The stock price of the target company usually rises immediately after the announcement of a coming merger. The stock price of the acquirer usually falls at that time.
After the agreement has closed, the stock price of the combined company should equal the pre-merger value of each company, plus whatever accretion of value has come about through the combination itself (this accretion is known as "synergy"), divided by the number of post-merger shares.
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Typically, when two companies announce a combination, whether it is designated formally as a marger or an acquisition, one is the acquirer, the other the acquired, or "target," and the announcement will specify a per-share value that the acquirer will pay, well above the pre-announcement target company stock price. This excess payment is known as the control premium.
For example, in September 2009, Kraft Foods offered to acquire the U.K.-based confectioner Cadbury in a part-cash, part-stock-swap deal that led to the valuation of each Cadbury share at a 27-percent control premium.
Cadbury resisted, contending that the offer was low. In January 2010, the parties reached an agreement that entailed a 48-percent premium to what the market price had been before that offer.
After the Announcement
Suppose two firms announce a friendly acquisition of one by the other, with the transaction to close two months subsequent to that announcement. The market price of the target firm will soon rise to a point close to the contracted-for price. Yet as a rule, the market price during the pre-closing period will not coincide with the contract price. After all, the deal might unravel during that interval, or regulatory authorities might step in to block it. There will be a discount of market price against contract price that will reflect the market's estimate of the probability of such an event.
As the closing date nears, unless a hitch in plans does develop, the market price should approach the contract price. There are hedge funds that employ a specialised trading strategy in which they invest in targets during this period in order to profit from that approach. This is known as merger arbitrage or risk arbitrage. As Magnum Funds notes on its website, this is often a good bet because "historically the vast majority of friendly acquisition offers that have been announced are completed."
The price of the acquirer typically drops somewhat during the period between announcement and closing. The full-risk arb play, accordingly, is not only to buy the target but to sell the acquirer.
After the Closing
After the closing, the target company's share price ceases to exist. What will happen to the combined company's share price depends on how successful the merger was in identifying a synergy. For example, the target may have been in a business similar to that of the acquirer, but with a different geographical base. In this case, the combination could allow the two firms, given their similarity, to cut costs (enjoying economies of scale) while catering to the larger non-overlapping customer base.
One of the reason's that Kraft considered Cadbury a good buy was that it was "highly complementary to Kraft's geographical footprint," according to an analysis by The Applied Finance Group.
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