deck_4629083-LBO Flashcards
What’s the purpose of Purchase Price Allocation in an M&A deal? Can you explain how it works?
• The ultimate purpose is to make the combined B/S balance. This is harder than it sounds b/c many items get adjusted up or down (e.g. PPE)‚ some items disappear altogether (e.g. the Seller’s Shareholders’ Equity)‚ and some new items get created (e.g. Goodwill).• To complete the process‚ you look at every single item on the Seller’s B/S and then assess the fair market value of all those items‚ adjusting them up or down as necessary.• So if the buyer pays‚ say $1B for the Seller‚ you figure out how much of that $1B gets allocated to each Asset on the B/S.• Goodwill (and Other Intangible Assets) serves as the “plug” and ensures that both sides balance after you’ve made all the adjustments. Goodwill is roughly equal to the Equity Purchase Price minus the Seller’s Shareholders’ Equity and other adjustments.
Explain the complete formula for how to calculate Goodwill in an M&A deal.
Goodwill = Equity Purchase Price - Seller Book Value + Seller’s Existing Goodwill - Asset Write-Ups - Seller’s Existing DTL + Write-down of Seller’s Existing DTA + Newly Created DTLs + Intercompany A/R - Intercompany A/P• Seller Book Value is just the Shareholders’ Equity number (technically‚ the Common Shareholders’ Equity number)• You add the Seller’s Existing Goodwill b/c it is “reset” and written down to $0 in an M&A deal.• You subtract the Asset Write-Ups b/c these are additions to the Assets side of the B/S - Goodwill is also an asset‚ so effectively you need less Goodwill to “plug the hole.”• Normally you assume 100% of the Seller’s existing DTL is written down.• The seller’s existing DTA may or may not be written down completely.• You add Intercompany A/R because they go away‚ which reduces the Assets side; the opposite applies for Intercompany A/P.
Why do we adjust the value of Assets such as PP&E in an M&A deal?
• B/c often the fair market value is significantly different from the B/S value. A perfect example is real estate - usually it appreciates over time‚ but due to the rules of accounting‚ companies must depreciate it on the B/S and show a declining balance over time to reflect the allocation of costs over a long time period.• Investments‚ Inventory‚ and other Assets may have also “drifted” from their fair market values since the B/S is recorded at historical cost for companies in most industries (exceptions‚ such as commercial banking‚ do exist).
What’s the logic behind Deferred Tax Liabilities and Deferred Tax Assets?
• The basic idea is that you normally write down most of the seller’s existing DTLs and DTAs to “reset” its tax basis‚ since it’s now part of another entity.• And then you may create new DTLs or DTAs if there are Asset Write-Ups or Write-Downs and the book and tax D&A numbers differ.• If there are write-ups‚ a DTL will be created in most deals since the Depreciation on the write-ups is not tax-deductible‚ which means that the company will pay more in cash taxes; the opposite applies for write-downs and there‚ a DTA would be created.
How do you treat items like Preferred Stock‚ Noncontrolling Interests‚ Debt‚ and so on‚ and how do they affect Purchase Price Allocation?
• Normally‚ you build in the option to repay (or in the case of Noncontrolling Interests‚ purchase the remainder of) these items or assume them in the Sources & Uses schedule. If you repay them‚ additional cash/debt/stock is required to purchase the seller.• However‚ that choice‚ does NOT affect Purchase Price Allocation.• You always start w/ the Equity Purchase Price there‚ which excludes the treatment of all these items. Also‚ you only use the seller’s Common Shareholders’ Equity in the PPA schedule‚ which excludes Preferred Stock and Noncontrolling Interests.
Do you use Equity Value or Enterprise Value for the Purchase Price in a merger model?
• This is a trick question because neither one is entirely accurate. The PPA schedule is based on the Equity Purchase Price‚ but the actual amount of cash/stock/debt used is based on that Equity Purchase Price plus the additional funds needed to repay debt‚ pay for transaction-related fees‚ and so on.• That number is not exactly “Enterprise Value” - it’s something in between Equity Value and Enterprise Value‚ and it’s normally labeled “Funds Required” in a model.
