M&A Modeling Flashcards
Why would one company want to buy another company?
One company will want to buy another company 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, i.e. the Present Value of its future cash flows.
• The Buyer’s expected IRR from the acquisition exceeds its WACC. Buyers often acquire Sellers to save money via consolidation and economies of scale, to grow geographically or gain market share, to acquire new customers or distribution channels, and to expand their products. Deals are also motivated by competition, office politics, and ego.
How can you analyze an M&A deal and determine whether or not it makes sense?
The qualitative analysis depends on the factors above: Could the deal help the company expand geographies, products, or customer bases, give it more intellectual property, or improve its team? The 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 Buyer’s WACC. Finally, 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).
In a merger model, you start by projecting the financial statements of the Buyer and Seller. Then, you estimate the Purchase Price and the mix of Cash, Debt, and Stock used to fund the deal. You create a Sources & Uses schedule and Purchase Price Allocation schedule to estimate the true cost of the acquisition and its effects.
Then, you 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.
The Combined Net Income equals the Combined Pre-Tax Income times (1 – Buyer’s Tax Rate), and to get the Combined EPS, you divide that by the Buyer’s Existing Share Count + New Shares Issued in the Deal.
You calculate the 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. For example, if the Seller contributes $100 in Pre-Tax Income, but the deal costs the Buyer only $70 in Interest Expense, and it doesn’t issue any new shares, the deal will be accretive because the Buyer’s Earnings per Share (EPS) will increase. A deal will be dilutive if the opposite happens. For example, if the Seller contributes $100 in Pre-Tax Income but the deal costs the Buyer $130 in Interest Expense, and its share count remains the same, its EPS will decrease.
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. • Cost of Cash = Foregone Interest Rate on Cash * (1 – Buyer’s Tax Rate) • Cost of Debt = Interest Rate on New Debt * (1 – Buyer’s Tax Rate) • Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e. Net Income / Equity Value. • Seller’s Yield = Reciprocal of the Seller’s P / E multiple, calculated using the Purchase Equity Value. 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.
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. Although metrics such as EBITDA and Unlevered FCF are better in some ways, they don’t reflect the deal’s full impact because they exclude Interest and the effects of new shares.
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 on average premiums for similar deals in the market (usually between 10% and 30%). You can then use the DCF, Public Comps, and other valuation methodologies to sanity-check this figure. The Purchase Price for private Sellers is based on the standard valuation methodologies, and you usually link it to a multiple of EBITDA or EBIT since private companies don’t have publicly traded shares. If the Buyer expects significant synergies, it is often willing to pay a higher premium or multiple for the Seller, though the impact isn’t necessarily 1:1.
What are the advantages and disadvantages of each purchase method (Cash, Debt, and Stock) in M&A deals?
Cash tends to be the cheapest option; most companies earn little Interest Income on it, so they don’t lose much by using it to fund deals. It’s also fastest and easiest to close Cash-based deals. The downside is that using Cash limits the Buyer’s flexibility in case it needs the funds for something else in the near future. Debt is normally cheaper than Stock but more expensive than Cash, and deals involving Debt take more time to close because of the need to find investors. Debt also limits the Buyer’s flexibility because additional Debt makes future Debt issuances more difficult and expensive. Finally, 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. In some cases, the Buyer can also issue Stock more quickly than it can issue Debt.
How does an Acquirer determine the mix of Cash, Debt, and Stock to use in a deal?
Since Cash is cheapest for most Acquirers, they’ll use all the Cash they can before moving to the other funding sources. So you might assume that the Cash Available equals the Acquirer’s current Cash balance minus its Minimum Cash balance. 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. So if it’s levered at 2x EBITDA now and similar companies have up to 4-5x Debt/EBITDA, it might be able to raise Debt up to that level. Finally, there’s no strict limit on the Stock an Acquirer might issue, but very few companies would issue enough to give up control of the company, and some Acquirers will issue Stock only up to the point at which the deal turns dilutive.
Which purchase method does a Seller prefer in an M&A deal?
The Seller has to balance TAXES with the CERTAINTY OF PAYMENT and POTENTIAL FUTURE UPSIDE. To a Seller, Debt and Cash are similar because they mean immediate payment, but also immediate capital gains taxes and no potential upside if the Buyer’s share price increases. But there’s also no risk if the Buyer’s share price decreases. Stock is more of a gamble because the Seller could end up with a higher price if the Buyer’s share price increases, but it could also get a lower price the share price drops. The Seller also avoids immediate taxes with Stock since it pays taxes only when the shares are sold. So the preferred method depends on the Seller’s confidence in the Buyer: Cash and Debt are better when there’s uncertainty, while Stock may be better with large, stable Buyers.
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 Acquirer loses future projected Interest Income by using Cash to fund a deal. The Cost of Debt is represented by the Interest Expense on New Debt. For both of these, you take the interest rate and multiply 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. It’s equal to the reciprocal of the Buyer’s P / E Multiple, i.e. 1 / (Buyer’s P / E multiple).
Isn’t the Foregone Interest on Cash just an “opportunity cost”? Why do you include it?
No, it’s not just an “opportunity cost” because the Acquirer’s projected Pre-Tax Income already includes the Interest Income that the company expects to earn on its Cash balance. So if an Acquirer expects $90 in Operating Income and $10 in Interest Income for a total of $100 in Pre-Tax Income, its projected Pre-Tax Income will fall if it uses Cash to fund the deal.
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?
