Merger Model - Basic Flashcards
Walk me through a basic merger model.
A merger model is used to analyze the financial profile 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 Acquistion - 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.
What’s the difference between a merger and an acquisition?
They are the same thing, the difference is the size.
Why would a company want to acquire another company?
They will be better off after the acquisition
Gain market share
wants to grow quickly
buyer believes the other company is undervalued
A buyer wants to acquire the seller’s customers so it can up sell and cross sell to them
The buyer thinks they can achieve significant synergies.
Why would an acquisition be dilutive?
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.
Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?
If the deal involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on cash, then compare it against the seller’s pre-tax income
A company with a higher P/E acquires one with a lower P/E - is this accretive or dilutive?
it depends if this deal is stock, debt, or cash.
If it is 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.
What are the complete effects of an acquisition?
Foregone interest on cash
Additional Interest Debt
Additional shares outstanding
Combined financial statements
Creation of goodwill and other intangibles
Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?
Because the strategic acquirer can realize revenue and cost synergies that the private equity cannot unless it combines the company with a complementary portfolio company. Those synergies boost the effect valuation for the target company.
Why do Goodwill & Other Intangibles get created in an acquisition?
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 intellect property - valuable, but not true financial Assets that show up on the Balance Sheet.
What is the difference between Goodwill and Other Intangible Assets?
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.
What are synergies, can you provide a few examples?
The buyer gets more value than out of an acquisition than what the financials would predict.
Revenue synergies - combined company can cross sell products to new customers.
Cost synergies - the combined company can consolidate buildings and administrative staff and can lay off redundant employees.
How are synergies used in merger models?
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.
Are revenue or cost synergies more important?
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.
How much debt could a company issue in a merger or acquisition?
Generally you would look at Comparable Companies / Precedent Transactions to determine this. You would use the combined company’s LTP 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.
How do you determine the Purchase Price for the target company in an acquisition?
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 to win shareholder approval.
