Merger Model Advanced Flashcards
What’s the difference between purchase accounting and pooling accounting in an M&A deal?
In purchase accounting, the sellers shareholders equity number is wiped out and the premium paid over that is recorded as goodwill on the combined balance sheet post acquisition
In pooling accounting, you simply combined the two shareholders equity numbers rather than worrying about Goodwill and the related items that get created
These are specific requirements for using pulling accounting so 99% of M&A deals use purchase accounting
Pooling accounting has been phased out in 2001 and replaced by purchase accounting, which is now the standard method used for accounting in M&A deals.
Key differences:
Pooling of interests, combined the assets and liabilities of both companies at their book value
Purchase accounting recorded assets and liabilities at their fair values
So in pooling of interests and tangible assets were not included, and there were no amortized costs
In purchase accounting, any excess paid over the fair value price was recorded as Goodwill, which needed to be amortized
So under FASB in 2001 this change was made because pooling of interests just combined book values. It didn’t really reflect the current market value. It didn’t include intangible assets like Goodwill that meant like the new company did not have to pay any amortized costs that you know have an impact on corporate earnings or an overstatement of company earnings
it’s more so just like the switch was made to provide more accurate and transparent financial information to investors and stakeholders.
Walk me through a concrete example of how to calculate revenue synergies?
Let’s say that Microsoft is going to acquire yahoo yahoo makes money from search advertising online and they make a certain amount of revenue per search RPS
Let’s say this RPS is $.10 right now if Microsoft acquired it, we might assume that they could boost this RPS by 0.01 or 0.02 cents because of their superior monetization
So to calculate the additional revenue from the synergy we could multiply this one cent or two cent by yahoo’s total number of searches, get the total additional revenue and then select a margin on it determine how much flows through to the combined companies operating income.
Another example:
Let’s say company a and Company be decide to merge they identify that they can sell more products together than separately, which is a revenue synergy
For example, if A sells 100 units of product X at $10 each, it’s revenue is $1000
Similar company sells 50 units of product Y at $20 each it revenues $1000
So separately total revenue is $2000
After the merger they estimate that because of cross selling opportunities, they can sell 10% more of each product
So A now sells 110 units of product X and company sells 55 units of product Y
The new revenues are:
Company A 110 units times $10 per unit equals $1100
Company B 55 units $20 per unit equals $1100
So the total revenue after the merger is $2200. The revenue synergy from the merger is the increase and revenue which is $2200 merged revenue -$2000 separate revenue equaling $200.
Walk me through an example of how to calculate expense synergies?
Let’s say that Microsoft still wants to acquire yahoo
Microsoft has 5000 S G and A related employees where yahoo has around 1000
Microsoft calculates that transaction. It will only need about 200 yahoo SGA 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 800 employees. Microsoft is going to fire post transaction by their average salary.
Another example:
Say both Company A and Company B spend money on advertising their products after the merger they decide to run a combined advertising campaign which reduces the total advertising cost
Say company A spends $1000 on advertising and Company B spends 800. The total cost is 1800.
After the merger, they run a combined advertising campaign that cost 1500 so the cost savings from advertising is $300
How do you take into account NOLs in an M&A deal?
You apply section 382 to determine how much of the sellers NOLs are usable each year
Allowable NOLs = equity purchase price x highest of past three months adjusted long-term rates
So if our equity purchase price were $1 billion and the highest adjusted long-term rate for 5% then we could use $1 billion times 5% which equals $50 million of NOLs each year.
If the seller had 250 million in NOLs, then the combined company could use 50 million of them each year for five years to offset its taxable income
Net operating losses are losses that a company incurs when its allowable tax deductions exceeded its taxable income and a given tax. These losses can be carried forward to future future tax years to offset taxable income, reducing the companies future tax liability.
Say a company has $100,000 in revenue but $150,000 in allowable tax deductions which could be expenses like salaries rent supplies depreciation they’re just expenses that a company incurs that can be subtracted from their taxable income so if this goes negative right if it’s 100,000-150,000 giving us 50,000 that would be a -50,000 right so that would be our operating loss for the year
The following year we now have 200,000 in revenue and 100,000 in these allowable tax deductions that means we would have $100,000 in taxable income, but because of the NOL from the first year, we can reduce our taxable income in the second year to $50,000
Why do deferred tax liabilities DTL’s and deferred tax assets DTA’s get created in M&A deals?
