Merger Model

Question 1

Why would a company want to acquire another company?

Answer 1

A company would acquire another company if it believes it will earn a good return on its investment - either in the form of a literal ROI‚ or in terms of a higher EPS number‚ which appeals to shareholders.
There are several reasons why a buyer might believe this to be the case:
• The buyer wants to gain market share by buying a competitor.
• The buyer needs to grow quickly and sees an acquisition as a way to do that.
• The buyer believes the seller is undervalued.
• The buyer wants to acquire the seller’s customers so it can up-sell and cross-sell products and services to them.
• The buyer thinks the seller has a critical technology‚ intellectual property‚ or other “secret sauce” it can use to significantly enhance its business.
• The buyer believes it can achieve significant synergies and therefore make the deal accretive for its shareholders.

Question 2

Walk me through a basic merger model.

Answer 2

• A merger model is used to analyze the financial profiles of 2 companies‚ the purchase price and how the purchase is made‚ and it determines whether the buyer’s EPS increases or decreases afterward.
• Step 1 is making assumptions about the acquisition - the price and whether it was done using cash‚ stock‚ debt‚ or some combination of those. Next‚ you determine the valuations and shares outstanding of the buyer and seller and project the Income Statements for each one.
• Finally‚ you combine the Income Statements‚ adding up line items such as Revenue and Operating Expenses‚ and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer’s Tax Rate and get the Combined Net Income‚ and then divide by the new share count to determine the combined EPS.
• You could also add in the part about Goodwill and combining the Balance Sheets‚ but it’s best to start with answers that are as simple as possible at first.

Question 3

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

Answer 3

• There’s always a buyer and a seller in any M&A deal - the difference is that in a merger‚ the companies are similarly-sized‚ whereas in an acquisition the buyer is significantly larger (often by a factor of 2-3x or more).
• Also‚ 100% stock (or majority stock) deals are more common in mergers because similarly sized companies rarely have enough cash to buy each other‚ and cannot raise enough debt to do so either.

Question 4

Why would an acquisition be dilutive?

Answer 4

• An acquisition is dilutive if the additional Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash‚ additional interest paid on debt‚ and the effects of issuing additional shares.
• Acquisition effects - such as the amortization of Other Intangible Assets - can also make an acquisition dilutive.

Question 5

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

Answer 5

YES:
• Cost of Cash = Foregone Interest on Cash * (1 - Buyer Tax Rate)
• Cost of Debt = Interest Rate on Debt * (1 - Buyer Tax Rate)
• Cost of Stock = Reciprocal of Buyer’s P/E Multiple (i.e. E/P or NI/Equity Value)
• Yield of Seller = Reciprocal of Seller’s P/E Multiple (ideally calculated using Purchase Price rather than the Seller’s Current Share Price)

• You calculate each of the Costs‚ take the weighted average‚ and then compare that number to the Yield of the Seller (the reciprocal of the Seller’s P/E multiple).
• If the weighted “Cost” average is less than the Seller’s Yield‚ it will be accretive since the purchase itself “costs” less than what the buyers get out of it; otherwise‚ it will be dilutive.

Example: The buyer’s P/E multiple is 8x and the seller’s P/E multiple is 10x. The buyer’s int. rate on cash is 4%‚ and int. rate on debt is 8%. The buyer is paying with 20% cash‚ 20% debt‚ and 60% stock. The buyer’s tax rate is 40%:
• Cost of Cash = 4% * (1 - 40%) = 2.4%
• Cost of Debt = 8% * (1 - 40%) = 4.8%
• Cost of Stock = 1/8 = 12.5%
• Yield of Seller = 1/10 = 10%
• Weighted Average Cost = 20%(2.4%) + 20%(4.8%) + 60%(12.5%) = 8.9% < 10%
• Summary: Since Weighted Average Cost < Seller’s Yield‚ the deal is ACCRETIVE.

Question 6

Wait a minute‚ though‚ does [the rule of thumb for determining whether an acquisition will be accretive or dilutive] work all the time?

Answer 6

• NO‚ there are a number of assumptions here that rarely hold up in the real world: the seller and buyer have the same tax rates‚ there are no other acquisition effects such as new D&A‚ there are no transaction fees‚ no synergies‚ etc.
• And most importantly‚ the rule truly breaks down if you use the seller’s current share price rather than the price the buyer is paying to purchase it.
• It’s a great way to quickly assess a deal‚ but it is NOT a hard-and-fast rule.

Question 7

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

Answer 7

• TRICK QUESTION: You can’t tell unless you also know that it’s an all stock deal. If it’s an all-cash or all-debt deal‚ the P/E multiple of the buyer doesn’t matter b/c no stock is being issued.
• If it is an all-stock deal‚ then the deal will be accretive since the buyer “gets” more in earnings for each $1.00 used to acquire the other company that it does from its own operations. The opposite applies if the buyer’s P/E multiple is lower than the seller’s.

Question 8

Why do we focus so much on accretion/dilution? Is EPS really that important? Are there cases where it’s not relevant?

Answer 8

• EPS is important mostly b/c institutional investors value it and base many decisions on EPS and P/E multiples - not the best approach‚ but it is how they think.
• A merger model has many purposes besides just calculating EPS accretion/dilution - for example‚ you could calculate the IRR of an acquisition if you assume that the acquired company is resold in the future‚ or even that it generates cash flows indefinitely into the future.
• An equally important part of a merger model is assessing what the combined financial statements look like and how key items change.
• So it’s not that EPS accretion/dilution is the ONLY important point in a merger model - but is what’s most likely to come up in interviews.

Question 9

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

Answer 9

• You use the same Valuation methodologies we discussed in the Valuation section. If the seller is a public company‚ you would pay more attention to the premium paid over the current share price to make sure it’s “sufficient” (generally in the 15-30% range) to win shareholder approval.
• For private sellers‚ more weight is placed on the traditional methodologies.

Question 10

All else being equal‚ which method would a company prefer to use when acquiring another company - cash‚ stock‚ or debt?

Answer 10

Assuming the buyer had unlimited resources‚ it would almost always prefer to use cash when buying another company. Why?
• Cash is cheaper than debt b/c int. rates on cash are usually under 5% whereas debt int. rates are almost always higher than that. Thus‚ foregone interest on cash is almost always LESS than the additional interest paid on debt for the same amount of cash or debt.
• Cash is almost always cheaper than stock b/c most companies P/E multiples are in the 10-20x range‚ which equals 5-10% for “Cost of Stock”
• Cash is also less risky than debt b/c there’s no chance the buyer might fail to raise sufficient funds from investors‚ or that the buyer might default.
• Cash is also less risky than stock b/c the buyer’s share price could change dramatically once the acquisition is announced.

