Merger Model (Basic)

Question 1

Why would a company want to acquire another company?

Answer 1

A company would acquire another company if it believes it will earn a good return on its investment - either in the form of a literal ROI‚ or in terms of a higher EPS number‚ which appeals to shareholders.
There are several reasons why a buyer might believe this to be the case:
• The buyer wants to gain market share by buying a competitor.
• The buyer needs to grow 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 products and services to them.
• The buyer thinks the seller has a critical technology‚ intellectual property‚ or 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 2

Walk me through a basic merger model.

Answer 2

• A merger model is used to analyze the financial profiles of 2 companies‚ the purchase price and how the purchase is made‚ and it determines whether the buyer’s EPS increases or decreases afterward.
• Step 1 is making assumptions about the acquisition - the price and whether it was done using cash‚ stock‚ debt‚ or some combination of those. Next‚ you determine the valuations and shares outstanding of the buyer and seller and project the Income Statements 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 and get the Combined Net Income‚ and then divide by the new share count to determine the combined EPS.
• You could also add in the part about Goodwill and combining the Balance Sheets‚ but it’s best to start with answers that are as simple as possible at first.

Question 3

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

Answer 3

• There’s always a buyer and a seller in any M&A deal - the difference is that in a merger‚ the companies are similarly-sized‚ whereas in an acquisition the buyer is significantly larger (often by a factor of 2-3x or more).
• Also‚ 100% stock (or majority stock) deals are more common in mergers because similarly sized companies rarely have enough cash to buy each other‚ and cannot raise enough debt to do so either.

Question 4

Why would an acquisition be dilutive?

Answer 4

• An acquisition is dilutive if the additional 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 the amortization of Other Intangible Assets - 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:
• Cost of Cash = Foregone Interest on Cash * (1 - Buyer Tax Rate)
• Cost of Debt = Interest Rate on Debt * (1 - Buyer Tax Rate)
• Cost of Stock = Reciprocal of Buyer’s P/E Multiple (i.e. E/P or NI/Equity Value)
• Yield of Seller = Reciprocal of Seller’s P/E Multiple (ideally calculated using 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 buyers get 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 int. rate on cash is 4%‚ and int. rate on debt is 8%. The buyer is paying 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%
• Weighted Average Cost = 20%(2.4%) + 20%(4.8%) + 60%(12.5%) = 8.9% < 10%
• Summary: Since Weighted Average Cost < Seller’s Yield‚ the deal is ACCRETIVE.

Question 6

Wait a minute‚ though‚ does [the rule of thumb for determining whether an acquisition will be accretive or dilutive] work all the time?

Answer 6

• NO‚ 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 D&A‚ there are no transaction fees‚ no synergies‚ etc.
• 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 7

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

Answer 7

• 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 multiple of the buyer doesn’t matter b/c no stock is being issued.
• If it is an all-stock deal‚ then the deal will be accretive since the buyer “gets” more in earnings for each $1.00 used to acquire the other company that it does from its own operations. The opposite applies if the buyer’s P/E multiple is lower than the seller’s.

Question 8

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

Answer 8

• EPS is important mostly b/c institutional investors value it and base many decisions on EPS and P/E multiples - not the best approach‚ but it is how they think.
• A merger model has many purposes besides just calculating EPS accretion/dilution - for example‚ you could calculate the IRR of an acquisition if you assume that the acquired company is resold in the future‚ or even that it generates cash flows indefinitely into the future.
• An equally important part of a merger model is assessing what the combined financial statements look like and how key items change.
• So it’s not that EPS accretion/dilution is the ONLY important point in a merger model - but is what’s most likely to come up in interviews.

Question 9

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

Answer 9

• You use the same Valuation methodologies we discussed in the Valuation section. 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 10

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

Answer 10

Assuming the buyer had unlimited resources‚ it would almost always prefer to use cash when buying another company. Why?
• Cash is cheaper than debt b/c int. rates on cash are usually under 5% whereas debt int. rates are almost always higher than that. Thus‚ foregone interest on cash is almost always LESS than the additional interest paid on debt for the same amount of cash or debt.
• Cash is almost always cheaper than stock b/c most companies P/E multiples are in the 10-20x range‚ which equals 5-10% for “Cost of Stock”
• Cash is also less risky than debt b/c there’s no chance the buyer might fail to raise sufficient funds from investors‚ or that the buyer might default.
• Cash is also less risky than stock b/c the buyer’s share price could change dramatically once the acquisition is announced.

