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When a firm acquires another entity, there usually is a predictable short-term effect on the stock price of both companies. In general, the acquiring company's stock will fall while the target company's stock will rise.

The reason the target company's stock usually goes up is that the acquiring company typically has to pay a premium for the acquisition: unless the acquiring company offers more per share than the current price of the target company's stock, there is little incentive for the current owners of the target to sell their shares to the takeover company.

The acquiring company's stock usually goes down for a number of reasons. First, as we mentioned above, the acquiring company must pay more than the target company currently is worth to make the deal go through. Beyond that, there are often a number of uncertainties involved with acquisitions. Here are some of the problems the takeover company could face during an acquisition:

  • A turbulent integration process - problems associated with integrating different workplace cultures
  • Lost productivity because of management power struggles
  • Additional debt or expenses that must be incurred to make the purchase
  • Accounting issues that weaken the takeover company's financial position, including restructuring charges and goodwill

We should emphasize that what we've discussed here does not touch on the long-term value of the acquiring company's stock. If an acquisition goes smoothly, it will obviously be good for the acquiring company in the long run.

To learn more about this subject, check out The Basics of Mergers and Acquisitions.

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