M&A Concepts and Overview Flashcards
Why would one company want to buy another company?
One company will buy another if it believes it will be better off after the acquisition takes place. For example:
The seller’s asking price is less than its Implied Value.
The buyers expected IRR from the acquisition exceeded its WACC
Buyers often acquire sellers to save money via consolidation and economies of scale, to grow geographically or gain market scale, to acquire new customers or distribution channels, and to expand their products.
How can you analyze an M&A deal and determine whether or not it makes sense?
Could the deal help the company expand geographies, products, or customer bases, give it more intellectual property, or improve its team.
Quantitative analysis might include a valuation of the seller to see if it’s undervalued, as well as a comparison of the expected IRR to the buyers WACC
EPS accretion/ dilution is very important in most deals because few buyers want to execute dilutive deals; investors focus tremendously on near-term EPS, so dilutive deals tend to make companies’ stock prices decline.
Walk me through a merger model (accretion/ dilution analysis)
- Project the financial statements of the Buyer and Seller
- Estimate the Purchase Price and the mix of Cash, Debt, and Stock used to fund the deal.
- Create sources & uses schedule and Purchase Price Allocation schedule to estimate the true cost of the acquisition and its effects.
- Combine the Balance sheets of the buyer and Seller, reflecting the cash, debt, and stock used, new goodwill created, and any write-ups. You then combine the Income Statements, reflecting the foregone interest on cash, interest on debt, and synergies. If debt or cash changes over time, your interest figures should also change.
- You calculate accretion/ dilution by taking the combined EPS, dividing it by the buyer’s standalone EPS, and subtracting 1.
Why might an M&A deal be accretive or dilutive?
A deal is accretive if the extra Pre-Tax income from a seller exceeds the cost of the acquisition in the form of Foregone Interest on Cash, Interest Paid on New Debt, and New Shares Issued.
A deal will be dilutive if the opposite happens.
How can you tell whether an M&A deal will be accretive or dilutive?
You compare the Weighted Cost of Acquisition to the Seller’s Yield at its purchase price.
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.
Why do you focus so much on EPS in M&A deals?
Because it’s the only easy-to-calculate metric that also captures the FULL impact of the deal - the Foregone interest on cash, interest on new debt, and new shares issued.
How do you determine the Purchase price in an M&A deal?
If the seller is public, you assume a premium over the seller’s current share price based in average premiums for similar deals in the market. You can then use the DCF, Public Comps, and other valuation methodologies to sanity-check this figure.
What are the advantages and disadvantages of using cash as a purchase method?
Cash tends to be the cheapest option; companies don’t lose too much income on interest. It’s also fastest and easiest to close.
The downside is that using Cash limits the Buyer’s flexibility incase it needs the funds for something else in the near future.
What are the advantages and disadvantages of using Debt as a purchase method?
Debt is normally cheaper than stock but more expensive than cash, and deals involving debt take more time to close because they need to find investors.
What are the advantages and disadvantages of using Stock as a purchase method?
Stock tends to be the most expensive option, though it can sometimes be the cheapest, on paper, if the Buyer trades at very high multiples.
IT dilutes the buyer’s existing investors, but it also prevents the Buyer from paying any additional cash expense for the deal.
How does an Acquirer determine the mix of Cash, Debt, and Stock to use in a deal?
They will use all the cash they can before moving to the other funding sources
After that, Debt tends to be the next cheapest option. An acquirer might be able to raise Debt up to the level where its Debt / EBITDA and EBITDA / Interest ratios stay in line with those of peer companies.
Finally, there is stock. There is no strict limit, however very few companies would issue enough to give up control of the company, or they will issue up until the point before it turns dilutive.
What’s the impact of each purchase method in an M&A deal, and how do you estimate the Cost of each method?
The Cost of cash is represented by the Foregone interest on cash.
The cost of debt is represented by the interest expense on new debt.
For both of these you take the interest rate and multiple by (1 - acquirer’s tax rate) to estimate the after-tax costs.
The cost of stock is represented by the additional shares that get created in a deal and how those shares reduce the combined company’s eps.
Why might an Acquirer choose to use stock or debt even if it could pay for the Seller in cash?
The acquirer might not necessarily be able to draw on its entire cash balance if, for example, much of the cash is in overseas subsidiaries or otherwise locked up.
Also, the buyer might be preserving its Cash for a future expansion plan or Debt maturity.
Are there cases where EPS accretion/dilution is NOT important? What else could you look at?
Yes, if the buyer is private or it has negative EPS, it won’t care about whether the deal is accretive or dilutive.
It also makes sense if the Buyer is far bigger than the seller.
You can analyze the qualitative merits of the deal, compare the IRR to the discount rate, and value the buyer before and after the deal.
What are the main problems with merger models?
EPS is not always a meaningful metric.
Net Income and cash flow are very different, so EPS accretive deals might be horrible from a cash flow perspective.
They don’t capture the inherit risk.
