A merger occurs when the board of directors of twosimilar-sized companies agree to combine the two companies to form one companyfor which they have to seek the shareholder’s approval. An acquisition occursusually when a larger company purchases a majority stake in a smaller companybut does not change its name or legal structure. A takeover is when anacquiring firm attempts to take control over the target firm by acquiring amajority stake. There are two types of acquisitions; friendly transaction andhostile takeover.
A friendly transaction is when the board of directors of thetarget firm endorse the bid from the acquiring firm. Whilst a hostile takeoveris when the board of directors of the target company object to a bid from theacquiring company but the acquiring firm attempt to force it through byattempting to convince the shareholders directly and surpassing the board ofdirectors.The merger and acquisition process begins with the valuationof the target firm by the acquiring firm. This gives the acquiring firm an ideaon how much they need to bid to acquire a company. The acquiring firm will tryto value the target firm as low as possible in order to achieve a lower cost ofacquisition. Whereas the target company will attempt to value their company ashigh as possible in order to generate as much revenue as they can.
Threedifferent ways they may value a company include; comparative ratios,replacement costs and discounted cash flow. A comparative ratio that can beused by acquiring firms are; Price-Earnings Ratio (P/E Ratio). ThePrice-Earnings Ratio is the relationship between the company’s stock price andearnings per share. This gives the acquiring company an idea of how profitablethe target company will be which is arguably the main incentive for a mergerand acquisition. The equation is very simple:P/E = Stock Price Per Share / Earnings Per ShareEssentially it shows the acquiring company how much theywould be paying per unit of earnings of the target company.