue: keeps the target’s holders out but costs issue expenses.
- Loan stock: defers cash, but target holders get a fixed claim and may not like it.
The rules in more depth
Why the P/E matters
If the bidder issues shares priced on a high P/E to buy earnings priced on a lower one, each share it issues buys fewer earnings than it carries, which dilutes EPS.
Why synergy changes the result
Higher combined earnings lift the value of the enlarged company, so the gain is shared and both sides can win.
Why cash is attractive to a hostile target’s holders
They are leaving. Shares in the bidder keep them tied to a company that took over theirs.
Why gearing changes the P/E
More debt raises financial risk, so the market may require a higher return and so a lower multiple.
Effect on analysis
Compute new shares, combined earnings and EPS, test the value per share and check who gains, with and without synergy.
Worked examples
Example 1: shares to issue. A bidder’s share price is ₦30. It offers ₦360m for a target.
- Shares = 360m ÷ 30.
- New shares = 12m.
- These go to the target’s shareholders.
Example 2: EPS after a share deal. The bidder earns ₦100m on 50m shares (EPS ₦2.00) at a P/E of 15. The target earns ₦30m. The bidder issues 12m shares.
- Combined earnings = ₦130m; shares = 62m.
- EPS = 130 ÷ 62 = ₦2.10, up 4.9%.
- The price paid is 360 ÷ 30 = a P/E of 12, below the bidder’s 15, so EPS rises.
Example 3: cash from debt. The same deal is paid for with ₦360m borrowed at 10%. Tax is 25%.
- After-tax interest.
360 × 10% × 0.75 = ₦27m. - Earnings = 130 − 27 = ₦103m on 50m shares.
- EPS = ₦2.06, up 3.0%, with more gearing.
Example 4: who gains. A target’s P/E at the offer is 14 and the bidder’s is 10. All-share, no synergy.
- The bidder pays more earnings-multiple than it uses to value itself.
- EPS falls and the bidder’s shareholders lose.
- Only synergy or a rise in the P/E can reverse this.
How to score full marks
- Compute the shares or cash needed.
- Show combined earnings, shares, EPS and value per share.
- Split gains between the two groups of holders.
- Test with and without synergy.
- For debt, use after-tax interest and note the gearing effect.
- Link the consideration to the type of bid.
Common mistakes in the exam
- Dividing by the target’s share price instead of the bidder’s.
- Forgetting to add the new shares to the share count.
- Ignoring tax relief on interest.
- Assuming the P/E stays the same after heavy borrowing.
- Saying a share deal never dilutes.
- Forgetting that cash can be unattractive for tax reasons to target holders.
Quick revision
- Consideration: shares, cash, debt or a mix.
- New shares = offer value ÷ bidder’s price.
- All-share with higher P/E and no synergy: bidder’s holders lose.
- Synergy lets both sides gain.
- Cash from debt: tax relief but gearing; hostile bids prefer cash.
- CAMA 2020: ss. 127, 142, 149, 154(1).
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. Shares to issue in an all-share offer equal:
- Offer value ÷ bidder’s share price
- Offer value ÷ target’s share price
- Offer value × P/E
- Earnings ÷ offer
Show the answer
A. They are the bidder’s shares.
Question 2. An all-share deal at a higher P/E than the bidder’s, with no synergy, tends to:
- Lose value for the bidder’s shareholders
- Gain value for them
- Leave EPS unchanged
- Raise the P/E
Show the answer
A. EPS is diluted.
Question 3. Synergy in a share deal can:
- Allow both sets of shareholders to gain
- Remove all risk
- Cancel the tax
- Lower earnings
Show the answer
A. Combined earnings rise.
Question 4. Paying with debt-financed cash gives:
- Tax relief on interest
- No change in gearing
- Lower risk
- Dilution
Show the answer
A. But gearing rises.
Question 5. A hostile bid is more likely to succeed with:
- An all-cash offer
- An all-share offer
- Loan stock only
- No offer
Show the answer
A. Target holders may not want shares.
Question 6. X offers 3 new shares for 2 of Y’s 500,000 shares. New shares issued:
- 750,000
- 333,333
- 1,500,000
- 500,000
Show the answer
A. 500,000 × 3 ÷ 2.
Question 7. After a debt-financed takeover, the P/E may:
- Change because of higher gearing
- Never change
- Double
- Equal the interest rate
Show the answer
A. Financial risk rises.
Question 8. Loan stock as consideration:
- Defers cash but gives target holders a fixed claim
- Gives votes
- Is free
- Removes tax
Show the answer
A. Some holders dislike it.
Question 9. EPS after a share takeover is:
- Combined earnings ÷ combined shares
- Bidder’s earnings only
- Target’s earnings only
- Price ÷ earnings
Show the answer
A. Include the new shares.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Describe the forms of purchase consideration. (4 marks) (b) Explain why a hostile bid is more likely to succeed with a cash offer. (3 marks) (c) State the three conditions under which an all-share takeover destroys value for the bidder. (3 marks)
Question 12 (20 marks). Alpha Plc has 4m shares and earns ₦8m at a P/E of 12. It will buy Beta Ltd, which earns ₦3m, for ₦30m. Tax is 25%. (a) Calculate the shares to issue if paid in shares. (3 marks) (b) Calculate the EPS and share price after the takeover, ignoring synergy, and the gain to each set of shareholders.
(6 marks) (c) Calculate the EPS and value if instead paid in cash borrowed at 8%, with the P/E unchanged. (6 marks) (d) Explain why the P/E may change in (c). (2 marks) (e) State three factors in choosing the consideration. (3 marks)
Question 13 (10 marks). (a) AB (5m shares at ₦64) buys XY (2m at ₦35) by shares at market values. Calculate the shares to issue. (3 marks) (b) Explain how synergy changes who gains in an all-share deal. (4 marks) (c) State two reasons to use debt for consideration. (3 marks)
Model answers
Show the model answer to Question 11
(a) Forms (4 marks). New shares issued to the target’s holders; cash from reserves, a share issue or borrowing; debt securities; or a mix. (1 each)
(b) Cash (3 marks). Target holders in a hostile bid have not agreed the deal. (1) They may not want to hold shares in the bidder. (1) Cash lets them leave. (1)
(c) Conditions (3 marks). The consideration is all shares; the price is on a higher P/E than the bidder’s; there is no increase in combined profits. (1 each)
Show the model answer to Question 12
(a) Shares (3 marks).
- Price = 12 × (8 ÷ 4) = ₦24. (1)
- Shares = 30m ÷ 24 = 1.25m. (2)
(b) Share deal (6 marks).
- Combined earnings = ₦11m
- shares = 5.25m.
- EPS = ₦2.095. (2)
- Value = 11 × 12 = ₦132m, or ₦25.14 a share. (2)
- Alpha’s holders.
4m × 25.14 = ₦100.6m against ₦96m, a gain of ₦4.6m. - Beta’s holders.
1.25m × 25.14 = ₦31.4m against ₦30m, a gain of ₦1.4m. (2)
(c) Cash (6 marks).
- Interest = 30 × 8% = ₦2.4m
- after tax = ₦1.8m. (2)
- Earnings = 11 − 1.8 = ₦9.2m on 4m shares, EPS = ₦2.30. (2)
- Value = 9.2 × 12 = ₦110.4m, or ₦27.60 a share, a gain of ₦3.60 a share, or ₦14.4m. (2)
(d) P/E (2 marks). Borrowing raises gearing and financial risk. (1) Investors may require a higher return, which lowers the P/E. (1)
(e) Factors (3 marks). Ability to raise cash or debt; effect on gearing and EPS; what target holders will accept (cash for a hostile bid); tax relief on interest; dilution. Any three. (1 each)
Show the model answer to Question 13
(a) Shares (3 marks).
- Value of XY.
2m × 35 = ₦70m. (1.5) - Shares = 70m ÷ 64 = 1,093,750. (1.5)
(b) Synergy (4 marks). Without synergy, a share deal at a higher P/E transfers value from the bidder’s holders to the target’s. (2) With synergy, combined earnings rise, so the value of the enlarged company rises and both groups of holders can gain. (2)
(c) Debt (3 marks). Tax relief on interest. (1.5) The bidder’s holders keep all the gain and avoid dilution. (1.5)
Pathfinder on Share, cash and debt consideration and their effect on shareholders
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
AB Limited (5 million shares at ₦64 and EPS ₦4.00) intends to acquire XY Limited (2 million shares at ₦35 and EPS ₦2.50) through an offer of shares at current market values. The shares to issue are 35 × 2,000,000 ÷ 64 = 1,093,750. Read the section on the purchase consideration and worked example 1.
Revise first: The purchase consideration
Case questions ask who gains under each consideration. See the sections on all-share consideration and cash or debt consideration.
Revise first: All-share consideration
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: May 2014 short-answer 13.
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