M&A

Question 1

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x. Will the deal be accretive?

Answer 1

Can’t know unless its a 100% stock deal. If it is, then the Buyer’s PE reveals that the WCA is 1/25 (4%) vs the Seller’s Yield of 1/15 (6.7%) which shows that it is an accretive deal

Question 2

Walk me through the full math for the deal now.
Assume that Company A has 10 shares outstanding at a share price of $25.00, and its Net
Income is $10. It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of
$10 as well. Assume the same tax rates for both companies. How accretive is this deal?

Answer 2

Company A’s EPS is $10 / 10 = $1.00.
To do the deal, Company A must issue 6 new shares since $150 / $25.00 = 6, so the Combined
Share Count is 10 + 6 = 16.
Since no Cash or Debt were used and the tax rates are the same, the Combined Net Income =
Company A Net Income + Company B Net Income = $10 + $10 = $20.
The Combined EPS, therefore, is $20 / 16 = $1.25, so there’s 25% accretion.

Question 3

Company A now uses Debt with an Interest Rate of 10% to acquire Company B. Is the deal
still accretive? At what interest rate does it change from accretive to dilutive?

Answer 3

The Weighted Cost of Acquisition would be 10% * (1 – 40%), or 6%, so the deal would still be
accretive because that Cost is less than the Seller’s Yield of 6.7%. 11.1% would make the deal dilutive

Question 4

How can you tell whether an M&A deal will be accretive or dilutive?

Answer 4

x Cost of Cash = Foregone Interest Rate on Cash * (1 – Buyer’s Tax Rate)
x Cost of Debt = Interest Rate on New Debt * (1 – Buyer’s Tax Rate)
x Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e. Net Income / Equity Value.
x Seller’s Yield = Reciprocal of the Seller’s P / E multiple, calculated using the Purchase
Equity Value.
x Weighted Cost of Acquisition = % Cash Used * Cost of Cash + % Debt Used * Cost of Debt + %
Stock Used * Cost of Stock.
If the Weighted Cost is less than the Seller’s Yield, the deal will be accretive, if the Weighted
Cost is greater than the Seller’s Yield, the deal will be dilutive.

Question 5

What are the Combined Equity Value and Enterprise Value in this deal?
Assume the original 100% Stock structure, and that Equity Value = Enterprise Value for both
the Buyer and Seller.

Answer 5

Combined Equity Value = Buyer’s Equity Value + Value of Stock Issued in the Deal = $250 + $150
= $400.
Combined Enterprise Value = Buyer’s Enterprise Value + Purchase Enterprise Value of Seller =
$250 + $150 = $400.

Question 6

How do the Combined EV / EBITDA and P / E multiples change if the purchase method
changes?

Answer 6

EV/EBITDA doesn’t change, but P/E do because of stock issued and cash/debt use that affects net income

Question 7

Without doing any math, what range would you expect for the Combined P / E multiple?

Answer 7

Cannot average them, but you know it will be between 25x-15x, and if there is a big size difference, it’ll be closer to 25x. If they are similar sizes, it will be more in the middle

Question 8

Now assume that Company A is twice as big financially, so its Equity Value is $500 and its
Net Income is $20. Will a 100% Stock deal be more or less accretive?

Answer 8

The deal is less accretive because the buyer, company A, has a higher weighting, and the yield on the 25x bigger weight drags down the combined EPS

Question 9

Now do the math. What is the accretion/dilution in a 100% Stock deal?

Answer 9

The Buyer previously represented $250 / $400, or 63%, of the total company, but now it
represents $500 / $650, or 77%, of the total company, so we’d expect the accretion to fall by
around 10-15%.
Company A’s share price is now $50.00, it still has 10 shares outstanding, and its Equity Value is
$500. Its EPS is $20 / 10 = $2.00.
To acquire Company B, Company A must issue 3 additional shares since $150 / $50.00 = 3.
Since both companies have the same tax rate and no Cash or Debt was used, you can add
together the Net Income figures: Combined Net Income = $20 + $10 = $30.
The new share count is 10 + 3 = 13, and $30 / 13 = $2.31. This is about 15% higher than the
Buyer’s standalone EPS ($0.15 is 15% of $1.00, and $0.30 is 15% of $2.00).
So it’s about 10% lower than the 25% accretion when Company A was smaller.