Question 11

Could there be cases where cash is actually more expensive than debt or stock in an acquisition?

Answer 11

• With debt this is impossible‚ b/c it makes no logical/financial sense: why would a bank ever pay more on cash you’ve deposited than it would charge to customers who need to borrow money?
• With stock it is almost impossible‚ but sometimes if the buyer has an extremely high P/E multiple (e.g. 100x)‚ the reciprocal of that (1%) might be lower than the after-tax cost of cash. This is rare‚ extremely rare.

Question 12

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

Answer 12

• It might be saving its cash for something else‚ or it might be concerned about running low on cash if business takes a turn for the worst.
• The buyer’s stock may also be trading at an all-time high and it might be eager to use that “currency” instead‚ for the reasons stated above: stock is less expensive to issue if the company has a high P/E multiple and therefore a high stock price.

Question 13

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

Answer 13

• You would look at Comparable Companies and Precedent Transactions to determine this. You would use the combined company’s EBITDA figure‚ find the median Debt/EBITDA ratio of the companies or deals you’re looking at‚ and apply that to the company’s own EBITDA figure to get a rough idea of how much debt it could raise.
• You could also look at “Debt Comps” for similar‚ recent deals and see what types of debt and how many tranches they have used.

Question 14

When would a company be most likely to issue stock to acquire another company?

Answer 14

• The buyer’s stock is trading at an all-time high‚ or at least at a very high level‚ and it’s therefore “cheaper” to issue stock than it normally would be.
• The seller is almost as large as the buyer and it’s impossible to raise enough debt or use enough cash to acquire the seller.

Question 15

Let’s say that a buyer doesn’t have enough cash available to acquire the seller. How could it decide between raising debt‚ issuing stock‚ or some combination of those?

Answer 15

There’s no simple rule to decide - key factors include:
• The relative “cost” of both debt and stock: For example‚ if the company is trading at a higher P/E multiple it may be cheaper to issue stock (e.g. P/E of 20x = 5% cost‚ but debt at 10% interest = 10%*(1 - 40%) = 6% cost.
• Existing Debt: If the company already has a high debt balance‚ it likely can’t raise as much new debt.
• Shareholder dilution: Shareholders do not like the dilution that comes w/ issuing new stock‚ so companies try to minimize this.
• Expansion Plans: If the buyer expands‚ begins a huge R&D effort‚ or buys a factory in the future‚ it’s less likely to use cash and/or debt and more likely to issue stock so that it has enough funds available.

Question 16

Let’s say that Company A buys Company B using 100% debt. Company B has a P/E multiple of 10x and Company A has a P/E multiple of 15x. What interest rate is required on the debt to make the deal dilutive?

Answer 16

• Company A Cost of Stock = 1/15 = 6.67%
• Company B Yield = 1/10 = 10%
• Therefore‚ the after-tax Cost of Debt must be above 10% for the acquisition cost to exceed Company B’s Yield.
• 10% / (1 - 40%) = 16.67%‚ so we can say “above approximately 17%” for the answer. That is an exceptionally high interest rate‚ so a 100% debt deal here would almost certainly be accretive instead.

Question 17

Let’s go through another M&A scenario. Company A has a P/E of 10x‚ which is higher than the P/E of Company B. The interest rate on debt is 5%. If Company A acquires Company B and they both have 40% tax rates‚ should Company A use debt or stock for the most accretion?

Answer 17

• Company A Cost of Debt = 5%*(1 - 40%) = 3%
• Company A Cost of Stock = 1/10 = 10%
• Company B Yield = Higher than 10% since its P/E multiple is lower
• Therefore‚ this deal will always be accretive regardless of whether Company A uses debt or stock since both “cost” less than Company B’s Yield.
• However‚ Company A will achieve far more accretion if it uses 100% debt b/c the Cost of Debt (3%) is much lower than the Cost of Stock (10%).

Question 18

This is a multi-part question. Let’s look at another M&A scenario:
• Company A: Enterprise Value of 100‚ Market Cap of 80‚ EBITDA of 10‚ Net Income of 4.
• Company B: Enterprise Value of 40‚ Market Cap of 40‚ EBITDA of 8‚ Net Income of 2.

First‚ Calculate the EV/EBITDA and P/E multiples for each one.

Answer 18

• Company A: EV/EBITDA = 100/10 = 10x; P/E = 80/4 = 20x

* Company B: EV/EBITDA = 40/8 = 5x; P/E = 40/2 = 20x

Question 19

This is a multi-part question. Recall:
• Company A: EV of 100‚ Market Cap of 80‚ EBITDA of 10‚ NI of 4‚ EV/EBITDA = 10x‚ P/E = 20x
• Company B: EV of 40‚ Market Cap of 40‚ EBITDA of 8‚ NI of 2‚ EV/EBITDA = 5x‚ P/E = 20x

Company A decides to acquire Company B using 100% Cash. Company A does NOT pay any kind of premium to acquire Company B. What are the combined EBITDA and P/E multiples?

Answer 19

• In this scenario‚ Company B’s Market Cap gets wiped out b/c it no longer exists as an independent entity‚ and Company A’s cash balance decreases b/c it has used its cash to acquire Company B.
• So the Combined Market Cap = 80. Previously‚ A had 20 more Debt than Cash‚ and B had the same amount of Cash and Debt.
• To get real numbers here‚ let’s just say that A had 60 of Debt and 40 of Cash. Afterward‚ the Debt remains at 60 but all the cash is gone b/c it used the Cash to acquire B. We don’t need to look at B’s numbers at all b/c its Cash and Debt cancel each other out.
• So the combined Enterprise Value = 80 + 60 = 140. It is no coincidence‚ of course‚ that Combined Enterprise Value = Company A Enterprise Value + Company B Enterprise Value. That is how it should always work in an acquisition where there was no premium paid for the seller.
• You add the EBITDA and Net Income from both companies to get the combined figures. This is not 100% accurate b/c Interest Income changes for Company A since it’s using cash and b/c the tax rates may be different‚ but we’re going to ignore those for now since the impact will be small:
• Combined EV/EBITDA = 140 / (10 + 8) = 140/18 = 7.78x
• Combined P/E = 80 / (4 + 2) = 80/6 = 13.3x

Question 20

This is a multi-part question. Recall:
• Company A: EV of 100‚ Market Cap of 80‚ EBITDA of 10‚ NI of 4‚ EV/EBITDA = 10x‚ P/E = 20x
• Company B: EV of 40‚ Market Cap of 40‚ EBITDA of 8‚ NI of 2‚ EV/EBITDA = 5x‚ P/E = 20x

Now‚ let’s say that Company A instead uses 100% debt‚ at a 10% interest rate and 25% tax rate‚ to acquire Company B. Again‚ Company A pays no premium for Company B. What are the combined multiples?

