Merger Model

Question 1

Merger model walkthrough

Answer 1

• In a merger model you analyse the impact on a company’s earnings per share when they buy another company based on how they buy it, cash debt or stock and based on the financial profiles of the target and the acquirer
• The first step is to assume a purchase price, and then how much they are paying in cash, debt and stock
• Step two is to look at the financial profiles of buyer and seller, including enterprise value and tax rate
• Step three is to project the income statements for buyer and seller
• Then combine income statements for buyer and seller, accounting for the acquisition effects including the foregone interest on cash, interest paid on new debt and changes in shares outstanding if using shares to buy the company, as well as the benefits to revenue and other line items from synergies.
• Then calculate net income making sure you use the acquirers tax rate, and then work out earnings per share and examine the accretion / dilution by comparing new EPS to old EPS.

Question 2

• Why would one company want to buy another?

Answer 2

Capture market share, capture additional growth opportunities, diversify revenue streams, diversify geography, obtain customers for cross-selling/upselling, critical resource/ intellectual property, revenue/cost synergies, seller may be undervalued.

Question 3

• What are the effects of acquiring another company?

Answer 3

If you have cash, will get foregone interest on cash, if financing using debt will pay more interest, if using stock shares outstanding will go up,

Question 4

• How can you tell if acquisition is accretive or dilutive before doing the model?

Answer 4

Depends on interest/foregone interest on cash, compare interest / foregone interest on cash * purchase price to the sellers pre-tax income, if all stock: buyer P/E > seller P/E transaction will be accretive because they are paying less per dollar of earnings than they are currently worth

Question 5

• What is best way to purchase company?

Answer 5

All else equal, use cash because foregone interest on cash will be lower than interest rate on debt. Also wuld prefer cash to equity, because cost of equity much higher than foregone interest on cash

Question 6

• How much can someone pay for a company?

Answer 6

If cash, cant exceed balance sheet cash number

Question 7

• How much stock can you give up to acquire company?

Answer 7

Less than 50% because don’t want to give up control of your company

Question 8

How do you determine the purchase price for the merger model?

Answer 8

Use valuation methods, such as DCF, precedent transactions, public comps. Can also use senstivitiyh tables to examine purchase prices impact on accretion/dilution

Question 9

What happens to share price if buyer deemed to overpaid?

Answer 9

Buyers share price will decline by the amount that they deem to have overpaid

Question 10

How to determine maximum purchase price if using merger model to base it on?

Answer 10

Set accretion to 0%, and work backwards to work out the top purchase price

Question 11

• Why do goodwill and intangibles get created in merger model?

Answer 11

Book value of equity of acquired company is usually less than the purchase price, so goodwill and intangibles have to be created to make up the difference

Question 12

• What is goodwill?

Answer 12

Not amortized over time, theoretically indefinite (like brand name).

Question 13

• What are Intangibles?

Answer 13

Amortized over time and have a fixed life span

Question 14

• Why do you have value write ups in a merger model?

Answer 14

Most times, the book values of assets are significantly different to the actual market value, so write ups compensate for this

Question 15

• What is deferred tax liability?

Answer 15

Usually created because of write ups to asset values, restoring them to fair market value

Question 16

• What is write up?

Answer 16

Asset values are marked up on a balance sheet

Question 17

• What is write down?

Answer 17

Asset values are market down on balance sheet

Question 18

• What is a synergy and some examples? Common examples?

Answer 18

1+1 = 3, when joining companies, the value is greater than the sum of their parts. Revenue and cost synergies

Question 19

Examples of revenue synergies?

Answer 19

Revenue synergies: Cross-selling, upselling, new markets, new industries.

Question 20

Example of costs synergies?

Answer 20

Consolidating buildings, reduced manufacturing, laying off employees, acquired can use economies of scale of acquiring

Question 21

Which out of revenue or cost synergies are more important?

Answer 21

• Expense synergies are more important than revenue, as they are ‘real’ numbers rather than completely hypothetical.

Question 22

Impact of synergies on merger model?

Answer 22

• Effect of synergies on merger model? Always will make more accretive, boosting earnings per share

Question 23

What impact do sensitivity tables have on the model?

Answer 23

• Senstivity table inputs for merger model? Types of funding, purchase price, synergies

Question 24

Is cash or debt better to buy a company for an acquisition? How about a merger? How about a PE firm?

Answer 24

Cash > debt for m&a because foregone interest on cash is much lower than interest rate on debt. PE firm prefers leverage. End goal is much different; M&A wants to generate cash flows, PE firm wants to increase value.

Question 25

What is a divestiture

Answer 25

Sale of an interest of a business entity or an asset or group of assets

Question 26

What is a control premium

Answer 26

The percentage above current market value one would consider paying to convince the buinsess owner or shareholders to hand over the business or shares

Question 27

Is an equity raise or debt raise more dilutive to EPS? What are the exceptions to the common rule?

Answer 27

Equity is typically more dilutive to EPS than debt. However, if the cost of equity is lower than cost of debt, raising debt can be more dilutive than raising equity

Question 28

Name the four major transaction adjustments in an accretion/dilution analysis

Answer 28

• Post-merger cost savings (synergies)
• Amortisation of intangible assets (like goodwill)
• New interest raised on debt
• New shares and dividends raised on equity

Question 29

What is an asset step-up?

Answer 29

Adjusting book value to assets to their market value after an acquisition

Question 30

If $250mn of long-term debt is raised, what are the impacts to the financial ststaments? Assume 40% tax rate and ignore interest.