[MUSIC] Let's talk now about how to pay for a deal okay. We talked about synergies. We talked about how to value synergies. And we talked about how to price a deal given the synergy. But now what we're going to learn, is that acquirers can choose to pay either cash or stock, okay? So deals are not necessarily paid off with cash as in this picture, sometimes what the target is going to get is stock in the merger company. So now what we're going to figure out is what the key difference is okay. Let's go back to HP-Compaq okay. Suppose that the final price is $27 we just figured out that the price have to be between 21 and 34 given our evaluation of synergies. So let's say the price was $27. I'm gonna show you in a second what the price actually was okay. Let's say for now it's $27. Compaq had $1.7 billion outstanding approximately. So if you do the math, this is going to represent $16 a share okay. So think about this. If you're paying cash, you're going to pay $16 a share what happens? HP takes cash out of its pocket, okay. And gives to Compaq share holders right. Compaq share holders give their shares to HP and they $16 in cash. Okay, so paying cash is extremely simple. We wouldn't even need to be talking about it if there wasn't another way to pay for a deal. So really the most interesting thing that we have to learn here is that in some cases companies are paying with stock, okay. How does this work? It's actually an issuance, okay. It's a stock issuance. What HP is going to do, is to issue new shares okay, and gives the shares to Compaq shareholders in exchange for Compaq shares. So Compaq disappears of course, right. Compaq is going to disappear. So the shares of Compaq disappear in exchange for the shares of Compaq, the shareholders of Compaq are going to get shares of HP and of course HP is going to become the new merged firm okay? A key variable in a stock merger is what we think of, what we call the exchange ratio. What is the exchange ratio? The exchange ratio is the number of shares of the acquire that each target shareholder receives, so in this case it's the number of shares of Hewlett Packard that each Compaq shareholder is going to receive. All right, that's how HP is going to pay for the deal. What should be the exchange ratio then? What is the exchange ratio? Let's go back to our $16 number. Let's say that the final price is 27 billion, and let's say then that HP is paying $16 a share right. If you think about the math, for a compact shareholder to get $16, and remember what you're going to get is you're going to get HP stock. So the exchange ratio, the number of shares that you're getting, times the HP stock price has to equal $16. So let's see how the math works. Notice that to do this calculation, we have to make an assumption about the stock price. As we're going to see next, and I think we've talked about this in the course already in module one, the stock market is going to react to the deal. But let's say that we use HP's pre-deal stock price to do this calculation okay. We already learned that HP's pre-deal stock price was $23.21. Okay, so, right. The way the math work here is that if you want to get $16 you have to divide 16 / $23.21 right. And this is how you would compute the exchange ratio. What does this mean? It means that if you want ten shares of Compaq, and then the deal is financed with stock, you would receive 6.9 shares of HP, okay. That's what the math comes up to, okay. It's a 0.69 exchange rate, okay. So if own ten share, if you own 100 shares of Compaq just to make the number round, you would receive 69 shares of Hewlett-Packard, okay. This particular merger was financed what actually happened to be financed by stock so HP didn't use cash at all okay. And the exchange ratio was 0.6325. So, it's not too far from what we computed right? So if a Compaq shareholder had a thousand shares of Compaq, you got 632.5 shares okay. And then of course there are legal ways to deal with this decimal okay. So that's how HP actually paid for Compaq. And here comes something really interesting. We saw this graph already in module one. What happened when HP announced that this deal, okay, the stock market reacted immediately right. On September 5th of 2001, the stock market reacted to this deal, and actually what the market did is it sends HP's stock price down by 23 minus 18, by $5 a share. Used to be $23. In the day it after it started trading after the deal was announced, HP stock price went down to $18. So the deal was very poorly received by the market. And remember, Compaq shareholders are paid in stock so what they're getting in stock, so let's try to figure out how much was HP's offer worth following the market reaction. Think about this, the actual value of the offer after the announcement was much lower, right. Instead of 23, okay you have 18 here. The exchange ratio is still the same, okay. So what Compaq shareholders are getting is actually 11.4, right. Compaq's stock price prior to the deal was 12.35, okay. So it really didn't make much sense, right at that point right? What should have happened to Compaq stock price after the deal was announced? Compaq stock price should have gone down as well, right? Which is exactly what happened. The deal was announced at this exchange ratio. The market hated the deal so much that even the stock price of the target went down in this case, okay? So, Compaq stock prize is also decreased. And the surprising thing in this deal is that the Compaq management actually managed to convince the shareholders that the market reaction was to be ignored okay. So the opposition to this deal actually came from within Hewlett-Packard, rather than from Compaq shareholders okay. And this is an example that we can generalize, okay. And we can think about, what happens when mergers are announced. In the general, we have evidence about that in the finest literature, okay. M&A deals are very interesting because they