Answer 20

• Once again‚ Company B’s Market Cap gets wiped out since it no longer exists as an independent entity. So Combined Market Cap = 80.
• The combined company has 40 of additional Debt‚ so if we continue with the assumption that A has 60 of Debt and 40 of Cash‚ the Enterprise Value is 80 + 60 + 40 - 40 = 140‚ the same as in the previous example (IMPORTANT: Regardless of the purchase method‚ the combined Enterprise Value stays the same).
• The Combined EBITDA is still 18‚ so EV/EBITDA = 140/18 = 7.78x
• But the combined Net Income has changed. Normally‚ Company A Net Income + Company B Net Income = 6‚ but now we have 40 of debt at 10% interest‚ which is 4‚ and when multiplied by (1 - 25%)‚ equals 3.
• So Net Income falls to 6 - 3 = 3‚ and Combined P/E = 80/3 = 26.7x

Question 21

This is a multi-part question. Recall:
• Company A: EV of 100‚ Market Cap of 80‚ EBITDA of 10‚ NI of 4‚ EV/EBITDA = 10x‚ P/E = 20x
• Company B: EV of 40‚ Market Cap of 40‚ EBITDA of 8‚ NI of 2‚ EV/EBITDA = 5x‚ P/E = 20x

What was the point of this multi-step scenario and these questions? What does it tell you about valuation multiples and M&A activity?

Answer 21

There are a few main takeaways from this exercise:

1. Regardless of the purchase method (cash‚ stock‚ debt‚ or some combination of those)‚ the Combined Enterprise Value for the new entity stays the same.
2. Company B’s Market Cap (and the book version of it - Shareholders’ Equity) always gets wiped out when it is acquired (technically‚ whenever the acquisition is for over 50% of Company B).
3. Regardless of the purchase method‚ the Combined EV/EBITDA multiple does not change b/c Combined Enterprise Value always stays the same and b/c the Combined EBITDA is not affected by changes in interest or additional shares outstanding.

Question 22

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

Answer 22

B/c the strategic acquirer can realize revenue and cost synergies that the private equity firm cannot unless it combines the company with a complementary portfolio company. Those synergies make it easier for the strategic acquirer to pay a higher price and still realize a solid return on investment.

Question 23

What are the effects of an acquisition?

Answer 23

1. Foregone Interest on Cash - The buyer loses the Interest it would have otherwise earned if it uses cash for the acquisition.
2. Additional Interest on Debt - The buyer pays additional Interest Expense if it uses debt.
3. Additional Shares Outstanding - If the buyer pays with stock‚ it must issue additional shares.
4. Combined Financial Statements - After the acquisition‚ the seller’s financial statements are added to the buyer’s.
5. Creation of Goodwill & Other Intangibles - These Balance Sheet items that represent the premium paid to a seller’s Shareholders’ Equity also get created.

Question 24

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

Answer 24

• These represent the amount that the buyer has paid over the book value (Shareholders’ Equity) of the seller. You calculate the number by subtracting the seller’s Shareholders’ Equity (technically the Common Shareholders’ Equity) from the Equity Purchase Price.
• Goodwill and Other Intangibles represent the value of customer relationships‚ employee skills‚ competitive advantages‚ brand names‚ intellectual property‚ and so on - valuable‚ but not physical Assets in the same way factories are.

Question 25

What is the difference between Goodwill and Other Intangible Assets?

Answer 25

• Goodwill typically stays the same over many years and is not amortized. It changes only if there’s Goodwill Impairment (or another acquisition).
• Other Intangible Assets‚ by contrast‚ are amortized over several years and affect the Income Statement by reducing Pre-Tax Income.
• Technically‚ Other Intangible Assets might represent items that “expire” over time‚ such as copyrights or patents‚ but you do not get into that level of detail as a banker - it’s something that accountants and auditors would determine post-acquisition.

Question 26

What are some more advanced acquisition effects that you might see in a merger model?

Answer 26

• PPE and Fixed Asset Write-Ups: You may write up the values of these Assets in an acquisition‚ under the assumption that the market values exceed the book values.
• Deferred Tax Liabilities and Deferred Tax Assets: You may adjust these up or down depending on the asset write-ups and deal type.
• Transaction and Financing Fees: You also need to factor in these fees into the model somewhere.
• Inter-Company A/R & A/P: Two companies “owing” each other cash no longer makes sense after they’ve become the same company.
• Deferred Revenue Write-Down: Accounting rules state that you can only recognize the “profit portion” of the seller’s Deferred Revenue post-acquisition. So you often write down the “expense portion” of the seller’s Deferred Revenue over several years in a merger model.
* You do NOT need to know all the details for entry-level interviews‚ but you should be aware that there are more advanced adjustments in M&A deals.

Question 27

What are synergies‚ and can you provide a few examples?

Answer 27

• Synergies refer to cases where 2 + 2 = 5 (or 6‚ or 7…) in an acquisition. The buyer gets more value out of an acquisition than what the financials would otherwise suggest.
• There are 2 types: Revenue Synergies and Cost (or Expense) Synergies.
• Revenue Synergies: The combined company can cross-sell products to new customers or up-sell additional products to customers. It might also be able to expand into new geographies as a result of the deal.
• Expense Synergies: The combined company can consolidate buildings and administrative staff and can lay off redundant employees. It might also be able to shut down redundant stores or locations.

Question 28

How are synergies used in merger models?

Answer 28

• Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue (all additional Revenue costs something) - additional Revenue then flows through the rest of the combined Income Statement‚ and you reflect the additional expenses as well.
• Expense Synergies: Normally you reduce the combined COGS or Operating Expenses by this amount‚ which in turn boosts the combined Pre-Tax Income and Net Income‚ increasing the EPS and making the deal more accretive.

Question 29

Are revenue or expense synergies more important?

Answer 29

• Revenue synergies are rarely taken seriously b/c they’re so hard to predict.
• Expense synergies are taken a bit more seriously b/c it’s more straightforward to see how buildings and locations might be consolidated and how many redundant employees might be eliminated.

Question 30

Let’s say a company overpays for another company - what happens afterward?

Answer 30

A high amount of Goodwill & Other Intangibles would be created if the purchase price is far above the Shareholders’ Equity of the target. In the years following the acquisition‚ the buyer may record a large Goodwill Impairment Charge if it reassess the value of the seller and finds that it truly overpaid.

