As M&A activities pick up, the option of cash flow based debt financing of such event is weighed against equity or voting stock based funding. In times of economic slowdown banks also pull back a lot from the corporate lending market and reduce their exposures substantially. Non bank financial institutions step in to fill this void.
The choice between debt and equity stock funding of M&A is a major issue in corporate finance. According to the conservative line the acquirer should carefully weigh the tax advantage of debt fund against the consequences of default in the repayment of debt in financial distress. . In the event of default in payment or repayment, the lenders can sell the mortgaged assets of the company for the recovery of their dues.
Debts offer a tax advantage because interest on loan is tax deductible, while dividends on stock are not. Issuing equity or voting stock to the members of the selling company can be burdensome to the acquirer since that is likely to result in the dilution of his control over the company.
The acquiring company goes for issue of equity stock where its shares are overvalued and allots debt instruments in case its shares are undervalued. However, the selling company may be reluctant to accept overvalued stocks of the buying corporation without adjustment of the share exchange ratio on that ground.
Even where debt financing of M&A is cheaper than equity, it is advisable for the acquiring company to keep certain unused debt capacity as a buffer. Even in case the earnings of the company fall below unforeseen levels, this cushion will be able to service the debts as long such loan exposure is manageable.
In acquisitions where shareholders of the target company are removed without any allotment of shares or debt instruments in the buying company, they are bought out by payment of the entire purchase consideration in cash. Cash deals are advantageous in times of falling interest rates. Moreover, unlike stock payment, cash deal does not result in dilution of control for the acquiring company since there is no allotment of shares of the acquiring company in favor of share holders of the acquiring company.