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
an asset write down creates a deferred tax asset
You write down and write up assets because they’re book value what’s on the balance sheet often differs substantially from their fair market value
They are also created due to differences in the way companies account for income and expenses on their financial statements versus how they are treated for tax purposes
An asset write up creates a deferred tax liability because you’ll have a higher depreciation expense on the new asset, which means you save on taxes in the short term, but eventually you’ll have to pay them back hence the liability
DTL occurs when a companies tax income is lower than its accounting income, like if a company uses an accelerated depreciation method for tax purposes, but straight line depreciation for accounting purposes it will create a DTL.
The opposite applies for an asset write down and a deferred tax asset. They represent taxes a company has overpaid or prepaid, and can be used to offset future tax liabilities. They are created when a companies tax income is higher than its accounting income. This can occur due to differences and recognizing revenue expenses.
Say a company purchases a machine for $100,000 and say for accounting purposes they use straight line depreciation over 10 years making your annual depreciation expense $10,000
Now for tax purposes, say they use accelerate depreciation, which results in 20,000 depreciation expense
Your accounting income will be lower than your taxable income because it’s deducting less depreciation for accounting purposes, so this means the company will owe less in taxes, but now more in the future when the tax appreciation slows down. Depreciation is tax deductible so if you incur more of a depreciation expense, you’re gonna have more of a tax saving.
Now if a company had a bad year and reported a loss of $50,000 tax code allows companies to carry forward losses and deduct them from future profits this loss carry forward creates a DTA
This company expects to be profitable in the future It can use this DTA to reduce its future tax liability if the company acquires another company can also use the DTA making the other company, more attractive to acquire.
Now it’s just the opposite like you’ll have your loss amount multiplied by your tax rate whatever that tax savings amount is is carried forward, basically which can help reduce tax liabilities in the future only up the amount of its taxable income.
Now, in terms of an M&A deal, say a company has a building on its books valued at $100,000 but the fair market value is $150,000. You could write up the value of the building to $150,000 on its balance sheet.
This right up will increase the depreciation expense for tax purposes which reduces taxable income and therefore taxes payable but, for accounting purposes, the depreciation remains on the original cost of $100,000 resulting in higher accounting income so the difference between the tax payable on the accounting income and the lower tax payable on the taxable income is a deferred tax liability.
Now for a DTA say a company has inventory on its books valued at 100,000 but due to unforeseen circumstances, the market value is only 70,000 this company would write down the value of the inventory to 70,000 on its balance sheet
This right down will decrease our depreciation expense, which will increase our taxable income and taxes payable in the future but for accounting purposes are appreciation remains the same the hundred thousand dollars resulting in lower accounting income
So now the difference between our tax payable on our accounting income, and our higher tax payable on our taxable income is a DTA which represents future tax savings due to the asset write down.
How do DTLs and DTAs affect the balance sheet adjustment in an M&A deal?
You take them into account with everything else when calculating the amount of Goodwill and other intangibles to create on your pro forma balance sheet
The formulas are as follows:
Deferred tax asset = asset write down * tax rate
Deferred tax liability = asset write up * tax rate
So let’s say you were buying a company for $1 billion with half cash and half debt and you had $100 million asset write up and a tax rate of 40%. In addition the seller has total assets of $200 million total liabilities of $150 million and shareholders equity of $50 million .
Here’s what would happen to the combined companies, balance sheet, ignoring transaction and financing fees
First you simply add the sellers assets and liabilities (but not shareholders equity it is wiped out) to the buyers to get your initial balance sheet. assets are up by $200 million and liabilities are down by $150 million.
Then cash on the asset side goes down by $500 million
You have an asset right up of $100 million so assets go up by $100 million
Debt on the liabilities and equity goes up $500 million
You get a new deferred tax liability of $40 million ($100 million* 40%) on the liabilities and equity side
Assets are down by $200 million total and liabilities and shareholders equity are up by $690 million (500+40+150)
So you need Goodwill and intangibles of $890 million on the assets side to make both sides balance
Could you get DTL’s or DTAs in an asset purchase?
