Cash versus Common Stock

The distinction between cash and common stock financing in a merger is an important one. If cash is used, the cost of an acquisition is not dependent on the acquisition gains. All other things being the same, if common stock is used, the cost is higher because Firm A's shareholders must share the acquisition gains with the shareholders of Firm B. However, if the NPV of the acquisition is negative, then the loss will be shared between the two firms.

Whether a firm should finance an acquisition with cash or with shares of stock depends on several factors, including the following:

1. Sharing gains. If cash is used to finance an acquisition, the selling firm's shareholders will not participate in the potential gains from the merger. Of course, if the acquisition is not a success, the losses will not be shared, and shareholders of the acquiring firm will be worse off than if stock had been used.

2. Taxes. Acquisition by paying cash usually results in a taxable transaction. Acquisition by exchanging stock is generally tax-free.

3. Control. Acquisition by paying cash does not affect the control of the acquiring firm. Acquisition with voting shares may have implications for control of the merged firm.

In the 1980s, cash deals were the rule. In the 1990s, stock deals became much more common. Today, cash deals are relatively rare, at least in large mergers.

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