Question 11

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

Answer 11

• With debt this is impossible‚ b/c it makes no logical/financial 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 12

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

Answer 12

• It might be saving its cash for something else‚ or it might be concerned about running low on cash if business takes a turn for the worst.
• The buyer’s stock may also be trading at an all-time high and it might be eager to use that “currency” instead‚ for the reasons stated above: stock is less expensive to issue if the company has a high P/E multiple and therefore a high stock price.

Question 13

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

Answer 13

• You would look at Comparable Companies and Precedent Transactions to determine this. You would use the combined company’s EBITDA figure‚ find the median Debt/EBITDA ratio of the companies or deals you’re looking at‚ and apply that to the company’s own EBITDA figure to get a rough idea of how much debt it could raise.
• You could also look at “Debt Comps” for similar‚ recent deals and see what types of debt and how many tranches they have used.

Question 14

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

Answer 14

• 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.
• 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 15

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 15

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 w/ 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 16

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 16

• Company A Cost of Stock = 1/15 = 6.67%
• Company B Yield = 1/10 = 10%
• Therefore‚ the after-tax Cost of Debt must be above 10% for the acquisition cost to exceed Company B’s Yield.
• 10% / (1 - 40%) = 16.67%‚ 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 17

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 17

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

Question 18

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.

First‚ Calculate the EV/EBITDA and P/E multiples for each one.

Answer 18

• Company A: EV/EBITDA = 100/10 = 10x; P/E = 80/4 = 20x

* Company B: EV/EBITDA = 40/8 = 5x; P/E = 40/2 = 20x

Question 19

This is a multi-part question. Recall:
• Company A: EV of 100‚ Market Cap of 80‚ EBITDA of 10‚ NI of 4‚ EV/EBITDA = 10x‚ P/E = 20x
• Company B: EV of 40‚ Market Cap of 40‚ EBITDA of 8‚ NI of 2‚ EV/EBITDA = 5x‚ P/E = 20x

Company A decides to acquire Company B using 100% Cash. Company A does NOT pay any kind of premium to acquire Company B. What are the combined EBITDA and P/E multiples?

Answer 19

• In this scenario‚ Company B’s Market Cap gets wiped out b/c it no longer exists as an independent entity‚ and Company A’s cash balance decreases b/c it has used its cash to acquire Company B.
• So the Combined Market Cap = 80. 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 b/c it used the Cash to acquire B. We don’t need to look at B’s numbers at all b/c its Cash and Debt cancel each other out.
• So the combined Enterprise Value = 80 + 60 = 140. It is no coincidence‚ of course‚ that Combined Enterprise Value = Company A Enterprise Value + Company B Enterprise Value. That is how it should always work in an acquisition where there was no premium paid for the seller.
• You add the EBITDA and Net Income from both companies to get the combined figures. This is not 100% accurate b/c Interest Income changes for Company A since it’s using cash and b/c the tax rates may be different‚ but we’re going to ignore those for now since the impact will be small:
• Combined EV/EBITDA = 140 / (10 + 8) = 140/18 = 7.78x
• Combined P/E = 80 / (4 + 2) = 80/6 = 13.3x

Question 20

This is a multi-part question. Recall:
• Company A: EV of 100‚ Market Cap of 80‚ EBITDA of 10‚ NI of 4‚ EV/EBITDA = 10x‚ P/E = 20x
• Company B: EV of 40‚ Market Cap of 40‚ EBITDA of 8‚ NI of 2‚ EV/EBITDA = 5x‚ P/E = 20x

Now‚ let’s say that Company A instead uses 100% debt‚ at a 10% interest rate and 25% tax rate‚ to acquire Company B. Again‚ Company A pays no premium for Company B. What are the combined multiples?

Answer 20

• Once again‚ Company B’s Market Cap gets wiped out since it no longer exists as an independent entity. So Combined Market Cap = 80.
• 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 80 + 60 + 40 - 40 = 140‚ the same as in the previous example (IMPORTANT: Regardless of the purchase method‚ the combined Enterprise Value stays the same).
• The Combined EBITDA is still 18‚ so EV/EBITDA = 140/18 = 7.78x
• But the combined Net Income has changed. Normally‚ Company A Net Income + Company 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 6 - 3 = 3‚ and Combined P/E = 80/3 = 26.7x

Question 21

This is a multi-part question. Recall:
• Company A: EV of 100‚ Market Cap of 80‚ EBITDA of 10‚ NI of 4‚ EV/EBITDA = 10x‚ P/E = 20x
• Company B: EV of 40‚ Market Cap of 40‚ EBITDA of 8‚ NI of 2‚ EV/EBITDA = 5x‚ P/E = 20x

What was the point of this multi-step scenario and these questions? What does it tell you about valuation multiples and M&A activity?

