Merger Model - Basic

Question 1

Walk me through a basic merger model.

Answer 1

“A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer’s EPS increases or decreases.

Step 1 is making assumptions about the acquisition – the price and whether it was cash, stock or debt or some combination of those. Next, you determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement 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 2

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

Answer 2

There’s always a buyer and a seller in any M&A deal – the difference between “merger” and “acquisition” is more semantic than anything. In a merger the companies are close to the same size, whereas in an acquisition the buyer is significantly larger.

Question 3

Why would a company want to acquire another company?

Answer 3

Several possible reasons:

• The buyer wants to gain market share by buying a competitor.
• The buyer needs to grow more 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 to them.
• The buyer thinks the seller has a critical technology, intellectual property or some 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 4

Why would an acquisition be dilutive?

Answer 4

An acquisition is dilutive if the additional amount of 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 amortization of intangibles – 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, here it is:

• Cost of Cash = Foregone Interest Rate on Cash * (1 – Buyer Tax Rate)
• Cost of Debt = Interest Rate on Debt * (1 – Buyer Tax Rate)
• Cost of Stock = Reciprocal of the buyer’s P / E multiple, i.e. E / P or Net Income / Equity Value.
• Yield of Seller = Reciprocal of the seller’s P / E multiple (ideally calculated using the 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 buyer gets 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 interest rate on cash is 4% and interest rate on debt is 8%. The buyer is paying for the seller 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 = 10.0%

Weighted Average Cost = 20% * 2.4% + 20% * 4.8% + 60% * 12.5% = 8.9%

Since 8.9% is less than the Seller’s Yield, this deal will be accretive.

Note: 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 Depreciation and Amortization, there are no transaction fees, there are no synergies, and so on.

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 6

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

Answer 6

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 multiples of the buyer and seller don’t matter because no stock is being issued.

Sure, generally getting more earnings for less is good and is more likely to be accretive but there’s no hard-and-fast rule unless it’s an all-stock deal.

Question 7

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

Answer 7

In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive.

On an intuitive level if you’re paying more for earnings than what the market values your own earnings at, you can guess that it will be dilutive; and likewise, if you’re paying less for earnings than what the market values your own earnings at, you can guess that it would be accretive.

Question 8

What are the complete effects of an acquisition?

Answer 8

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 financials are added to the buyer’s.
5. Creation of Goodwill & Other Intangibles – These Balance Sheet items that represent a “premium” paid to a company’s “fair value” also get created.

Note: There’s actually more than this (see the advanced questions), but this is usually sufficient to mention in interviews.

Question 9

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

Answer 9

It might be saving its cash for something else or it might be concerned about running low 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 instead (in finance terms this would be “more expensive” but a lot of executives value having a safety cushion in the form of a large cash balance).

Question 10

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

Answer 10

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 boost the effective valuation for the target company.

Question 11

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

Answer 11

These represent the value over the “fair market value” of the seller that the buyer has paid. You calculate the number by subtracting the book value of a company from its equity purchase price.

More specifically, Goodwill and Other Intangibles represent things like the value of customer relationships, brand names and intellectual property – valuable, but not true financial Assets that show up on the Balance Sheet.

Question 12

What is the difference between Goodwill and Other Intangible Assets?

Answer 12

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 hitting the Pre-Tax Income line.

There’s also a difference in terms of what they each represent, but bankers rarely go into that level of detail – accountants and valuation specialists worry about assigning each one to specific items.

Question 13

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

Answer 13

Yes. You could also have a Purchased In-Process R&D Write-off and a Deferred Revenue Write-off.

The first refers to any Research & Development projects that were purchased in the acquisition but which have not been completed yet. The logic is that unfinished R&D projects require significant resources to complete, and as such, the “expense” must be recognized as part of the acquisition.

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

Question 14

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

Answer 14

Synergies refer to cases where 2 + 2 = 5 (or 6, or 7…) in an acquisition. Basically, the buyer gets more value out of an acquisition than what the financials would predict.

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 new products to existing customers. It might also be able to expand into new geographies as a result of the deal.
• Cost 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 15

How are synergies used in merger models?

Answer 15

Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue – this additional Revenue then flows through the rest of the combined Income Statement.

Cost Synergies: Normally you reduce the combined COGS or Operating Expenses by this amount, which in turn boosts the combined Pre-Tax Income and thus Net Income, raising the EPS and making the deal more accretive.

Question 16

Are revenue or cost synergies more important?

Answer 16

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

That said, the chances of any synergies actually being realized are almost 0 so few take them seriously at all.

Question 17

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

Answer 17

Assuming the buyer had unlimited resources, it would always prefer to use cash when buying another company. Why?

• Cash is “cheaper” than debt because interest rates on cash are usually under 5% whereas debt interest rates are almost always higher than that. Thus, foregone interest on cash is almost always less than additional interest paid on debt for the same amount of cash/debt.
• Cash is also less “risky” than debt because there’s no chance the buyer might fail to raise sufficient funds from investors.
• It’s hard to compare the “cost” directly to stock, but in general stock is the most “expensive” way to finance a transaction – remember how the Cost of Equity is almost always higher than the Cost of Debt? That same principle applies here.
• Cash is also less risky than stock because the buyer’s share price could change dramatically once the acquisition is announced.

