Merger Model Basic

Question 1

Walk me through a basic merger model?

Answer 1

Used to analyze the financial profiles of two companies, the purchase price and how the purchase price is made, and determine whether the buyers EPS increases or decreases.

Step one 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 forgone interest on cash and interest paid on debt in the combined pretax income line.

Apply the buyers tax rate to get the combined net income and then divide by the new share count to determine the combined EPS.

Accretion/dilution = pro forma EPS - acquirers EPS/acquirers EPS

If combined EPS is higher than acquirers EPS, then it is accretive.

Forgone interest on cash refers to the interest income that could’ve been earned if the cash had been invested, but was not because the cash was used for another purpose.

Question 2

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

Answer 2

There’s always a buyer and seller in any M&A deal the difference between merger and acquisition is more semantic than anything. Meaning the distinction often lies, and how the deal is presented rather than the actual mechanics of the transaction and practical differences.

In a merger, the companies are close to the same size whereas in an acquisition, the buyer is significantly larger.

A merger occurs when two companies of roughly equal size and strength come together to form a new entity. Both companies stocks are surrendered, and new stocks are issued under the name of the new business mergers are typically friendly and voluntary aimed at achieving synergies, expanding market reach and reducing operational costs .

Acquisitions on the other hand is when one company takes over another. The acquired company ceases to exist as an independent entity and its assets become part of the acquiring company. Acquisitions can be friendly or hostile and usually involve a larger company purchasing a smaller one with the goals often to gain market share acquire new technologies or achieve economies of scale .

This refers to the cost advantages that companies experience when they increase production and become more efficient essentially as a company produces more goods the cost per unit of those goods decreases this happens because fixed costs like rent salaries and equipment are spread over a large number of units and variable cost like materials and labor can also decrease due to bulk purchasing and improve operationally efficiencies.

Internal economies of scale arise from within the company include factors, improve production techniques, better management and bulk purchasing a materials

External economies of scale occur within the industry, such as a local infrastructure improves or when suppliers reduce prices due to increased the man from multiple companies in the same industry.

Question 3

Why would a company want to acquire another company?

Answer 3

Financial decisions:

Undervalued seller: the buyer believes the seller is undervalued and sees an opportunity to purchase the company at a lower price than its intrinsic value.

Accretive deal: the buyer believes it can achieve significant synergies, making the deal, accretive for shareholders. This means the acquisition will increase the buyers earnings per share.

Rapid growth: the buyer needs to grow more quickly and sees acquisition as a way to achieve this faster than organic growth.

Strategic decisions:

Market share: the buyer wants to gain market share by buying a competitor, thereby strengthening its position in the industry

Customer base: the buyer wants to acquire the sellers customers to upsell and cross, sell its own products or services.

Technology and intellectual property: the buyer thinks the seller has critical technology, intellectual property, or some other secret sauce that can significantly enhance its business

Synergies: the buyer believes that combining operations will create synergies such as cost savings or in increased revenue that neither company could achieve alone

Cross-selling comes from the idea of selling across different product lines to the same customer when you cross cell you are offering additional products or services that complement the customer has already bought or considering buying for example, if a customer buys a laptop might sell a laptop or software that enhances the functionality

The goal is to meet more of the customers needs and increase the overall value of the sale. It helps maximize revenue from existing customers.

Accretive deals in an acquisition is if it increases the acquiring companies EPS after the deals completed it typically happens when the acquired companies earnings are higher than the cost of the acquisition. Leading to a positive impact on the acquirer EPS. Increases EPS, Adds value

Dilutive deals as a decreases acquiring companies this can occur. The acquired. Companies earnings are lower than the cost of the acquisition or if additional shares are issued to finance the deal thereby reducing the EPS. Decreases EPS, reduces value

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 buyers foregone interest on cash.

Additional interest paid on debt and the effects such as amortization of intangibles can also make an acquisition dilutive.

Lower earnings contribution
Issuing new shares
Negative earnings
High PE ratio
Integration costs
Intangible assets amortization

Imagine company A buys company B here’s how it can be dilutive

Net income contribution company B contributes $1 million in net income
Interest on cash company A loses $200,000 in interest income because it used its cash reserves
Interest on debt company A pay $500,000 interest on debt finance acquisition
Amortization intangibles Company A to amortize $400,000 worth of intangible assets annually

Adding those together, this is $1.1 million exceeding the net income contribution from company B of $1 million making the acquisition dilutive

In summary, the sellers income is not enough to cover the buyers lost interest on cash. This additional interest on debt and amortization of intangibles, therefore making it dilutive.