Question 31

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

Answer 31

• The buyer’s share price would fall by whatever per-share dollar amount corresponds to the $50M loss in value. It would NOT necessarily be cut in half.
• Depending on the deal structure‚ the seller would effectively only receive half of what it had originally negotiated.
• This illustrates one of the major risks of all-stock deals: sudden changes in share price could dramatically impact the valuation (there are ways to hedge against that risk).

Question 32

Why do most mergers and acquisitions fail?

Answer 32

• M&A is “easier said than done.” In practice‚ it’s very difficult to acquire and integrate a different company‚ realize synergies‚ and also turn the acquired company into a profitable division.
• Many deals are also done for the wrong reasons‚ such as the CEO’s massive ego or pressure from shareholders. Any deal done without both parties’ best interests in mind is likely to fail.

Question 33

What role does a merger model play in deal negotiations?

Answer 33

• The model is used as a sanity check and as a way to test various assumptions. A company would NEVER decide to do a deal b/c of the output of a model.
• It might say‚ “OK‚ the model tells us this deal could work and would be moderately accretive - it’s worth exploring in more detail.”
• It would never say‚ “Aha! This model predicts 21% accretion - we should have acquired this company yesterday!”
• Emotions‚ ego and personalities play a far bigger role in M&A than numbers do.

Question 34

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

Answer 34

• The most common variables to analyze are Purchase Price‚ %Stock/Cash/Debt‚ Revenue Synergies‚ and Expense Synergies. Sometimes you also look at different operating sensitivities‚ like Revenue Growth or EBITDA Margin‚ but it’s more common to build these into your model as different scenarios instead.
• You might look at sensitivity tables showing the EPS accretion/dilution at different ranges for the Purchase Price vs. Cost Synergies‚ Purchase Price vs. Revenue Synergies‚ or Purchase Price vs % Cash (and so on).

Question 35

If the seller has existing Debt on its Balance Sheet in an M&A deal‚ how do you deal with it?

Answer 35

• You assume that the Debt either stays on the Balance Sheet or is refinanced (paid off) in the acquisition. The terms of most Debt issuance state that they must be repaid in a “change of control” scenario (i.e. when a buyer acquires over 50% of a company)‚ so you often assume that the Debt is paid off in a deal.
• That increases the price that the buyer needs to pay for the seller.

Question 36

If you use Cash or Debt to acquire another company‚ it’s clear how you could use them to pay off existing Debt‚ but how does that work with Stock?

Answer 36

• Remember what happens when a company issues shares: it sells the shares to new investors and receives cash in exchange for them. Here‚ they would do the same thing and issue a small portion of the shares to 3rd party investors rather than the seller to raise the cash necessary to repay the debt.
• The buyer might also wait until the deal closes before it issues additional share to pay off the debt. And it could also use cash on-hand to repay the debt‚ or refinance the debt with a new debt issuance.

Question 37

What’s the purpose of Purchase Price Allocation in an M&A deal? Can you explain how it works?

Answer 37

• The ultimate purpose is to make the combined B/S balance. This is harder than it sounds b/c many items get adjusted up or down (e.g. PPE)‚ some items disappear altogether (e.g. the Seller’s Shareholders’ Equity)‚ and some new items get created (e.g. Goodwill).
• To complete the process‚ you look at every single item on the Seller’s B/S and then assess the fair market value of all those items‚ adjusting them up or down as necessary.
• So if the buyer pays‚ say $1B for the Seller‚ you figure out how much of that $1B gets allocated to each Asset on the B/S.
• Goodwill (and Other Intangible Assets) serves as the “plug” and ensures that both sides balance after you’ve made all the adjustments. Goodwill is roughly equal to the Equity Purchase Price minus the Seller’s Shareholders’ Equity and other adjustments.

Question 38

Explain the complete formula for how to calculate Goodwill in an M&A deal.

Answer 38

Goodwill = Equity Purchase Price - Seller Book Value + Seller’s Existing Goodwill - Asset Write-Ups - Seller’s Existing DTL + Write-down of Seller’s Existing DTA + Newly Created DTLs + Intercompany A/R - Intercompany A/P
• Seller Book Value is just the Shareholders’ Equity number (technically‚ the Common Shareholders’ Equity number)
• You add the Seller’s Existing Goodwill b/c it is “reset” and written down to $0 in an M&A deal.
• You subtract the Asset Write-Ups b/c these are additions to the Assets side of the B/S - Goodwill is also an asset‚ so effectively you need less Goodwill to “plug the hole.”
• Normally you assume 100% of the Seller’s existing DTL is written down.
• The seller’s existing DTA may or may not be written down completely.
• You add Intercompany A/R because they go away‚ which reduces the Assets side; the opposite applies for Intercompany A/P.

Question 39

Why do we adjust the value of Assets such as PP&E in an M&A deal?

Answer 39

• B/c often the fair market value is significantly different from the B/S value. A perfect example is real estate - usually it appreciates over time‚ but due to the rules of accounting‚ companies must depreciate it on the B/S and show a declining balance over time to reflect the allocation of costs over a long time period.
• Investments‚ Inventory‚ and other Assets may have also “drifted” from their fair market values since the B/S is recorded at historical cost for companies in most industries (exceptions‚ such as commercial banking‚ do exist).

Question 40

What’s the logic behind Deferred Tax Liabilities and Deferred Tax Assets?

Answer 40

• The basic idea is that you normally write down most of the seller’s existing DTLs and DTAs to “reset” its tax basis‚ since it’s now part of another entity.
• And then you may create new DTLs or DTAs if there are Asset Write-Ups or Write-Downs and the book and tax D&A numbers differ.
• If there are write-ups‚ a DTL will be created in most deals since the Depreciation on the write-ups is not tax-deductible‚ which means that the company will pay more in cash taxes; the opposite applies for write-downs and there‚ a DTA would be created.

Question 41

How do you treat items like Preferred Stock‚ Noncontrolling Interests‚ Debt‚ and so on‚ and how do they affect Purchase Price Allocation?

Answer 41

• Normally‚ you build in the option to repay (or in the case of Noncontrolling Interests‚ purchase the remainder of) these items or assume them in the Sources & Uses schedule. If you repay them‚ additional cash/debt/stock is required to purchase the seller.
• However‚ that choice‚ does NOT affect Purchase Price Allocation.
• You always start w/ the Equity Purchase Price there‚ which excludes the treatment of all these items. Also‚ you only use the seller’s Common Shareholders’ Equity in the PPA schedule‚ which excludes Preferred Stock and Noncontrolling Interests.