Answer 21

There are a few main takeaways from this exercise:

1. Regardless of the purchase method (cash‚ stock‚ debt‚ or some combination of those)‚ the Combined Enterprise Value for the new entity stays the same.
2. Company B’s Market Cap (and the book version of it - Shareholders’ Equity) always gets wiped out when it is acquired (technically‚ whenever the acquisition is for over 50% of Company B).
3. Regardless of the purchase method‚ the Combined EV/EBITDA multiple does not change b/c Combined Enterprise Value always stays the same and b/c the Combined EBITDA is not affected by changes in interest or additional shares outstanding.

Question 22

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

Answer 22

B/c 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 make it easier for the strategic acquirer to pay a higher price and still realize a solid return on investment.

Question 23

What are the effects of an acquisition?

Answer 23

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 financial statements are added to the buyer’s.
5. Creation of Goodwill & Other Intangibles - These Balance Sheet items that represent the premium paid to a seller’s Shareholders’ Equity also get created.

Question 24

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

Answer 24

• These represent the amount that the buyer has paid over the book value (Shareholders’ Equity) of the seller. You calculate the number by subtracting the seller’s Shareholders’ Equity (technically the Common Shareholders’ Equity) from the Equity Purchase Price.
• Goodwill and Other Intangibles represent the value of customer relationships‚ employee skills‚ competitive advantages‚ brand names‚ intellectual property‚ and so on - valuable‚ but not physical Assets in the same way factories are.

Question 25

What is the difference between Goodwill and Other Intangible Assets?

Answer 25

• 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 reducing Pre-Tax Income.
• Technically‚ Other Intangible Assets might represent items that “expire” over time‚ such as copyrights or patents‚ but you do not get into that level of detail as a banker - it’s something that accountants and auditors would determine post-acquisition.

Question 26

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

Answer 26

• PPE 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 A/R & A/P: 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 27

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

Answer 27

• Synergies refer to cases where 2 + 2 = 5 (or 6‚ or 7…) in an acquisition. The buyer gets more value out of an acquisition than what the financials would otherwise suggest.
• 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 additional products to customers. It might also be able to expand into new geographies as a result of the deal.
• Expense 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 28

How are synergies used in merger models?

Answer 28

• Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue (all additional Revenue costs something) - additional Revenue then flows through the rest of the combined Income Statement‚ and you reflect the additional expenses as well.
• Expense Synergies: Normally you reduce the combined COGS or Operating Expenses by this amount‚ which in turn boosts the combined Pre-Tax Income and Net Income‚ increasing the EPS and making the deal more accretive.

Question 29

Are revenue or expense synergies more important?

Answer 29

• Revenue synergies are rarely taken seriously b/c they’re so hard to predict.
• Expense synergies are taken a bit more seriously b/c it’s more straightforward to see how buildings and locations might be consolidated and how many redundant employees might be eliminated.

Question 30

Let’s say a company overpays for another company - what happens afterward?

Answer 30

A high amount of Goodwill & Other Intangibles would be created if the purchase price is far above the Shareholders’ Equity of the target. In the years following the acquisition‚ the buyer may record a large Goodwill Impairment Charge if it reassess the value of the seller and finds that it truly overpaid.

Question 31

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

Answer 31

• The buyer’s share price would fall by whatever per-share dollar amount corresponds to the $50M loss in value. It would NOT necessarily be cut in half.
• Depending on the deal structure‚ the seller would effectively only receive 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 the valuation (there are ways to hedge against that risk).

Question 32

Why do most mergers and acquisitions fail?

Answer 32

• M&A is “easier said than done.” In practice‚ it’s very difficult to acquire and integrate a different company‚ realize synergies‚ and also turn the acquired company into a profitable division.
• Many deals are also done for the wrong reasons‚ such as the CEO’s massive ego or pressure from shareholders. Any deal done without both parties’ best interests in mind is likely to fail.

Question 33

What role does a merger model play in deal negotiations?

Answer 33

• The model is used as a sanity check and as a way to test various assumptions. A company would NEVER decide to do a deal b/c of the output of a model.
• It might say‚ “OK‚ the model tells us this deal could work and would be moderately accretive - it’s worth exploring in more detail.”
• It would never say‚ “Aha! This model predicts 21% accretion - we should have acquired this company yesterday!”
• Emotions‚ ego and personalities play a far bigger role in M&A than numbers do.

Question 34

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

Answer 34

• The most common variables to analyze 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 35

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

Answer 35

• You assume that the Debt either stays on the Balance Sheet or is refinanced (paid off) in the acquisition. The terms of most Debt issuance 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 36

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 36

• 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 share 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.