Merger Model Flashcards
EPS Accretion
Buyer’s EPS increases after acquisition
EPS Dilution
Buyer’s EPS decreases after acquisition
What are some reasons a company would do an acquisition?
1) Gain market share
2) Grow more quickly
3) Believes seller is undervalued
4) Acquire the seller’s customers
5) Acquire IP
6) Eliminate a threat
8) Intangible benefits over the long term
**Growth is a key factor here
A buyer will ONLY acquire a seller if…
It believes it will gain something from the deal
What is the difference between a merger and an acquisition?
Fundamentally the same thing –>
Merger is two companies of similar size
Acquisition is 2 companies of different sizes
Walk me through a merger model.
1) Determine the purchase price and purchase method (debt/cash/equity)
2) Project the buyer and seller’s financial statements
3) Combine buyer and seller’s Income Statements
4) Calculate Goodwill and combine Balance Sheets (adjust for acquisition affects)
5) Adjust the combined Income Statement for acquisition affects
6) Calculate accretion/dilution and create sensitivity tables
When would a deal be dilutive? (definition of dilutive)
When the amount of extra net income the seller contributes is not enough to offset the foregone interest on cash, interest paid on debt, and the effects of issuing shares
When would a buyer prefer to issue shares in an acquisition?
If the stock is trading at high P/E multiple
Note: Cost of equity is reciprocal of P/E multiple so a high price relative to NI means that the cost of equity will be very low
What is the first rule of thumb for 100% stock deals and P/E multiples?
Buyer P/E > Seller P/E –> Accretive
Buyer P/E < Seller P/E –> Dilutive
*P/E = Equity Value/Net Income
How would you interpret a P/E of 10x?
If you bought it, you’d be getting $0.10 in earnings for each dollar you pay for the company
What is the second rule of thumb (in determining accretion/dilution for all deals)?
Weighted Cost for Buyer < Yield of Seller –> Accretive
Weighted Cost for Buyer > Yield of Seller –> Dilutive
Yield of Seller Formula
Reciprocal of seller P/E ratio
Cost of Cash Formula
Foregone Interest on Cash * (1 - Buyer’s Tax Rate)
Cost of Debt Formula
Interest Rate on Debt * (1 - Buyer’s Tax Rate)
Cost of Stock Formula
Reciprocal of buyer P/E ratio
What is the problem with our 2 Rules of Thumb?
They don’t account for
1) Acquisition affects (synergies, new D&A, etc)
2) Premium paid
What are 5 Main Acquisition Affects?
1) Foregone Interest on Cash
2) Additional Interest on Debt
3) Additional Shares Outstanding
4) Combined Financial Statements
5) Creation of Goodwill and Other Intangibles
What are some examples of some more advanced acquisition effects?
1) PPE and Fixed Asset Write Ups - may write up if market value exceeds book value
2) Transaction and Financing Fees - Deduct from Cash and RE at time of transaction
3) Deferred Tax Asset - Write off Completely
4) Deferred Tax Asset - Write off and then create new ones based on buyer’s tax rate*newly created intangibles and fixed asset write ups
Revenue Synergies
Examples include price increase or additional volumes sold
*Rarely taken seriously because impossible to predict
Expense Synergies
Examples include Reduction in Force and Building Consolidation
- Much more grounded in reality and are easier to estimate
What are some reasons most integrations fail?
1) Synergy Failures
2) Cultural Differences
3) Integration Difficulties
4) Poor Rationale
What happens when a buyer overpays for a company?
Goodwill Impairment and Write Downs
How do PPE write up acquisition affects impact deferred tax liabilities?
During an acquisition, you’d acquire the PPE of the seller and may need to write up the values if the market value exceeds the book value. In addition you would write off the sellers existing DTLs and create new ones based on:
Buyers Tax Rate*(PPE and Fixed Asset Write Up and Newly Created Intangibles)
How do you determine the purchase price in a transaction?
Precedent Transactions, Comparable Companies, DCF
All else being equal, which method would a company prefer to use when acquiring another company?
Cash because it is typically cheaper and less risky than debt and equity
How would you determine the amount of debt a company could issue in a merger or acquisition?
Look at comps and find the median Leverage Ratio = (Debt/EBITDA)
When would a company be most likely to issue stock in an acquisition?
1) Stock us trading at an all time high
2) Seller is almost as large as the buyer and it is impossible to raise enough debt or use enough cash to acquire the seller
If a buyer doesn’t have enough cash available to acquire a seller, how could it decide between debt and equity?
