When one company decides to merge with another company, it's not uncommon for shareholders to receive a premium to convert their shares into the merged entity. Even in a merger of equals, the company initiating the merger will offer either cash or stock to shareholders of the "acquired" company. A cash deal offers shareholders money for their shares. A stock deal allows shareholders to exchange their shares for new stock in the combined entity.
A cash merger happens when the acquiring firm buys the target company's stock with cash. Think of a cash merger as shareholders of the target company being bought out. In a straight cash merger, the acquiring firm will make a tender offer at a price that is acceptable to the shareholders of the target company, who must vote to approve the deal. A basic example is a company offering to pay $25 cash for each share of the target company's stock currently selling at a market price of $17. This represents an $8, or 47 percent, premium.
It's common practice for an acquiring company to offer stock rather than cash to complete a merger deal. A key term you'll hear regarding a stock merger is the "conversion ratio." This is the ratio that converts the target company's shares into shares in the combined firm. For example, if you owned 1,000 shares in a target company that received a stock merger offer with a conversion ratio of 1.275, you would receive 1,275 shares in the merged company, or 1,000 times 1.275.
If the number of shares you receive in the merged entity is not a whole number, you'll receive cash in lieu of the fractional share. For example, if the conversion ratio gives you 156.25 new shares, a stock merger will assume that you received the fractional share (in this case, 0.25 shares) and you sold it for cash. To figure out the cash portion, divide your cost basis in the old shares and multiply the result by 0.25. If your cost basis in the target company was $5,725, divide this amount by 156.25 to arrive at $36.64. Multiply this amount by 0.25 to arrive at $9.16. You'll have 156 shares in the merged entity, plus receive $9.16 cash.
Some mergers combine a stock-for-stock transaction with a cash portion. For example, a stock merger offering you 0.5 shares plus $10 in cash for every share you own means you'll have to multiply 0.5 and $10 by the number of shares you hold in the target company. If you owned 400 shares in the old company, you'll own 200 shares in the merged company plus receive $2,000 in cash, or $10 multiplied by 200 shares.
Stock and Cash Merger Example
If your basis in the old company was $6,000 and your new basis in the combined entity is $10,000, your gain is $4,000. For tax purposes, you report a capital gain of $2,000 for the cash you received, and your basis in the new company is $6,000. If your basis in the old company was $9,000, your gain is $1,000. You'll report a gain of $1,000 to the IRS even though you received cash of $2,000 in the transaction. Finally, if your cost basis in the old shares was $11,000, this means you suffered a loss on the transaction. Even though you can't report the loss, the $2,000 you received reduces your basis in the new shares to $8,000.
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