How do you reflect transaction costs‚ financing fees‚ and miscellaneous expenses in a merger model?
• You expense transaction and miscellaneous fees (such as legal and accounting services) upfront and capitalize the financing fees and amortize them over the term of the debt.• Expensed transaction fees come out of Retained Earnings when you adjust the B/S (and Cash on the other side)‚ while Capitalized Financing Fees appear as a new Asset on the Balance Sheet (and reduce Cash immediately) and are amortized each year according to the tenor of the debt.• In reality‚ you pay for all of these fees upfront in cash. However‚ since financing fees correspond to a long-term item rather than a one-time transaction‚ they’re amortized over time on the Balance Sheet. It’s similar to how new CapEx spending is depreciated over time.• NONE of this affects Purchase Price Allocation. These fees simply increase the “Funds Required” number discussed above‚ but they make absolutely NO impact on the Equity Purchase Price or on the amount of Goodwill created.
How would you treat Debt differently in the Sources & Uses table if it is refinanced rather than assumed?
• If the buyer assumes the Debt‚ it appears in BOTH the Sources and Uses columns and has no effect on the Funds Required.• If the buyer pays off the Debt‚ it appears only in the Uses column and increases the Funds Required.
What are the 3 main transaction structures you could use to acquire another company?
• The 3 main structures are the Stock Purchase‚ Asset Purchase‚ and 338(h)(10) Election.• Note that Stock Purchases and Asset Purchases exist in some form in countries worldwide‚ but that the 338(h)(10) Election is specific to the US - however‚ there may be equivalent legal structures in other countries.• Part of the reason that both parties favor the 338(h)(10) structure is that buyers typically agree to pay more to compensate sellers for the favorable tax treatment they receive.• See p. 49 (of 66) of BIWS - Merger Model Guide for comparison table.
Would a seller prefer a Stock Purchase or an Asset Purchase? What about the buyer?
• A seller almost always prefers a Stock Purchase to avoid double taxation and to dispose of all its Liabilities.• A buyer almost always prefers an Asset Purchase so it can be more careful about what it acquires and to get the tax benefit from being able to deduct D&A on Asset Write-Ups for tax purposes.• However‚ it’s not always possible to “pick” one or the other - for example‚ if the seller is a large public company only a Stock Purchase is possible in 99% of cases.
Why might a company want to use 338(h)(10) when acquiring another company?
A Section 338(h)(10) election blends the benefits of a Stock Purchase and an Asset Purchase:• Legally it is a Stock Purchase‚ but accounting-wise it’s treated like an Asset Purchase.• The seller is still subject to double-taxation - capital gains on any Assets that have appreciated and on the proceeds from the sale.• But the buyer receives a step-up tax basis on the new Assets it acquires‚ and it can depreciate and amortize them so it saves on taxes.Even though sellers still get taxed twice‚ buyers will often pay more in a 338(h)(10) deal b/c of the tax-savings potential. It’s particularly helpful for:• Sellers w/ high NOL balances (more tax-savings for the buyer b/c this NOL balance will be written down completely - so more of the excess purchase price can be allocated to Asset Write-Ups)• Companies that have been S-Corporations for over 10 years - in this case they do not have to pay taxes on the appreciation of their Assets. • NOTE: The requirements to use 338(h)(10) are complex and it cannot always be used. For example‚ if the seller is a C-Corporation it can’t be applied; also‚ if the buyer is not a C-Corporation (e.g. a private equity firm)‚ it also can’t be used.
How do you take into account NOLs in an M&A deal?
• You apply Section 382 to determine how much of the Seller’s NOLs are usable each year.• Allowable Annual NOL Usage = Equity Purchase Price * Highest of Past 3 Months’ Adj. Long-Term Rates• So if our Equity Purchase Price were $1B and the highest adj. long-term rate were 5%‚ then we could use $1B * 5% = $50M of NOLs each year.• If the Seller had $250M in NOLs‚ then the combined company could use $50M of them each year for 5 years to offset its taxable income.
