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 Earnings Per Share (EPS) number, which appeals to shareholders.

Also, gain market share, grow more quickly, belief that the seller is undervalued, acquire seller’s customers, etc.

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 to get the Combined Net Income, and then divide by the new share count to determine the combined EPS.

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

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

Answer 5

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 because 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 than it does from its own operations. The opposite applies if the buyer’s P / E multiple is lower than the seller’s.

Question 6

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

Answer 6

EPS is important mostly because 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 it is what’s most likely to come up in interviews.

Question 7

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

Answer 7

You use the same standard valuation methodologies. 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 8

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

Answer 8

Assuming the buyer had unlimited resources, it would almost always prefer to use cash when buying another company. Cash is cheaper than debt because interest rates on cash are usually under 5% and debt is higher than that. Cash is almost always cheaper than stock because P/E multiples are usually in the 10-20x range. Cash is also less risky than debt and cash is less risky than stock.

Question 9

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

Answer 9

Debt no, but stock maybe for a company with an extremely high P/E multiple (think Tesla). The reciprocal of that might be lower than the after tax cost of cash.

Question 10

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

Answer 10

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.

Its 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 11

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

Answer 11

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.

Question 12

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

Answer 12

1. 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.
2. 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 13

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 13

• 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
• 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 with issuing new stock, so companies try to minimize this.
• Expansion plans. If the buyer has expansion plans, might be less likely to use cash/debt

Question 14

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 14

10% / (1 – 40%) = 16.7%, 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 15

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 15

Company A will achieve far more accretion if it uses 100% debt because the Cost of Debt (3%) is much lower than the Cost of Stock (10%).

Question 16

• 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.
Now, Company A decides to acquire Company B using 100% cash. What are the combined EBITDA and P / E multiples?

Answer 16

• Company A: EV / EBITDA = 100 / 10 = 10x, P / E = 80 / 4 = 20x
• Company B: EV / EBITDA = 40 / 8 = 5x, P / E = 40 / 2 = 20x
• Combined EV / EBITDA = 180 / (10 + 8) = 180 / 18 = 10x.
• Combined P / E = 120 / (4 + 2) = 120 / 6 = 20x.

Question 17

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

Answer 17

Because 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 18

What are the effects of an acquisition?

Answer 18

1. Foregone Interest on Cash
2. Additional Interest on Debt
3. Additional Shares Outstanding
4. Combined Financial Statements
5. Creation of Goodwill & Other Intangibles

Question 19

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

Answer 19

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 20

What is the difference between Goodwill and Other Intangible Assets?

Answer 20

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.

Question 21

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

Answer 21

• PP&E and Fixed Asset Write-Ups
• Deferred Tax Liabilities and Deferred Tax Assets
• Transaction and Financing Fees
• Inter-Company Accounts Receivable and Accounts Payable
• Deferred Revenue Write-Down

Question 22

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

Answer 22

The buyer gets more value than out of an acquisition than what the financials would otherwise suggest.
There are 2 types: revenue synergies and cost (or expense) synergies.

Question 23

How are synergies used in merger models?

Answer 23

• 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) – this 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 24

Are revenue or expense synergies more important?

Answer 24

Revenue synergies are rarely taken seriously because they’re so hard to predict. Expense 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 25

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

Answer 25

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 reassesses the value of the seller and finds that it truly overpaid.

Question 26

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

Answer 26

The buyer’s share price would fall by whatever per-share dollar amount corresponds to the $50 million 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

Question 27

Why do most mergers and acquisitions fail?

Answer 27

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.

Question 28

What role does a merger model play in deal negotiations?

Answer 28

The model is used as a sanity check and as a way to test various assumptions.

Question 29

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

Answer 29

The most common variables to analyze are Purchase Price, % Stock/Cash/Debt, Revenue Synergies, and Expense Synergies.

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.

Question 30

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

Answer 30

You assume that the Debt either stays on the Balance Sheet or is refinanced (paid off) in the acquisition. The terms of most Debt issuances 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 31

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 31

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 shares 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 32

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

Answer 32

The ultimate purpose is to make the combined Balance Sheet balance.

This harder than it sounds because many items get adjusted up or down (e.g. PP&E), 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 Balance Sheet and then assess the fair market values of all those items, adjusting them up or down as necessary.

Question 33

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

Answer 33

Goodwill = Equity Purchase Price – Seller Book Value + Seller’s Existing Goodwill – Asset Write-Ups – Seller’s Existing Deferred Tax Liability + Write-Down of Seller’s Existing Deferred Tax Asset + Newly Created Deferred Tax Liability + Intercompany Accounts Receivable – Intercompany Accounts Payable

Question 34

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

Answer 34

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.

Question 35

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

Answer 35

The 3 main structures are the Stock Purchase, Asset Purchase, and 338(h)(10) Election.

Question 36

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

Answer 36

A seller almost always prefers a Stock Purchase to avoid double taxation and to dispose of all its Liabilities

The 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.

Question 37

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

Answer 37

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.

Question 38

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

Answer 38

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’ Adjusted Long-Term Rates

Question 39

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

Answer 39

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 deferred tax liability, and an asset write-down creates a deferred tax asset.

Question 40

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

Answer 40

Let’s say that Company A sells 10,000 widgets per year in North America at an average price of $15.00, and Company B sells 5,000 widgets per year in Europe at an average price of $10.00. 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% * 5,000 * $15.00 in revenue, or $15,000.
It will also have expenses associated with 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 with 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 41

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 41

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 with the seller’s existing customers.

You approach it that way because 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 42

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

Answer 42

Let’s say that Company A wants to acquire Company B. Company A has 5,000 SG&A-related employees, whereas Company B has around 1,000. 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 43

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

Answer 43

If the buildings are leased, you assume that both lease expenses go away and are replaced with 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 Expenses to determine the synergies.

Question 44

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

Answer 44

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 45

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

Answer 45

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.