Acquisition Premium

Accounting Conservatism

What is an acquisition premium?

An acquisition premium is the difference between the estimated real value of a business and the real price paid to obtain it. The acquisition premium represents the increase in the purchase cost of a target company during a merger and an acquisition. A business is not required to pay a premium for the acquisition of another business; depending on the situation, he may even benefit from a discount.

The acquisition premium is known as “goodwill”.

The basics of acquisition premiums

In mergers and acquisitions, the company that pays to acquire another is known as the buyer, while the company to buy or acquire is called the target company.

When a company decides it wants to acquire another, it will first try to estimate the real value of the target company. For example, Macy’s enterprise value, using data from its 2020 10-K report, is estimated to be $ 11.81 billion. Once the real value of the business has been determined, the buying company will decide how much it is willing to pay in addition to the real value in order to make an attractive offer, especially if other companies are considering an acquisition. For example, a buyer may decide to pay a 20% premium to buy Macy’s. The total acquisition cost he will propose will therefore be $ 11.81 billion x 1.2 = $ 14.17 billion. If this bonus offer is accepted, the value of the purchase premium will be $ 14.17 billion – $ 11.81 billion = $ 2.36 billion, or as a percentage, 20%.

The acquisition premium can also be assessed using the share price. For example, if Macy’s is currently trading at $ 26 per share and an acquirer is willing to pay $ 33 per share for the outstanding shares of the target company, the purchase premium can be calculated as follows: ($ 33 – $ 26) / $ 26 = 27%. Not all companies intentionally pay a premium for an acquisition. Using our example price per share, if there was no premium offer on the table and the acquisition cost was agreed to be $ 26 per share, but the value of the company drops to 16 $ before the acquisition becomes final, the purchaser will end up paying a premium of ($ 26 – $ 16) / $ 16 = 62.5%. In cases where the target share price drops dramatically, its product becomes obsolete or concerns are expressed about the future of the industry, the buying company can withdraw its offer.

An acquirer will generally pay an acquisition premium to enter into an agreement and avoid competition. An acquisition premium could also be paid if the acquirer believes that the synergy created by the merger or acquisition will be greater than the total cost of acquisition of the target. The amount of the premium often depends on various factors such as competition within the industry, the presence of other bidders and the motivations of the buyer and seller.

The acquisition premium is recorded as goodwill on the acquirer’s balance sheet. The value of a company’s brand name, a solid customer base, good customer relations, good employee relations, and any patents or proprietary technologies acquired from the target company are taken into account in the good will. An adverse event, such as a drop in cash flow, an economic depression, an increased competitive environment, etc., can cause a goodwill impairment, which occurs when the market value of the intangible asset falls below its cost. acquisition. Any impairment leads to a reduction in the goodwill account on the balance sheet and a loss in the income statement.

An acquirer can buy a target company at a lower price, that is, less than its fair market value. When this occurs, negative goodwill is recognized.

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