Why do deferred tax liabilities (DTLs) and deferred tax assets (DTAs) get created in M&A deals?
• These get created when you write-up assets - both tangible and intangible - and when you write down assets in a transaction. An Asset Write-up creates a DTL and an Asset Write-Down creates a DTA.• You write down and write up assets b/c their book values (what’s on the B/S) often differ substantially from their “fair market values.”• An asset write-up creates a DTL b/c you’ll have a higher Deprecation Expense on the new asset‚ which means you save on taxes in the short-term‚ but eventually you’ll have to pay them back‚ so you get a liability. The opposite applies for an asset write-down and a DTA.
How do DTLs and DTAs affect the Balance Sheet Adjustments in an M&A deal?
• You take them into account w/ everything else when calculating the amount of Goodwill & Other Intangibles to create on your pro-forma B/S. The formulas are as follows:• DTA = Asset Write-Down * Tax Rate; DTL = Asset Write-Up * Tax Rate• So let’s say you were buying a company for $1B w/ 50% cash and 50% debt‚ and you had a $100M asset write-up and a tax rate of 40%. In addition‚ the seller has total Assets of $200M‚ total Liabilities of $150M‚ and Shareholders’ Equity of $50M. Here’s what would happen on the combined company’s balance sheet (ignoring transaction and financing fees):• First‚ you simply add the seller’s Assets and Liabilities (but NOT Shareholders’ Equity - it is wiped out) to the buyer’s to get your “initial” B/S. Assets are up by $200M an Liabilities are up by $150M.• Then Cash on the Assets side goes down by $500M.• You have an Asset Write-Up of $100M‚ so Assets go up by $100M; Debt on the Liabilities & Equity side goes up by $500M.• You get a new DTL of $40M ($100M * 40%) on the Liabilities & Equity Side.• Assets are down by $200M total and Liabilities & Shareholders’ Equity are up by $690M ($500 + $40 + $150)• So you need Goodwill & Intangibles of $890M on the Assets side to make both sides balance.
Could you get DTLs or DTAs in an Asset Purchase?
No‚ b/c in an Assets Purchase‚ the book basis of assets always matches the tax basis. DTLs and DTAs get created in Stock Purchases b/c the book values of Assets are written up or written down‚ but the tax values do not.
How do you factor in DTLs into forward projections in a merger model?
• You create a book vs. cash tax schedule and figure out what the company owes in taxes based on the Pre-Tax Income on its books‚ and then you determine what it actually pays in cash taxes based on its NOLs and its new D&A expenses (from any Asset Write-Ups)• Anytime the “cash” tax expense exceeds the “book” tax expense you record this as a decrease to the Deferred Tax Liability on the B/S; if the “book” expense is higher‚ then you record that as an increase to the DTL.
Can you give me an example of how you might calculate revenue synergies?
• Sure‚ let’s say that Company A sells 10‚000 widgets/year in N. America at an average price of $15 and Company B sells 5000 widgets/year in Europe at an average price of $10. Company A believes that it can sell its own widgets to 20% of Company B’s customers‚ so after it acquires Company B it will earn an extra 20% * 5000 * $15 in revenue or $15‚000.• It will also have expenses associated w/ those extra sales‚ so you need to reflect those as well (if it has a 50% margin‚ for example‚ it would reflect an additional $7‚500 rather than $15‚000 to Operating Income and Pre-Tax Income on the combined Income Statement.• This last point about expenses associated w/ revenue synergies is important and one that a lot of people forget - there’s no such thing as “free” revenue with no associated costs.
Should you estimate revenue synergies based on the seller’s customers and the seller’s financials‚ or the buyer’s customers and the buyer’s financials?
• Either one works. You could assume that the buyer leverages the seller’s products or services and sells them to its own customer base - but typically you assume an uplift to the seller’s average selling price‚ or something else that the buyer can do w/ the seller’s existing customers.• You approach it that way b/c the buyer‚ as a larger company‚ can make more of an immediate impact on the seller than the seller can make on the buyer.
Walk me through an example of how to calculate expense synergies.