Question 10

Company A has a P / E of 10x, a Debt Interest Rate of 10%, a Cash Interest Rate of 5%, and
a tax rate of 40%.
It wants to acquire Company B at a purchase P / E multiple of 16x using 1/3 Stock, 1/3 Debt,
and 1/3 Cash. Will the deal be accretive?

Answer 10

No - it will be dilutive. If you do the math, WCA will be 6.33%, but the yield is only 6.25%

Question 11

Company A has an Equity Value of $1,000 and Net Income of $100. Company B has a
Purchase Equity Value of $2,000 and Net Income of $50.
For a 100% Stock deal to be accretive, how much in synergies must be realized?

Answer 11

Company A’s P / E is $1,000 / $100 = 10x, so its Cost of Stock is 10%. Company B’s P / E is
$2,000 / $50 = 40x, so its Yield is 1 / 40, or 2.5%.
Without synergies, this deal would be highly dilutive.
For the deal to turn accretive, Company B’s Yield must exceed 10%. That means that its
Purchase P / E multiple must be below 10x, which means its Net Income must be above $200
rather than $50.
So there must be $150 in after-tax synergies for this deal to be accretive. At a 40% tax rate,
there must be $250 in pre-tax synergies.

Question 12

An Acquirer has an Equity Value of $1 billion, Cash of $50 million, EBITDA of $100 million, Net Income of $50 million, and a Debt / EBITDA ratio of 2x. Peer companies have a median Debt / EBITDA ratio of 4x.
It wants to acquire another company for a Purchase Equity Value of $500 million. The Seller has a Net Income of $30 million, EBITDA of $50 million, and no Debt.
What’s the best way to fund this deal?

Answer 12

The Acquirer is unlikely to use Cash due to minimum cash balance.
The Acquirer’s P / E multiple is 20x, so its Cost of Stock is 1 / 20, or 5%.
That’s a fairly low Cost of Stock, so there’s a chance that the company’s After-Tax Cost of Debt might be higher (e.g., if the Interest Rate on Debt were above 8.33%).
However, there’s no information on the Cost of Debt, so our best guess is that Debt is still cheaper than Stock.
The company could afford to boost its Debt / EBITDA from 2x to 4x since peer companies have leverage in that range.
The Combined Company has $150 million in EBITDA, and 4 * $150 million = $600 million.
The Acquirer has $200 million in Debt before the deal takes place, so it could afford to issue $400 million in additional Debt.
The remaining $100 million would be issued in Stock.

Question 13

An Acquirer has an Equity Value of $500 million, Cash of $100 million, EBITDA of $50 million, Net Income of $25 million, and a Debt / EBITDA ratio of 3x.
Similar companies in the market have Debt / EBITDA ratios of 5x.
What’s the BIGGEST acquisition this company might be able to complete?

Answer 13

The Acquirer couldn’t use its entire Cash balance to fund a deal, but it might be able to use a
substantial portion of it, such as $50 million or $80 million.
It could afford to use leverage up to 5x EBITDA, which means that it could use $100 million in additional Debt to fund a deal. That number might change based on the Seller’s Debt and EBITDA as well.
There’s no limit on how much Stock the company could issue, but it would be unlikely to give up control just to make an acquisition, so $500 million in Stock is likely the maximum.
A more realistic level might be about half its Current Equity Value ($250 million), or whatever amount turns the deal dilutive.
So the best answer is: “In theory, the Acquirer might be able to fund a deal for up to $650 to $700 million. But in reality, unless it wants to issue a massive amount of Stock, the maximum level would be closer to $400 to $650 million.”

Question 14

An Acquirer with an Equity Value of $500 million and Enterprise Value of $600 million buys
another company for a Purchase Equity Value of $100 million and Purchase Enterprise Value
of $150 million.
What are the Combined Equity Value and Enterprise Value?