It’s not a contradiction; it’s just a different way of measuring the Cost of Equity. The “Reciprocal of the P / E Multiple” method measures Cost of Equity in terms of EPS impact, whereas the CAPM method measures it based on the stock’s expected annual returns. Neither method is “the correct one”: You just use them in different contexts. In most cases, regardless of the method you use, Equity will be the most expensive funding source for a company.
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. Finally, if the Acquirer is trading at very high multiples – e.g., a 100x P / E multiple – then it might be cheaper to use Stock to fund the deal.
Are there cases where EPS accretion/dilution is NOT important? What else could you look at?
Yes, there are many cases where EPS accretion/dilution doesn’t matter. For example, 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 little difference if the Buyer is far bigger than the Seller (e.g., 10x – 100x its size). Besides EPS accretion/dilution, you can also analyze the qualitative merits of the deal, compare the IRR to the Discount Rate, and value the Buyer before and after the deal. Finally, you can create a Contribution Analysis where you look at how much the Buyer and Seller “contribute” to each financial metric and then base the ownership of the Combined Company (and, therefore, the purchase price) on that.
How does a Merger differ from an Acquisition?
There’s no mechanical difference in a merger model or the other analyses because there’s always a Buyer and Seller in any M&A deal. The difference is that in a Merger, the companies will be closer in size, while Buyer is significantly larger than the Seller in an acquisition. 100% Stock or majority-Stock deals are also more common in Mergers because similarly sized companies can rarely use Cash or Debt to acquire each other. You’ll also place more weight on methods such as the Contribution Analysis because 100% Stock deals are so common.
What are the main PROBLEMS with merger models?
First, EPS is not always a meaningful metric. Second, Net Income and cash flow are very different, so EPS-accretive deals might be horrible from a cash-flow perspective.
Third, merger models don’t capture the risk inherent in M&A deals. 100% Cash deals almost always look accretive, even though the integration process might go wrong, legal issues might arise, and customers or shareholders might revolt.
Finally, merger models don’t capture the qualitative factors of a deal such as cultural fit or management’s ability to work together.
Why do most M&A deals fail?
Most deals fail because of the human element – there might be a cultural mismatch, the Buyer might not have uncovered something important in due diligence, or the Buyer might have had stupid reasons for doing the deal in the first place. Also, the Buyer or Seller might underperform financially, which could turn an apparently attractive deal into money-losing one.
Company A, with a P/E of 25x, acquires Company B for a purchase P/E multiple of 15x. Will the deal be accretive?
You can’t tell unless you know that it’s a 100% Stock deal. If it is a 100% Stock deal, then it will be accretive because the Buyer’s P / E is higher than the Seller’s, indicating that the Buyer’s Cost of Acquisition (1 / 25, or 4%) is less than the Seller’s Yield (1 / 15, or 6.7%).
Walk me through the full math for the deal below. Assume that Company A has 10 shares outstanding at a 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?
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.
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? (Company A: 10 shares, $25/share, NI of $10, Company B: Purchase Eqv: $150, NI: $10)
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.
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. (Company A: 10 shares, $25/share, NI of $10, Company B: Purchase Eqv: $150, NI: $10)
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.
How do the Combined EV/EBITDA and P/E multiples change if the purchase method changes?
The Combined EV / EBITDA stays the same regardless of the purchase method, but the Combined P / E multiple will change based on the Stock issued and the Cash and Debt used since those affect the Combined Net Income.
Without doing any math, what range would you expect for the Combined P/E multiple?
The Combined P/E multiple should be in between the Buyer’s P/E multiple and the Seller’s Purchase P/E multiple, so between 25x and 15x here. If Company A is much larger than Company B, the Combined P / E multiple will be closer to the 25x of Company A. But if they’re closer in size, the Combined P / E multiple will be in the middle of this range. You cannot average the P / E multiples of both companies because they may be different sizes; a weighted average also won’t work because the purchase method affects the combined multiple.
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? (Company A: 10 shares, $25/share, NI of $10, Company B: Purchase Eqv: $150, NI: $10)
The deal will be less accretive. The intuition is that the company that is not making the deal dilutive – the Buyer – now has a higher weighting in all the calculations. Since Company A’s P / E is the same, but Company A is significantly bigger, its lower Yield “drags down” the Combined EPS for the entire company. The Combined P / E multiple will still be between 15x and 25x, but it will be closer to 25x because Company A is weighted more heavily.
Now do the math. What is the accretion/dilution in a 100% Stock deal? (Company A: 10 shares, $25/share, NI of $10, Company B: Purchase Eqv: $150, NI: $10, new Company A is $500 Equity Value, $20 NI)
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.
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?
Company A’s After-Tax Cost of Stock is 1/10, or 10%, its After-Tax Cost of Debt is 10% * (1 – 40%) = 6%, and its After-Tax Cost of Cash is 5% * (1 – 40%) = 3%. Company B’s Yield is 1 / 16, or 6.25%. The Weighted Cost of Acquisition is 10% * 1/3 + 6% * 1/3 + 3% * 1/3 = 3.33% + 2% + 1% = 6.33%. Since the Weighted Cost is slightly above Company B’s Yield, the deal will be dilutive.
Company A buys Company B using 100% Debt. Company B has a purchase P/E multiple of 10x and Company A has a P/E multiple of 15x. What Debt interest rate is required to make the deal dilutive?
Company B’s Yield is 1 / 10, or 10%, so the After-Tax Cost of Debt must be above that for the deal to be dilutive. Assuming the company has a tax rate of 40%, 10% / (1 – 40%) = 16.667%, which you can round to “Nearly 17%.” That is an exceptionally high interest rate, so a 100% Debt deal would almost certainly be accretive.