Question 18

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

Answer 18

Generally you would look at Comparable Companies/ Precedent Transactions to determine this. You would use the combined company’s LTM (Last Twelve Months) EBITDA figure, find the median Debt/EBITDA ratio of whatever companies you’re looking at, and apply that to your own EBITDA figure to get a rough idea of how much debt you could raise.

You would also look at “Debt Comps” for companies in the same industry and see what types of debt and how many tranches they have used.

Question 19

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

Answer 19

You use the same Valuation methodologies we already discussed. 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 20

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

Answer 20

There would be an incredibly high amount of Goodwill & Other Intangibles created if the price is far above the fair market value of the company. Depending on how the acquisition goes, there might be a large goodwill impairment charge later on if the company decides it overpaid.

A recent example is the eBay / Skype deal, in which eBay paid a huge premium and extremely high multiple for Skype. It created excess Goodwill & Other Intangibles, and eBay later ended up writing down much of the value and taking a large quarterly loss as a result.

Question 21

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

Answer 21

The buyer’s share price would fall by whatever per-share dollar amount corresponds to the $50 million loss in value. Note that it would not necessarily be cut in half.

Depending on how the deal was structured, the seller would effectively only be receiving 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 valuation.

Question 22

Why do most mergers and acquisitions fail?

Answer 22

Like so many things, M&A is “easier said than done.” In practice it’s very difficult to acquire and integrate a different company, actually realize synergies and also turn the acquired company into a profitable division.

Many deals are also done for the wrong reasons, such as CEO ego or pressure from shareholders. Any deal done without both parties’ best interests in mind is likely to fail.

Question 23

What role does a merger model play in deal negotiations?

Answer 23

The model is used as a sanity check and is used to test various assumptions. A company would never decide to do a deal based on the output of a model.

It might say, “Ok, the model tells us this deal could work and be moderately accretive – it’s worth exploring more.”

It would never say, “Aha! This model predicts 21% accretion – we should definitely acquire them now!”

Emotions, ego and personalities play a far bigger role in M&A (and any type of negotiation) than numbers do.

Question 24

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

Answer 24

The most common variables to look at 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 25

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

Answer 25

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.

Question 26

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

Answer 26

With debt this is impossible because it makes no logical 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 27

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

Answer 27

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 28

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 28

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 with 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 29

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 29

• Company A Cost of Stock = 1 / 15 = 6.7%
• Company B Yield = 1 / 10 = 10.0%

Therefore, the after-tax Cost of Debt must be above 10% for the acquisition cost to exceed Company B’s Yield.

10% / (1 – 40%) = 16.7%, 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 30

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 30

• 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 because the Cost of Debt (3%) is much lower than the Cost of Stock (10%).

Question 31

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.

1. Calculate the EV / EBITDA and P / E multiples for each one.
2. Now, Company A decides to acquire Company B using 100% cash. What are the combined EBITDA and P / E multiples?
3. Now, let’s say that Company A instead uses 100% debt, at a 10% interest
   rate and 25% tax rate, to acquire Company B. What are the combined multiples?
4. What was the point of this scenario and these questions? What does it tell you about valuation multiples and M&A activity?

Answer 31

• Company A: EV / EBITDA = 100 / 10 = 10x, P / E = 80 / 4 = 20x.
• Company B: EV / EBITDA = 40 / 8 = 5x, P / E = 40 / 2 = 20x.

In this scenario, you add the Market Caps of both companies together and then adjust for the Cash, Debt, and Stock used.

Combined Market Cap = 120. 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 because it used the Cash to acquire B. We don’t need to look at B’s numbers at all because its Cash and Debt cancel each other out.

So the Combined Enterprise Value = 120 + 60 = 180.

You add the EBITDA and Net Income from both companies to get the combined figures. This is not 100% accurate because Interest Income changes for Company A since it’s using cash, but it’s small enough to ignore here:

• Combined EV / EBITDA = 180 / (10 + 8) = 180 / 18 = 10x.
• Combined P / E = 120 / (4 + 2) = 120 / 6 = 20x.

Once again, you can add the Market Caps so the Combined Market Cap is 120.

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 120 + 60 + 40 – 40 = 180, the same as in the previous example.

The combined EBITDA is still 18, so EV / EBITDA = 180 / 18 = 10x.

But the combined Net Income has changed. Normally, A Net Income + 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 3, and Combined P / E = 120 / 3 = 40x.

The main takeaway is that the combined P / E multiple may be much different depending on the purchase method (cash/stock/debt).

The EV / EBITDA multiple, however, is not affected because EBITDA excludes interest income and interest expense. And regardless of the cash, debt, or stock used, the combined Enterprise Value will always be the same.

Think about it: if you use Cash, Enterprise Value goes up… if you raise additional Debt, Enterprise Value also goes up… and if you issue stock, Enterprise Value also goes up because the Combined Market Cap goes up.

Question 32

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

Answer 32

• PP&E 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 Accounts Receivable and Accounts Payable – 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 33

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

Answer 33

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 34

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 34

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 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.