Answer 14

The Combined Enterprise Value equals the Enterprise Value of the Buyer plus the Purchase Enterprise Value of the Seller, so it’s $600 million + $150 million = $750 million.
You can’t determine the Combined Equity Value because it depends on the purchase method:
Combined Equity Value = Acquirer’s Equity Value + Value of Stock Issued in Deal.
If it’s a 100% Stock deal, the Combined Equity Value will be $500 million + $100 million = $600 million, but if it’s 100% Cash or Debt, the Combined Equity Value = $500 million.
And if the % Stock Used is above 0% but less than 100%, the Combined Equity Value will be between $500 and $600 million.

Question 15

How do the Combined Equity Value and Enterprise Value relate to the purchase method?

Answer 15

Enterprise value doesn’t change. But equity value depends on the value of stock issued, which can range from 0 to the purchase equity value of the second company. It depends on the structure of the deal financing.

Question 16

Let’s say this same Acquirer (Equity Value of $500 million and Enterprise Value of $600 million) has Net Income of $50 million and EBITDA of $100 million.
The Target (Purchase Equity Value of $100 million and Purchase Enterprise Value of $150
million) has Net Income of $10 million and EBITDA of $15 million.
What are the Combined P / E and EV / EBITDA multiples in a 100% Stock deal? Assume the same tax rates for the Acquirer and Target.

Answer 16

The Combined Equity Value in a 100% Stock deal is $500 million + $100 million = $600 million, and the Combined Enterprise Value is $600 million + $150 million = $750 million.
The Combined EBITDA is $115 million, and the Combined Net Income, assuming the same tax rates, is $50 million + $10 million = $60 million.
Therefore, the Combined P / E multiple is $600 million / $60 million = 10x, and the Combined
EV / EBITDA multiple is $750 million / $115 million = ~6.5x.

Question 17

How would those Combined Multiples change in a 100% Cash or Debt deal?

Answer 17

The Combined EV / EBITDA multiple would stay the same because neither the Combined Enterprise Value nor the Combined EBITDA is affected by the purchase method.
The Combined P / E multiple would change because the Combined Equity Value would be lower, at $500 million, in a 100% Cash or Debt deal.
The Combined Net Income would also change because of the Foregone Interest on Cash and Interest on Debt.
In most cases, the Combined P / E multiple will be lower in a 100% Cash deal because the Combined Equity Value will decline by a greater percentage than the Combined Net Income.
It will also tend to be lower in a 100% Debt deal, but you’d have to run the numbers to see for
sure – if the Interest Rate on Debt is relatively high and the Seller’s P / E multiple is low, the Combined P / E multiple might increase.

Question 18

What are the possible ranges for the Combined Multiples after a deal takes place?

Answer 18

The Combined Multiples should always be between the Buyer’s multiples and the Seller’s purchase multiples.
No averaging! The Combined Multiples will be closer to the Buyer’s multiples if the Buyer is much bigger, but
they’ll be in the middle of the range if the Buyer and Seller are closer in size.

Question 19

Consider this M&A scenario:
x Company A: Enterprise Value of $100, Equity Value of $80, EBITDA of $10, Net Income of $4, and Tax Rate of 50%.
x Company B: Enterprise Value of $40, Equity Value of $40, EBITDA of $8, Net Income of $2, and Tax Rate of 50%.
Calculate the EV / EBITDA and P / E multiples for each company.

Answer 19

Company A EV / EBITDA = $100 / $10 = 10x; P / E = $80 / $4 = 20x.
Company B EV / EBITDA = $40 / $8 = 5x; P / E = $40 / $2 = 20x.

Question 20

Company A acquires Company B using 100% Cash and pays no premium to do so. Assume a 5% Foregone Interest Rate on Cash.
What are the Combined EBITDA and P / E multiples?

Answer 20

Combined EV / EBITDA = Combined Enterprise Value / Combined EBITDA = $140 / $18 = ~7.8x.
Combined P / E = Combined Equity Value / Combined Net Income.
The Combined Equity Value is just the Acquirer’s Equity Value of $80 since no Stock was used.
We can add together both companies’ Net Incomes since they have the same tax rate, so the Combined Net Income is $6. But we have to adjust for the Foregone Interest on Cash as well.
The Acquirer used $40 in Cash, and 5% * $40 = $2. After the 50% tax rate, that’s a $1 loss.
So the Combined Net Income is $5, which makes the Combined P / E = $80 / $5 = 16x.

