Merger Model

Question 1

Walk me through a basic merger model.

Answer 1

• basic merger model: used to evaluate whether the transaction will be beneficial to the company’s earnings.

1. Determine the purchase price
2. Determine how to finance the transaction (cash, stocks, debt, or combinations of those)
3. Determine Valuations and Project Income Statements
4. Combine Income Statements
   - add key line items (combine revenue and operating expense)
   - adjust for financing effects (forgone interests on cash & interest paid on debt)
   - to calculate the pre-tax income
5. Apply the buyer’s tax rate
6. Divide by New Share Count to determine the EPS

Question 2

What’s the difference between a merger and an acquisition?

Answer 2

semantic difference
- merger: same size
- acquisition: big size company acquire small size company

Question 3

3. Why would a company want to acquire another company?

Answer 3

1. Gain market share
2. Needs to grow more quickly and see an acquisition is a way to do that
3. Seller is undervalued
4. Wants to acquire the seller’s customers ==> can up-sell and cross-sell
5. seller has a critical technology
6. believes that there are significant synergy

Question 4

4. Why would an acquisition be dilutive?

Answer 4

If the additional net income the seller contributes is not enough to offset the foregone interest on cash, interest paid on debts, and the effects of issuing new shares

Question 5

5. Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?

Answer 5

1. If the deal involves just cash and debt ==> sum up interest expense for debt and foregone interest on cash, and compare it with the seller’s pre-tax income
2. if it’s an all stock deal ==> if the buyer has a higher P/E than seller ==> accretive; if buyer has a lower P/E than seller ==> dilutive
3. If the deal involves stock, cash, and debt ==> no short cut

Question 6

A company with a higher P/E acquires one with a lower P/E – is this accretive or dilutive?

Answer 6

trick question. can’t tell unless this is an all stock deal. if an all stock deal:
accretive

Question 7

What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?

Answer 7

if is an all-stock deal
- buyer has a higher P/E/ ==> accretive
- seller has a higher P/E ==> dilutive

Question 8

8. What are the complete effects of an acquisition?

Answer 8

1. foregone interest on cash
2. interest paid on debt
3. additional shares outstanding
4. combined financial statements
5. creation of goodwill & other intangible

Question 9

9. If a company were capable of paying 100% in cash for another company, why would it choose NOT to do so

Answer 9

1. save cash for something else
2. concerned if the business is taking a turn for the worst
3. its stock may be trading at all-time-high and would prefer to use stock

Question 10

10. Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?

Answer 10

• strategic acquirers can realize cost and revenue synergies PE firms can’t

Question 11

11. Why do Goodwill & Other Intangibles get created in an acquisition?

Answer 11

premium above fair market value

Question 12

12. What is the difference between Goodwill and Other Intangible Assets?

Answer 12

• Goodwill doesn’t amortize
• other intangible assets do amortize and affect the I/S by hitting the pre-tax income line

Question 13

13. Is there anything else “intangible” besides Goodwill & Other Intangibles that could also impact the combined company?

Answer 13

• Purchase in process R&D
• Deferred Revenue write-off: The second refers to cases where the seller has collected cash for a service but not yet recorded it as revenue, and the buyer must write-down the value of the Deferred Revenue to avoid “double-counting” revenue.

Question 14

14. What are synergies, and can you provide a few examples?

Answer 14

Basically, the buyer gets more value than out of an acquisition than what the financials would predict.
1. Revenue synergies
2. Cost synergies

Question 15

15. How are synergies used in merger models?

Answer 15

1. Revenue synergy:
2. estimate the additional revenue that the combined company will generate because of synergies and apply a margin assumption
3. Cost synergy: reduce the combined COGS or Operating Expenses

Question 16

16. Are revenue or cost synergies more important?

Answer 16

No one in M&A takes revenue synergies seriously because they’re so hard to predict. Cost synergies are taken a bit more seriously because it’s more straightforward to see how buildings and locations might be consolidated and how many redundant employees might be eliminated.

Question 17

17. All else being equal, which method would a company prefer to use when acquiring another company – cash, stock, or debt?

Answer 17

it would always prefer to use cash when buying another company.
1. Cash is cheaper than debt because interest rate on cash are usually under 5%, and interest of debt are a lot always higher than that
2. Cash is less risky
3. stock is the most expensive way to finance a transaction because it’s not tax deductible
4. cash is also less risky than stock because share price could change dramatically

Question 18

18. How much debt could a company issue in a merger or acquisition?

Answer 18

• look at debt comps
• use the combined company’s Last Twelve Month EBITDA figure, find the median Debt/EBITDA ratio, and apply that to your own EBITDA figure

Question 19

19. How do you determine the Purchase Price for the target company in an acquisition?

Answer 19

Same valuation methodologies as we discussed.

Question 20

20. Let’s say a company overpays for another company – what typically happens afterwards and can you give any recent examples?

Answer 20

• increadible high amount of goodwill and other intangibles created
• there might be large impairments later on
• such as the eBay/Skype deal

Question 21

21. A buyer pays $100 million for the seller in an all-stock deal, but a day later the market decides it’s only worth $50 million. What happens?

Answer 21

The seller effectively only receives half of what it had originally negotiated because the value of the shares they were paid in has decreased.

Question 22

22. Why do most mergers and acquisitions fail?

Answer 22

1. difficult to realize synergies
2. CEO ego or pressure from shareholders.

Question 23

23. What role does a merger model play in deal negotiations?

Answer 23

• used as a sanity test
• A company would never decide to do a deal based on the output of a model.

Question 24

24. What types of sensitivities would you look at in a merger model? What variables would you look at?

Answer 24

1. purchase price
2. % stock/cash/stock
3. Revenue synergies
4. Expense synergies