Key Rule 2

Question 1

How does a merger model work? Steps

Answer 1

Step 1: determine the purchase price
Step 2: determine the purchase method
Step 3: project financial profiles and statements of buyer n seller
Step 4: combine the buyer and sellers’ IS
Step 5: calculate goodwill and allocate the purchase price
Step 6: combine BS and adjust for acquisition effects
Step 7: adjust the combined IS for acquisition effects
Step 8: calculate accretion/ dilution and create sensitivity tables

Question 2

Step 1: determine the purchase price

Answer 2

Value the company:
- use a combination of public comps, precedent transactions and the DCF to come up with reasonable price
- if public: come up with a per-share purchase price
- if private: assume an implied equity value based on the valuation

Question 3

Step 2: determine the purchase method

Answer 3

How to pay for it: cash, stock, or debt
- cash: normal transaction, but there is issue of foregone interest on cash
- stock: diluted ownership of existing shareholders, increases additional shares outstanding and reduces EPS - upset investors

Question 4

Step 3: project the financial profiles and statements of the buyer and seller

Answer 4

Comes straight from the 3 statement models you’ve created for the buyer and seller:
- valuation: share price, share outstanding, EVs
- Tax rate
- revenue
- operating income
- interest income/expense
- pre tax/ net income
- shares outstanding and EPS: for accretion/dilution

Question 5

Step 4: combine the buyers and sellers’ income statements

Answer 5

• add together everything on the income statements down to the pre-tax income line
• multiply the combined pre-tax income by (1 - buyer’s tax rate) to get combined net income
• add new shares issued to the buyer’s shares outstanding
• divide net income by that new share count to determine EPS
• do not add in seller’s shares outstanding - all wiped out in acquisition

Question 6

Step 5: calculate the goodwill and allocate the purchase price

Answer 6

• seller’s shares outstanding disappear completely and its shareholders equity is also wiped out
• goodwill calculation
• adjust value of seller’s PP&E and other assets
• usually reset seller’s existing goodwill and write down to 0
• create deferred tax liabilities due to the adjustments to PP&E and other Assets

Key thing: adjust a bunch of items on the BS in a merger model, need to create goodwill (and other intangible assets) to plug the holes and represent the premium a buyer pays over a seller’s shareholders equity

Question 7

Difference between goodwill and other intangible assets

Answer 7

Goodwill is not amortised and doesn’t change unless there is an impairment charge
VS
Other intangible assets amortise over time, reflecting how they expire.

Question 8

Goodwill calculation example

• buyer has 10k assets, 8k liabilities, 2k Equity
• seller has 1k assets, 0.8k liabilities, 0.2k equity
• buyer pays 0.5k for the seller, using 100% cash

Answer 8

Assets = 11k - 500 = 10.5k
Liabilities + Equity = 10.8k

Therefore difference is 300 dollars - our goodwill asset

Question 9

Step 6: combine the balance sheets and adjust for acquisition effects
- current asserts
- LT assets
- current liabilities
- LT liabilities
- Shareholders’ Equity

Answer 9

• Current assets: add most of these items, subtract any cash buyer uses to acquire the seller
• LT assets: adjust PP&E, goodwill and OI assets up or down
• current liabilities: add everything here, add or subtract debt if buyer uses debt to acquire, or pays off seller’s debt
• LT liabilities: add most of the items here, debt same as above, adjust deferred tax liability
• shareholders’ equity: write out sellers SE, but add dollar value of new shares issued by buyer

Question 10

Step 8: calculate accretion/ dilution and create sensitivity tables

Answer 10

To calculate accretion/ dilution, compare new combined EPS number to the old projected EPS of the buyer pre acquisition
- if buyer projected to have EPS of £1 prior to acquisition, but combined now projected to have £1.10 EPS, 10% accretion and £0.90 EPS is 10% dilution
- then create sensitivity tables which allow the change of EPS at different purchase prices, transaction structures, and purchase methods
E.g. might see how EPS changes when you buy a company with 30,40,50% cash at purchase prices ranging.
Allows you to assess whether or not the deal still works under different assumptions.

Question 11

Step 7: adjust the combined IS for acquisition effects

Answer 11

• synergies
• depreciation and amortisation
• foregone interest on cash: cash used x interest rate
• interest paid on new debt: debt used x interest rate
• shares outstanding: old buyer shares outstanding + shares issued in deal