Look at the relative cost of both debt and stock
Existing Debt
Shareholder Dilution
Expansion Plans
Is combined P/E multiple dependent on the purchase method?
Yes
Is combined EV/EBITDA dependent on the purchase method?
No, because EBITDA excludes interest expense and interest income. Regardless of cash, debt, or stock, the combined Enterprise Value will always be the same
Why would a strategic acquirer typically be willing to pay more for a company than a PE firm would?
Strategic acquirer can realize revenue and cost synergies that a PE firm cannot unless it combines the company with a complementary portfolio company
Why do Goodwill and other Intangibles get created in an acquisition?
Represents the amount the buyer has paid over the book value (shareholder’s equity) of the seller
How is Goodwill Calculated?
Goodwill = Equity Purchase Price - Seller’s Shareholder Equity
What is the difference between Goodwill and Other Intangible Assets?
Goodwill is impaired (not amortized) whereas Other Intangibles are amortized
If a buyer pays $100m for the seller in an all-stock deal, but a day later the market decides that its only worth $50m. What happens?
Buyer’s share price will fall by whatever per-share dollar amount corresponds to the $50m loss in value. *It would not necessarily be cut in half
Why do most M&A transactions fail?
It’s difficult to realize synergies, integrate effectively, and turn the acquired company into a profitable division
What are some examples of sensitivities you may run for mergers?
EPS Accretion/Dilution for:
Purchase Price v Cost Synergies
Purchase Price v Revenue Synergies
Purchase Price v Cash
If the seller has existing debt on its balance sheet in an M&A deal, how do you deal with it?
Assume the debt either
1) stays on the balance sheet or
2) is refinanced (paid off in the acquisition)
*often assume that the debt is paid off in the deal - increases the price that the buyer needs to pay for the seller
How can a company use stock in an M&A deal to pay off existing debt?
When a company issues shares, it sells the shares to new investors and receives cash in exchange for them. Here, they would issue a small portion of shares to third party investors rather than the seller raise the cash necessary to repay the debt
What is the logic behind DTL and DTAs?
Normally, they are written down in an M&A transaction to “reset” the tax basis since now they are part of a new entity
Additional DTLs and DTAs may be created if there are asset write ups and write downs and the book and tax D&A numbers differ
Asset Write Up: DTL created (depreciation on write ups is not tax-deductible meaning company will pay more in cash taxes)
Asset Write Down: DTA created (opposite; company will pay less in cash taxes)
Do you use Equity Value or Enterprise Value for the purchase price in a merger model?
Neither!
Actual amount of cash/stock/debt used is based on the Equity Purchase Price + Additional Funds needed to repay debt, pay for transaction fees, and so on
*Normally labeled as “Funds Required” and somewhere in-between Enterprise Value and Equity Value
How do you reflect transaction costs, financing fees, and miscellaneous expenses in a merger model?
Expense transaction and miscellaneous fees (legal and accounting) upfront
Capitalize financing fees and amortize them over the term of the debt
Why are financing fees capitalized?
Financing fees correspond to long term item rather than one-time transaction, they’re amortized over time on the balance sheet (similar to how new capex spending is depreciated over time)
How are NOLs taken into account in M&A deals?
Net Operating Losses (NOLs) are used to offset the taxable income of the combined company (Asset
Section 382: Allowable Annual NOL Usage = Equity Purchase Price * Highest of Past 3-Months’ Adjusted Long-Term Rates
Ex: Seller has $250m in NOL, combined company could use $50 million of them for 5 years to offset its taxable income
Why do DTLs and DTAs get created in M&A deals?
DTLs and DTAs get created in Stock Purchases because the book values of assets are written up or down, but the tax values are not
Assets are written up or written down because their book value (B/S values) differ widely from fair market values
In write ups, DTL is created because buyer will have a higher depreciation expense on the new asset, so buyer will save on taxes in the short term. Eventually buyer will have to pay them back so a liability gets created
This happens to Real Estate a lot
How do DTLs and DTAs affect B/S adjustments in an M&A transaction?
Deferred Tax Asset = Asset Write Down * Tax Rate
*created b/d depreciation on the write downs is not tax deductible, this means the company will pay less in cash taxes in the long term
Deferred Tax Liability = Asset Write Up * Tax Rate
*Created b/c depreciation on the write ups is not tax deductible, this means the company will pay more in cash taxes in the long term
Three Main Transaction Structures in an M&A Transaction?