Question 42

Do you use Equity Value or Enterprise Value for the Purchase Price in a merger model?

Answer 42

• This is a trick question because neither one is entirely accurate. The PPA schedule is based on the Equity Purchase Price‚ but the actual amount of cash/stock/debt used is based on that Equity Purchase Price plus the additional funds needed to repay debt‚ pay for transaction-related fees‚ and so on.
• That number is not exactly “Enterprise Value” - it’s something in between Equity Value and Enterprise Value‚ and it’s normally labeled “Funds Required” in a model.

Question 43

How do you reflect transaction costs‚ financing fees‚ and miscellaneous expenses in a merger model?

Answer 43

• You expense transaction and miscellaneous fees (such as legal and accounting services) upfront and capitalize the financing fees and amortize them over the term of the debt.
• Expensed transaction fees come out of Retained Earnings when you adjust the B/S (and Cash on the other side)‚ while Capitalized Financing Fees appear as a new Asset on the Balance Sheet (and reduce Cash immediately) and are amortized each year according to the tenor of the debt.
• In reality‚ you pay for all of these fees upfront in cash. However‚ since financing fees correspond to a long-term item rather than a one-time transaction‚ they’re amortized over time on the Balance Sheet. It’s similar to how new CapEx spending is depreciated over time.
• NONE of this affects Purchase Price Allocation. These fees simply increase the “Funds Required” number discussed above‚ but they make absolutely NO impact on the Equity Purchase Price or on the amount of Goodwill created.

Question 44

How would you treat Debt differently in the Sources & Uses table if it is refinanced rather than assumed?

Answer 44

• If the buyer assumes the Debt‚ it appears in BOTH the Sources and Uses columns and has no effect on the Funds Required.
• If the buyer pays off the Debt‚ it appears only in the Uses column and increases the Funds Required.

Question 45

What are the 3 main transaction structures you could use to acquire another company?

Answer 45

• The 3 main structures are the Stock Purchase‚ Asset Purchase‚ and 338(h)(10) Election.
• Note that Stock Purchases and Asset Purchases exist in some form in countries worldwide‚ but that the 338(h)(10) Election is specific to the US - however‚ there may be equivalent legal structures in other countries.
• Part of the reason that both parties favor the 338(h)(10) structure is that buyers typically agree to pay more to compensate sellers for the favorable tax treatment they receive.
• See p. 49 (of 66) of BIWS - Merger Model Guide for comparison table.

Question 46

Would a seller prefer a Stock Purchase or an Asset Purchase? What about the buyer?

Answer 46

• A seller almost always prefers a Stock Purchase to avoid double taxation and to dispose of all its Liabilities.
• A buyer almost always prefers an Asset Purchase so it can be more careful about what it acquires and to get the tax benefit from being able to deduct D&A on Asset Write-Ups for tax purposes.
• However‚ it’s not always possible to “pick” one or the other - for example‚ if the seller is a large public company only a Stock Purchase is possible in 99% of cases.

Question 47

Why might a company want to use 338(h)(10) when acquiring another company?

Answer 47

A Section 338(h)(10) election blends the benefits of a Stock Purchase and an Asset Purchase:
• Legally it is a Stock Purchase‚ but accounting-wise it’s treated like an Asset Purchase.
• The seller is still subject to double-taxation - capital gains on any Assets that have appreciated and on the proceeds from the sale.
• But the buyer receives a step-up tax basis on the new Assets it acquires‚ and it can depreciate and amortize them so it saves on taxes.

Even though sellers still get taxed twice‚ buyers will often pay more in a 338(h)(10) deal b/c of the tax-savings potential. It’s particularly helpful for:
• Sellers w/ high NOL balances (more tax-savings for the buyer b/c this NOL balance will be written down completely - so more of the excess purchase price can be allocated to Asset Write-Ups)
• Companies that have been S-Corporations for over 10 years - in this case they do not have to pay taxes on the appreciation of their Assets.
• NOTE: The requirements to use 338(h)(10) are complex and it cannot always be used. For example‚ if the seller is a C-Corporation it can’t be applied; also‚ if the buyer is not a C-Corporation (e.g. a private equity firm)‚ it also can’t be used.

Question 48

How do you take into account NOLs in an M&A deal?

Answer 48

• You apply Section 382 to determine how much of the Seller’s NOLs are usable each year.
• Allowable Annual NOL Usage = Equity Purchase Price * Highest of Past 3 Months’ Adj. Long-Term Rates
• So if our Equity Purchase Price were $1B and the highest adj. long-term rate were 5%‚ then we could use $1B * 5% = $50M of NOLs each year.
• If the Seller had $250M in NOLs‚ then the combined company could use $50M of them each year for 5 years to offset its taxable income.

Question 49

Why do deferred tax liabilities (DTLs) and deferred tax assets (DTAs) get created in M&A deals?

Answer 49

• These get created when you write-up assets - both tangible and intangible - and when you write down assets in a transaction. An Asset Write-up creates a DTL and an Asset Write-Down creates a DTA.
• You write down and write up assets b/c their book values (what’s on the B/S) often differ substantially from their “fair market values.”
• An asset write-up creates a DTL b/c you’ll have a higher Deprecation Expense on the new asset‚ which means you save on taxes in the short-term‚ but eventually you’ll have to pay them back‚ so you get a liability. The opposite applies for an asset write-down and a DTA.

Question 50

How do DTLs and DTAs affect the Balance Sheet Adjustments in an M&A deal?

Answer 50

• You take them into account w/ everything else when calculating the amount of Goodwill & Other Intangibles to create on your pro-forma B/S. The formulas are as follows:
• DTA = Asset Write-Down * Tax Rate; DTL = Asset Write-Up * Tax Rate
• So let’s say you were buying a company for $1B w/ 50% cash and 50% debt‚ and you had a $100M asset write-up and a tax rate of 40%. In addition‚ the seller has total Assets of $200M‚ total Liabilities of $150M‚ and Shareholders’ Equity of $50M. Here’s what would happen on the combined company’s balance sheet (ignoring transaction and financing fees):
• First‚ you simply add the seller’s Assets and Liabilities (but NOT Shareholders’ Equity - it is wiped out) to the buyer’s to get your “initial” B/S. Assets are up by $200M an Liabilities are up by $150M.
• Then Cash on the Assets side goes down by $500M.
• You have an Asset Write-Up of $100M‚ so Assets go up by $100M; Debt on the Liabilities & Equity side goes up by $500M.
• You get a new DTL of $40M ($100M * 40%) on the Liabilities & Equity Side.
• Assets are down by $200M total and Liabilities & Shareholders’ Equity are up by $690M ($500 + $40 + $150)
• So you need Goodwill & Intangibles of $890M on the Assets side to make both sides balance.

