Merger Model - Basic

Question 1

Walk me through a basic merger model

Answer 1

1: Make assumptions about the acquisition i.e. price, cash vs. debt vs. stock acquisition.

2. Determine the valuations and shares outstanding of the buyer and seller, project out and Income Statement for each one.
3. Combine the Income Statements, adjust for Foregone Interest on Cash, and Interest Paid on Debt in the Combined Pre-Tax Income line. Apply Buyer’s effective Tax Rate to get Combined Net Income, then divide by new share count to determine combined EPS.
4. Calculate IRR and perform any sensitivities needed.

Question 2

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

Answer 2

There is always a buyer and a seller in M&A deals, but in mergers the companies are of comparable size, but in acquisitions the buyer is significantly larger

Question 3

Why would a company want to acquire another company?

Answer 3

Strategic:
- Buyer wants to gain share in Seller’s market
- Buyer wants to grow quickly in current market
- Buyer wants to acquire a technology, IP or person that it can use in its own business
- Buyer thinks it can achieve synergies to make the deal accretive to its shareholders

Financial:
- Buyer believes the Seller is undervalued, and can optimize business to sell at a premium
- Buyer wants to scale the business and sell at a premium

Question 4

Why would an acquisition be dilutive?

Answer 4

If the additional amount of Net Income the Seller contributes is not enough to offset the buyer’s Foregone Interest on Cash, Additional Interest on Debt, and the effects of issuing additional shares

Question 5

What is the rule of thumb for calculating accretive vs. dilutive acquisitions?

Answer 5

Just cash and debt: sum up the interest expense for debt and foregone interest on cash, then compare to seller’s Pre-Tax Income

Stock: If the buyer has a higher P/E than the seller, it will be accretive (and vice-versa)

Cash, debt and stock: No rule of thumb.

Question 6

What are the complete financial impacts of an acquisition?

Answer 6

Foregone interest on cash: Buyer loses the Interest Income it would have otherwise earned by saving the cash it used in the acquisition

Additional interest on debt: Buyer pays additional Interest Expense on debt used to fund the deal

Additional shares outstanding: If a Buyer pays with stock, it must issue additional shares

Combined financial statements: After the acquisition, the Seller’s financials are added to the Buyer’s

Creation of Goodwill and other Intangibles: These balance sheet items represent a premium that is paid above a company’s fair value

Question 7

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

Answer 7

It might prefer the safety of having a large cash balance to the additional returns offered through a debt or stock deal

Question 8

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

Answer 8

Because the strategic buyer can realize revenue and cost synergies that the private equity firm cannot unless it combines the target with another portfolio company. The synergies will boost the effective valuation of the target company.

Question 9

What is the difference between Goodwill and Other Intangible Assets?

Answer 9

Goodwill typically stays the same over many years and is not amortized (can be written down if impaired or if the buyer is later acquired)

Other Intangible Assets are amortized over several years and impact the Pre-Tax Income of the Buyer.

Question 10

Is there anything else intangible other than Goodwill and Other Intangibles that could also impact the combined company?

Answer 10

Yes - you can write off in-process capitalized R&D and deferred revenue.

Question 11

Give examples of the two types of synergies.

Answer 11

Revenue: The combined company can cross-sell products to new customers or up-sell new products to existing customers.

Cost: The combined company can consolidate buildings and admin staff and lay off redundant employees. It can also shut down redundant stores or locations

Question 12

How are synergies used in merger models?

Answer 12

Revenue synergies are usually added to the revenue figure for the combined company (with an assumed margin)

Cost synergies are used to reduce COGS or Opex, which boost Pre-Tax Income (and Net Income, after applying the tax rate) and EPS, which makes the deal more accretive.

Question 13

Are revenue or cost synergies more important in merger models?

Answer 13

Revenue synergies are hard to predict and are usually not taken seriously.

Cost synergies are easier to predict, as you can value the number of employees / leases to be eliminated, for example

Question 14

All else being equal, would a company prefer to use cash, debt or stock in an acquistion?

Answer 14

Cash is cheaper than debt, as Interest Income on cash is usually less than Interest Expense on debt.

Cash is less risky than debt as it removes the possibility of default by the Buyer

Stock is generally the most expensive method, as Cost of Equity (expected returns) is normally higher than Cost of Debt.

The stock price could also change after a stock deal, which is irrelevant in a cash deal.

Question 15

How much debt could a company issue to fund a M&A deal?

Answer 15

Look at comps / precedents to determine this:
- Find the median Debt/EBITDA ratio of comp/precedent companies
- Apply this ratio to the combined company’s LTM EBITDA
- Result will show roughly how much debt can be raised to fund the deal

You can also look at debt comps to see what types of debt and how many tranches have been used

Question 16

How do you determine the purchase price for the target company in an acquisition?

Answer 16

Use one of the common valuation methods.

In an acquisition of a public company, ensure the premium of the current share price is sufficient (around 15-30%)

Question 17

What might happen if a company overpays for another company?

Answer 17

There would be a large goodwill balance, which may be written down if the Buyer assesses there to be impairment at a later date. This would lead to a large negative impact on Net Income in the period of the write-down.

Question 18

A Buyer pays $100mm for a Seller in an all-stock deal, but a day later the market decides the target is only worth $50mm. What happens?

Answer 18

The buyer’s share price would fall by whatever per-share $ amount corresponds to the $50mm loss in value (not necessarily half).

Depending on how the deal was structured, the Seller would effectively only be receiving half of what it had originally negotiated.

Question 19

Why do most M&A deals fail?

Answer 19

Difficulty in negotiating the deal, integrating the new company, and realizing synergies.

Many deals are done without the interests of both parties in mind.

Question 20

What role does a merger model play in deal negotiations?

Answer 20

Functions as a sanity check, and to test the outcomes of changing assumptions/inputs.

Valuations usually not based on merger models.

Question 21

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

Answer 21

Common variables: purchase price, % stock / debt / cash, revenue/cost synergies

Sensitivity tables would show EPS accretion/dilution at different ranges for:
- Purchase Price vs. Cost Synergies
- Purchase Price vs. Revenue Synergies
- Purchase Price vs. % Cash etc.