M&A Deals and Merger Models Flashcards
Why would one company buy another company?
Because you think you’ll be better off after buying the company
If a target’s implied value is $625M, but the firm is asking $500M for the business, when would a company purchase this company?
- Asking Price is less than its Implied Value
- The Acquirer’s expected IRR rom the acquisition exceeds its WACC
What is the definition of accretive?
characterized by gradual growth or increase.
If a deal is accretive to EPS, then the transaction must _______ its EPS.
If a deal is accretive to EPS, then the transaction must increase its EPS.
What is the definition of dilutive?
Causing a reduction in the value of a shareholding due to the issue of additional shares in a company without an increase in assets.
What are the two most important financial criteria for a deal to occur?
- Target price must be reasonable
- Deal must be neutral or accretive to EPS
When would consolidation drive a financial decision to acquire a company?
If the biggest and second-biggest companies in the market combine, they can get better deals with suppliers and save money
When would geographic expansion drive a financial decision to acquire a company?
The Buyer operates mostly in Europe, which is a declining/mature market. It wants to acquire the Seller to expand into Asia and grow more quickly.
When would gaining market share drive a financial decision to acquire a company?
Neither the Buyer nor the Seller is growing because the market is competitive and the products/services are nearly the same. But if one company acquires another, it instantly captures market share.
When would an undervalued company drive a financial decision to acquire a company?
Seller is Undervalued: The Seller’s asking price seems attractive because its share price has fallen significantly; the Buyer sees an opportunity to get a cheap Asset
When would a tax reduction drive a financial decision to acquire a company?
Tax Reductions: The Buyer could “invert” by acquiring a Seller in a low-tax jurisdiction like Ireland and then claiming it is “headquartered” there.
What is the sell-side M&A process?
- Plan the process and create marketing materials
- Contact the initial set of buyers
- Set up management meetings
- Solicit bids from buyers
- Conduct final negotions, arrange financing, and close the deal.
Why do companies frequently fund acquisitions with debt?
Companies prefer to fund acquisitions with Debt rather than Equity because Debt is cheaper.
Why is debt cheaper than equity?
Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders’ expected returns are lower than those of equity investors (shareholders).
What is the dividend payout ratio?
The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company.
What is the average dividend payout ratio?
15%
https://www.readyratios.com/sec/ratio/dividend-payout/
Which is the cheapest source of financing among these three choices:
- Debt
- Cash
- Stock
Cash, it will almost always prefer to use that Cash first because Cash is even cheaper than Debt (companies earn almost nothing on extra Cash).
Which financing is most common with a merger of equals?
- Cash
- Debt
- Stock
Usually 100% stock because company doens’t have enough cash and would have to take out a large amount of debt.
What are the components of a merger model?
- Summarizes the financial profiles of the Buyer and Seller, including projections and each company’s Equity Value and Enterprise Value.
- Lists the purchase price, i.e. the amount the Buyer is planning to pay for the Seller, and the mix of Cash, Debt, and Stock the Buyer will use.
- Includes other key terms of the deal, such as the interest rates on Cash and Debt and estimates for synergies – ways to boost revenue or cut costs.
- Shows what the Buyer and Seller look like as a combined entity and how the combined EPS compares with the Buyer’s standalone EPS.
Why is EPS used as a key metric for the merger model?
It’s the only easy-to-calculate metric that captures the FULL impact of the deal.
Why are EBITDA and NOPAT poor metrics to use when looking at outcome of a merger?
Metrics such as EBITDA and NOPAT will never capture the effects of the deal because they are before Interest Income and Interest Expense and they do not reflect the share count.
Other than EPS, what could be used to asses the impact of a deal?
Levered Free Cash Flow per Share
What is “Fully diluted shares outstanding”?
Fully diluted shares outstanding is the total number of shares a company would theoretically have if all dilutive securities were exercised and converted into shares. Dilutive securities include options, warrants, convertible debt, and anything else that can be converted into shares.
What is the simplified equation for calculating new EPS following a deal?
Which of the following metrics is used as the base price of a firm using the merger model?
- Enterprise Value
- Equity Value
and Why?
you always start with the Seller’s Purchase Equity Value because, at the bare minimum, the Buyer needs to pay that much to acquire the Seller’s shares.
Why isn’t Enterprise Value used as the base price of a company in the merger model?
- The seller may not provide the buyer with the company’s cash
- The buyer may choose to refinance debt, so does not pay debt up front.
How do you find the cost (rate) of debt for a deal?
