Understanding and Calculating the Exchange Ratio

Understanding and Calculating the Exchange Ratio

Understanding and Calculating the Exchange Ratio

What Is the Exchange Ratio?

The exchange ratio is the number of new shares given to existing shareholders after a company merger or acquisition. It ensures that shareholders receive the same relative value in the merged entity.

Key Takeaways

  • The exchange ratio calculates the shares an acquiring company issues for each share an investor owns in a target company.
  • The target company purchase price often includes a price premium paid by the acquirer for 100% control.
  • The exchange ratio considers the intrinsic value and underlying value of the shares and the company.
  • There are two types of exchange ratios: fixed and floating.

Understanding the Exchange Ratio

An exchange ratio gives shareholders a corresponding stock amount in the acquiring company, maintaining relative value from the target company. The target company share price is typically increased by the takeover premium, an additional amount paid for full control of the company.

Relative value doesn’t mean receiving the same number of shares or dollar value based on current prices. Instead, intrinsic and underlying values of the shares and the company are considered to determine the exchange ratio.

Calculating the Exchange Ratio

The exchange ratio exists in stock or mixed stock and cash deals. The calculation is:

Exchange Ratio = Target Share Price รท Acquirer Share Price

The target share price is the price offered for the target shares. Since share prices can change before the deal closes, the exchange ratio can be fixed or floating.

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A fixed exchange ratio remains constant until the deal closes, ensuring control percentage is known. A floating exchange ratio varies to provide the fixed value to the target company, regardless of share price changes.

Example of the Exchange Ratio

In a 2-to-1 exchange ratio, the buyer offers two shares of their company for one share of the seller’s company. If the buyer’s shares trade at $10 and the seller’s at $15, the effective offer is $20 for a $15 share.

Fixed exchange ratios are usually limited by caps and floors to account for extreme stock price changes. Caps and floors prevent significant differences in consideration for the seller and the buyer.

After the deal is announced, there is often a valuation gap between the shares to reflect time value of money and risks. Merger arbitrage takes advantage of this gap, where investors buy one seller share and short two buyer shares to secure the difference if the deal goes through.

If the deal closes, investors receive two buyer shares for one seller share, resulting in $20 in cash after closing the short position. Investors net $2 after deducting the initial outlay of $18.

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