No, because in an asset purchase, the book basis of assets always matches the tax basis
they get created in a stock purchase because the book values of assets are written up or written down, but the tax values are not.
How do you account for DTL‘s in forward projections in a merger model?
You create a book versus cash tax schedule and figure out what the company owes in taxes based on the pretax income on its books and then you determine what it actually pays in cash taxes based on its NOLs and newly created amortization and depreciation 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 balance sheet.
If the book expense is higher then your record that as an increase to the DTL.
Explain the complete formula for how to calculate Goodwill in an M&A deal?
Goodwill = equity purchase price - seller book value + sellers existing Goodwill - asset write ups - sellers existing deferred tax liability + write down of sellers existing deferred tax asset + newly created deferred tax liability
Seller book value is just the shareholders equity number
You add the sellers existing Goodwill because it gets written down zero dollars in an M&A deal
You subtract the asset write ups because these are additions to the assets side of the balance sheet. Goodwill is also an asset so effectively you need less goodwill to plug the hole.
Normally, you assume 100% of the sellers existing DTL is written down
The sellers existing DTA may or may not be written down completely
Explain why we would write down the sellers existing deferred tax asset, in an M&A deal?
You write it down to reflect the fact that deferred tax assets include NOLs and that you might use these NOLs post transaction to offset the combined entities taxable income.
In an asset or 338(h)(10) purchase you assume that the entire NOL balance goes to zero dollars in the transaction and then you write down the existing deferred tax asset by this NOL write down
In a stock purchase, the formula is:
DTA write down = buyer tax rate* MAX(0, NOL Balance - Allowed Annual NOL Usage* Expiration Period in Years)
This formula is saying if we’re going to use up all these NOLs post transaction let’s not write anything down otherwise let’s write down the portion that we cannot actually use post transaction i.e. whatever our existing NOL balance is minus the amount we can use per year times the number of years.
What’s a section 338 H10 election and why might a company want to use it in an M&A deal?
A Section 338H 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 on its 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/amortize them so it saves on taxes.
Even though the seller still gets taxed twice, buyers will often pay more in a 338H 10 deal because the tax savings potential it’s particularly helpful for…
Sellers with high NOL balances more tax savings for the buyer because this NOL balance will be written down completely, and so more of the purchase price can be allocated to asset write ups
If the company has been an S corporation for over 10 years in this case, it doesn’t have to pay a tax on the appreciation of its assets
The requirements to use 338H 10 are complex and bankers don’t deal with this. That is the role of lawyers and tax accountants
What is an exchange ratio and when would companies use it in an M&A deal?
An exchange ratio is an alternative way of structuring, 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 100 million in an all stock deal. Normally you would determine how much stock to issue by dividing the hundred million by the buyer stock price and using that to get the new share count.
With an exchange ratio, by contrast, you would tie the number of new shares to the buyers own shares so the seller might receive 1.5 shares of the buyer shares for each of it 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 buyers share price will rise after the transaction
Walk me through the most important terms of a purchase agreement in an M&A deal.
There are dozens, but here are the most important ones
Purchase price stated as a per share amount for public companies
Form of consideration, cash stock, or debt
Transaction structure, stock asset or 338H 10
Treatment of options assumed by the buyer cashed out or ignored
Employee retention to employees have to sign non-solicit or noncompete agreements. What about management?
Reps and 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 the buyer?
What’s an earnout and why would a buyer offer it to a seller in an M&A deal?
An earn out is a form of deferred payment and an M&A deal. It’s most common with private companies and startups and is highly unusual with public sellers.
It is usually contingent on financial performance or other goals. For example, the buyer might say we’ll give you an additional 10 million in three years if you can hit 100 million 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
How would an accretion /dilution model be different for a private seller?
The mechanics are the same, but the transaction structure is more likely to be an asset purchase or 338H 10 election private sellers also don’t have earnings per share so you would only project down to net income on the sellers income statement
Note that accretion /dilution makes no sense if you have a private buyer because private companies do not have earnings per share