Question 51

Could you get DTLs or DTAs in an Asset Purchase?

Answer 51

No‚ b/c in an Assets Purchase‚ the book basis of assets always matches the tax basis. DTLs and DTAs get created in Stock Purchases b/c the book values of Assets are written up or written down‚ but the tax values do not.

Question 52

How do you factor in DTLs into forward projections in a merger model?

Answer 52

• You create a book vs. cash tax schedule and figure out what the company owes in taxes based on the Pre-Tax Income on its books‚ and then you determine what it actually pays in cash taxes based on its NOLs and its new D&A expenses (from any Asset Write-Ups)
• Anytime the “cash” tax expense exceeds the “book” tax expense you record this as a decrease to the Deferred Tax Liability on the B/S; if the “book” expense is higher‚ then you record that as an increase to the DTL.

Question 53

Can you give me an example of how you might calculate revenue synergies?

Answer 53

• Sure‚ let’s say that Company A sells 10‚000 widgets/year in N. America at an average price of $15 and Company B sells 5000 widgets/year in Europe at an average price of $10. Company A believes that it can sell its own widgets to 20% of Company B’s customers‚ so after it acquires Company B it will earn an extra 20% * 5000 * $15 in revenue or $15‚000.
• It will also have expenses associated w/ those extra sales‚ so you need to reflect those as well (if it has a 50% margin‚ for example‚ it would reflect an additional $7‚500 rather than $15‚000 to Operating Income and Pre-Tax Income on the combined Income Statement.
• This last point about expenses associated w/ revenue synergies is important and one that a lot of people forget - there’s no such thing as “free” revenue with no associated costs.

Question 54

Should you estimate revenue synergies based on the seller’s customers and the seller’s financials‚ or the buyer’s customers and the buyer’s financials?

Answer 54

• Either one works. You could assume that the buyer leverages the seller’s products or services and sells them to its own customer base - but typically you assume an uplift to the seller’s average selling price‚ or something else that the buyer can do w/ the seller’s existing customers.
• You approach it that way b/c the buyer‚ as a larger company‚ can make more of an immediate impact on the seller than the seller can make on the buyer.

Question 55

Walk me through an example of how to calculate expense synergies.

Answer 55

• Let’s say that Company A wants to acquire Company B. Company A has 5000 SG&A related employees‚ whereas Company B has around 1000.
• Company A calculates that post-transaction‚ it will only need about 800 of Company B’s SG&A employees‚ and its existing employees can take over the rest of the work.
• To calculate the Operating Expenses the combined company would save‚ we would multiply these 200 employees that Company A is going to fire post-transaction by their average salary‚ benefits‚ and other compensation expenses.

Question 56

How do you think about synergies if the combined company can consolidate buildings?

Answer 56

• If the buildings are leased‚ you assume that both lease expenses go away and are replaced w/ a new‚ larger lease expense for the new or expanded building. So in that case‚ it is a simple matter of New Lease Expense - Old‚ Separate Lease Expense to determine the synergies.
• If the buildings are owned‚ it gets more complicated b/c one or both of them will be sold‚ or perhaps leased out to someone else. Then you would have to look at Depreciation and Interest savings‚ as well as additional potential income if the building is rented out.

Question 57

What if there are CapEx synergies? For example‚ what if the buyer can reduce its CapEx spending because of certain assets the seller owns?

Answer 57

• In this case‚ you would start recording a lower CapEx charge on the combined SCF‚ and then reflect a reduced Depreciation charge on the I/S from that new CapEx spending each year.
• You would not start seeing the results until Year 2 b/c reduced Depreciation only comes after reduced CapEx spending. This scenario would be much easier to model w/ a full PP&E schedule where you can adjust the spending and the resulting Depreciation each year.

Question 58

What happens when you acquire a 30% stake in a company? Can you still use an accretion/dilution analysis?

Answer 58

• You record this 30% as an “Investment in Equity Interest” or “Associate Company” on the Assets side of the B/S‚ and you reduce Cash to reflect the purchase (assuming that Cash was used). You use this treatment for all ownership percentages between 20% and 50%.
• You can still use an accretion/dilution analysis; just make sure that the new Net Income reflects the 30% of the other company’s Net Income that you are entitled to.

Question 59

What happens when you acquire a 70% stake in a company?

Answer 59

• For all acquisitions where over 50% (but less than 100%) of another company gets acquired‚ you still go through the purchase price allocation process and create Goodwill‚ but you record a Noncontrolling interest on the Liabilities side for the portion you do NOT own. You also consolidate 100% of the other company’s statements with your own‚ even if you only own 70% of it.
• Example: You acquire 70% of another company using Cash. The company is worth $100‚ and has Assets of $180‚ Liabilities of $100‚ and Equity of $80.
• You add all of its Assets and Liabilities to your own‚ but you wipe out its Equity since its no longer considered an independent entity. The Assets side is up by $180 and the Liabilities side is up by $100. You also used $70 of Cash‚ so the Assets side is now only up by $110.
• We allocate the purchase price here‚ and since 100% of the company was worth $100 but its Equity was only $80‚ we create $20 of Goodwill - so the Assets side is up by $130.
• On the Liabilities side‚ we create a Noncontrolling Interest of $30 to represent the 30% of the company that we do NOT own. Both sides are up by $130 and balance.

Question 60

Let’s say that a company sells a subsidiary for $1000‚ paid for by the buyer in Cash. The buyer is acquiring $500 of Assets with the deal‚ but it’s assuming no Liabilities. Assume a 40% tax rate. What happens on the 3 statements after the sale?

Answer 60

• Income Statement: We record a Gain of $500‚ since we sold Balance Sheet Assets of $500 for $1000. That boosts Pre-Tax Income by $500 and Net Income by $300 assuming a 40% tax rate.
• Cash Flow Statement: Net Income is up by $300‚ but we subtract the Gain of $500 in the CFO section‚ so cash flow is down by $200 so far. We add the full amount of sale proceeds ($1000) in the CFI section‚ so cash at the bottom is up by $800.
• Balance Sheet: Cash on the Assets side is up by $800‚ but we’ve lost $500 in Assets‚ so the Assets side is up by $300. On the other side‚ Shareholders’ Equity is also up by $300 due to the increased Net Income.
• In this scenario‚ you’d also have to go back and remove revenue and expenses from this sold-off division and label them “Discontinued Operations” on the financial statements prior to the close of the sale.