Look at the YTM or coupon rates of the company’s current Debt or the YTM or coupon rates for the Debt of peer companies
How do you find the cost (rate) of equity for a deal?
The Cost of Equity is based on Buyer Net Income / Buyer Equity Value, or the reciprocal of the Buyer’s P / E multiple.
How do you find the cost (rate) of cash for a deal?
The Cost of Cash is supposed to be similar to the Risk-Free Rate, so the risk profile of Cash must be similar to the risk profile of government bonds.
How do you calculate the weighted cost of the acquisition?
Weighted Cost of Acquisition =
% Cash Used * After-Tax Cost of Cash +
…% Debt Used * After-Tax Cost of Debt +
…% Stock Used * After-Tax Cost of Stock
This Weighted Cost tells us how much the Buyer is “giving up,” in percentage terms, to acquire the Seller.
How is the “yield” of a merger defined?
This “Yield” is how much you get in Net Income for each $1.00 spent on Company B’s stock.
Is the deal accretive, dilutive, or neutral to EPS?
Weighted Cost of Acquisition < Yield of Seller
Accretive
Is the deal accretive, dilutive, or neutral to EPS?
Weighted Cost of Acquisition > Yield of Seller
Dilutive
Is the deal accretive, dilutive, or neutral to EPS?
Weighted Cost of Acquisition == Yield of Seller
Neutral
What is the P/E ratio rule for all-stock deals?
- 100% Stock Deal, Buyer’s P / E > Seller’s P / E at Purchase Price: Accretive
- 100% Stock Deal, Buyer’s P / E = Seller’s P / E at Purchase Price: Neutral
- 100% Stock Deal, Buyer’s P / E < Seller’s P / E at Purchase Price: Dilutive
Assume an all-stock deal
If the Buyer’s P / E is 10x and the Seller’s Purchase P / E is 5x, what is the:
- Buyer’s Weighted Cost of Acquisition
- Seller’s Yield
So if the Buyer’s P / E is 10x and the Seller’s Purchase P / E is 5x, the Buyer’s Weighted Cost of Acquisition is 1/10, or 10%, and the Seller’s Yield is 1/5, or 20%.
Is the deal accretive, dilutive, or neutral to EPS?
- Buyer’s Weighted Cost of Acquisition is 1/10, or 10%
- Seller’s Yield is 1/5, or 20%.
Accretive since the WAC < Seller’s Yield
Is the deal accretive, dilutive, or neutral to EPS?
- Buyer’s Weighted Cost of Acquisition is 1/4, or 25%
- Seller’s Yield is 1/5, or 20%.
Dilutive since the WAC > the Seller’s Yield
What are some parameters in the merger model which could inject error into the analysis?
- Share Prices and Tax Rates: As mentioned above, the Buyer’s share price won’t necessarily stay the same after a deal is announced. And the Combined Tax Rate may not necessarily be the Buyer’s tax rate.
- Purchase Price: We’ve assumed that the purchase price is the Seller’s Purchase Equity Value. But in real life, the Buyer may refinance the Seller’s Debt and pay for other fees associated with the deal. Sometimes the Seller can even use a portion of its Cash balance to fund the deal, further complicating the purchase price.
- Synergies: “Synergies” are ways for the Combined Company to boost revenue or cut costs after the acquisition takes place. For example, maybe the Combined Company no longer needs 10 separate offices – it can consolidate and move everyone into 8 offices instead, which will reduce its rental expense.
Under what two conditions would a company not care about EPS when conducting a merger model?
- Acquirer is a private company
- Company has negative net income
What is a drawback of a merger model in terms of risk?
Merger Models Don’t Capture the Risk of M&A Deals – 100% Cash deals are almost always accretive. If the Acquirer earns 1.0% on Cash, that’s a 0.6% After-Tax Cast of Cash. So the Seller’s P / E would have to be above 166x for the deal to be dilutive.
What two aspects drive the purchase price of an M&A deal?
- The company’s implied/intrinsic value (from DCF, etc.)
- The premium above intrinsic value to purchase the company
Why must company offer a signficant premium over current share price to buy that company?
Investors need a higher price to incentivize them to sell everything.
What is a reasonable offer price?
- Current Share Price: $15.00
- Average Premium Paid in This Market for Acquired Companies: 30%
Calculated Offer Price for Company: $19.50
What is the minimum price you can pay for a private company?
The “minimum price” is the lowest number the owners of the company will accept.
For a private seller, how is the purchase price often defined?
For a private Seller, the purchase price is linked to the company’s Implied Value from the valuation methodologies more closely.
