What is a bargain purchase option?
A bargain purchase option is a type of options contract that gives the holder the right, but not the obligation, to acquire an asset or business at a pre-determined price that is lower than the fair value of the asset or business. This type of option is commonly used in mergers and acquisitions (M&A) as a way to provide a buyer with the ability to acquire an asset or business at a discounted price.
How Bargain Purchase Options are Used in Mergers and Acquisitions?
When a company exercises a bargain purchase option, it is required to recognize the difference between the fair value of the asset or business and the option exercise price as a gain in its income statement. This gain is commonly referred to as a "bargain purchase gain."
For example, suppose a company has a bargain purchase option to acquire a business for $10 million, and the fair value of the net assets of the business is determined to be $12 million. If the company exercises the option, it would recognize a gain of $2 million in its income statement, which would be reported as "Bargain purchase gain" in the income statement.
Differences between Bargain Purchase Options and Call Options
It is important to note that a bargain purchase option is not the same as a call option, which gives the holder the right, but not the obligation, to acquire an asset at a pre-determined price that is higher than the fair value of the asset. A call option is typically used as a way to speculate on the future value of an asset, whereas a bargain purchase option is used as a way to acquire an asset or business at a discounted price.
Bargain Purchase Options in Leveraged Buyouts
Bargain purchase options are also used in leveraged buyouts (LBO) as a way for the acquirer to acquire a target company at a discounted price. It allows the acquirer to purchase a target company using a combination of equity and debt financing, with the option to acquire the remaining shares at a pre-determined price in the future. This allows the acquirer to spread out the cost of the acquisition over time, making it more manageable.
Conclusion
In conclusion, bargain purchase options are a useful tool in mergers and acquisitions and leveraged buyouts as a way for a buyer to acquire an asset or business at a discounted price. It allows the buyer to recognize a gain in its income statement, commonly referred to as a "bargain purchase gain" when the option is exercised. It is important to differentiate between a bargain purchase option and a call option, as the latter is used for speculation on the future value of an asset, while the former is used for acquiring an asset or business at a discounted price
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