Basically saying company B provides $1 million in profit but the total cost is 1.1 million so this is just not a good deal for the buyer.

If the sellers net income is more than enough to cover these cost increasing the buyers EPS, then it would be accretive

Question 5

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

Answer 5

If the deal involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on cash and then compare it against the sellers pre tax income.

All stock deal you can use a shortcut to assess, whether it is accretive.

If the deal involves cash stock and debt, there’s no quick rule of thumb you can use unless you’re lightning fast with mental math.

Compare P/E Ratios:

The P/E ratio measures a companies current share price relative to its per share earnings. It indicates how much investors are willing to pay for each dollar of earnings a higher PE ratio means investors, expect higher growth and are willing to pay more for future earnings a lower P/E ratio suggest lower growth expectations

If the buyers P/E ratio is higher than the sellers P/E ratio, the acquisition is likely to be accretive. This is because the buyer is effectively purchasing earnings at a lower cost, lower PE and its own earnings. When these lower cost earnings are added to the buyers higher cost earnings the overall earnings per share increases

If the buyers P/E ratio is lower than the sellers P/E ratio, the acquisition is likely to be dilutive. In this case. The buyer is purchasing earnings at a higher cost a higher PE than its own earnings. When these higher cost earnings are added to the buyers lower cost earnings the overall EPS decreases.

Example:
Buyers PE ratio 20 sellers PE ratio 15
Investors paid $20 for every one dollar of earnings
Investors pay $15 for every dollar of earnings

Since the buyers P/E ratio is higher, the acquisition is accretive . The buyer is acquiring earnings at a lower cost, which boosts its overall EPS.

Question 6

A company with a higher PE acquires one with a lower lower PE is this accretive or dilutive?

Answer 6

Trick question generally considered to be accretive

Can’t tell unless you also know that it’s an all stock deal

If it is an all cash or all debt, PE does not matter because no stock is issued

Generally, more earnings for less is good and is more likely to be accretive, but no set rule unless it’s an all stock deal

Imagine a pizza with eight slices each slice represents your EPS add more cheese earnings to each slice without increasing your number of slices then each slice becomes more valuable This is accretive.

Add more slices without more cheese than each slice has less cheese number of shares increases without a proportional increased and earnings than the EPS decreases. This is dilutive.

Question 7

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

Answer 7

All stock deal if the buyer has a higher PE than the seller, it will be accretive if lower dilutive.

If you’re paying more for earnings than what the market values, your own earnings dilutive paying less for earnings than the market value of earnings accretive.

Another way of thinking about it is if the combined companies EPS is higher than the acquirer standalone EPS before the transaction then it will be accretive. It’s dilutive if the combined eps is lower.

If cash is used the cost is the foregone interest on that cash
If that is used the cost is the interest expense on the new debt
If stock is issued, the cost is the dilution of existing shareholders

You also want to look at interest rates, higher interest rates on debt increase the cost potentially making the deal dilutive

And synergies expected synergies from the deal, can make an otherwise dilutive deal accretive by increasing the combined companies earnings

And tax rates the effective tax rate of the combined entity can also affection/dilution analysis

You really need a detailed financial model to be built if you wanna accurately assess this .

Accretive comes from accretion, which means gradual or incremental growth
Dilutive is derived from dilution, which refers to the reduction in concentration in finance terms. It represents the reduction in value for existing shareholders.

Question 8

What are the complete effects of an acquisition?

Answer 8

Foregone interest on cash. Buyer loses the interest it would have otherwise earned if it uses cash for the acquisition.

Additional interest on debt. the buyer pays additional interest expense if it uses debt

Additional shares outstanding the buyer pays with stock must issue additional shares .

Combined financial statements after the acquisition, the sellers financials are added to the buyers

Creation of Goodwill and other intangibles these balance sheet items that represent a premium paid to a companies fair value also get created

Changes in capital Structure, depending on the financing and other tax implications

Depending on cash equity and debt financing there could be increased leverage there’s more debt there could be increased interest, expenses stock issuance decrease of EPS depletion of cash reserves and what not

There could be tax attributes, deductions, or credits, state, local taxes, maybe even international tax considerations

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

Might be saving its cash

might be concerned if Buisness takes a turn for the worse, safety cushion form of large, cash balance many companies use this

higher the stock fewer the shares needed to be issued to finance the acquisition. So might use instead

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 PE firm cannot unless it combines the company with a complementary portfolio company, the synergies boost the effective valuation for the target company.

