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An exchange ratio is a financial calculation of fairly specific intent, that is generally used only when one publicly-owned company is the target of acquisition by another. In technical terms, it is the number of shares in the new company that a shareholder can expect to receive, in exchange for his shares in the old company. An exchange ratio, in principle, attempts to account for the differences in existing risk between two merging companies.
There are various methods by which an exchange ratio is calculated. Generally, stock valuations are conducted by third party brokers to determine the price of an individual share for both companies, and are specified in the contract between the two businesses. Brokers typically charge a percentage of the overall total of the transaction as payment.
Like all ratios, an exchange ratio is essentially a way of expressing a numerical fraction. In many cases the top number of the fraction, known as the numerator, is the average price per share of one of the companies — and the bottom number, the denominator, is the initial public offering (IPO) price of the other company. This is hardly a rule, however, and it is up to the companies themselves to negotiate the terms of the exchange ratio. Other factors that can play a part in determining it include, but are certainly not limited to, outstanding number of shares, outstanding debt, the market value of any equity, and cash flow.
Typically, a target company's shares are given a premium price above what the value of the company's stocks themselves would sell for in open trading. This is generally done as a way to sweeten the deal for shareholders who may otherwise be reticent about the transaction. A ten to 20% is not unusual, though higher and lower offers may be made depending on the circumstances of a particular offer. Shareholders on both sides ultimately vote on whether or not to accept the deal, and the shares are sold en masse to complete the acquisition.
By the nature of an exchange ratio, it is not applied when a private company in involved in the transaction, as these are not publicly traded and have no shareholders. In such cases, accountants attempt to evaluate the private company's assets, revenue, credit or bond rating, and other criteria to determine an agreeable purchase price. In such a case, rather than shareholders, it is up to company ownership to decide on the sale.
There is another meaning of exchange-ratio in economics. It can be used to talk about the ratio of goods and money.
For example, every product or commodity that is for sale has an exchange ratio. You exchange a certain amount of money for the commodity. So if you bought one apple for two dollars, the ratio will be 1:2 and so forth. Since prices of goods are always changing, this exchange ratio is never constant.
In class, when we talk about the value we get from an exchange- like the purchase of a commodity like I mentioned, we call this the exchange value.
@fify-- No, it doesn't quite work that way. If the companies really wanted to decide on an exchange ratio based on their personal judgment only, they could. There is nothing that prevents them from doing it legally.
But most companies would not want to do that for several reasons. First of all, there is usually more than one or two shareholders in a company, there are many. The exchange ratio affects every one of them individually so they have a vested interest in making sure that it is a legitimate number.
So most companies will get a valuation report from financial experts. The companies will use the report to decide on the ratio. And if there are any
legal problems and disagreements in the future, these reports will also be good solid evidence in court.
Another point I should make is that, when I say that "the companies" decide on the ratio, I'm talking about the Board of Directors of the companies. The Board of Directors might be also be shareholders of that company or it might not. That's also something to keep in mind.
I don't get this very much but I'm trying to figure it out for my assignment.
Can the ratio be anything that the parties want it to be since their approval is all that is required?
Is there any oversight or regulation that determines whether an exchange ratio is fair and just and that there is no undervaluing or overvaluing of shares?
I mean, do the guys that run the two companies basically get together and argue over ratios until they get one that satisfies them both?
What happens if they can't agree?
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