Merger Model - Basic Flashcards
Let’s say a company overpays for another company – what typically happens afterwards and can you give any recent examples?
- 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 Microsoft / Skype deal, in which Microsoft paid a huge premium and extremely high multiple for Skype. It created excess Goodwill & Other Intangibles, and Microsoft later ended up writing down much of the value and taking a large quarterly loss as a result.
What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?
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.
All else being equal, which method would a company prefer to use when acquiring another company – cash, stock, or debt?
Assuming the buyer had unlimited resources, it would always prefer to use cash when buying another company, why?
1. • 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.
2. • Cash is also less “risky” than debt because there’s no chance the buyer might fail to raise sufficient funds from investors.
3.• 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.
Why would a company want to acquire another company?
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.
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 firm cannot unless it combines the company with a complementary portfolio company.
Those synergies boost the effective valuation for the target company.
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.
And if it’s an all-stock deal you can use a shortcut to assess whether it is accretive (see question regarding this).
But 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.
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.
That said, the chances of any synergies actually being realized are almost 0 so few take them seriously at all.
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.
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.
- What types of sensitivities would you look at in a merger model?
- What variables would you look at?
• The most common variables to look at are:
- Purchase Price/Exit Price
- % Stock/Cash/Debt
- Revenue/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).
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 intellectual property – valuable, but not true financial Assets that show up on the Balance Sheet.
A company with a higher P/E acquires one with a lower P/E – is this accretive or dilutive?
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.
What are synergies, and can you provide a few examples?
Synergies refer to cases where 2 + 2 = 5 (or 6, or 7…) in an acquisition. Basically, the buyer gets more value than 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.
Is there anything else “intangible” besides Goodwill & Other Intangibles that could also impact the combined company?
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.
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 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.
If a company were capable of paying 100% in cash for another company, why would it choose NOT to do so?
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).
