The shareholders of the amalgamating company are given the shares of the amalgamated company in exchange for the shares held by them in the amalgamating company. For example when TOMCO was emerged with Hindustan Lever Limited, shareholders of TOMCO were given the shares of Hindustan Lever Limited in the ratio of 2:15; that means 2 shares of Hindustan lever Limited were given in lieu of 15 shares of TOMCO . How is the exchange ratio determined? The commonly used bases for establishing the exchange ratio are: earnings per share, market price per share, and book value per share.
Earnings per share: Suppose the earnings per share of the acquiring firm are Rs 5.00 and the earnings per share of the target firm Rs 2.00. An exchange ratio based on earnings per share will be 0.4 that is (2/5). This means 2 shares of the acquiring firms will be exchanged for 5 shares of the target firm.
While earnings per share reflect prime facie the earnings power, there are some problems in an exchange ratio based solely on current earnings per share of the merging companies because it fails to take into account the following:
* The difference in the growth rates of earnings of the two companies
* The gains in earnings arising out of merger
* The differential risks associated with the earnings of the two companies
Moreover, there is the measurement problem of defining the normal level of current earnings. The current earnings per share may be influenced by certain transient factors like a windfall profit, or an abnormal labor problem, or a large tax relief. Finally, how can earnings per share, when they are negative, be used?
Market Price per share: The exchange ratio may be based on the relative market prices of the shares of the acquiring firm and the target firm. For example, if the acquiring firm’s equity share sells for Rs 50 and the target firm’s equity share sells for Rs 10 the exchange ratio based on the market price is 0.2 that is (10/50). This means that 1 share of the acquiring firm will be exchanged for 5 shares of the target firm.
When the shares of the acquiring firm and the target firm are actively traded in a competitive market, market prices have considerable merit. They reflect current earnings, growth prospects and risk characteristics. When the trading is meager market prices, however, may not be very reliable. In the extreme case market prices may not be available if the shares are not traded. Another problem with market prices is that they may be manipulated by those who have a vested interest.
Book value per share: The relative book values of the two firms may be used to determine the exchange rate. For example, if the book value per share of the acquiring company is Rs 25 and the book value per share of the target company is Rs 15, the book value based exchange ratio is 0.6 =(15/25).
The proponents of book value contend that it provides a very objectives basis. This, however is not convincing argument because book values are influenced by accounting policies which reflect subjective judgments. There are still serious objections against the use of the book value.
1. Book values do not reflect changes in purchasing power of money.
2. Book values often are highly different from true economic values.