Question 61

Let’s say that we decide to buy 100% of another company’s subsidiary for $1000 in cash. This subsidiary has $500 in Assets and $300 in Liabilities‚ and we are acquiring all the Assets and assuming all the Liabilities. What happens on the statements immediately afterward?

Answer 61

• Income Statement: No changes.
• Cash Flow Statement: We record $1000 for “Acquisitions” in the CFI section‚ so cash at the bottom is down by $1000.
• Balance Sheet: Cash is down by $1000 on the Assets side‚ but we add in the subsidiary’s Assets of $500‚ so this side is down by $500 so far. We also create $800 worth of Goodwill b/c we bought this subsidiary for $1000‚ but (Assets minus Liabilities) was only $200. So the Assets side is up by $300. The other side is up by $300 b/c of the assumed Liabilities‚ so both sides balance.

Question 62

What’s the purpose of calendarization in a merger model?

Answer 62

• You need to make sure that the buyer and the seller use the same fiscal years post-transaction. Normally you change the seller’s financial statements to match the buyer’s.
• If the buyer’s fiscal year ends on December 31 and the seller’s ends on June 30‚ for example‚ you would have to take Q3 (Jan - Mar) and Q4 (Apr - Jun) from the seller’s most recent fiscal year and then add Q1 (Jul - Sep) and Q2 (Oct - Dec) from the seller’s current fiscal year to match the buyer’s current fiscal year.
• The 2nd point here is that you may also need to create a stub period from the date when the deal closes to the end of the buyer’s current fiscal year.
• For example‚ if the deal closes on September 30 but the fiscal year ends on December 31‚ the buyer and seller are still one combined company for that 3-month period and you need to account for that‚ normally via a separate “stub period” right before the start of the first full fiscal year as a combined entity.

Question 63

Let’s say that the buyer’s fiscal year ends on December 31‚ the seller’s fiscal year ends on June 30‚ and the transaction closes on September 30. How would you create a merger model for this scenario?

Answer 63

• You would need to create quarterly financial statements for both the buyer and the seller for the Sep 30 - Dec 31 period‚ and you would show that as the first “combined” period in the merger model.
• So you would combine the Income Statements‚ Balance Sheets‚ and Cash Flow Statements for that 3-month period‚ and then keep them combined for the rest of the time after that (adjusting the seller’s financial statements to match the fiscal year of the buyer‚ as in the example above).
• Normally you do not care much about accretion/dilution for stub periods like this‚ so you would just calculate it for the first full fiscal year after the transaction close.

Question 64

Let’s say that the buyer’s fiscal year ends on December 31‚ the seller’s fiscal year ends on June 30‚ and the transaction closes on March 31 (instead of Sep. 30 as previously assumed) How would you create a merger model for this scenario?

Answer 64

• In this case‚ you need a 9-month stub period rather than a 3-month stub period in the previous case.
• So you would need to find or create quarterly financial statements for Q4 of the seller’s fiscal year ending June 30‚ and then Q1 and Q2 for the next year.
• You would also take the last 3 quarters of the buyer’s fiscal year and combine the statements from that period w/ the seller’s‚ taking into account all the normal acquisition effects for that period.

Question 65

Let’s say that the buyer’s fiscal year ends on December 31‚ the seller’s fiscal year ends on June 30‚ and the transaction closes on a random date like August 17 (instead of Sep. 30 as previously assumed) How would you create a merger model for this scenario?

Answer 65

• There are a couple options here; you could attempt to “roll-forward” the financial statements to this date in between quarterly end dates. For example‚ you might create an Aug. 17 Balance Sheet by looking at the B/S as of Jun. 30 and the B/S as of Sep. 30 and averaging them (since Aug. 17 is roughly in the middle).
• For the I/S and SCF‚ you could just take the Jul. 1 - Sep. 30 quarterly numbers and multiply by (43/90) since 43 days of the quarter will pass in the “combined” period between Aug. 17 and Sep. 30.
• The main problem is that this method creates a lot of extra work‚ b/c now you have to roll forward all the statements to this random date‚ figure out the numbers from that date to the end of the quarter‚ and then add additional quarters until the end of the buyer’s fiscal year.
• So in practice‚ you usually assume a cleaner close date in merger models unless you need 100% precision for some reason.

Question 66

What is an exchange ratio and when would companies use it in an M&A deal?

Answer 66

• An exchange ratio is an alternate way of restructuring a 100% stock M&A deal‚ or any M&A deal with a portion of stock involved.
• Let’s say you were going to buy a company for $100M in a 100% stock deal. Normally you would determine the number of shares to issue by dividing the $100M by the buyer’s stock price.
• With an exchange ratio by contrast‚ you would tie the number of new shares to the buyer’s own shares - so the seller might receive 1.5 shares of the buyer’s shares for each of its shares‚ rather than shares worth a specific dollar amount.
• Buyers might prefer to do this if they believe their stock price is going to decline post-transaction. Sellers‚ on the other hand‚ would prefer a fixed dollar amount in stock unless they believe the buyer’s share price will rise after the transaction.

Question 67

Isn’t there still some risk with an exchange ratio? If the stock price swings wildly in one direction or the other‚ the effective purchase price would be very different. Is there any way to hedge against that risk?

Answer 67

• Yes‚ you can use something called a collar‚ which guarantees a certain price based on the range of the buyer’s stock price to the seller’s stock price. Here’s an example:
• Suppose that we had a 100% stock deal w/ a 1.5x exchange ratio (i.e. the seller receives 1.5 of the buyer’s shares for each 1 of its own shares). The buyer’s share price is $20 and the seller has 1000 shares outstanding. Right now‚ it’s worth $30‚000 (1000 * 1.5 * $20) to the seller. Here’s how we could set up a collar:
• If the buyer’s share price falls below $20/share‚ the seller still receives the equivalent of $20 per buyer share in value. So if the buyer’s share price falls to $15‚ now the seller would receive 2000 shares instead.
• If the buyer’s share price is between $20 and $40 per share‚ the normal 1.5x exchange ratio is used. So the value could be anything from $30‚000 to $60‚000.
• If the buyer’s share price goes above $40 per share‚ the seller can only receive the equivalent of $40 per buyer share in value. So if the buyer’s share price rises to $80‚ the seller would receive only 750 shares instead.
• Collar structures are not terribly common in M&A deals‚ but they are useful for reducing risk on both sides when stock is involved.

Question 68

Walk me through the most important terms of a Purchase Agreement in an M&A deal.

