An acquisition premium is the difference between the estimated real value of a company and the actual price paid to obtain it. Acquisition premium represents the increased cost of buying a target company during a merger and acquisition. There is no requirement that a company pay a premium for acquiring another company; depending on the situation, it may even get a discount.

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In mergers and acquisitions, the company paying to acquire another is known as the acquirer, while the company to be purchased or acquired is referred to as the target firm.

When a company decides it wants to acquire another, it will first attempt to estimate the real value of the target company. For example, the enterprise value of Macy’s, using data from its 2017 10-K report, is estimated to be \$11.81 billion. After the real value of the company has been determined, the acquiring company will decide how much it is willing to pay on top of the real value in order to present an attractive deal, especially if there are other firms considering acquisition. For example, an acquirer may decide to pay a 20% premium to buy Macy’s. The total acquisition cost it will propose will, therefore, be \$11.81 billion x 1.2 = \$14.17 billion. If this premium offer is accepted, then the acquisition premium value will be \$14.17 billion - \$11.81 billion = \$2.36 billion, or in percentage form, 20%.

The acquisition premium can also be evaluated using share price. For instance, if Macy’s is currently trading for \$26 per share, and an acquirer is willing to pay \$33 per share for the target company’s outstanding shares, the acquisition premium can be calculated as (\$33 - \$26)/\$26 = 27%. Not every company intentionally pays a premium for an acquisition. Using our price per share example, if there was no premium offer on the table and the acquisition cost was agreed at \$26 per share, but the value of the company drops to \$16 before the acquisition becomes final, the acquirer will find itself paying a premium of (\$26 - \$16)/\$16 = 62.5%. In cases where the target’s stock price falls dramatically, its product becomes obsolete or concerns are raised about the future of the industry, then the acquiring company may withdraw its offer.

An acquirer will typically pay an acquisition premium to close a deal and ward off competition.  An aquisition premium might be paid, too, if the acquirer believes that the synergy created from the merger or acquisition will be greater than the total cost of acquiring the target. The size of the premium often depends on various factors such as competition within the industry, the presence of other bidders and the motivations of the buyer and seller.

Acquisition premium is recorded as goodwill on the acquirer’s balance sheet. The value of a company’s brand name, solid customer base, good customer relations, good employee relations and any patents or proprietary technology acquired from the target company are factored into goodwill. An adverse event, such as declining cash flows, economy depression, increased competitive environment, etc., can lead to an impairment of goodwill, which occurs when the market value of the intangible asset drops below its acquisition cost. Any impairment results in a decrease in the goodwill account on the balance sheet and a loss on the income statement.

An acquirer can purchase a target company for a discount, that is, for less than its fair market value. When this occurs, negative goodwill is recognized.

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