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 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 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?
There’s always a buyer and a seller in any M&A deal - the difference between “merger” and “acquisition” is more semantic than anything.
In a merger, the companies are close to the same size, whereas in an acquisition the buyer is significantly larger.
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 accretiv for its shareholders
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 forgone 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?
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 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.
What are the complete effects of an acquisition?
- Foregone Interest on Cash - The 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 - If the 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 & Other Intangibles - These Balance Sheet items that represent a “premium” paid to a company’s “fair value” also get created.
Note: There’s actually more than this (see the advanced questions), but this is usually sufficient to mention in interviews.
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).
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.
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 intellectually 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.
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.
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 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.
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 consildate buildings and administrative staff and can lay off redundant employees. It might also be able to shut down redundant stores or locations.
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.
