400 Question Flashcards - Merger Model
Why would a company want to acquire another company?
A company would acquire another company if it believes it will earn a good return on its investment - either in the form of a literal ROI‚ or in terms of a higher EPS number‚ which appeals to shareholders.
There are several reasons why a buyer might believe this to be the case:
• The buyer wants to gain market share by buying a competitor.
• The buyer needs to grow quickly and sees an acquisition as a way to do that.
• The buyer believes the seller is undervalued.
• The buyer wants to acquire the seller’s customers so it can up-sell and cross-sell products and services to them.
• The buyer thinks the seller has a critical technology‚ intellectual property‚ or other “secret sauce” it can use to significantly enhance its business.
• The buyer believes it can achieve significant synergies and therefore make the deal accretive for its shareholders.
Walk me through a basic merger model.
- A merger model is used to analyze the financial profiles of 2 companies‚ the purchase price and how the purchase is made‚ and it determines whether the buyer’s EPS increases or decreases afterward.
- Step 1 is making assumptions about the acquisition - the price and whether it was done using cash‚ stock‚ debt‚ or some combination of those. Next‚ you determine the valuations and shares outstanding of the buyer and seller and project the Income Statements for each one.
- Finally‚ you combine the Income Statements‚ adding up line items such as Revenue and Operating Expenses‚ and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer’s Tax Rate and get the Combined Net Income‚ and then divide by the new share count to determine the combined EPS.
- You could also add in the part about Goodwill and combining the Balance Sheets‚ but it’s best to start with answers that are as simple as possible at first.
What’s the difference between a merger and an acquisition?
- There’s always a buyer and a seller in any M&A deal - the difference is that in a merger‚ the companies are similarly-sized‚ whereas in an acquisition the buyer is significantly larger (often by a factor of 2-3x or more).
- Also‚ 100% stock (or majority stock) deals are more common in mergers because similarly sized companies rarely have enough cash to buy each other‚ and cannot raise enough debt to do so either.
Why would an acquisition be dilutive?
- An acquisition is dilutive if the additional Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash‚ additional interest paid on debt‚ and the effects of issuing additional shares.
- Acquisition effects - such as the amortization of Other Intangible Assets - can also make an acquisition dilutive.
Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?
YES:
• Cost of Cash = Foregone Interest on Cash * (1 - Buyer Tax Rate)
• Cost of Debt = Interest Rate on Debt * (1 - Buyer Tax Rate)
• Cost of Stock = Reciprocal of Buyer’s P/E Multiple (i.e. E/P or NI/Equity Value)
• Yield of Seller = Reciprocal of Seller’s P/E Multiple (ideally calculated using Purchase Price rather than the Seller’s Current Share Price)
- You calculate each of the Costs‚ take the weighted average‚ and then compare that number to the Yield of the Seller (the reciprocal of the Seller’s P/E multiple).
- If the weighted “Cost” average is less than the Seller’s Yield‚ it will be accretive since the purchase itself “costs” less than what the buyers get out of it; otherwise‚ it will be dilutive.
Example: The buyer’s P/E multiple is 8x and the seller’s P/E multiple is 10x. The buyer’s int. rate on cash is 4%‚ and int. rate on debt is 8%. The buyer is paying with 20% cash‚ 20% debt‚ and 60% stock. The buyer’s tax rate is 40%:
• Cost of Cash = 4% * (1 - 40%) = 2.4%
• Cost of Debt = 8% * (1 - 40%) = 4.8%
• Cost of Stock = 1/8 = 12.5%
• Yield of Seller = 1/10 = 10%
• Weighted Average Cost = 20%(2.4%) + 20%(4.8%) + 60%(12.5%) = 8.9% < 10%
• Summary: Since Weighted Average Cost < Seller’s Yield‚ the deal is ACCRETIVE.
Wait a minute‚ though‚ does [the rule of thumb for determining whether an acquisition will be accretive or dilutive] work all the time?
- NO‚ there are a number of assumptions here that rarely hold up in the real world: the seller and buyer have the same tax rates‚ there are no other acquisition effects such as new D&A‚ there are no transaction fees‚ no synergies‚ etc.
- And most importantly‚ the rule truly breaks down if you use the seller’s current share price rather than the price the buyer is paying to purchase it.
- It’s a great way to quickly assess a deal‚ but it is NOT a hard-and-fast rule.
A company with a higher P/E acquires one with a lower P/E - is this accretive or dilutive?
- TRICK QUESTION: You can’t tell unless you also know that it’s an all stock deal. If it’s an all-cash or all-debt deal‚ the P/E multiple of the buyer doesn’t matter b/c no stock is being issued.