Synergies relate to the combined value and performance of some aspect of the company that’s greater than the sum of the individual components

So a strategic acquirer can integrate the target company into its existing operations leading to both revenue and cost synergies where as private equity firms typically do not have existing operations that can be integrated with the target company. They might achieve the synergies if they combine it with a portfolio company, but it’s less common and less immediate so if strategic acquirer can save $10 million annually through synergies, this saving can be capitalized into the purchase price making the target more valuable to them compared to a PE firm that cannot realize these synergies as easily.

Also, when looking at the timeline of these acquisitions, a strategic acquirer is looking to hold the company for much longer period than a private equity firm because in private equity you know hold it for 3 to 5 years and then just resell it where is most if not, some of not most strategic requires or just looking to integrate to their own operations for benefits.

Question 11

Why do Goodwill and 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

Subtract the book value of a company from its equity purchase price

Customer relationships, brand names, and intellectual property valuable, but not true financial assets

The value that isn’t captured by physical assets alone.

Goodwill is an accounting plug, purchase price - (fmv-liabilities)

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. The test for impairment usually is annually and ensures its value is not overstated on the balance sheet.

Other intangible assets are amortized over several years and affect the income statement by hitting the pretax income line. For example, a patent might be amortized over its legal life for 20 years.

There’s differences in terms of what they actually represent, but bankers rarely go into the level of detail, accountants and evaluation specialists worry about this.

Question 13

Is there anything else intangible besides Goodwill and other intangibles that could also impact the combined company?

Answer 13

Yes, you could also have a purchased in process R and D write off and a deferred revenue right off

The first refers to any research and 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 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 were 2+2 = 5 or six or seven in an acquisition basically the buyer gets more value than out of an acquisition then what the financials would predict

There are two types, revenue, synergies, and cost or expense synergies

Revenue synergies the combined company can sell products to new customers or upsell new products to existing customers, and might also be able to expand in a new geographies as a result of the deal. The combined company can generate higher sales than the two companies could separately.

Synergies the combined company can consolidate buildings and administrative staff and offer redundant employees and might also be able to shut down redundant stores or locations

Revenue Synergies make more cost synergies save more

Disney and Pixar, when Disney acquired Pixar, they combined their animation capabilities and talent leading to successful movies like toy story and finding Nemo.

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 energies normally reduce the combined, COGS or operating expenses by this amount which intern boosts the combined pretax income and thus net income, raising the EPS and making the deal more accretive.

Revenue synergy example
Let’s say company A and company be merge and you expect 20 million in revenue synergies with a 30% margin profit margin

Combined revenue would be the $200 million existing plus the $20 million in synergies for now $220 million revenue

Additional profit take the $20 million multiply by the 30% profit margin you’re not looking at $6 million in additional profit

Income statement impact
Revenue $220 million
COGS adjusted to reflect cost of the additional $20 million in revenue
Gross profit increased by additional profit from synergies
Operating expenses adjusted for any new costs related to synergies
Net income reflects the overall impact of the synergies

Cost synergy example
Let’s say company a company be merged and you expect $10 million in cost synergies

Combined operating expenses initially projected at 150 million
Cost synergies $10 million in annual savings
Adjusted operating expenses $150 million -$10 million equals $140 million

Income statement impact
Revenue assume combined revenue remains $200 million
COGS assume combined COGS remains $100 million
Gross profit $200 million in revenue -$100000,000 in COGS equals $100 million
Operating expenses adjusted to $40 million initial $50 million -$10 million and synergies
Operating income $100 million gross profit $140 million operating expenses equals -$40 million initially
Adjusted operating income with cost synergies $100 million gross profit -$140 million adjusted operating expenses equals -$40000,000 plus $10 million synergies to equal —$30 million net income reflects the improved operating income after taxes and interest .

Question 16

Are revenue or cost synergies more important?

Answer 16

No one in M&A takes revenue synergy 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 accompany 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%. Where is 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 equities almost always higher than the cost of debt that same principle applies here.

Cash is also less risky than stock because the buyers 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 or precedent transactions to determine this. You would use the combined companies LTM 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 how much debt you could raise.

For example, if the industry average debt/EBITDA ratio is 4X and the combined companies EBITDA is $50 million. The company could potentially issue of the $200 million in debt.

We use the debt to EBITDA ratio because it’s a key metric used by lenders and investors to assess a companies leverage the median ratio from comps or precedent transactions will provide us with a standard measure of how much debt is typically sustainable in the industry, this will help us ensure that the debt level we propose is reasonable and can be supported by the combined companies earnings.

You could also look at DEBT comps for companies in the same industry and see what types of debt and how many tranches they have used.

Tranches are portions of a larger pool of assets

Take the pool of assets and divided into tranches sold to investors with similar risk level and maturity day

Question 19

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

Answer 19

You use the same evaluation 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 to 30% range to win shareholder approval.