Answer 68

There are dozens‚ but here are the most important points:
• Purchase Price: Stated as a per-share amount for public companies; just a number (the Equity Purchase Price) for private companies.
• Form of Consideration: Cash‚ Stock‚ Debt…
• Transaction Structure: Stock‚ Asset‚ or 338(h)(10)
• Treatment of Options: Assumed by the buyer? Cashed Out? Ignored?
• Employee Retention: Do employees have to sign non-solicit or non-compete agreements? What about management?
• Reps & Warranties: What must the buyer and seller claim is true about their respective businesses?
• No-Shop/Go-Shop: Can the seller “shop” this offer around and try to get a better deal‚ or must it stay exclusive to this buyer.

Question 69

What’s an Earnout and why would a buyer offer it to a seller in an M&A deal?

Answer 69

• An earnout is a form of “deferred payment” in an M&A deal (it’s most common w/ private companies and start-ups) and is highly unusual for public sellers.
• It is usually contingent on financial performance or other goals - for example‚ the buyer might say “We’ll pay you an additional $10M in 3 years if you can hit $100M in revenue by then.”
• Buyers use it to incentivize sellers to continue to perform well and to discourage management teams from taking the money and running off to an island in the South Pacific once the deal is done.

Question 70

Normally we create Goodwill b/c we pay more for a company than what its Shareholders’ Equity says it’s worth. But what if the opposite happens? What if we paid $1000 in Cash for a Company‚ but its Assets were worth $2000 and its Liabilities were worth $800?

Answer 70

• First off‚ you would reverse any new write-ups to Assets to handle this scenario the easy way‚ if possible. So if we had Asset Write-Ups of $300‚ then it would be easy to simply reverse those and make it so the Assets were worth only $1700‚ which would result in positive Goodwill instead.
• If it is not possible to do that (e.g. there were no Asset Write-Ups or they cannot be reversed for some reason) then we need to record a gain on the Income Statement for this “Negative Goodwill.”
• In this case the company’s Shareholders’ Equity is $1200 but we paid $1000 for it‚ so we do the following:
• Income Statement: Record a Gain of $200‚ boosting Pre-Tax Income by $200 and Net Income by $120 at a 40% tax rate.
• Cash Flow Statement: Net Income is up by $120‚ but we subtract the Gain of $200‚ so Cash is down by $80 so far. Under CFI‚ we record the $1000 acquisition‚ so Cash at the bottom is down by $1080.
• Balance Sheet: Cash is down by $1080‚ but we have $2000 of New Assets‚ so the Assets side is up by $920. On the other side‚ Liabilities is up by $800 and Shareholders’ Equity is up by $120 due to the increased Net Income‚ so both sides are up by $920 and balance.

Question 71

What if Shareholders’ Equity [of the target] is negative?

Answer 71

Nothing is different. You still wipe it out‚ allocate the purchase price‚ and create Goodwill.

Question 72

How would an accretion/dilution model be different for a private seller?

Answer 72

• The mechanics are the same‚ but the transaction structure is more likely to be an Asset Purchase or 338(h)(10) Election; private sellers also don’t have Earnings per Share so you would only project down to Net Income on the seller’s Income Statement.
• Note that accretion/dilution makes no sense if you have a private buyer because private companies do not have Earnings per Share.

Question 73

Explain what a contribution analysis is and why we might look at it in a merger model.

Answer 73

• A 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.
• Example: Let’s say that the buyer is set to own 50% of the new company and that the seller will own 50%. But the buyer has $100M of revenue and the seller has $50M of revenue - a contribution analysis would tell us that the buyer “should” own 66% instead b/c it’s contributing 2/3 of the combined revenue.
• It’s most common to look at this w/ merger of equals scenarios‚ and less common when the buyer is significantly larger than the seller.

Question 74

How would I calculate “break-even synergies” in an M&A deal and what does the number mean?

Answer 74

• To do this‚ you would get the EPS accretion/dilution to $0.00 and then back-solve in Excel to get the required synergies to make the deal neutral to EPS.
• It’s important b/c you want an idea of whether or not a deal “works” mathematically‚ and a high number for the break-even synergies tells you that you’re going to need A LOT of cost savings or revenue synergies to make it work.

Question 75

Normally in an accretion/dilution model you care most about combining both companies’ Income Statements and Balance Sheets. But let’s say I want to combine all 3 financial statements - how would I do this?

Answer 75

1. Always combine the buyer’s and seller’s Balance Sheets first (remember to wipe out the seller’s Shareholders’ Equity)
2. Make the necessary Pro-Forma Adjustments (cash‚ debt‚ stock‚ goodwill/intangibles‚ etc.)
3. Project the combined Balance Sheet using standard assumptions for each item.
4. Combine and project the Income Statement.
5. Then‚ project the Cash Flow Statement and link everything together as you normally would with any other 3-statement model. You can usually just add items together here‚ but you may eliminate some of the seller’s investing or financing activities depending on what the buyer wants to do.
   • You never combine the I/S or SCF BEFORE the acquisition closes. You only look at the combined statements immediately AFTER the acquisition and into future years.

Question 76

How do you handle options‚ convertible debt‚ and other dilutive securities in a merger model?

Answer 76

• The exact treatment depends on the terms of the Purchase Agreement - the buyer might assume them or it might allow the seller to “cash them out” if the per-share purchase price is above the exercise prices of these dilutive securities.
• If you assume that they’re exercised‚ then you calculate dilution to the Equity Purchase Price in the same way you normally would - the Treasury Stock Method for options‚ and the “if converted” method for convertibles.

Question 77

Can you explain what “Pro Forma” numbers are in a merger model?

Answer 77

• This gets confusing b/c there are contradictory definitions. The simplest one is that Pro-Forma numbers exclude certain non-cash acquisition effects (e.g. Amortization of Newly Created Intangibles‚ Depreciation of PP&E Write-Up‚ Deferred Revenue Write-Down‚ Amortization of Financing Fees)
• Some people include all of these‚ other people include only some of these‚ and companies themselves report numbers in different ways. Excluding Amortization of Intangibles is the most common adjustment here.
• While a lot of companies report numbers this way‚ the concept itself is flawed and inconsistent b/c companies themselves already include existing non-cash charges like D&A and stock-based compensation. To make things even more confusing‚ some people will also add back some or all of those items as well.

Question 78

If you’re looking at a reverse merger (i.e. a private company acquires a public company)‚ how would the merger model be different?

Answer 78

• Mechanically‚ it’s similar b/c you still allocate purchase price‚ combine and adjust the Balance Sheets‚ and combine the Income Statements‚ including acquisition effects.
• The difference is that accretion/dilution is not meaningful if it’s a private company b/c it doesn’t have an EPS number; so you would place more weight on a contribution analysis‚ or even on something like the IRR of the acquisition.