give us a chance to look at how the market reacts, right. This is what we just did we are thinking about HP Compaq. There was a management forecast the synergies and all that. But then the market is going to do its own calculation, right? And it's obvious that if the merger is positive NPV for the acquirer as we already learned in this course then stock prices, is stock prices should go up, right? If the merger is positive NPV for the target Which in the case of Compaq it wasn't that clear right. Stock price of the target should go up. So let's see what happens on average okay. So this is a graph that comes from a famous research paper on M&A deals, okay. What it's showing is that the stock price reaction of for, for target companies, okay? So when a deal is announced this is what happens on average to the stock price of a target, okay? Targets end up earning a significant premium on average, right? So when a deal is announced the stock price of a target should zap by. Here you have a number between 15 and 20%, okay? So stock prices of targets are going up significantly. Notice also that there is a little bit of a trend here before the deal is announced. Of course what happens in the real world is that in some cases there are rumors that ends up trickling to the market, so the target stock price may end up reacting a little bit before the deal is announced. That's why this graph starts a few days earlier. It's not just a three day announcement return or a one day announcement return as we did with HP Compaq okay. What about acquirers? Acquirers actually is, what you see is a flat line on average okay? So the acquirer's stock price on average doesn't seem to increase when a new M&A deal is announced okay? Of course, that doesn't mean that all deals are zero MPV. But on average that's what we find okay? The bottom line is that what the research seems to suggest is that on average merchants create value but most of the value ends up going to the target firm okay? Fine, so remember our, our discussion about synergies and premium, right? What this means is that mergers do generate synergies, right, so targets get, a very high NPV if you want, right cuz their, their stock price is going up by 20% on average but the acquirer end up paying too much, okay. So all the premium goes to the target and none, none of the premium stays with the acquirer on average, of course right. So that's what the evidence shows. So the negative reaction that happened to Hewlett-Packard is a little bit extreme, but there are many deals that actually not successful for acquirers, at least in the short term okay? Of course that, the short term stock price reaction may not be right as we discussed already in the course. The market is trying to do these calculations, trying to figure out what's going to happen in the future, right? Is this view going to add value or not. And this is a very hard calculation to do, right? It's possible that the management was right okay? Compaq management actually liked this deal they wanted to be acquired by HP. They managed to convince the shareholders to go along. So what can we do to try to figure out? The first thing you might be thinking is that we can try to look at long term stock price reaction instead of just looking at the short term how the market reacted immediately to a deal. Let's try to see what happens in the long term okay. We can certainly do that, this is what you have here in this graph okay. So the deal, this is 2001 here at the last corner. So, that's when the deal was announced and here the blue line is HP. Okay, and then you have two other companies to compare the stock prices to, actually, the red line is an index. This is the S&P 500 index okay? And, here in the bottom, you have IBM okay. If you read the management description of the HP-Compaq merger they were mostly concerned with IBM and Dell. Those were the main competitors of HP at that time okay. So what do we see here? This is 2002, after 2007 okay it seems that HP actually did pretty well. Right when you look at this, on the face of it, HP did significantly better than the competitors. It seems that HP did pretty well in the years following the merger. Of course there is a problem with doing long term stock price reaction. It's very difficult to find a good comparison right. What we would like to see is, suppose the deal had never happened. Suppose HP had not acquired Compaq. What would have happened to HP's stock price? But that will, this we will never know, okay. Right, so the only thing we can do is to compare to competitors, compare to the market. In this case It seems that, at least there is no evidence that the merger was destroying value if we're looking six, seven years ahead okay? We can also do qualitative analysis to think about this deal, so here I have two articles for you. The first one is from Fortune and the article was actually about the fact that the deal was failing, okay. So you can read here, buying Compaq has not paid off for HP investors, not by a long shot, okay. Which seems to be a little bit inconsistent with the stock price chart that you just saw. And we can also find an article that says the merger worked, okay. This is the merger that worked, HP and Compaq okay. And it was very, this article's talking precisely about the fact that this deal was very poorly received by the market, but in the long term it ended up creating shareholder value. The bottom line is that we never know okay. This is a big problem with M&A research and trying to understand M&A in the real world is that it's very difficult for outside observers and sometimes even for management to figure out if a deal worked in the long term or not. So sometimes, in most cases you have to rely on your intuition and you have to, you can of course observe the short term market reaction. But the long term market reaction and this qualitative reaction to the deal is a little bit harder to interpret.