M&A deal structuring: All cash or stock or seller financing

Recently my colleague and I were discussing the impact of the deal structuring on the valuation of the target company (from the eyes of the acquirer and its shareholders). Few of the points discussed here are as follows:
1. Any investment (Greenfield/brown-field/acquisition) should be aimed towards creating the highest NPV for the company. Also if the deal is profitable, then rarely do firms have issues in tapping the capital market. Hence structuring has only a marginal impact.
2. A company which is not excessively levered (manufacturing firms with huge debts) or is a bank with minimum capital requirements should always go for all cash deal rather than a stock deal. This is because of following reasons:
a. If the company has huge stockpiles of cash/cash equivalents, then most likely this money is earning a miniscule LIBOR rate and any wise business investments should beat this return by a huge margin. (low opportunity cost)
b. If the company does not have too much capital, then cash deal will force them to borrow and debt servicing often improves the financial prudence of the target.
c. I believe a bird in hand is better than 2 in the bush. A company should either return the surplus to the shareholders as dividends or it should invest. Otherwise management forgets its fiduciary duties and tends to squander away the money through pvt. Jets.
d. Also it puts a cap on the size of acquisitions and its frequency. Thereby minimizing the risk taken by share holders.
3. Seller financing is very common when a PE or financial firm is selling the asset. This involves the seller to fund the acquisition by loaning part of the proceeds (sometimes working capital/corporate debt to run the firm too). The only question one needs to ask themselves why was the seller in such a hurry to offload the asset that it did not even stop to collect the cheque? Any FCFE computation would look very rosy because of the reduced capital requirements, but one should not under estimate the risks.
4. Unless there is a severe liquidity crunch, share dilution rarely works in the benefit for the existing share holders. Lesser the mouths to feed, the more for me.
5. Not to mention that stock deal means 100% financing through equity. Since equity is more expensive then debt/free cash, unless the stock is over-priced it rarely makes a good business case.
6. Also because of the exit restrictions stock deal don’t have an earnout components (or have smaller mgmt retention bonus). Hence acquirer takes in more risks than the conventional deals.
7. EPS bump: A lot of firms trading at very high PE ratio believe that by acquiring another company trading at a much lower PE ratio, they increase the EPS of their company and hence create share holder wealth. But the challenge remains in convincing the investors that the bigger elephant will continue to grow at the same rate.

 

How Interest rate changes effects your stocks.

How the Balance sheets of corporates are affected:
1) Take banks and financial institutions.
Calculating their impact is simple. They pay the depositors a particular interest rate and buy treasury bonds, or distribute it as loans. Many of the fixed deposit, bonds have fixed rates which need to be honored irrespective of the present conditions. So a fall in the interest rates causes higher profits and vice versa.

2) Leveraged industries
These are companies which have taken huge loans for their new plant, expansions etc. Any rise/fall in the interest rates has huge impacts in the interest outgo, hence the profitability.

3) Fall in the sales
The real estate is rising because the interest rates are low and it if often cheeper to pay an EMI then to pay a rent. A rise in interest rates greatly effects the spending of consumers and corporates, less houses, machinary and cars will be bought leading to a slowdown in the production and revenues of the corporates and hence lower profits.

Common sense says, most IT companies, and established Business houses have little or no debt, so their valuations should not be impacted much. But no:

1) Growth oriented companies:
They are traded at very high PE ratios, because their revenues are expected to increase by 30-40% each year and this expectation of future earnings beef up their stock prices.
100 rupees 5.5% interest grows by 1.7 over 10 years but will grow to 1.8 if interest rates is increased to 6%. So any change in interest rate changes the present value of the future earnings and hence changes the stock price.

2) Stable companies:
Their impact is also almost the same. If bond market gives 5.5%, you expect that your blue chip stock gives you at least 7% (1.5% risk premium) through dividends and stock price appreciation. Now if the interest rate increase to 6%, the only way you will get (6 + 1.5 = 7.5%) returns is that if the stock value dips from 100 to 99 ( .5% change in interest rate cause a 1% dip in the stock price)