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# Why Acquisition Doesn’t Always Benefit Shareholders

April 16, 2016

When some company acquires another company we generally feel that it creates value for shareholders, but this doesn’t happens always.

Check the numbers of this company lets call it company X which is growing its sales by 5%. The tax rate is 34%. The current income statement numbers and projected numbers will be

Company XYear 1Year 2(Projected)
Sales50005250
Cost and expenses
cost of goods sold3422.73591.4
selling, general and administrative expenses12501315
interest expenses100105
Total costs and expenses4772.75011.4
Income before income taxes227.3238.6
Income taxes77.381.1
Net Income150157.5
YoY sales increase5%
Net income as % of sales3%3%
Shares outstanding(million)7575
EPS22.1
PE1414
Price per shares2829.4

Lets take another small size unlisted company and call it company Y which is growing its sales by 5%

Company YYear 1Year 2(Projected)
Sales238.1250
Cost and expenses
cost of goods sold160.6171.1
selling, general and administrative expenses61.962.5
interest expenses4.85.0
Total costs and expenses227.3238.6
Income before income taxes10.811.4
Income taxes3.73.9
Net Income7.17.5
YoY sales increase5%
Net income as % of sales3% 3%
Shares outstanding(million)
EPS
PE
Price per shares

Case 1: Company X acquires company Y through equity funding

We are giving  the PE of 14, so lets assume that the company will be acquired by paying 14 times the earnings. Which becomes 7.1 x 14 = 99.4 million . Company X will acquire company Y by paying 99.4 million.  Company X share price is 28 , therefore for funding of 99.4 million company X has to issue 99.4/28 = 3.6 million additional shares. This will increase the number of shares outstanding to 78.6 million (75+3.6)

After the acquisition the sales of company Y will be added to sales of company X . Therefore the new income statement for year 2 will be as below

Note: We are adding the 2nd year projected numbers of Company X and Y

Company X After Acquiring Company YYear 1
Sales5500.1
Cost and expenses
cost of goods sold3762.5
selling, general and administrative expenses1377.5
interest expenses110
Total costs and expenses5250
Income before income taxes250
Income taxes85
Net Income165
YoY sales increase10%
Net income as % of sales3%
Shares outstanding(million)78.6
EPS2.1
PE14
Price per shares29.4

Notice that after adding the sales figures there is a year on year increase by 10% But this increase in sales is bringing no change in the EPS and Share price of the company because of increase in the number of shares. The EPS of the company is 2.1 with acquisition which is same as year 2 EPS of company X  without acquisition.  The 10% sales growth is not bringing any positive change , the things are same. In short annual sales growth from 5% to 10% has not benefited shareholders, whose shares increases in value by 5% whether Compay X acquires Company Y or not. Acquisition of another company through equity dilution doesn’t creates value for shareholders.

Case 2: Company X finances the acquisition of company Y with borrowed money

In this case lets assume the Company X will pay the amount of 99.4 million by borrowing money at the rate of interest of 8% this will result in increase in interest expenses. The new profit and loss statement will be like
below

Company X After Acquiring Company YYear 1
Sales5500.1
Cost and expenses
cost of goods sold3762.5
selling, general and administrative expenses1377.5
interest expenses118
Total costs and expenses5258
Income before income taxes242
Income taxes85
Net Income159.7
YoY sales increase10%
Net income as % of sales3%
Shares outstanding(million)75
EPS2.13
PE14
Price per shares29.82

Because of increased debt interest expense will increase to 118 from 100 million. Pretax income therefore falls from 250 million to 242 million, reducing net income from 165 million to 159.7 million. The number of shares outstanding will be 75 million only as funding is not through equity. This will result in increase in EPS to 2.13 from the previous case of 2.10 and the PE multiple of 14 the stock price will become 29.82  from the previous case of 29.4  There will be slight increase in the share price.

But in reality there won’t be increase in share price because a high debt company gets low PE multiple. If PE is reduced to 13 the stock price will become 27.69 that is reduction in the value.

So debt-funded acquisition also doesn’t increase the shareholders wealth and in fact it could reduce it. This is the  reason why companies like Suzlon, 3i infotech, Opto circuits etc who did lot acquisition by taking debt were the wealth destroyer for shareholders.

Case 3 Acquisition takes place through surplus cash

In this case there won’t be equity dilution, there won’t be increase in interest expense, The PE multiple wont go down. The income statement in this case will be

Company X After Acquiring Company YYear 1
Sales5500.1
Cost and expenses
cost of goods sold3762.5
selling, general and administrative expenses1377.5
interest expenses110
Total costs and expenses5250
Income before income taxes250.1
Income taxes85
Net Income165.06
YoY sales increase10%
Net income as % of sales3%
Shares outstanding(million)75
EPS2.20
PE14
Price per shares30.08

You can see in this case there is rise in EPS and the share price. This will result in slight increase in value for shareholder.

In the next article I will write on the cases when acquisition actually benefits shareholders.

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