Question 21

Now let’s say that Company A instead uses 100% Debt with a 10% interest rate to acquire
Company B.
Again, Company A pays no premium for Company B. What are the combined multiples?

Answer 21

The Combined EV / EBITDA multiple remains the same at ~7.8x because it is not affected by the purchase method.
The Combined Equity Value is still just the Acquirer’s Equity Value of $80.
The Combined Net Income before adjustments is $6, but now we must adjust for the Interest on Debt.
If Company A uses $40 of Debt to acquire Company B, it will pay $40 * 10% * (1 – 50%), or $2, in After-Tax Interest.
So the Combined Net Income is $4, which makes the Combined P / E = $80 / $4 = 20x.

Question 22

Why is the Purchase Price in an M&A deal NOT equal to the Seller’s Purchase Equity Value or Purchase Enterprise Value exactly?

Answer 22

The real price depends on the treatment of the Seller’s Cash and Debt in the deal.
If the Buyer repays the Seller’s entire Debt balance with transaction funding and uses the Seller’s entire Cash balance to fund the deal, the real price will be close to the Purchase Enterprise Value, but that hardly ever happens.
In most cases, the Buyer will “replace” the Seller’s existing Debt with new Debt, which doesn’t affect the cash price. And the Buyer hardly ever uses the Seller’s entire Cash balance to fund the deal – at most, it might use a portion of it.
So the real price the Buyer pays is usually between the Purchase Equity Value and Purchase Enterprise Value of the Seller.
Many other issues, such as the transaction fees and the treatment of Preferred Stock, Capital Leases, and Unfunded Pensions, also explain this difference.

Question 23

What information do you need from the Buyer and Seller to create a full merger model?

Answer 23

At the minimum, you need Income Statement projections for both companies over the next 1-2 years. But ideally, you will also create cash-flow projections that show how both companies’ Cash and Debt balances change over time.
You do not need full 3-statement projections for both companies – similar to a DCF analysis, cash flow estimates without full Balance Sheet projections are fine.

Question 24

Why is a Sources & Uses schedule important in a full merger model?

Answer 24

The Sources & Uses schedule is important because it tells you how much the Buyer really pays for the Seller.
The Purchase Equity Value and Purchase Enterprise Value can be deceptive for the reasons outlined above.
But with the S&U schedule, you add up the total cost of acquiring the company – its shares, any refinanced Debt, and any transaction fees – and then show the amount of Cash, Debt, and Stock that will be used to pay for it.
The S&U schedule is also helpful for reflecting more unusual scenarios, such as a Seller using some of its Cash in the deal or a Buyer repaying its own Debt.

Question 25

What’s the purpose of a Purchase Price Allocation schedule in a merger model?

Answer 25

Helps balance the balance sheet essentially, determines the amount of goodwill. So you estimate the new Goodwill with this schedule, factor in write-ups of Assets such as PP&E and Intangibles, and also include other acquisition effects such as the creation of Deferred Tax
Liabilities and changes to existing Deferred Tax items.

Question 26

Why do Deferred Tax Liabilities get created in many M&A deals?

Answer 26

DTL based on expectation that cash taxes will be higher than book taxes bc in the combo of companies, D&A on asset write ups are non deductible for cash taxes during a stock purchase. They will have more cash taxes until the write ups are fully depreciated, and there will be less DTL every time the buyer pays more in cash taxes than book - this goes down to 0 too.

Question 27

An Acquirer purchases a company for a $1 billion Equity Purchase Price, and this Target has $600 million in Common Shareholders’ Equity and no Goodwill.
The Acquirer plans to write up the Target’s PP&E and Other Intangible Assets by $100.
Walk me through the Purchase Price Allocation process, assuming a 40% tax rate.

Answer 27

Allocable Purchase Price Premium = $400M, then subtract OIA/WriteUps = $300M. Then must create a deferred tax liability of 100M*40% = 40M which means that you are now at $340M due to increase in liabilities side. So in total, 340M$ in assets.

Question 28

What happens if the Acquirer purchases another company for a $1 billion Equity Purchase Price, but the Target’s Common Shareholders’ Equity is $1.5 billion?
Assume there are no write-ups or other adjustments.

