What Exactly Is an Acquisition Premium?

An acquisition premium is the sum of the projected true worth of a firm and the purchase price paid for it. The higher cost of purchasing a target firm during a merger and acquisition (M&A) deal is known as an acquisition premium.

A corporation does not always have to spend more money when it buys another business; in certain cases, it can even get a discount.

Knowledge of Acquisition Premiums

The business that pays to buy another company in an M&A situation is referred to as the acquirer, while the company being bought or acquired is known as the target firm.

Factors That Justify Paying An Acquisition Premium

An acquiring business often pays an acquisition premium to seal the purchase and eliminate rivalry. If the acquirer thinks the synergy from the purchase will be more than the overall cost of purchasing the target firm, they may also pay an acquisition premium. The premium’s magnitude often relies on several variables, including industry competitiveness, the availability of competing bids, and the buyer and seller’s objectives.

What’s the Process for an Acquisition Premium?

When a corporation decides to purchase another company, it will first try to determine the target company’s true worth. For instance, Macy’s is projected to have an enterprise value of $11.81 billion based on information from its 2017 10-K filing. To offer the target business an appealing transaction, the acquiring company must first establish the genuine worth of its target. This is particularly important if other companies are also contemplating an acquisition.

In the scenario above, an acquirer can pay a 20% premium to purchase Macy’s. Therefore, $11.81 billion times 1.2 is $14.17 billion, the total amount it will suggest. If this premium offer is accepted, the purchase premium value, expressed as a percentage, will be $2.36 billion ($14.17 billion – $11.81 billion), or 20%.

How to Determine the Acquisition Premium

The share price of a target firm may also be used to determine the acquisition premium. For example, suppose Macy’s shares sell at $26 each, and a buyer is ready to pay $33 each for the target company’s outstanding shares. In that case, you may determine the acquisition premium as ($33 – $26/$26) = 27%.

For the sake of our price-per-share example, let’s say that no premium bid was made and that the agreed-upon purchase cost was $26 per share. Before the purchase is completed, if the company’s valuation falls below $16, the acquirer must pay a premium of ($26 – $16)/$16, or 62.5%.

Financial Accounting Acquisition Premiums

The percentage of the purchase price that exceeds the net fair value of all the assets acquired in the acquisition and the liabilities taken in the transaction is referred to as the acquisition premium, or goodwill, in financial accounting. The purchasing business separates goodwill into its account on its financial sheet.

Intangible assets such as the value of a target firm’s brand, strong customer base, positive customer relations, positive staff relations, and patents or proprietary technologies acquired from the target company are considered when calculating goodwill. A negative occurrence, such as diminishing cash flows, a downturn in the economy, a rise in competition, and the like, may cause goodwill to be impaired, which happens when the market value of the target company’s intangible assets falls below its purchase price. Any impairment causes goodwill to drop on the balance sheet and causes a loss to appear on the income statement.

A target firm may be bought by an acquirer at a discount or for less money than it is worth. When this happens, bad will is discernible.

Conclusion

• The difference between a company’s projected true worth and the amount paid to acquire it in an M&A deal is the acquisition premium.
• The purchase premium is shown as “goodwill” on the balance sheet in financial accounting.
• An acquiring corporation may even get a discount for buying a target company; a premium is unnecessary.