• Let’s say that Company A wants to acquire Company B. Company A has 5000 SG&A related employees‚ whereas Company B has around 1000.• Company A calculates that post-transaction‚ it will only need about 800 of Company B’s SG&A employees‚ and its existing employees can take over the rest of the work.• To calculate the Operating Expenses the combined company would save‚ we would multiply these 200 employees that Company A is going to fire post-transaction by their average salary‚ benefits‚ and other compensation expenses.
How do you think about synergies if the combined company can consolidate buildings?
• If the buildings are leased‚ you assume that both lease expenses go away and are replaced w/ a new‚ larger lease expense for the new or expanded building. So in that case‚ it is a simple matter of New Lease Expense - Old‚ Separate Lease Expense to determine the synergies.• If the buildings are owned‚ it gets more complicated b/c one or both of them will be sold‚ or perhaps leased out to someone else. Then you would have to look at Depreciation and Interest savings‚ as well as additional potential income if the building is rented out.
What if there are CapEx synergies? For example‚ what if the buyer can reduce its CapEx spending because of certain assets the seller owns?
• In this case‚ you would start recording a lower CapEx charge on the combined SCF‚ and then reflect a reduced Depreciation charge on the I/S from that new CapEx spending each year.• You would not start seeing the results until Year 2 b/c reduced Depreciation only comes after reduced CapEx spending. This scenario would be much easier to model w/ a full PP&E schedule where you can adjust the spending and the resulting Depreciation each year.
What happens when you acquire a 30% stake in a company? Can you still use an accretion/dilution analysis?
• You record this 30% as an “Investment in Equity Interest” or “Associate Company” on the Assets side of the B/S‚ and you reduce Cash to reflect the purchase (assuming that Cash was used). You use this treatment for all ownership percentages between 20% and 50%.• You can still use an accretion/dilution analysis; just make sure that the new Net Income reflects the 30% of the other company’s Net Income that you are entitled to.
What happens when you acquire a 70% stake in a company?
• For all acquisitions where over 50% (but less than 100%) of another company gets acquired‚ you still go through the purchase price allocation process and create Goodwill‚ but you record a Noncontrolling interest on the Liabilities side for the portion you do NOT own. You also consolidate 100% of the other company’s statements with your own‚ even if you only own 70% of it.• Example: You acquire 70% of another company using Cash. The company is worth $100‚ and has Assets of $180‚ Liabilities of $100‚ and Equity of $80.• You add all of its Assets and Liabilities to your own‚ but you wipe out its Equity since its no longer considered an independent entity. The Assets side is up by $180 and the Liabilities side is up by $100. You also used $70 of Cash‚ so the Assets side is now only up by $110. • We allocate the purchase price here‚ and since 100% of the company was worth $100 but its Equity was only $80‚ we create $20 of Goodwill - so the Assets side is up by $130.• On the Liabilities side‚ we create a Noncontrolling Interest of $30 to represent the 30% of the company that we do NOT own. Both sides are up by $130 and balance.
Let’s say that a company sells a subsidiary for $1000‚ paid for by the buyer in Cash. The buyer is acquiring $500 of Assets with the deal‚ but it’s assuming no Liabilities. Assume a 40% tax rate. What happens on the 3 statements after the sale?
• Income Statement: We record a Gain of $500‚ since we sold Balance Sheet Assets of $500 for $1000. That boosts Pre-Tax Income by $500 and Net Income by $300 assuming a 40% tax rate.• Cash Flow Statement: Net Income is up by $300‚ but we subtract the Gain of $500 in the CFO section‚ so cash flow is down by $200 so far. We add the full amount of sale proceeds ($1000) in the CFI section‚ so cash at the bottom is up by $800.• Balance Sheet: Cash on the Assets side is up by $800‚ but we’ve lost $500 in Assets‚ so the Assets side is up by $300. On the other side‚ Shareholders’ Equity is also up by $300 due to the increased Net Income.• In this scenario‚ you’d also have to go back and remove revenue and expenses from this sold-off division and label them “Discontinued Operations” on the financial statements prior to the close of the sale.
