Key Rule 3

Question 1

Key rule 3

Answer 1

How does the payment method affect the deal?

Trade offs between different methods of financing an acquisition

Question 2

If a buyer pays more for a seller

Answer 2

Deal will be more dilutive, assuming mix of cash/stock/debt stays the same

Question 3

A deal will generally be dilutive if

Answer 3

The amount of pre-tax income the seller contributes is not enough to offset the foregone interest on cash

• buyer almost always prefers to use 100% cash when acquiring a seller, because cash is cheaper than debt and doesn’t require loss of ownership
• sellers also prefer cash because its less risky than equity which may fall in price

Question 4

What will buyer look at when choosing to use debt or stock issuance

Answer 4

Debt: look at % of debt used in recent, similar deals as well as leverage ratio
Stock issuance: look at how much ownership its giving up and how much its diluting existing shareholders, also will look at share price.

Question 5

Rules of thumb for merger models

Answer 5

1 - 100% stock deals and P/E multiples
2 - how to determine accretion/dilution for all deals

Question 6

Rule 1: 100% stock deals and P/E multiples

Answer 6

In an all-stock deal, if the buyer has higher P/E than the seller, deal will be accretive.
- P/E = EV/ Net Income
Buyer EV = 100, NI = 10, PE = 10x, so 10p per £ paid
Seller EV = 80, NI = 10, PE = 8x, so 12.5p per £ paid

You get more for your money with the seller because its PE multiple is lower, so the buyer would get more for each dollar invested in the seller than what it is currently earning - accretion

Question 7

Assumptions with Rule 1

Answer 7

Simplification
- assumes that buyer and seller have same tax rates
- no premium paid for the seller over its current share prices
- also that there are no other acquisition effects like D&A from asset write-ups

Rule rarely holds up, but if sellers P/E is higher than the buyer’s P/E, almost 100% deal will be dilutive

Question 8

Rule 2: how to determine accretion/ dilution for all deals

Answer 8

To determine whether a deal is accretive or dilutive:
- calculate the weighted cost for the buyer and compare it to the yield of the seller.
- if buyer’s cost > the seller’s yield, its dilutive

Question 9

Cost of cash
Cost of debt
Cost of stock
Yield of seller

Answer 9

Cost of cash = foregone interest rate on cash x (1 - buyer tax rate)
Cost of debt = interest rate on debt x (1 - buyer tax rate)
Cost of stock = reciprocal of buyers P/E multiple
Yield of seller - reciprocal of seller’s P/E multiple

Question 10

If cost of any cash/debt/stock exceed yield of seller

Answer 10

Dilutive, so dont use that financing method.

Find the optimal financing method by finding what would happen with different weightings and then what the cost would be

Question 11

Is cash always the cheapest way to acquire a company

Answer 11

Not always
If the buyer has an extremely high P/E multiple, like 100%, reciprocal is 1% which may be lower than the after-tax cost of cash for them

Question 12

Problem with rule 2

Answer 12

Doesnt account for other acquisition effects - synergies, new D&A, etc
- shows what deal would look like on a non-synergy, cash-only basis
Also doesn’t account for premium paid for the seller, unless you use the purchase price for the seller’s yield rather than its current share price

E.g.
sellers net income is 100 mil, market cap is 1 bil, P/E = 10, current yield is 10%
BUT, if buyer pays 1.5 billion for the seller, EFFECTIVE yield is only 6.667%