Answer 28

Cannot make negative goodwill, so you show it as a gain on the income sheet. This increases net income, but since the gain is non cash the cash balance falls as the shareholder’s equity on the LE side increases.

Question 29

I don’t believe you. Walk me through what happens if an Acquirer purchases a Target for an Equity Purchase Price $80, in 100% Cash, and the Target has $200 in Assets, $100 in Liabilities, and $100 in Common Shareholders’ Equity.

Answer 29

You write down the Seller’s CSE completely, add the $200 in Assets and $100 in Liabilities to the Acquirer’s Balance Sheet, and then reduce the Cash balance by $80.
So far, the Assets side is up by $120 but the Liabilities side is up by only $100, so the Balance Sheet is out of balance.
But then you record a Gain of $20 on the Income Statement to reflect this “bargain purchase,” which boosts Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate.
On the CFS, Net Income is up by $12, but you subtract the $20 Gain because it was non-cash, so Cash at the bottom is down by $8 (the intuition is that the company pays taxes on something it didn’t receive in cash).
On the BS, Cash is down by $8 on the Assets side, so the Assets side is now up by $112, and on the L&E side, Shareholders’ Equity is up by $12 because of the increased Net Income, so both sides are now up by $112 and balance.

Question 30

What are the main adjustments you make when combining the Balance Sheets in an M&A deal?

Answer 30

You reflect the Cash, Debt, and Stock used in the deal, create new Goodwill, write up Assets such as PP&E and Other Intangibles, and reflect refinanced Debt. You also show new Deferred Tax Liabilities and the write-offs of existing DTLs and DTAs.
You must also write down the Seller’s CSE and reflect transaction and financing fees (transaction fees affect Equity and financing fees are deducted from the new
Debt balance).
There are many other adjustments; for example, you might reduce Accounts Receivable or Accounts Payable to reflect intercompany receivables or payables, and you might write down the Deferred Revenue balance after the transaction closes because accounting rules state that companies can recognize only the profit portion of Deferred Revenue after a deal.

Question 31

Give me an example of how you might estimate revenue and expense synergies in an M&A deal.

Answer 31

With revenue synergies, you might assume that the Seller can sell its products to some of the Buyer’s customer base. So if the Buyer has 100,000 customers, 1,000 of them might buy widgets from the Seller. Each widget costs $10.00, so that is $10,000 in extra revenue.
There will also be COGS and possibly Operating Expenses associated with these extra sales, so
you must factor those in as well. For example, if the cost of each widget is $5.00, then the Combined Company will earn only $5,000 in extra Pre-Tax Income.
With expense synergies, you might assume that the Combined Company can close a certain number of offices or lay off redundant employees, particularly in functions such as IT, accounting, and administrative support. So if both companies, combined, have 10 offices, and management feels that only 8 offices will
be needed after the merger, the combined rental expense will decline. If each office costs $100,000 per year to rent, there will be 2 * $100,000 = $200,000 in expense synergies, which will boost the Combined Pre-Tax Income by $200,000.

Question 32

Why do many merger models tend to overstate the impact of synergies?

Answer 32

This is due to the fact that people don’t factor in the costs associated with revenue synergies (or synergies at all into merger models sometimes), the time it takes to realize synergies, and the integration costs associated with them.

Question 33

Why do many merger models misstate the Foregone Interest on Cash and Interest on Debt?

Answer 33

This is because many mergers don’t model cash and debt flows into the future. Interest Income will be understated since the Cash balance tends to grow over time, while the Foregone Interest on Debt will be
overstated since the Combined Company can repay Debt with its cash flow.

Question 34

How do you calculate the Combined Company’s Debt repayment capacity in a merger model?

Answer 34

Project CFO only, It’s similar to what you do in a DCF to project Unlevered Free Cash Flow, but you’re estimating
the company’s Free Cash Flow – which includes Net Interest Expense – here.
You have to include the Net Interest Expense because it directly impacts a company’s ability to repay Debt and to generate Cash; the purpose is different from that of a DCF since you’re not valuing a company but instead tracking its Cash and Debt balances.

Question 35

How should you treat Stock-Based Compensation in a merger model?

Answer 35

Ignore it!