For private sellers more weight is placed on the traditional methodologies.

So for public companies, you normally take a market value approach. You want to look at the stock price for example if a company stock is trading at $50 per share and the acquirer offers a 20% premium. The purchase price per share would be $60.

You would also look at things like comparable company analysis use valuation multiples of similar public companies estimate the targets value Companies have an average EV/EBITDA multiple 10X and the target EBITDA is $100 million. The estimated EV would be $1 billion.

You could also look at precedent transactions analyze multiples paid in similar past transactions determine a fair price for example of similar companies were required and an average EV/EBITDA multiple of 12 X and the target EBITDA is $100 million. The purchase price might be $1.2 billion dollars.

For private companies, you might want to use a DCF where you want to estimate the present value of the targets projected future cash flows for example if the present value of future cash flows is calculated to be 500 million this becomes the basis for the purchase price you could also use comparable company analysis, and precedent transactions.

You also need to consider networking capital adjustments adjust the purchase price based on the targets networking capital compared to a predefine target level considered debt and cash adjustments. Adjust for the target debt and cash balances to arrive at the equity value and synergies, considering potential synergies of the acquisition might bring, which can justify a higher purchase price

The whole point of considering networking capital is just to make sure the company has sufficient working capital to continue its operations post acquisition so usually a working capital peg is established which is just an agreed-upon target level of working capital. The seller must deliver at closing this ensures, the buyer receives a business with sufficient capital to operate normally without needing immediate additional funding Example, if the peg is $10 million in the actual working capital at closing is $9 million the purchase price might be reduced by $1 million.

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 and 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’s overpaid.

Initial overstatement of Goodwill, the excess purchase prices recorded as Goodwill. This is inflating our balance sheet, but if the acquired company under performs or market conditions worsen, the fair value of Goodwill may decline this will lead to impairment charges, which are recorded as expenses on the income statement, impairment charges reduce the net income and negatively affect the company stock price and investor perception

Recent example is salesforce and demand Ware or salesforce acquired demand Ware for $2.9 billion in 2016 despite high expectations. The deal was criticized for overpaying as of your turn on invested capital did not meet sales first salesforces cost of capital

Here’s an example company an acquires company B for $15 million the fair value of company B’s identifiable net assets so assets minus liabilities is $10 million.

The difference of $5 million is recorded as Goodwill on company A balance sheet

So purchase price was $15 million. Our fair value of net assets is $10 million and our goodwill is 15,000,000-10,000,000 which is 5 million

a year later company Bs performance declines due to market changes and it’s fair value drops

company A conducts an impairment test determines that the fair value of company B including Goodwill is now $12 million so our calculation impairment goes as is carrying value or book value value is now $15 million the initial purchase price our fair value is $12 million 15-12 is 3 million

To account for it company a records a $3 million impairment charge on its income statement, reducing the Goodwill on its balance sheet

It’s updated balance sheet would be $5 million initial -$3 million impairment equals $2 million

Impact a $3 million expenses recorded reducing income and Goodwill on the balance sheet is reduced to $2 million

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 buyers 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 was 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.

Among other things, cultural misfit, differences and corporate culture conflicts misunderstandings poor due diligence inadequate research and analysis. There could be unforeseen issues, hidden liabilities or overestimated, synergies, overvaluation integration, challenges, management issues, retention problems, losing key employees external factors that are just uncontrollable, economic, downturns, regulatory changes, etc..

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 ha ha 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.

Valuation assessment earnings impact synergy analysis scenario planning financing structure risk assessments just provides a comprehensive financial framework that supports informed decision-making and can Aidan effective negotiation strategies.

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 percentage of stock percentage of cash percentage of 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 in your model as different scenarios instead.

You might look at sensitivity tables showing the EPS accretion/dilution at different ranges for the purchase price versus cost synergies purchase price versus revenue, synergies or purchase price versus percentage of cash and so on..

Variables are the inputs or factors that can change in affect the outcome of a financial model. They are the elements you adjust to see how they impact the models results. Examples include revenue growth rate cost of good sold operating expenses, interest rates, tax rates, etc..

Sensitivities refer to the analysis of how changes in these variables affect the outcome of the model. Sensitivity analysis helps you understand the relationship between the variables and the results it involves adjusting one variable at a time to see its impact on the dependent variable like net income, cash flow, or valuation

Examples include revenue sensitivity how changes in revenue growth rates affect net income cost sensitivity how variations in COGS or operating expenses, impact profitability, interest rate sensitivity how changes in interest rate influence the cost of debt and overall financial health so on.