- If it is an all-stock deal‚ then the deal will be accretive since the buyer “gets” more in earnings for each $1.00 used to acquire the other company that it does from its own operations. The opposite applies if the buyer’s P/E multiple is lower than the seller’s.
Why do we focus so much on accretion/dilution? Is EPS really that important? Are there cases where it’s not relevant?
- EPS is important mostly b/c institutional investors value it and base many decisions on EPS and P/E multiples - not the best approach‚ but it is how they think.
- A merger model has many purposes besides just calculating EPS accretion/dilution - for example‚ you could calculate the IRR of an acquisition if you assume that the acquired company is resold in the future‚ or even that it generates cash flows indefinitely into the future.
- An equally important part of a merger model is assessing what the combined financial statements look like and how key items change.
- So it’s not that EPS accretion/dilution is the ONLY important point in a merger model - but is what’s most likely to come up in interviews.
How do you determine the Purchase Price for the target company in an acquisition?
- You use the same Valuation methodologies we discussed in the Valuation section. If the seller is a public company‚ you would pay more attention to the premium paid over the current share price to make sure it’s “sufficient” (generally in the 15-30% range) to win shareholder approval.
- For private sellers‚ more weight is placed on the traditional methodologies.
All else being equal‚ which method would a company prefer to use when acquiring another company - cash‚ stock‚ or debt?
Assuming the buyer had unlimited resources‚ it would almost always prefer to use cash when buying another company. Why?
• Cash is cheaper than debt b/c int. rates on cash are usually under 5% whereas debt int. rates are almost always higher than that. Thus‚ foregone interest on cash is almost always LESS than the additional interest paid on debt for the same amount of cash or debt.
• Cash is almost always cheaper than stock b/c most companies P/E multiples are in the 10-20x range‚ which equals 5-10% for “Cost of Stock”
• Cash is also less risky than debt b/c there’s no chance the buyer might fail to raise sufficient funds from investors‚ or that the buyer might default.
• Cash is also less risky than stock b/c the buyer’s share price could change dramatically once the acquisition is announced.
Could there be cases where cash is actually more expensive than debt or stock in an acquisition?
- With debt this is impossible‚ b/c it makes no logical/financial sense: why would a bank ever pay more on cash you’ve deposited than it would charge to customers who need to borrow money?
- With stock it is almost impossible‚ but sometimes if the buyer has an extremely high P/E multiple (e.g. 100x)‚ the reciprocal of that (1%) might be lower than the after-tax cost of cash. This is rare‚ extremely rare.
If a company were capable of paying 100% in cash for another company‚ why would it choose NOT to do so?
- It might be saving its cash for something else‚ or it might be concerned about running low on cash if business takes a turn for the worst.
- The buyer’s stock may also be trading at an all-time high and it might be eager to use that “currency” instead‚ for the reasons stated above: stock is less expensive to issue if the company has a high P/E multiple and therefore a high stock price.
How much debt could a company issue in a merger or acquisition?
- You would look at Comparable Companies and Precedent Transactions to determine this. You would use the combined company’s EBITDA figure‚ find the median Debt/EBITDA ratio of the companies or deals you’re looking at‚ and apply that to the company’s own EBITDA figure to get a rough idea of how much debt it could raise.
- You could also look at “Debt Comps” for similar‚ recent deals and see what types of debt and how many tranches they have used.
When would a company be most likely to issue stock to acquire another company?
- The buyer’s stock is trading at an all-time high‚ or at least at a very high level‚ and it’s therefore “cheaper” to issue stock than it normally would be.
- The seller is almost as large as the buyer and it’s impossible to raise enough debt or use enough cash to acquire the seller.
Let’s say that a buyer doesn’t have enough cash available to acquire the seller. How could it decide between raising debt‚ issuing stock‚ or some combination of those?
There’s no simple rule to decide - key factors include:
• The relative “cost” of both debt and stock: For example‚ if the company is trading at a higher P/E multiple it may be cheaper to issue stock (e.g. P/E of 20x = 5% cost‚ but debt at 10% interest = 10%*(1 - 40%) = 6% cost.
• Existing Debt: If the company already has a high debt balance‚ it likely can’t raise as much new debt.
• Shareholder dilution: Shareholders do not like the dilution that comes w/ issuing new stock‚ so companies try to minimize this.
• Expansion Plans: If the buyer expands‚ begins a huge R&D effort‚ or buys a factory in the future‚ it’s less likely to use cash and/or debt and more likely to issue stock so that it has enough funds available.
