Financing an m&a transaction introduction

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Mergers and acquisitions (M&As) are part of the life cycle of any business. They can help businesses expand, acquire new knowledge, move into new areas, or improve their output with one simple transaction – it’s no wonder that M&A activity hit a record high in 2015. But along with these benefits and opportunities comes great expense – for both parties. A standard M&A deal will usually involve lawyers, administrators, and investment banks, and that’s before the actual cost of the acquisition has been factored in.
There’s no doubt about it – mergers and acquisitions are expensive, and without huge amounts of spare cash on hand, companies will have to seek out alternative financing options in order to pay for their transactions.
There are a number of different methods for financing mergers and acquisitions, and the chosen method will depend not only on the state of the company, but also on overall activity in M&A and finance at the time of the transaction.
The main decisions to be made referring to the financing of mergers and acquisitions are:

    • to what extent to use debt versus equity;

    • whether to fund the acquisition internally or externally;

    • whether to borrow locally in the foreign acquirer’s own country, or whether to borrow in another country

Debt versus equity
From a tax perspective, the most important decision is to be made whether to fund the transacition by debt or equity (Klingberg, Lawall, Schmidt, 2004).
Interest payable on debt finance will generally be deductible locally provided that the borrowed funds are used in the income producing activities of the borrower. The major exceptions to this general rule are:

  • when the thin capitalization rules are breached, a portion of the interest is not deductible (Rohatgi, 2002, p. 395,Powell et al., 2005);

  • interest expenses incurred in respect of acquisitions from related companies may result in debt creation rules being breached, and a deduction being disallowed;

  • interest expenses incurred in the production of tax exempt income may be non-deductible.

The deductibility of interest will generally mean that debt is, in principle, a more tax efficient form of finance than equity. When the funds are provided by a related company, debt facilitates the movement of profits from the target’s country to the lender’s country. If the tax rates in the lender’s country are lower than those in the target’s country, such a movement in profits will reduce taxes overall.
On the other hand, if the tax rates of the target’s country are lower than those in the lender’s country, equity finance may produce the most favourable overall result.

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