Question 36

Why might you calculate metrics such as Debt / EBITDA and EBITDA / Interest for the Combined Company in an M&A deal?

Answer 36

To tell you how much debt you can use realistically to fund a deal - the metric can go up higher than the average if you can pay it down quickly

Question 37

Why would one company want to buy another company?

Answer 37

If it believes it will be better off after the acquisition takes place, via consolidation and EOS, geographic/market share growth, new customers or distribution channels, or product expansion. It will also be motivated by competition, office politics, and ego. Asking prices is less than its implied value, and IRR > WACC.

Question 38

How can you analyze an M&A deal and determine whether or not it makes sense?

Answer 38

Qualitative analysis, quantitative analysis through valuation (IRR v WACC), and EPS accretion/dilution

Question 39

Walk me through a merger model (accretion/dilution analysis).

Answer 39

1) Project financial statements of buyer and seller
2) Then estimate Purchase Price mix for financing
3) Sources and Uses schedule, PPA to estimate true cost
4) Combine Balance sheets to calculate Goodwill, etc
5) Combine Income statements: foregone interest on cash, interest on debt, synergies
6) Combined Net income, Combined EPS (to get that divide combined net income by buyer’s existing share count + new shares issued)
7) Take combined EPS, divide by Buyer EPS, and subtract 1

Question 40

Why might an M&A deal be accretive or dilutive?

Answer 40

Accretive if Pre tax income from seller (seller’s yield), exceeds WCA. And opposite for dilution.

Question 41

Why do you focus so much on EPS in M&A deals?

Answer 41

Only easy to calculate metric that includes the full impact of the deal (takes into account the different types of financing)

Question 42

How do you determine the Purchase Price in an M&A deal?

Answer 42

If seller is public, based it on average industry premiums and do valuation to sanity-check.
If private, base it on valuation and multiples

Question 43

What are the advantages and disadvantages of each purchase method (Cash, Debt, and Stock) in M&A deals?

Answer 43

Cash is cheapest, but then you won’t have as much flexibility in the future if you need cash. Also minimum cash balance limits you. Debt is in between, but takes more time to close bc you need investors. Limits buyer’s flexibility, and risk increases for future debt. Stock is most expensive due to its dilutive effect, but avoids cash spending. Quicker than debt sometimes

Question 44

How does an Acquirer determine the mix of Cash, Debt, and Stock to use in a deal?

Answer 44

Uses cash up to minimum cash balance, debt up to peer companies debt/ebitda rations, and stock up to where you would turn dilutive or lose control of your company.

Question 45

Which purchase method does a Seller prefer in an M&A deal?

Answer 45

Debt and Cash are best seeing s seller has to balance taxes with certainty of payment and potential future upside - debt and cash are immediate payment, but no good things if stock goes up. If the want to be riskier, they can get stock which will pay off well if the combined company does well (but vice versa if it fails)

Question 46

Isn’t the Foregone Interest on Cash just an “opportunity cost”? Why do you include it?

Answer 46

You include it bc it isn’t an opportunity cost since you are projecting the model 1-2 years into the future when you would have already had the cash.

Question 47

Isn’t it a contradiction to calculate the Cost of Stock by using the reciprocal of the Acquirer’s P / E multiple? What about the Risk-Free Rate, Beta, and the Equity Risk Premium?

Answer 47

Neither one is correct, you just use them in different contexts.

Question 48

Why might an Acquirer choose to use Stock or Debt even if it could pay for the Seller in
Cash?

Answer 48

If trading at high multiples, might be cheaper to use stock. Also, might have less cash to draw on and want to use it for expansion plan or for safety in the future

Question 49

Are there cases where EPS accretion/dilution is NOT important? What else could you look at?

Answer 49

Not important if they are private, or have a negative EPS. Also makes little difference is the buyer is far bigger

Question 50

How does a Merger differ from an Acquisition?

Answer 50

No real difference, just if they are more similar in size or not

Question 51

What are the main PROBLEMS with merger models?

Answer 51

EPS isn’t always a meaningful metric, Net Income and cash flow are very different, so EPS-accretive deals might be horrible from a cash-flow perspective. No qualitative risk factors or integration issues involved

Question 52

Why do most M&A deals fail?

Answer 52

The human element