1) Stock Purchase - Buyer acquires: All Assets and Liabilities + Off-B/S Items (*typical purchase)
Book basis of assets may not match tax basis of assets (so DTL and DTA created)
2) Asset Purchase - Buyer acquires: Only certain assets and liabilities of the seller
Book basis of assets matches the tax basis of assets
3) 338(h) (10) Election - Buyer acquires: All Assets and Liabilities + Off-B/S Items
Book basis of assets matches the tax basis of assets
Can you get DTLs or DTAs in an Asset Purchase?
No, in an asset purchase the book basis of assets always matches the tax basis.
DTLs and DTAs get created in stock purchases because the book values of assets are written up or written down, but the tax values are not
What is a DTA?
DTA is a deferred tax asset and is created when taxes are paid or carried forward but cannot yet be recognized on the company’s income statement
What is a DTL?
DTL is a Deferred Tax Liability and it represents an obligation to pay taxes in the future.
Obligation originates when a company or individual delays an event that would cause it to also recognize tax expenses in the current period
How are DTLs factored into forward projections in a merger model?
Create a book v tax schedule –> figure out what the company owes in taxes based on the Pre-Tax income on its books and then determine what it actually pays in cash taxes based on its NOLs and new D&A expense (from any asset write ups)
Cash Tax Expense > Book Tax Expense - Decrease to DTL
Cash Tax Expense < Book Tax Expense - Increase to DTL
What is a CapEx synergy and how do they impact financial statements?
CapEx synergies occur when if the buyer can reduce its CapEx spending because of certain assets the seller owns.
Lower the CapEx charge on the combined CFS and reflect reduced Depreciation charge on the Income Statement (Note wouldn’t start seeing results until year 2)
If you acquire a 70% stake in a company, can you still use accretion/dilution analysis?
Goodwill is created and a Liability is created for Noncontrolling Interests for the portion you don’t own
You consolidate 100% of the other company’s statements with your own even if you own 70% of it.
What is calendarization and what is its purpose?
Calendarization is the process of adjusting a company’s financials for the ending fiscal dates to match the calendar year
*Need to make sure the buyer and seller use the same fiscal years post-transaction. Normally you do this by changing the seller’s financial statements to match the buyers
What is a stub period and why are they created?
Stub period is a period of time between transaction closing date and the date of the next fiscal year (stub period is the first combined period in the merger model) - you would combined the I/S, C/F, and B/S for that stub period and keep them combined after
Stub periods need to be created from the date when the deal closes to the end of the buyer’s current fiscal year
*Normally don’t care much about accretion/dilution in stub periods so would calculate it for the first full fiscal year after the transaction close
What is an exchange ratio?
Exchange ratio is an alternate way of structuring a 100% stock M&A deal, or any M&A deal with a portion of stock involved
*Tie the number of new shares to the buyer’s own shares
Ex: Seller may receive 1.5 shares of the buyer’s shares for each of its shares
Why would a company want to perform an acquisition using an exchange ratio?
Buyers may prefer this if they believe their stock price will decline post-transaction
Sellers prefer a fixed dollar amount in stock unless they believe the buyer’s share price will rise after the transaction
What is a collar in a merger? (In the context of exchange ratio)
Collar guarantees a certain price based on the range of the buyer’s stock price to the seller’s stock price
Collars are a way to hedge against the risk of exchange ratios (if the buyer’s stock price swings wildly in one direction or the other)
What is an Earnout? Why is would a buyer offer it?
Earnout is a form of “deferred payment” in an M&A deal (common with start-ups)
It is terms of the deal contingent on future financial performance and other goals. It is offered to incentivize sellers to continue to perform well and to discourage management teams from taking money and running off to an island
What is a contribution analysis?
Contribution analysis compares how much Revenue, EBITDA, Pre-Tax Income, Cash, and possibly other items the buyer and seller are “contributing” to estimate what the ownership of the combined company should be
*Most common in a merger of equals
How would you solve for “break-even synergies”?
Set the EPS accretion/dilution to $0.00 and then back solve in excel to make the deal neutral to EPS.
*High number of break-even synergies tells you that you’re going to need a lot of cost savings or revenue synergies to make it work.
What is a reverse merger and how is it treated differently?
A reverse merger is when a private company acquires a public company
Mechanically it is similar to a traditional merger but accretion/dilution is not meaningful if it’s a private company because it doesn’t have an EPS. So there would be more weight on other metrics such as IRR
