How to Pay: With Cash or Stock?  605 Assuming that the acquirer is not capital constrained, the real issue is whether the risks and rewards of the deal should be shared with the target’s shareholders. When the acquiring company pays in cash, its shareholders carry the entire risk of capturing synergies and paying too much. If the com- panies exchange shares, the target’s shareholders assume a portion of the risk. To show the impact on value of paying in cash rather than shares, Exhibit 31.8 outlines a hypothetical transaction. Assume that the acquirer and the tar- get have a market capitalization of $1 billion and $500 million, respectively. The acquirer pays a total price of $650 million, including a premium of 30 per- cent. We calculate the estimated discounted-cash-flow (DCF) values after the transaction under two scenarios: (1) a downside scenario in which the value of operating improvements is $50 million lower than the premium paid, and (2) an upside scenario in which the value of these improvements is $50 million higher than the premium. (To simplify, we assume that market value equals intrinsic value for both the target and the acquirer.) If the payment is entirely in cash, the target’s shareholders get $650 million, regardless of whether the improvements are high enough to justify the premium. These shareholders do not share in the implementation risk. The acquirer’s share- holders see the value of their stake increase by $50 million in the upside case and decrease by the same amount in the downside case. They carry the full risk. EXHIBIT 31.8  Paying with Cash vs. Stock: Impact on Value Value to shareholders after transaction, $ million Market value before deal Acquirer 1,000 Target 500 Price paid (30% premium) 650 Ownership ratio (stock deal) 39.4%/60.6% Downside scenario (Synergies = 100) Upside scenario (Synergies = 200) Consideration in cash Combined value 1,600 1,700 Price paid (650) (650) Value of acquirer postdeal 950 1,050 Target value created (destroyed) 150 150 Value of acquirer predeal (1,000) (1,000) Acquirer value created (destroyed) (50) 50 Consideration in stock Combined value 1,600 1,700 Target’s share (39.4%) (630) (670) Value of acquirer postdeal 970 1,020 Target value created (destroyed) 130 170 Value of acquirer predeal (1,000) (1,000) Acquirer value created (destroyed) (30) 30 606  Mergers and Acquisitions Next, consider the same transaction paid for in shares. The target’s share- holders participate in the implementation risk by virtue of being shareholders in the new combined entity.25 In the upside case, their payout from the acqui- sition increases as improvements increase: they receive $670 million in value, as opposed to $650 million. Effectively, even more value has been transferred from the acquirer’s shareholders to the target’s shareholders. The acquirer’s shareholders are willing to allow this form of payment, however, because they are protected if implementation goes poorly. If the deal destroys value, the target’s shareholders now get less than before, but still a nice premium, since their portion of the combined company is worth $630 million, compared with the $500 million market value before the deal. From this perspective, two key issues should influence your choice of pay- ment. First, do you think the target, and/or your company, is overvalued or undervalued? During a bubble, you will be more inclined to pay in shares, as everybody will then share the burden of the market correction. In such a sce- nario, develop a perspective on relative overvaluation of the two businesses. If you believe your shares are more overvalued than the target’s, they are valu- able in their own right as transaction currency.26 Second, how confident are you in the ability of the deal to create value overall? The more confident you are, the more you should be inclined to pay in cash. When weighing whether to pay in cash or in shares, you should also consider what your optimal capital structure will be. Can your company raise enough cash through a debt offering to pay for the target entirely in cash? Overextend- ing credit lines to acquire a company can devastate the borrower. One company, an automotive supplier, borrowed cash to pay for a string of acquisitions. Oper- ating improvements did not materialize as originally expected (partly because execution of the post-merger plan was not rigorous), and the company ended up with a debt burden that it could not bear, leading to bankruptcy. If the capital structure of the combined entity cannot accommodate any extra debt incurred by paying cash for the acquisition, then you need to con- sider paying partially or fully in shares, regardless of any desire to share risk among the shareholders of the new entity. Focus on Value Creation, Not Accounting Many managers focus on the accretion and dilution of earnings brought about by an acquisition, rather than the value it could create. They do so despite nu- merous studies showing that stock markets pay no attention to the effects of 25 Target shareholders with small stakes can sell their shares in the public market to avoid implementation risk. Influential shareholders with large stakes, such as company founders and senior executives, will often agree not to sell shares for a specified period. In this case, they share the risk of implementation. 26 The signaling effect of share consideration is similar to that of share issuance. The capital markets will use this new information (that the shares might be overvalued) when pricing the shares.